Future of black gold

While a bear market is anathema for an economy, depressed oil prices are quite a boon for the Indian economy which depends to a large extent from imports to meet its domestic oil requirement. Such dependence on imports for a large and growing economy like India can become a limiting factor for its own well being. Hence lower oil prices are a blessing for the Indian economy. As we now all know that infrastructure is the need gap that need to be immediately addressed to accelerate the economy on to a different plane. Also, infrastructure, though much desired to kick start our economy is highly capital intensive. From where does India get this capital. While domestic sources are robust, getting funds from international sources is as crucial. International sources, in order to lend need to be assured about the stability and strength of our currency. The stability of the currency in turn is dependant on the fiscal deficit which has been rising for which the large oil bill is one of the key factors. Hence a depressed market in commodities that include oil, metal, food grains etc will go a long way in shaping the future of India-all these being crucial inputs for building infrastructure. But will the oil bill remain contained in the future. What if the global economy turns around and begins to chug along as in the past? What if China and India press the accelerator of their growth engines? Will prices of oil and other commodities sky rocket and scuttle our plans? After all we had witnessed unprecedented inflation in oil not so long ago and were are our wit's end. To answer the above question, we have taken a zoom in view of the sector and have put together our view.

While the price rise in oil seem to have abated,there is a view that is emerging that in the long run the price rise will resume all over again. This view is rooted in some real trends such as

1. Economic growth of China and India.
2. Depleting oil reserves. Some of the world's biggest oil fields are rapidly drying up.
3. Nationalization of oil fields which will lead to government control and politicisation of oil supplies. It is estimated that independent firms have control over only 20% of global reserves.
4. Underinvestment in oil exploration due to both high cost and high gestation period. The fear is that investment may fail to provide returns in the even of commercialization of some other form of non conventional energy. The moment technology renders solar energy available and affordable, the demand for conventional forms of energy like oil will crash leading to a value erosion of investments in this sector.

The above points paints an inflationary picture for the future.
However, is this true?

If one were to look at the past, the story that emerges is quite contrary. Over the past 200 years prices of commodities have headed downwards ( prices after having adjusted for inflation) on the basis of greater efficiencies in oil extraction, discovery of new and efficient technologies, discovery of alternatives etc.

One must also recognize that despite the worries about "peak oil" - the time when oil extraction will reach its peak and head terminally downwards - every bear market in commodities has been driven by demand contraction and not by constriction in supply.

And even when demand has subsequently picked up, some new form of energy - such as nuclear energy, natural gas, green technologies have risen to absorb some of the new demand and thus having a calming effect on oil prices.

Having adjusted for inflation the real price of oil today is the same as that of 1976 and that of 1870 when it was first unearthed. This has happened mainly because of discovery of new oil fields at one hand and greater energy productivity/efficiency at the other. The machinery - like cars, generators etc.- that draw energy from oil have themselves evolved substantially and produce a lot more for the same input. Hence even resumption in demand has not had the expected result of taking up the prices all over again.Therefor it would be presumptuous to believe that the guzzling engines of China and India will do that now - i.e. drive up oil prices.

One needs to look back into the 1980's when Japan and Europe were the drivers of world economy. Just like China and India today, they too made huge energy demands. But all throughout this period prices remained reasonably steady. This was due to new energy discovery that concurrently took place. Alternatives such as nuclear power met the rising demand from these countries. In fact even today, France draws 90% of its energy from nuclear power. The same has been witnessed in the recent past as well with the discovery of bio-fuels, synthetic oil and natural gas liquids. Some of these new "avtaars" perhaps have not been rendered commercial to this date but it is only a matter of time when the desired scales and commercial viability are reached.

Another interesting point to support the theory of low oil prices in the future is rooted in the insight that commodities are the means to an end and not an end in themselves. They are one of the several ingredients of end products like cars, engines etc. Hence beyond a point the end products cannot sustain high oil prices for it drives their own prices up and make them unviable for their customers. Thus the market itself seems to limit the price oil in this manner. For example if flying from Mumbai to Delhi were to cost Rs 1 lac, the market will reject the product. It will seek alternate solutions such as video conferencing as a substitute to flying. This is how the power of alternatives keeps a check on the prices of the primary product. Similarly if gold prices were to hit the roof, the market will simply replace gold ornaments for some other material and drive down the prices. When the prices of nickel and copper sky rocketed some years back the market looked to aluminium as an alternative.

So what are the boundaries that have been defined by the past trend. For Copper it was 0.45% of GDP, for Nickel it was 0.2%of GDP and for Oil it has been 7% of global GDP that has resulted in price collapse In 1979 oil prices collapsed after reaching this tipping point of 7% and so did they in the recent past.

However for some reason the market is still betting on higher oil prices for the future. Therefore while oil is trading in the spot market at USD 50 per barrel, the price of 3 yr. futures is at USD 70 . While such forecasts are being drawn up, it is worth while to note that till 2005 the expectations were exactly the opposite i.e. spot prices ran ahead of future prices. The recent collapse of the world economy has to some extent dispelled the erstwhile theory. Today any early signs of recovery is driving money straight into commodities causing erratic upward price swings. But will this trend sustain and will oil prices pick up with the the flow of good news?

This bullishness seems somehow very misplaced. The world economy is bruised and the wound runs deep. This is probably the biggest economic contractions since the Great Depression. While we will keep hearing of “green shoots” and resumption of growth here and there but it would be presumptuous to believe that we are on the verge of secular growth cycle like that which was witnessed from 2003 onwards till 2008. While India and some emerging markets may relatively do better, the global economy by and large will not see rapid growth in a hurry.

Even if revival begins and economies gain some traction, commodities for sure are not expected to lead this growth. The reason for this is rooted in the theory that commodity and oil prices bloom towards the mature stages of an overheated economy. We are not likely to see this kind of a situation in the near future.

Today the supply of oil and other commodities far outstrips the demand and this situation is likely to prevail for some time – perhaps a couple of years. Hence downward pressure on prices will continue to remain high. The commodity producers are facing this situation of falling demand by making temporary production cuts. For example world wide steel production is now down to 65% capacity from a high of 95% last year. Thus holding on to excess spare capacity has left producers with very little pricing power.

Inventory levels of many commodities are at a 5 to 10 year highs. To clear such large accumulation prices will have to soften to bring in incremental demand.

While several commodity producers will be pinning their hopes on China's growth engine to kick in once again and drive up demand but even the Dragon is unlikely to respond to such expectations.

China had been investing 40% of its GDP in export oriented industries. Hence it was easily consuming 25% to 50% of global commodity production. With the slump in export demand, China is not likely to regain the same appetite for commodities all over again. China is expected to focus on developing its domestic market in order to offset the lack of export demand. Thus it is most likely to make do with the capacity that it has already built up.

As such China’s impact on oil prices too seems very exaggerated. This is because while the countries belonging of the Organization of Economic Cooperation and Development consume about 50% of the global oil output, China accounts for only 10%. And going forward while the Dragon may still have some demand appetite going for it, the OECD countries on the other hand will for sure see demand shrinkage. As the world economy starts to contract by approximately 1.4 % in 2009-10, the demand for oil too will consequently contract by 2.8% (2.4 million barrels per day).

Another crucial point of note is that OPEC is in no position to dictate prices of oil in the current circumstances where its spare capacity stands at 8% of total world demand. ( their capacity to control prices dwindles the moment space capacity crosses the 5% mark).

Thus overall the hardening of oil prices does not seem to be very likely in the near future.

It has been observed commodities exhibit short and sharp bull market ( of 4 to 9 years) followed by long bear markets of between 11 to 27 years. Prices were driven up 10 times at the end of the last bull run that ended recently after a period of nearly nine years. Coincidentally this was congruent in magnitude and duration with the bull run that ended in 1979. Thus from 1979 till 2003 oil prices remained steady, a period of 24 years. Hence if one were to extrapolate based on this observation, we are still at the beginning of what could be a long bear market for commodities.

However at some points commodities may exhibit spike in prices. While price hikes now and then are a reality so is the overall downwards trend in prices supported by long term trend analysis. One needs to take note of the fact that long term trends have been repetitive over centuries and cannot be wished away so easily.

Thus in conclusion the case for stable oil prices is based on the following factors:-

1. The general trend over centuries has been a downwards price movement
2. Better efficiencies in energy consumption through better quality end products
3. Viability of alternatives and hence lesser dependence
4. Oil inflation has inherently been a function of demand fluctuation rather than supply issues
5. Growth slump is one of the worse that we are witnessing and while it will correct itself but will take quite some time to reach the levels that we saw in the recent past.
6. Depleted pricing power of oil producers due to rising inventory levels
7. In the wake of a shrinking export market,China will balance excess capacities and hence new investments are not likely to be as robust as in the past.
8. As such China consumes 10% of oil output while OPEC countries consume 50%. This 50% is the most affected demand led by a shrinking global economy
9. A bull run in commodities is usually followed by a longish bear run and trends of the past seem to repeat themselves based on analysis. Hence there is a reason to believe that the future will mirror the past.