Fallout of volatile oil prices

Posted on June 14, 2011. Filed under: Fossil fuels |

PAKISTAN’S economy is often affected by developments that take place outside the country’s borders and over which the policymakers in Islamabad have no control. Policies such as those adopted in framing national and provincial budgets and in determining the structure of tariffs matter.

But what also matter is what happens in some of the international markets. One of these is the oil market, given Pakistan’s large and increasing dependence on imported oil.

This is why it is important to take note of the decision taken on Wednesday June 8 by the representatives of the eleven states that make up the OPEC, the cartel of oil producers. The meeting ended in considerable acrimony and dashed expectations that the members of oil cartel will increase production to steady the markets. The development led to an increase in the price of Brent crude by $2 to $118.59 a barrel.

Saudi Arabia, with the OPEC-allocated level of production of 8.9 million barrels a day, is the largest member of the OPEC followed by Iran with 3.7 mbd, UAE 2.5 mbd, Kuwait 2.4 mbd, Venezuela 2.2 mbd and Nigeria 2.1 mbd. The remaining four – Angola, Algeria, Ecuador and Libya together account for 4.4 mbd. Ecuador is the smallest producer in the group with production of only 400,000 mbd. Iraq, the twelfth member, has not been subjected to a production quota since the country was invaded by the United States. The OPEC production of 26.2 mbd is 40 per cent of the world total. In December 2008, the members had agreed to produce 24.85 mbd but the actual production is about 10 per cent higher. Some of the large oil producing and exporting countries such as Russia have not joined the cartel.

The production quotas fixed by the cartel are not always followed by its members. Saudi Arabia, for instance, unilaterally increased its production to compensate for the decline in exports from Libya. It increased it again in May by about 200,000 and is set to add further production of 200,000 and 300,000. In spite of the OPEC determined quotas and the powerful oil ministries that manage production in their countries, no firm estimates are available as to how much the cartel really produces. This lends to a great deal of speculation and volatility in the oil market. There is a consensus among experts that the cartel is currently pumping about 1.3 mbd more than the agreed limit.

The oil ministers met in Vienna on June 8 to decide on the levels of production and it’s sharing among the members. Vienna is the city where the OPEC has its headquarters.The meeting was held as political turmoil in the Middle East was raging. Libya because of the civil war was not producing much oil and exporting even less.The country’s 1.3 mbd of exports seemed lost for as long as the struggle in the country remained unresolved. Its place at the meeting was contested by the government and the rebels. The ranks of the rebels were strengthened by the defection of the former oil minister. Small of the smaller Arab producers were also having political difficulties. Syria’s 150,000 barrels a day of oil exports were in jeopardy because of the mounting violence in the country.Yemen’s 260,000 barrels a day of production had virtually halted. The country’s president had gone to Saudi Arabia on the eve of the Vienna meeting. His future as well as that of his country remained uncertain. A complete breakdown in law and order could conceivably threaten the nearby Bab el Mandeb shipping lane through which an estimated 3.7 mbd passed. According to one oil expert, “Yemen was wild card. It could be the failed state in the middle of the gulf and it threatens the stability of the largest oil producer, Saudi Arabia.” In light of all these uncertainties, there was hope expressed on the eve of the meeting that the oil ministers, meeting in Vienna, will act to stabilize a jittery market. The decision to increase production would have been the first taken in nearly four years. The aim would have been to put a lid on the continuing increase in the price of oil following political problems in many countries of the Middle East. Saudi Arabia wanted the price of crude to settle down well below the current levels. Ali elNaimi, the Kingdom’s oil minister had indicated on several occasions that he wanted oil prices to remain between $70 to $80 a barrel, much below the trading range between $105 and $125 which has been in place for more than four months.

The Saudis were also concerned that the world demand would increase as the refineries, following the pe riod during which they shut down for maintenance, return to full production and that would add to the pressure on prices. Riyadh was nervous that at the current levels, the global economy may not be able to sustain the tepid recovery from the Great Recession of 2008-09. ElNaimi described the Vienna meeting “the worst we have ever had”. His attempt to raise production was blocked by Iran. Terhran was joined by several small producers who did not have the capacity to increase in output. A decline in the price of oil would have reduced their earnings. The Saudi minister wanted to add 2.5 mbd to the club’s production level. OPEC’s spare capacity of some $4 mbd is in the hands of just three countries – Saudi Arabia, Kuwait and the United Arab Emirates. All three were in favor of raising the level of output.

There was also some concern in several quarters about what is called “demand destruction” – when consumers begin to reduce consumption on a permanent basis by making changes in their life style while investments are made in developing non-oil sources of energy. Experts believe that this is likely to happen if the price of oil remains above $125 a barrel for a long period of time. After the difficult meeting in Vienna it has begun to approach that level.

What should be the reaction in Islamabad to the Vienna decision? Pakistan, like several other developing countries, tightly controls the oil market. Sale price at the service stations are set by the government and are well above the price at which the companies buy the product. The difference is collected by the government as a form of oil tax. There is uniform price in the country which means that the areas near the ports through which much of the oil comes subsidize those that are upcountry. This kind of regime produces enormous distortions which are not helpful for an economy that is so troubled most of the time.

Among the several structural changes the government needs to introduce is in the area of oil marketing. Ideally the government should let the price at the pump and at the points of distribution to be set by the market. It should reflect competition among the distributors. The state can charge a tax on sales so as not to affect the revenues generated by oil. The market should be allowed to develop instruments that will take out the wide fluctuations that have become the norm in oil trade.



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