Is Oil Really on the Boil ? : A New Perspective to Oil-Mania

It is claimed by all and sundry (government, oil companies, the market) that there is a net subsidy (under-recovery) of about Rs 225,000 crore. And that the poor man's fuel, kerosene, was, until recently, being heavily subsidised. Various facts about the market and domestic price of four energy items (kerosene, LPG, diesel and petrol) are presented for two different assumptions of international oil prices: at $80 and $130 a barrel. The concern here is not what the net tax on oil should be; rather, it is whether the GoI oil policy is transparent.
Five major oil facts are interesting, if not revealing. First, and most unusually, the price of diesel in India is considerably below (25% less) the price of petrol; the world prices diesel at 20 per cent above the price of petrol. Second, the consumer price of petrol in India is more than that in the US (at $4.40 a gallon), and among the highest in the developing world. In China, petrol is priced at only 74 cents a litre, compared to the average Indian price of $1.17 a litre. Third, with oil at $80/barrel, use of kerosene was being taxed by 5 per cent. Most people (including myself) believe that use of kerosene has been heavily subsidised. Fourth, at $80/barrel oil, the total tax gain to the economy was around Rs 91,000 crore; today, at $130/barrel oil, the total loss (subsidy) is only Rs 25,000 crore or only 0.5% of GDP. Fifth, and finally, there is little sign of the 5% of GDP loss figure (Rs 225,000 crore), which is fashionably being touted around as the loss from our oil policy. How is this patently false figure obtained? Via the oiliness of Indian policy, which is to first impose a tax on produced oil, and then sell it at a somewhat lower price, and then sell oil bonds to make up some of the difference! At the end of it, no one knows whether there is actually a subsidy or a tax, and what its cost to the economy is. A numerical example can help illustrate. Assume international oil is at Rs 100; there is first a Rs 50 tax, then a Rs 25 subsidy. The government claims it is subsidising by Rs 25, when it is indeed taxing by the same amount! The figures presented are also disturbing. Why is there not much more scrutiny and discussion about the oily expenditures involved with other non-transparent government policies? Such expenditures are greater, and help the poor less. But a greater problem might be that the government (RBI, Ministry of Finance, etc) may be making policy based on the certainty of $150-170/oil for the next year when there is not enough evidence to warrant this conclusion.
The oil bulls are correct in their explanations of why prices have jumped. It's indisputable that worldwide demand has surged, chiefly driven by strong growth in China, India and the Middle East. It's also true that most of the world's reserves are controlled by governments in places like Russia and Venezuela that mismanage production, thus curtailing supply growth.
But rather than forming a permanent new plateau for prices - as the bulls contend - those forces are causing a classically unstable market that's destined for a steep fall
In a normal oil market, the cost of producing the last, most expensive barrel of oil needed to satisfy worldwide demand sets the price for every barrel the world over. Other auction commodity markets work much the same way.
So even if Saudi Arabia produces at $4 a barrel, if the final, multi-millionth barrel required to heat houses and run cars costs $50, and is produced, for argument's sake, at a flagging field in West Texas, the world price is $50. That's what economists call the equilibrium price: It's where the price that customers are willing to pay meets the production cost, including a cushion, naturally, for profit or "the cost of capital."
But today, the sudden surge in demand and the production bottlenecks have thrown the market radically out of balance.
Almost exactly the same thing happened in the housing market. And both housing and oil supply react to a surge in demand with a long lag. In housing, the lag is caused by restrictive zoning and development laws, especially in coastal markets like California and Florida.
So when the economy roared back in 2002 and 2003, builders couldn't turn out homes fast enough for buyers armed with those cheap mortgages. As a result, prices spiked. They no longer bore any relation to the actual cost of buying and improving land, or constructing and marketing a new house (at some reasonable profit margin). Instead, frenzied buyers were setting the price.
Because builders were reaping huge windfall profits, they rushed to buy and develop land. And sure enough, those new houses were ready just as buyers were retreating to the sidelines because they could no longer afford to buy a home. That vast overhang of unsold homes is what's driving down prices today.
The story is much the same with oil, with a twist. A big swath of the market isn't really paying that $125 a barrel number you hear about seemingly every hour. In China, India and the Middle East, governments are heavily subsidizing oil for their consumers and corporations, leading to rampant over-consumption - and driving up prices even more.
But sooner or later the world won't keep paying those prices: Eventually, the price must fall back to the cost of that last barrel to clear the market.
So what does that barrel cost today? According to Stephen Brown, an economist at the Dallas Federal Reserve, that final barrel costs just $50 to produce. And when the price is $125, the incentive to pour out more oil, like homebuilders' incentive to build more two years ago, is irresistible.
We've learned another important lesson from the housing market: The longer prices stay stratospheric, the worse the eventual crash - simply because the higher the prices and bigger the profit margins, the bigger the incentive to over-produce !
A similar scenario occurred following the price explosion in the 1970s and early 1980s. The price spike caused the world to cut back sharply on oil consumption. By the mid-80s, oil prices had fallen from almost $40 to around $15. They remained extremely low for two decades.
It's impossible to predict how the adjustment this time will take shape, just as it was in housing. There the surge in supply came in places the experts swore there was "no supply," and wouldn't be any. Builders found a way to extend vast tracts of homes into California's Inland Empire and Central Valley, and even build "in-fill" projects near the densely-populated coasts.
An earlier bubble is also instructive. In the early 1980s silver prices jumped from $10 to $50 on the theory that the world was facing a permanent shortage of silver. Suddenly ads appeared asking homeowners to bring their tea sets and jewelry for a big price. Silver supplies poured from seemingly nowhere, out of peoples cupboards, of all places.
And so it will be with oil. We don't know where the new abundance will come from, from shale, or tar sands or coal or an OPEC desperate to regain market share. We just know that it will appear.With prices like these, it always does , as history has the knack of repeating itself !!!