Why oil prices should not fall further?

Why oil prices should not fall beyond a pointBy J. Srinivasan, Business Line, New Delhi, December 23, 2008.

There seems to be no stopping the oil prices' fall, just as there was no stopping its rise earlier this year. Truly, oi's movement has been dizzy, climbing to a high of $147 a barrel in July only to drop to around $50 today, and set go lower. Though there is a contention that a significant part of the oil price rise was actually the fall of the dollar, certainly cheaper oil at the moment is good, when the world economy remains mired in the financial crisis.

Freed of worry from at least from one of the major causes of inflation, countries can with confidence resort to fiscal measures, print money, to re-inflate their economies. But the dropping oil price suggests a deeper malaise: Economies are slowing dramatically. That oil demand" should be sliding even as winter is peaking in the West points to the economising that are happening.

Is cheap really as good as it seems, prima facie? There are several downsides to very cheap oil, especially if the world's environmental health is to be maintained. As it is, the world consumes about 83 million barrels of oil a day, with just the US accounting for a fourth. If this level of consumption rises, the consequences for the environment can be disastrous.

Continued cheap oil is certainly not good for the producing countries. After some time, it will start knocking on these economies and that can cause serious internal pressures to build. Iran is a case in point.

Negative impact

With two-thirds of the world's oil located in the historically disturbed region, continued low oil prices can have negative local, regional and global impact. A curious position of the West Asian region is that if prices go up beyond a point, it risks external pressures. If prices drop below a point where they begin to affect the local economies, internal problems rise. Often, the social impact of cheap oil on such countries as Nigeria or Venezuela gets ignored.

Internal troubles in West Asia are bad news for everyone, in the region or away from it. At best of times it is a tinderbox, and oil can easily fuel a dangerous conflagration. If oil supplies from West Asia get disturbed for any reason the biggest sufferers would be the Asian economies, especially China and India. Unlike the US or Europe, India and China have a" limited diversity of oil supply.

Crude prices need to be high enough, in the words of oil guru Mathew Simmons, for "the piper to be paid adequately." If prices are lower than they need to be, it leads to instability and high volatility. It is necessary that countries recover at least their production costs. Else, there is no incentive for them to bring out the oil. They might as well sit on it, with adverse consequences for its prices and world economies.

In a perverse sense, high oil prices are forced savings for profligate economies, especially of the West. Since oil demand is inelastic, nations will buy even if prices go up. But then the money that goes out, at least out of the Western economies, usually returns as investments by oil-exporting countries which, barring some, do not have large enough economies to absorb incomes on such scale. The UK's Barclays Bank has just received West Asian investment.

But the real negative consequence of a low price is it discourages energy conservation. If prices remain low, large consumers such as the US, China or India has no incentive to reduce consumption. They will not hesitate to burn cheap oil. In these countries, usually, fuel prices are subsidised to make them more affordable. Cheap oil would exacerbate the low prices, ending conservation efforts.

If the American was loathe to conserving petrol it was because he had got used to ridiculously low prices in the 1990s that, adjusted for Inflation, were lower than at any time since 1919. Burning oil on such a scale can impose large environmental costs.

It will worsen the already damaged environment and when oil prices go up, as they will once economies recover, these nations will face the double-whammy of not just high-cost fuel but also large environmental cleanup costs. Low oil prices also stifle development of alternative energy sources, such as solar and wind.

Addictive
Cheap oil is a major disincentive to technological innovation. For instance, there will be no incentive for car-makers to develop hybrid or smaller cars; or for people to look seriously at these alternatives. Large cars could be back in fashion. It also kills investments in public transportation by governments and in cost-saving initiatives by individuals by, say, biking or walking.

Because of the climatic conditions in India these may not seem real options for the people but in the West they are very real alternatives, especially as demonstrated by northern Europe. Cheap oil's greatest impact is on the industry.

Low oil prices will, sooner or later, affect investments in exploration. With fewer undiscovered or virgin fields not open to oil majors, companies are reaching deeper into the seas or extracting oil from tar sands. These are expensive processes involving large investments.

Even in the case of normal wells, it is not as if they just keep pumping out oil. After a time they begin to decline. At this point producers have to spend considerable amounts to maintain output. Not only does oil have to be brought out of the well it has also to be brought to collection points or refineries. So, each link of the oil chain involves large investments and expensive upkeep.

Mathew Simmons rightly says low oil prices are as dangerous to economies as drugs to the human body. "Another consumption item that makes people apparently feels good as long as it is used." Once it effects begin to show, then things turn real bad. Using cheap oil can be dangerously addictive too. ___________________________________
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