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Determination of Oil Prices

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General awareness or GK  is a must for cracking MBA entrance exams and for updating you on this MBARendezvous.com -India's content lead MBA website  has started series of articles to equip MBA aspirants with general awareness with the hope that you would get success in various MBA entrance exams

Following article on”Determination of Oil Prices” is part of our series on general awareness:  

21st century saw the unprecedented rise in energy demand and unprecedented growth in developing world spearheaded by India and china. Huge energy demand following the high economic growth is a matter of historical fact. In India energy constraints are the major bottlenecks in the high growth path of economy. Petroleum products like petrol, diesel, LPG, kerosene etc. are the important components of energy sector and a major element in the consumption basket of the consumer’s as well.  

Further such products has also been given important weight in the whole sale price index (officially used in India to measure inflation). Therefore stability in the prices of petroleum products is necessary for the stable and sustainable growth of the economy. Because of their importance in the macro-economic equilibrium as well as their effect on consumption, the successive governments never allow the oil prices to fluctuate too much due to populist as well as strategic reasons. 
 
Determination of Oil Prices
 
In the economic theory, prices are determined by the forces of demand and supply but in reality, neither in India nor in world such forces are allowed to act freely. In India due to sensitiveness of the issue , central government don’t allow oil marketing companies to increase the price and on the world stage, OPEC controls the crude oil price to keep the oil price in upward trajectory. Since , India imports 70%  of its total oil requirements we cannot afford to neglect the determination of oil price at International market and any discussion on the world oil prices cannot be completed without the discussion on OPEC.
 
OPEC  is the acronym of organization of petroleum exporting countries  founded in 1965 with headquarter in Vienna, Austria. It has 12 members and in 2008 Indonesia left OPEC as in that year it turns into a net importer of oil. OPEC controls the 40% of world oil supply and sits on the 70% of world oil reserves. Realizing the dependence of world on mineral oil and absence of any substitutes in the market, OPEC  was responsible for the 1st oil shock of 1973 and another oil shock in 1979. 
 
OPEC  acts as a semi- cartel. When all the producers of a commodity collude together to form a monopoly, then that collusion is called as Cartel. Since, 60% of the  oil is produced by non-OPEC countries, it can be called as semi-cartel where it controls the global oil supply to affect the oil price and rest of the producers behave as price takers. 
 
Suppose the world crude prices are 100$ per barrel ( 1barell= 158.76 lit.) but due to sluggish demand price moves downwards to reach 80$ per barrel in such a case, OPEC  will curtail the production by say 2 million barrel per day, such behavior will put the upward pressure on oil prices. If prices still don’t reach the desired level of 100$ per barrel they will further reduce the production. In this manner OPEC controls the crude oil supply to affect the world oil prices and non-OPEC countries act as price taker.
 
Apart from this, continuous soaring demand for oil from developing countries witnessing high growth, supply constraints, constraints on refining capacity, greed of OPEC, crises in oil rich middle east countries keep oil prices pushing upwards. Added to the above factors, sentiments in the market and speculation prevents the oil price indices from falling.
 
Oil Prices in India
 
In India the price of petroleum products were dictated by the central government under the administered price mechanism (APM) TILL 2002. In 2002, APM was dismantled and the oil marketing company’s where given freedom to charge prices according to the market condition. The move was hailed by everyone as it was thought to reduce subsidy burden on government exchequer and will improve efficiency in the sector as well. Such pricing was followed till 2004 but  afterwards, international crude prices consistently increased and therefore government  interrupted and the oil marketing company’s were not allowed to pass the market prices to the consumers. The following table presents the break-up of oil prices in India –
 
Percentage Cost
74% crude oil cost
11% Taxes
10% Refining cost
5% Distribution and marketing cost.
 
Despite of the above break-up the price determination of oil products in India still lacks transparency  it is because of the irony that on one hand government claims huge subsidy burden on petroleum products , on the other hand it imposes every possible tax on such products like-  custom duty, excise duty, sales tax, education cess, road cess etc. it might be because of the fact that in petroleum products  cross subsidization is implemented. When a product is sold below the market price then the loss is beard by govt. in the form of subsidy. In cross subsidization  the loss due to subsidy on one product is compensated by the price escalation on the other products. For instance subsidy on kerosene  and LPG is compensated  by the prices of petrol and diesel. Further if oil companies suffer huge losses due to subsidy then how they pay rich dividend to the govt. and maintain themselves in the fortune 500 companies needs immense logic. 
 
 According to the law of demand the price of commodity rises, its demand falls and if price falls, demand rises. But the products which are classified as necessities have little impact on their demand due to price change. Such type of demand is called ads inelastic demand. Petroleum products belong to the category of goods facing inelastic demand.
Reasons for consistent rise in oil prices in India—major factors responsible for consistent rise in the oil prices in India are :
 
•India is heavily dependent on oil imports to fulfill its need and therefore has little room to prevent the prices from rising when the international prices are soaring.
•India witnessed the second highest economic growth rate in Asia in the  first decade of 21st century. Higher the economic growth, higher will be the demand for energy and thereby for petroleum products.
•Elastic nature of demand for oil and the dependence on imports for its supply prevents the prices from falling. Moreover, domestic refining capacity is also not increasing at the required pace.
•Lack of alternatives of the mineral oil is another reason for high dependence on imported oil. The development of BIO-fuels is in the nascent stage. Though govt. had started selling ethanol blended petrol but still it is too little to impact the demand.
 
Impact of increased prices
 
The prices of petroleum products increase the cost of production and therefore put upward pressure on almost every sector of the economy. In agriculture tractors are used for tilling, pump sets for irrigation, threshers for the processing of grains etc. all run on diesel. If diesel prices are increased, they increase the cost of production of food. Further transportation of food grains also become expensive and thus increasing the food prices. In industrial sector also the petroleum products are the part of cost of production of almost every commodity and fluctuation in oil prices affect the industrial sector accordingly.                   
 
 In the service sector, transportation sector is the most adversely affected sector due to rise in oil prices be it road, rail, sea, air transport. In fact in Indian aviation industry the fuel costs 40% of the total cost whereas in the rest of the world it is approx 20%. Fuel prices are one of the most important factor behind the ailment of Indian aviation sector. Apart form this, since transportation is the integral cost of every sector, rise in transportation cost affects every sector of the economy. Thus rising oil prices directly affect the overall inflation affecting everyone in general and the vulnerable sections of the society in particular.
 
Measures to reduce prices
 
 once a nation rides on a high growth trajectory, it must ensure a sustainable energy supply to fuel such growth. In Indian scenario, to reduce the fluctuation of the energy supply, most suitable recourse is to generate the local and domestic sources of energy supply and reduce the dependence on imports. This can be achieved by increasing the domestic production of crude. Since nature has not  blessed India with huge oil reserves we have  to see alternatives of mineral oil to fuel growth. Such  alternatives  includes solar power, bio fuels, hydrogen energy, shale gas etc.
 
On the demand side also, reliance of petrol can be reduced by developing mass rapid transit system (MRTS) like metro, bus rapid transit (BRT) corridor in urban areas. Such developments may reduce the cost of  travel. Further good infrastructure on roads will give  hassle free traffic & that will also reduce fuel consumption.
 
oil price rise impacts  everyone, it is expedient to reduce the dependence on oil. Apart from economic reasons, reduced dependence on oil is also necessary for environment protection and international peace. For environmental reasons, it is a well known fact that vehicular pollution is the most important cause of environmental degradation. 
 
On  international relations front if we analyze the major geo political problems, we can surmise the importance of oil for world peace. For e.g. Falk island dispute between Argentina and  England, south china sea dispute between china and Vietnam, Iraq war, disputable claim of Russia over Lomonov ridge in arctic circle are all because of oil. 
 
Moreover the civil strife of most African nations like Sudan hovers around the oil wealth. Therefore not just for economic and welfare reasons but for environment and world peace, oil prices must be kept stable and dependence should be kept at minimum.
 
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