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Oil Prices History, Trends, Economics and Policies

Submitted By:

Group 8_Sec B

Achintya PR 13020841062

Manish Watharkar 13020841083

Nandana SS 13020841085

Pallavi Ghandat 13020841092

Prashant Patro 13020841094

Uttara Chattopadhyay 13020841114

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Index

Sl No Content Page No

1 Oil Prices History and Trends 3

2 History of Oil Prices in India 18

3 Economics of Oil Price 23

4 Policy Making with Oil Prices 33

5 Bibliography 41

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Oil Price History and Trends:

The EIA (Energy Information Administration) provides the average annual price for a

barrel of WTI crude oil since 1986:

Oil Price/Barrel

Oil Price/Barrel

Oil Price/Barrel

1986 $15.05

1995 $18.43

2004 $41.51

1987 $19.20

1996 $22.12

2005 $56.64

1988 $15.97

1997 $20.61

2006 $66.05

1989 $19.64

1998 $14.42

2007 $72.34

1990 $24.53

1999 $19.34

2008 $99.67

1991 $21.54

2000 $30.38

2009 $61.95

1992 $20.58

2001 $25.98

2010 $79.48

1993 $18.43

2002 $26.18

2011 $94.88

1994 $17.20

2003 $31.08

2012 $94.05

The trend can be plotted in the following graph as shown below. This has shown an

overall high increase in the oil price in the past years. The price rose highly during

initial year of 2001, and saw the only dip during the year 2008-09.

Crude Oil Price Trends:

Oil prices usually go up in the summer, driven by high demand for gasoline during

vacation driving times. Sometimes it will drop further in the winter, if there is lower

$0.00

$20.00

$40.00

$60.00

$80.00

$100.00

$120.00

1986

1987

1988

1989

1990

1991

1992

1993

1994

1995

1996

1997

1998

1999

2000

2001

2002

2003

2004

2005

2006

2007

2008

2009

2010

2011

2012

Oil Price/Barrel

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than expected demand for home heating oil, due to warmer weather. During 2008, there

was fear that economic growth from China and the U.S. would create so much demand

for oil that it would overtake supply, driving up prices. However, most analysts now

realize that such a sudden increase in oil prices was due to increased investment by

hedge fund and futures traders.

In addition, oil prices seem to be rising earlier and earlier each spring. In 2013, prices

started rising in January, reaching a peak of $118.90 in February. In 2012, oil prices

started rising in February. The price for a barrel of WTI (West Texas Intermediate)

crude broke above $100 a barrel on February 13, 2012. In 2011, prices didn't break

$100 a barrel until March 2, and didn't peak until May at $113 a barrel.

Fortunately, none of these peaks were as high as the June 2008 all-time high, when the

price of WTI crude oil hit $143.68 per barrel. By December, it plummeted to a low of

$43.70 per barrel. The U.S. average retail price for regular gasoline also hit a peak in July

2008 of $4.17, rising as high as $5 a gallon in some areas. By December, it had also

dropped to $1.87 a gallon.

Demand for oil:

The demand side of peak oil over time is concerned with the total quantity of oil that the

global market would choose to consume at various possible market prices and how this

entire listing of quantities at various prices would evolve over time. Total global

quantity demanded of world crude oil grew an average of 1.76% per year from 1994 to

2006, with a high growth of 3.4% in 2003–2004. After reaching a high of 85.6 million

barrels (13,610,000 m3) per day in 2007, world consumption decreased in both 2008

and 2009 by a total of 1.8%, despite fuel costs plummeting in 2008.Despite this lull,

world quantity-demanded for oil is projected to increase 21% over 2007 levels by 2030

(104 million barrels per day (16.5×106 m3/d) from 86 million barrels (13.7×106 m3)),

due in large part to increases in demand from the transportation sector. According to

the IEA's 2013 projections, growth in global oil demand will be significantly outpaced

by growth in production capacity over the next 5 years.

The world increased its daily oil consumption from 63 million barrels (10,000,000 m3)

(Mbbl) in 1980 to 85 million barrels (13,500,000 m3) in 2006. Energy demand is

distributed amongst four broad sectors: transportation, residential, commercial, and

industrial. In terms of oil use, transportation is the largest sector and the one that has

seen the largest growth in demand in recent decades. This growth has largely come

from new demand for personal-use vehicles powered by internal combustion

engines. This sector also has the highest consumption rates, accounting for

approximately 68.9% of the oil used in the United States in 2006, and 55% of oil use

worldwide as documented in the Hirsch report. Transportation is therefore of particular

interest to those seeking to mitigate the effects of peak oil.

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United States crude oil production peaked in 1970. In 2005, imports were twice as great

as production.

Although demand growth is highest in the developing world, the United States is the

world's largest consumer of petroleum. Between 1995 and 2005, US consumption grew

from 17,700,000 barrels per day (2,810,000 m3/d) to 20,700,000 barrels per day

(3,290,000 m3/d), 3,000,000 barrels per day (480,000 m3/d) increase. China, by

comparison, increased consumption from 3,400,000 barrels per day (540,000 m3/d) to

7,000,000 barrels per day (1,100,000 m3/d), an increase of 3,600,000 barrels per day

(570,000 m3/d), in the same time frame. The Energy Information Administration (EIA)

stated that gasoline usage in the United States may have peaked in 2007, in part because

of increasing interest in and mandates for use of bio fuels and energy efficiency.

As countries develop, industry and higher living standards drive up energy use, most

often of oil. Thriving economies, such as China and India, are quickly becoming large oil

consumers. China has seen oil consumption grow by 8% yearly since 2002, doubling

from 1996–2006. In 2008, auto sales in China were expected to grow by as much as 15–

20%, resulting in part from economic growth rates of over 10% for five years in a row.

Although swift, continued growth in China is often predicted, others predict China's

export-dominated economy will not continue such growth trends because of wage and

price inflation and reduced demand from the United States. India's oil imports are

expected to more than triple from 2005 levels by 2020, rising to 5 million barrels per

day (790×103 m3/d).

The EIA now expects global oil demand to increase by about 1,600,000 barrels per day

(250,000 m3/d). Asian economies, in particular China, will lead the increase.

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1947-2011:

Like prices of other commodities the price of crude oil experiences wide price swings in

times of shortage or oversupply. The crude oil price cycle may extend over several

years responding to changes in demand as well as OPEC and non-OPEC supply. We will

discuss the impact of geopolitical events, supply demand and stocks as well as NYMEX

trading and the economy.

Throughout much of the twentieth century, the price of U.S. petroleum was heavily

regulated through production or price controls. In the post World War II era, U.S. oil

prices at the wellhead averaged $28.52 per barrel adjusted for inflation to 2010

dollars. In the absence of price controls, the U.S. price would have tracked the world

price averaging near $30.54. Over the same post war period, the median for the

domestic and the adjusted world price of crude oil was $20.53 in 2010 prices. Adjusted

for inflation, from 1947 to 2010 oil prices only exceeded $20.53 per barrel 50 percent of

the time. (See note in the box on right.)

Until March 28, 2000 when OPEC adopted the $22-$28 price band for the OPEC basket

of crude, real oil prices only exceeded $30.00 per barrel in response to war or conflict in

the Middle East. With limited spare production capacity, OPEC abandoned its price

band in 2005 and was powerless to stem a surge in oil prices, which was reminiscent of

the late 1970s.

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Post World War II

Pre-Embargo Period

From 1948 through the end of the 1960s, crude oil prices ranged between $2.50 and

$3.00. The price oil rose from $2.50 in 1948 to about $3.00 in 1957. When viewed in

2010 dollars, a different story emerges with crude oil prices fluctuating between $17

and $19 during most of the period. The apparent 20% price increase in nominal prices

just kept up with inflation.

From 1958 to 1970, prices were stable near $3.00 per barrel, but in real terms the price

of crude oil declined from $19 to $14 per barrel. Not only was price of crude lower

when adjusted for inflation, but in 1971 and 1972 the international producer suffered

the additional effect of a weaker US dollar.

OPEC was established in 1960 with five founding members: Iran, Iraq, Kuwait, Saudi

Arabia and Venezuela. Two of the representatives at the initial meetings previously

studied the Texas Railroad Commission's method of controlling price through

limitations on production. By the end of 1971, six other nations had joined the group:

Qatar, Indonesia, Libya, United Arab Emirates, Algeria and Nigeria. From the foundation

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of the Organization of Petroleum Exporting Countries through 1972, member countries

experienced steady decline in the purchasing power of a barrel of oil.

Throughout the post war period exporting countries found increased demand for their

crude oil but a 30% decline in the purchasing power of a barrel of oil. In March 1971,

the balance of power shifted. That month the Texas Railroad Commission set proration

at 100 percent for the first time. This meant that Texas producers were no longer

limited in the volume of oil that they could produce from their wells. More important, it

meant that the power to control crude oil prices shifted from the United States (Texas,

Oklahoma and Louisiana) to OPEC. By 1971, there was no spare production capacity in

the U.S. and therefore no tool to put an upper limit on prices.

A little more than two years later, OPEC through the unintended consequence of war

obtained a glimpse of its power to influence prices. It took over a decade from its

formation for OPEC to realize the extent of its ability to influence the world market.

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Middle East Supply Interruptions

Yom Kippur War - Arab Oil Embargo*

In 1972, the price of crude oil was below $3.50 per barrel. The Yom Kippur War started

with an attack on Israel by Syria and Egypt on October 5, 1973. The United States and

many countries in the western world showed support for Israel. In reaction to the

support of Israel, several Arab exporting nations joined by Iran imposed an embargo on

the countries supporting Israel. While these nations curtailed production by five million

barrels per day, other countries were able to increase production by a million

barrels. The net loss of four million barrels per day extended through March of 1974. It

represented 7 percent of the free world production. By the end of 1974, the nominal

price of oil had quadrupled to more than $12.00.

Any doubt that the ability to influence and in some cases control crude oil prices had

passed from the United States to OPEC was removed as a consequence of the Oil

Embargo. The extreme sensitivity of prices to supply shortages became all too apparent

when prices increased 400 percent in six short months. From 1974 to 1978, the world

crude oil price was relatively flat ranging from $12.52 per barrel to $14.57 per

barrel. When adjusted for inflation world oil prices were in a period of moderate

decline. During that period OPEC capacity and production was relatively flat near 30

million barrels per day.

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In contrast, non-OPEC production increased from 25 million barrels per day to 31

million barrels per day.

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Crises in Iran and Iraq

In 1979 and 1980, events in Iran and Iraq led to another round of crude oil price

increases. The Iranian revolution resulted in the loss of 2.0-2.5 million barrels per day

of oil production between November 1978 and June 1979. At one point production

almost halted.

The Iranian revolution was the proximate cause of the highest price in post-WWII

history. However, revolution's impact on prices would have been limited and of

relatively short duration had it not been for subsequent events. In fact, shortly after the

revolution, Iranian production was up to four million barrels per day.

In September 1980, Iran already weakened by the revolution was invaded by Iraq. By

November, the combined production of both countries was only a million barrels per

day. It was down 6.5 million barrels per day from a year before. As a consequence,

worldwide crude oil production was 10 percent lower than in 1979.

The loss of production from the combined effects of the Iranian revolution and the Iraq-

Iran War caused crude oil prices to more than double. The nominal price went from

$14 in 1978 to $35 per barrel in 1981. Over three decades later Iran's production is only

two-thirds of the level reached under the government of Reza Pahlavi, the former Shah

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of Iran. Iraq's production is now increasing, but remains a million barrels below its peak

before the Iraq-Iran War.

OPEC Fails to Control Crude Oil Prices:

OPEC has seldom been effective at controlling prices. Often described as a cartel, OPEC

does not fully satisfy the definition. One of the primary requirements of a cartel is a

mechanism to enforce member quotas. An elderly Texas oil man posed a rhetorical

question: What is the difference between OPEC and the Texas Railroad Commission? His

answer: OPEC doesn't have any Texas Rangers! The Texas Railroad Commission could

control prices because the state could enforce cutbacks on producers. The only

enforcement mechanism that ever existed in OPEC is Saudi spare capacity and that

power resides with a single member not the organization as a whole.With enough spare

capacity to be able to increase production sufficiently to offset the impact of lower

prices on its own revenue; Saudi Arabia could enforce discipline by threatening to

increase production enough to crash prices. In reality even this was not an OPEC

enforcement mechanism unless OPEC's goals coincided with those of Saudi Arabia.

During the 1979-1980 periods of rapidly increasing prices, Saudi Arabia's oil minister

Ahmed Yamani repeatedly warned other members of OPEC that high prices would lead

to a reduction in demand. His warnings fell on deaf ears. Surging prices caused several

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reactions among consumers: better insulation in new homes, increased insulation in

many older homes, and more energy efficiency in industrial processes, and automobiles

with higher efficiency. These factors along with a global recession caused a reduction in

demand which led to lower crude prices.

Unfortunately for OPEC only the global recession was temporary. Nobody rushed to

remove insulation from their homes or to replace energy efficient equipment and

factories -- much of the reaction to the oil price increase of the end of the decade was

permanent and would never respond to lower prices with increased consumption of oil.

Higher prices in the late 1970s also resulted in increased exploration and production

outside of OPEC. From 1980 to 1986 non-OPEC production increased 6 million barrels

per day. Despite lower oil prices during that period new discoveries made in the 1970s

continued to come online.

OPEC was faced with lower demand and higher supply from outside the organization.

From 1982 to 1985, OPEC attempted to set production quotas low enough to stabilize

prices. These attempts resulted in repeated failure, as various members of OPEC

produced beyond their quotas. During most of this period Saudi Arabia acted as the

swing producer cutting its production in an attempt to stem the free fall in prices. In

August 1985, the Saudis tired of this role. They linked their oil price to the spot market

for crude and by early 1986 increased production from two million barrels per day to

five million. Crude oil prices plummeted falling below $10 per barrel by mid-1986.

Despite the fall in prices Saudi revenue remained about the same with higher volumes

compensating for lower prices.

A December 1986 OPEC price accord set to target $18 per barrel, but it was already

breaking down by January of 1987 and prices remained weak.

The price of crude oil spiked in 1990 with the lower production, uncertainty associated

with the Iraqi invasion of Kuwait and the ensuing Gulf War. The world and particularly

the Middle East had a much harsher view of Saddam Hussein invading Arab Kuwait than

they did Persian Iran. The proximity to the world's largest oil producer helped to shape

the reaction.

Following what became known as the Gulf War to liberate Kuwait, crude oil prices

entered a period of steady decline. In 1994, the inflation adjusted oil price reached the

lowest level since 1973.

The price cycle then turned up. The United States economy was strong and the Asian

Pacific region was booming. From 1990 to 1997, world oil consumption increased 6.2

million barrels per day. Asian consumption accounted for all but 300,000 barrels per

day of that gain and contributed to a price recovery that extended into 1997. Declining

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Russian production contributed to the price recovery. Between 1990 and 1996 Russian

production declined more than five million barrels per day.

OPEC continued to have mixed success in controlling prices. There were mistakes in

timing of quota changes as well as the usual problems in maintaining production

discipline among member countries.

The price increases came to a rapid end in 1997 and 1998 when the impact of the

economic crisis in Asia was either ignored or underestimated by OPEC. In December

1997, OPEC increased its quota by 2.5 million barrels per day (10 percent) to 27.5

million barrels per day effective January 1, 1998. The rapid growth in Asian economies

came to a halt. In 1998, Asian Pacific oil consumption declined for the first time since

1982. The combination of lower consumption and higher OPEC production sent prices

into a downward spiral. In response, OPEC cut quotas by 1.25 million barrels per day

in April and another 1.335 million in July. The price continued down through December

1998.

Prices began to recover in early 1999. In April, OPEC reduced production by another

1.719 million barrels. As usual not all of the quotas were observed, but between early

1998 and the middle of 1999 OPEC production dropped by about three million barrels

per day. The cuts were sufficient to move prices above $25 per barrel.

With minimal Y2K problems and growing U.S. and world economies, the price continued

to rise throughout 2000 to a post 1981 high. In 2000 between April and October, three

successive OPEC quota increases totalling 3.2 million barrels per day were not able to

stem the price increase. Prices finally started down following another quota increase of

500,000 effective November 1, 2000.

Russian production increases dominated non-OPEC production growth from 2000 to

2007 and was responsible for most of the non-OPEC increase since the turn of the

century.

Once again it appeared that OPEC overshot the mark. In 2001, a weakened US economy

and increases in non-OPEC production put downward pressure on prices. In response

OPEC once again entered into a series of reductions in member quotas cutting 3.5

million barrels by September 1, 2001. In the absence of the September 11, 2001

terrorist attacks, this would have been sufficient to moderate or even reverse the

downward trend.

In the wake of the attack, crude oil prices plummeted. Spot prices for the U.S.

benchmark West Texas Intermediate were down 35 percent by the middle of

November. Under normal circumstances a drop in price of this magnitude would have

resulted in another round of quota reductions. Given the political climate OPEC delayed

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additional cuts until January 2002. It then reduced its quota by 1.5 million barrels per

day and was joined by several non-OPEC producers including Russia which promised

combined production cuts of an additional 462,500 barrels. This had the desired effect

with oil prices moving into the $25 range by March 2002. By midyear the non-OPEC

members were restoring their production cuts but prices continued to rise as U.S.

inventories reached a 20-year low later in the year.

By year end oversupply was not a problem. Problems in Venezuela led to a strike at

PDVSA causing Venezuelan production to plummet. In the wake of the strike Venezuela

was never able to restore capacity to its previous level and is still about 900,000 barrels

per day below its peak capacity of 3.5 million barrels per day. OPEC increased quotas by

2.8 million barrels per day in January and February 2003.

On March 19, 2003, just as some Venezuelan production was beginning to return,

military action commenced in Iraq. Meanwhile, inventories remained low in the U.S. and

other OECD countries. With an improving economy U.S. demand was increasing and

Asian demand for crude oil was growing at a rapid pace.

The loss of production capacity in Iraq and Venezuela combined with increased OPEC

production to meet growing international demand led to the erosion of excess oil

production capacity. In mid 2002, there were more than six million barrels per day of

excess production capacity and by mid-2003 the excess was below two million. During

much of 2004 and 2005 the spare capacity to produce oil was less than a million barrels

per day. A million barrels per day is not enough spare capacity to cover an interruption

of supply from most OPEC producers.

In a world that consumes more than 80 million barrels per day of petroleum products

that added a significant risk premium to crude oil price and was largely responsible for

prices in excess of $40-$50 per barrel.

Other major factors contributing to higher prices included a weak dollar and the rapid

growth in Asian economies and their petroleum consumption. The 2005 hurricanes and

U.S. refinery problems associated with the conversion from MTBE to ethanol as a

gasoline additive also contributed to higher prices.

One of the most important factors determining price is the level of petroleum

inventories in the U.S. and other consuming countries. Until spare capacity became an

issue inventory levels provided an excellent tool for short-term price forecasts.

Although not well publicized OPEC has for several years depended on a policy that

amounts to world inventory management. Its primary reason for cutting back on

production in November 2006 and again in February 2007 was concern about growing

OECD inventories. Their focus is on total petroleum inventories including crude oil and

petroleum products, which is a better indicator of prices that oil inventories alone.

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In 2008, after the beginning of the longest U.S. recession since the Great Depression the

oil price continued to soar. Spare capacity dipped below a million barrels per day and

speculation in the crude oil futures market was exceptionally strong. Trading on NYMEX

closed at a record $145.29 on July 3, 2008. In the face of recession and falling petroleum

demand the price fell throughout the remainder of the year to the below $40 in

December.

Following an OPEC cut of 4.2 million b/d in January 2009 prices rose steadily in the

supported by rising demand in Asia. In late February 2011, prices jumped as a

consequence of the loss of Libyan exports in the face of the Libyan civil war. Concern

about additional interruptions from unrest in other Middle East and North African

producers continues to support the price while as of Mid-October 400,000 barrels per

day of Libyan production was restored.

Recessions and Oil Prices: It is worth noting that the three longest U.S. recessions since the Great Depression

coincided with exceptionally high oil prices. The first two lasted 16 months. The first

followed the 1973 Embargo started in November 1973 and the second in July 1981. The

latest began in December 2007 and lasted 18 months. Charts similar to the one at the

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right have been used to argue that price spikes and high oil prices cause recessions.

There is little doubt that price is a major factor.

The same graph makes an even more compelling argument that recessions cause low oil

prices.

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History of Oil Prices in India

Colonial Rule, 1858-1947

The first oil deposits in India were discovered in 1889 near the town of [Digboi] in the

state of Assam This discovery came on the heels of industrial development. The Assam

Railways and Trading Company (ARTC) had recently opened the area for trade by

building a railway and later finding oil nearby. The first well was completed in 1890 and

the Assam Oil Company was established in 1899 to oversee production. At its peak

during the Second World War the Digboi oil fields were producing 7,000 barrels per

day. At the turn of the century however as the best and most profitable uses for oil were

still being debated, India was seen not as a producer but as a market, most notably for

fuel oil for cooking. As the potential applications for oil shifted from domestic to

industrial and military usage this was no longer the case and apart from its small

domestic production India was largely ignored in terms of oil diplomacy and even

written off by some as hydrocarbon barren. Despite this however British colonial rule

laid down much of the country’s infrastructure, most notably the railways.

Independence, 1947-1991

After India won independence in 1947, the new government naturally wanted to move

away from the colonial experience which was regarded as exploitative. In terms of

economic policy this meant a far bigger role for the state. This resulted in a focus on

domestic industrial and agricultural production and consumption, a large public sector,

economic protectionism, and central economic planning.

The foreign companies continued to play a key role in the oil industry. Oil India

Limited was still a joint venture involving the Indian government and the British

owned Burma Oil Company(presently, BP) whilst the Indo-Stanvac Petroleum project in

West Bengal was between the Indian government and the American company SOCONY-

Vacuum (presently, ExxonMobil). This changed in 1956 when the government adopted

an industrial policy that placed oil as a “schedule A industry” and put its future

development in the hands of the state In October 1959 an Act of Parliament was passed

which gave the state owned Oil and Natural Gas Commission (ONGC) the powers to

plan, organise, and implement programmes for the development of oil resources and

the sale of petroleum products and also to perform plans sent down from central

government.

In order to find the expertise necessary to reach these goals foreign experts from West

Germany, Romania, the US, and the Soviet Union were brought in The Soviet experts

were the most influential and they drew up detailed plans for further oil exploration

which were to form part of the second five-year plan. India thus adopted the Soviet

model of economic development and the state continues to implement five-year plans

as part of its drive towards modernity. The increased focus on exploration resulted in

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the discovery of several new oil fields most notably the off-shore Bombay High field

which remains by a long margin India’s most productive well

Liberalization 1991-at present

The process of economic liberalisation in India began in 1991 when India defaulted on

her loans and asked for a $1.8 billion bailout from the IMF. This was a trickle-down

effect of the culmination of the cold war era; marked by the 1991 collapse of the Soviet

Union, India’s main trading partner. The bailout was done on the condition that the

government initiate further reforms, thus paving the way for India’s emergence as a free

market economy.

For the ONGC this meant being reorganised into a public limited company (it is now

called for Oil and Natural Gas Corporation) and around 2% of government held stocks

were sold off. Despite this however the government still plays a pivotal role and ONGC is

still responsible for 77% of oil and 81% of gas production while the Indian Oil

Corporation (IOC) owns most of the refineries putting it within the top 20 oil companies

in the world. The government also maintains subsidised prices. As a net importer of oil

however India faces the problem of meeting the energy demands for its rapidly

expanding population and economy and to this the ONGC has pursued drilling rights in

Iran and Kazakhstan and has acquired shares in exploration ventures in Indonesia,

Libya, Nigeria, and Sudan.

India’s choice of energy partners however, most notably Iran led to concerns radiating

from the US. A key issue today is the proposed gas pipeline that will run from

Turkmenistan to India through politically unstable Afghanistan and also through

Pakistan. However despite India’s strong economic links with Iran, India voted with the

US when Iran’s nuclear program was discussed by the International Atomic Energy

Agency although there are still very real differences between the two countries when it

comes to dealing with Iran

IOC, HPCL and HP

In the early 1990s, all roads virtually led to the Indian Oil Corporation, which was the

monarch of all it surveyed with half a dozen refineries in its portfolio. In contrast,

Hindustan Petroleum Corporation and Bharat Petroleum Corporation had only one

facility each in Mumbai (HPCL was also co-promoter of the three million tonne

Mangalore Refinery & Petrochemicals).

Madras Refineries, Cochin Refineries and the smaller Bongaigaon Refinery &

Petrochemicals were standalone entities processing petrol, diesel and LPG, but did not

have exclusive retail outlets. They depended on the Big Three to sell their products. On

the other hand, IBP was a standalone marketing entity whose job was to sell petrol and

diesel produced by these refiners.

It wasn’t exactly a level playing field which prompted Arthur D Little, a consultancy

firm, to suggest that IOC’s huge market share be reduced to ensure that other players in

the PSU space get a fair share of the pie.

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The international consultant had prepared an exhaustive report of India’s downstream

industry and mooted a merger of Madras Refineries and Cochin Refineries. A portion of

IOC’s market share (equivalent to the volumes it retailed on behalf of MRL and CRL),

could be set aside for this merged entity. This would include its retail outlets as well as

terminals and bottling plants.

Arthur D Little then proposed that IBP take over the marketing of BRPL’s products

(which was being done by IOC), akin to the MRL-CRL model, and get its share of retail

assets in the process. The report created quite a flutter in oil industry circles and,

perhaps, paved the way for a restructuring exercise some years later.

By this time, the Government had given its go-ahead to new refineries which its public

sector units would commission jointly with global players. While Oman Oil would team

up with HPCL and BPCL for two separate projects in Maharashtra and Madhya Pradesh,

Kuwait Petroleum Corporation would join hands with IOC for a coastal refinery in

Orissa.

Nobody reckoned with the delays that would accompany these ambitious projects.

HPCL called off its venture with Oman Oil because there were environmental concerns

in Ratnagiri — the proposed location for the refinery.

BPCL also faced similar issues in Bina which had attracted the attention of exploration

giant, Oil & Natural Gas Corporation keen on entering the fuels marketing arena. The

delays prompted Oman Oil to exit the project while a determined BPCL hung on.

Kuwait Petroleum’s participation in Paradip with IOC continued to be uncertain, and the

latter decided to go on its own. HPCL had in the meantimeopted for a new refinery in

Punjab in which big names such as Saudi Aramco and Exxon were keen to participate.

EXPERT COMMITTEES

It was also around this time in the mid to late-1990s that the Government set up expert

committees to look into the issue of freeing petrol, diesel and LPG prices which were

part of the subsidy basket. A panel headed by BPCL Chairman & Managing Director U.

Sundararajan submitted its report in 1995 and advocated complete deregulation of

prices.

It was quite a radical suggestion for a system where subsidies were the order the day.

The Government, of course, was in no hurry to implement these recommendations

because any dramatic price hikes would hit a section of society really hard. Yet, it was

beginning to realise that it made little sense not to revise prices when global prices were

heading upwards. The first signs of trouble were evident in 1997-98 when refiners were

strapped for cash and some like IOC resorted to short-term borrowings from the

wealthier ONGC.

There were other interesting dynamics panning out in the downstream space. The

Government decided that BPCL would now take charge of CRL while MRL and BRPL

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would go to IOC (which would eventually add IBP to its portfolio). This move put an end

to the problem of these standalone entities while ensuring additional capacity for BPCL.

Private players had also entered the landscape with Reliance commissioning its gigantic

refinery in Jamnagar, Gujarat. Essar Oil was also on course to getting its own facility

ready in the same State. The other big news concerned HPCL which refused to buy out

the stake of its partner, the AV Birla group keen on exiting MRPL. It was a costly

decision, something that the top management regrets even today because it resulted in

ONGC getting majority control of the refinery. HPCL’s stake was down to less than 20

per cent when it could have easily tilted the scales otherwise by paying virtually nothing

to take charge of a coastal facility.

ONGC could not have asked for a more cushy entry into the downstream space except

that its bosses in the Petroleum Ministry were categorical that it focused on its core

activity of exploration. It still has not been able to realise its vision of setting up a host of

retail outlets (under its brand name) across the country.

IOC and ONGC had, also around this time, explored the idea of coming together and

pooling their expertise in refining, marketing and exploration as well as getting into

new areas like power and petrochemicals. It was an ambitious partnership that

promised to deliver the moon except that practical realities were quite different. The

mega dream fell apart in some years with each company choosing to go on its own.

However, HPCL and BPCL had cause for cheer when their long overdue projects in

Punjab and Madhya Pradesh finally saw the light of day. The former got a strong partner

in the Lakshmi Mittal group, while Oman Oil wasted little time in heading back to the

Bina project with BPCL.

What was particularly impressive was that both refineries were commissioned at a time

when HPCL and BPCL were in the midst of a severe liquidity crunch. This was the time

crude prices had spiralled out of control and the oil companies had their backs to the

wall. Yet, they continued to invest because these refineries were critical to their growth

going forward especially in North India where their presence was little to write home

about.

IOC’s Paradip refinery is still some months away. It continues to be the largest player

but competition has become more intense. Private players like Reliance and Essar have

realised that marketing of fuels is a tough task when prices continue to be subsidised.

However, with petrol out of the administered pricing net and diesel rapidly following

suit, these companies are expected to be back in the local arena with a bang. Their

public sector rivals — IOC, BPCL and HPCL — are also gearing up for the challenge in

what promises to be a high voltage script in the coming years.

Refining capacity

From a little over 50 million tonnes in 1993, India’s refining capacity is now nearly 220

million tonnes. IOC leads the fray with 55 million tonnes with BPCL at 30 mt and HPCL

at 24 mt. Reliance has the single largest refining capacity of 62 mt with Essar at 20 mt.

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The next three years will see HPCL increase capacity at Visage and Bhatinda by nine mt

and BPCL following suit in Mumbai, Numaligarh, Bina and Kochi (14 mt). IOC will add

20 mt which will include a new refinery at Paradip, Orissa. Essar will see its capacity

increase by 18 mt, while MRPL will be up a tad at three mt. The 6 mt Nagarjuna Oil

refinery is also expected to be commissioned which means the country’s overall refining

capacity will be comfortably over 300 million tonnes by 2016.

Recessions and Oil Prices

It is worth noting that the three longest U.S. recessions since the Great Depression

coincided with exceptionally high oil prices. The first two lasted 16 months. The first

followed the 1973 Embargo started in November 1973 and the second in July 1981. The

latest began in December 2007 and lasted 18 months. Charts similar to the one at the

right have been used to argue that price spikes and high oil prices cause recessions.

There is little doubt that price is a major factor.

The same graph makes an even more compelling argument that recessions cause low oil

prices.

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Economics Oil Prices

Oil provides more than a third of the energy we use on the planet every day, more than

any other energy source. And you can draw a straight line between oil consumption and

gross-domestic- product growth. The more oil we burn, the faster the global economy

grows. On average over the last four decades, a 1 percent bump in world oil

consumption has led to a 2 percent increase in global GDP. That means if GDP increased

4 percent a year -- as it often did before the 2008 recession -- oil consumption was

increasing by 2 percent a year. At $20 a barrel, increasing annual oil consumption by 2

percent seems reasonable enough. At $100 a barrel, it becomes easier to see how a 2

percent increase in fuel consumption is enough to make an economy collapse.

Fortunately, the reverse is also true. When our economies stop growing, less oil is

needed. For example, after the big decline in 2008, global oil demand actually fell for the

first time since 1983. That’s why the best cure for high oil prices is high oil prices. When

prices rise to a level that causes an economic crash, lower prices inevitably follow. Over

the last four decades, every time oil prices have spiked, the global economy has entered

a recession.

When we consider the first oil shock, in 1973, when the Organization of Petroleum

Exporting Countries’ Arab members turned off the taps on roughly 8% of the world’s oil

supply by cutting shipments to the U.S. and other Israeli allies. Crude prices spiked, and

by 1974, real GDP in the U.S. had shrunk by 2.5%. The second OPEC oil shock happened

during Iran’s revolution and the subsequent war with Iraq. Disruptions to Iranian

production during the revolution sent crude prices higher, pushing the North American

economy into a recession for the first half of 1980. A few months later, Iran’s war with

Iraq shut off 6 percent of world oil production, sending North America into a double-dip

recession that began in the spring of 1981.

There are many ways an oil shock can hurt an economy. When prices spike, most of us

have little choice but to open our wallets. Paying more for oil means we have less cash

to spend on food, shelter, furniture, clothes, travel and pretty much anything else.

Expensive oil leaves a lot less money for the rest of the economy.

Worse, when oil prices go up, so does inflation. And when inflation goes up, central

banks respond by raising interest rates to keep prices in check. From 2004 to 2006, U.S.

energy inflation ran at 35 percent, according to the Consumer Price Index. In turn,

overall inflation, as measured by the CPI, accelerated from 1 percent to almost 6

percent. What happened next was a fivefold bump in interest rates that devastated the

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massively leveraged U.S. housing market. Higher rates popped the speculative housing

bubble, which brought down the global economy.

Triple-digit oil prices will end the lofty economic hopes of India and China, which are

looking to achieve the same sort of sustained growth that North America and Europe

enjoyed in the post-war era. There is an unavoidable obstacle that puts such ambitions

out of reach: Today’s oil isn’t flowing from the same places it did yesterday. More

importantly, it’s not flowing at the same cost.

Conventional oil production, the easy-to-get-at stuff from the Middle East or west Texas,

hasn’t increased in more than five years. And that’s with record crude prices giving

explorers all the incentive in the world to drill. According to the International Energy

Agency, conventional production has already peaked and is set to decline steadily over

the next few decades.

New reserves are being found all the time in new places. What the decline in

conventional production does mean, though, is that future economic growth will be

fueled by expensive oil from nonconventional sources such as the tar sands, offshore

wells in the deep waters of the world’s oceans and even oil shale’s, which come with

environmental costs that range from carbon-dioxide emissions to potential

groundwater contamination.

And even if new supplies are found, what matters to the economy is the cost of getting

that supply flowing. It’s not enough for the global energy industry simply to find new

caches of oil; the crude must be affordable. Triple-digit prices make it profitable to tap

ever-more-expensive sources of oil, but the prices needed to pull this crude out of the

ground will throw our economies right back into a recession.

What Affects Oil Supply?

OPEC is an organization of 12 oil-producing countries that produce 46% of the world's

oil. In 1960, they formed an alliance to regulate the supply, and to some extent, the price

of oil. These countries realized they had a non-renewable resource. If they competed

with each other, the price of oil would be so low that they would run out sooner than if

oil prices were higher.

OPEC's goal is to keep the price of oil at a stable price. A higher prices gives other

countries the incentive to drill new fields which are too expensive to open when prices

are low. The U.S. stores 700 million barrels of oil in the Strategic Petroleum Reserves. This

can be used to increase supply when necessary, such as after Hurricane Katrina. It is also

used to ward off the possibility of political threats from oil-producing nations.

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The U.S. also imports oil from non-OPEC member Mexico. This makes it less dependent

on OPEC oil. NAFTA is a free trade agreement that keeps the price of oil from Mexico

low, since it reduces trade tariffs.

What Affects Oil Demand?

The U.S. uses 21% of the world's oil. Two-thirds of this is for transportation. This is a

result of the country's vast network of Federal highways leading to suburbs built in the

1950s. This decentralization was in response to the threat of nuclear attack, which was

a great concern then. As a result, the country has not developed the infrastructure for a

national mass transit system. The European Union is the next biggest user, at 15% of the

world's oil production. China now uses 11%, as its use has grown rapidly.

What Else Affects Oil Price Futures?

Oil futures, or futures contracts, are agreements to buy or sell oil at a specific date in the

future at a specific price. Traders in oil futures bid on the price of oil based on what they

think the future price will be. They look at projected supply and demand to determine

the price. If traders think demand will increase because the global economy is growing,

they will drive up the price of oil. This can create high oil prices even when there is

plenty of supply on hand. That's known as an asset bubble. This happened in gold prices

during the summer of 2011. It happened in the stock market in 2007, and in housing in

2006. When the housing bubble burst, it led to the 2008 financial crisis.

How has oil prices behaved in recent decades?

The graph below shows the history of the price of oil since the early 1950s. The price

shown is the monthly average spot price of a barrel of West Texas intermediate crude

oil, measured in U.S. dollars. The gray bars in this and all the following figures represent

recessions, as defined by the National Bureau of Economic Research.

Spot Oil Price ($ Barrel)

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As it can be seen, a long period of oil price stability was interrupted in 1973. In fact, the

1970s show two distinct jumps in oil prices: one was triggered by the Yom Kippur War

in 1973, and one was prompted by the Iranian Revolution of 1979. Since then, oil prices

have regularly displayed volatility relative to the ’50s and ’60s.

The graph on the right shows the real oil price, calculated by dividing the price of oil by

the GDP deflator. This removes the effect of inflation and thus gives a more accurate

sense of what is happening to the price of the commodity itself. In essence, the “real”

measure allows you to compare oil prices over time in a way that you can’t when

inflation is also part of the change in price. You can see that real oil prices have varied a

lot over time, and large fluctuations tend to be concentrated over somewhat short

periods. You can also see that by the spring of 2008, as this posting was prepared, the

real price of oil has easily exceeded that of the late 1970s.

How closely is Oil Prices Tied to Economic Activity?

Recent developments in oil markets and the global economy have, once again, triggered

concerns about the impact of oil price shocks around the world. The economists have

started wondering whether the fuss is really necessary.

Increases in international oil prices over the past couple of years, explained partly by

strong growth in large emerging and developing economies, have raised concerns that

high oil prices could endanger the shaky recovery in advanced economies and small oil-

importing countries.

The notion that oil prices can have a macroeconomic impact is well accepted and the

debate has centered mainly on magnitude and transmission channels. Most studies have

focused on the US and other OECD economies. And much of the discussion has related to

the role of monetary policy, labour markets, and the intensity of oil in production.

The manner in which oil prices affect emerging and developing economies has received

surprisingly little attention compared with the large body of evidence for advanced

economies. The researchers have completely ignored the impact of oil prices and the

facts involved with it that characterize the relationship between oil prices and

macroeconomic aggregates across the

world.

The big picture

It is no surprise that import bills go up

when oil prices increase. It is more

surprising that GDP often goes up too.

The graph below depicts the

correlation between oil prices and GDP

for 144 countries from 1970 to 2010.

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More precisely, it shows the cyclical components of oil prices and GDP, with long-term

trends excluded. The set includes 19 oil-exporting countries, represented by red bars,

and 125 oil-importing countries, represented by blue bars. A positive correlation

indicates that when oil prices go up, GDP goes up, and when oil prices go down, GDP

goes down. Through this, we can say that in more than 80% of the countries, the

correlation between oil prices and GDP is positive, and in only two advanced economies

– the United States of America and Japan – it is negative. One of the main contributing

factors to this pattern is that in 90% of these countries, exports tend to move in the

same direction as oil prices.

Anatomy of oil shock episodes

Given that periods of high oil prices have generally coincided with good times for the

world economy, especially in recent years, it is important to disentangle the impact of

oil price increases on economic activity during episodes of markedly high oil prices.

There have been 12 episodes since 1970 in which oil prices have reached three-year

highs. The median increase in oil prices in these years was 27%. During this period,

there is no evidence of a widespread contemporaneous negative effect on economic

output across oil-importing countries, but rather value and volume increases in both

imports and exports. It is only in the year after the shock that negative impact on output

for a small majority of countries was found. (In the graph, we can see the Real GDP

growth in oil shock episodes less median growth from 1970-2010)

Small effects for oil importers

Taking into account the fact that higher oil prices are generally positively associated

with good global conditions, studies have shown that the effect becomes larger and

more significant as the ratio of oil imports to GDP increases.

To trace out the full impact of an oil shock, the below graph which gives the results

indicate that the typical oil importer can expect a cumulative GDP loss of about 0.3%

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over the first two years,

with little subsequent

impact. For countries with

oil imports of more than

4% of GDP (i.e., at or above

the average for middle-

and low-income oil

importers), however, the

loss increases to about

0.8% – and this loss

increases further for those

with oil imports above 5%

of GDP. In contrast to the

oil importers, oil exporters

show little impact on GDP in the first two years but then a substantial increase

consistent with the positive income effect, with real GDP 0.6% higher three years after

the initial shock.

To put these numbers in perspective, it is useful to think of an economy where oil

accounts for 4% of total expenditure and where aggregate spending is determined

entirely by demand. If the quantity of oil consumption remains unchanged, then a 25%

increase in the price of oil will cause spending on other items to decrease and, hence,

real GDP to contract by 1% of the total. From this reference point, one would expect the

possibility of substituting away from oil to reduce the overall impact on GDP. At the

same time, there could also be factors working in the opposite direction, via, for

example, confidence effects, market frictions, or changes in monetary policy. With our

estimates of the GDP loss at only about half the level implied by the direct price effect on

the import bill, the results presented here suggest the size of any such magnifying

effects, if present, is not substantial across countries.

Are oil price increases really that bad?

Conventionally, the researchers have it that oil shocks are bad for oil-importing

countries. It is also consistent with the large body of research on the impact of higher oil

prices on the US economy, although the magnitude and channels of the effect are still

being debated. Recent research indicates that oil prices tend to be surprisingly closely

associated with good times for the global economy. Indeed, we find that the US has been

somewhat of an outlier in the way that it has been negatively affected by oil price

increases. Across the world, oil price shock episodes have generally not been associated

with a contemporaneous decline in output but, rather, with increases in both imports

and exports. There is evidence of lagged negative effects on output, particularly for

OECD economies, but the magnitude has typically been small.

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Controlling for global economic conditions, and thus abstracting from the findings that

oil price increases generally appear to be demand-driven, makes the impact of higher oil

prices stand out more clearly. For a given level of world GDP, it is found that oil prices

have a negative effect on oil-importing countries and also that cross-country differences

in the magnitude of the impact depend to a large extent on the relative magnitude of oil

imports. The effect is still not particularly large, however, with our estimates suggesting

that a 25% increase in oil prices will typically cause a loss of real GDP in oil-importing

countries of less than half of 1%; spread over 2 to 3 years. These findings suggest that

the higher import demand in oil-exporting countries resulting from oil price increases

has an important contemporaneous offsetting effect on economic activity in the rest of

the world, and that the adverse consequences are mostly relatively mild and occur with

a lag.

The fact that the negative impact of higher oil prices has generally been quite small does

not mean that the effect can be ignored. Some countries have clearly been negatively

affected by high oil prices. Moreover, it cannot be ruled out that more adverse effects

from a future shock that is driven more by lower oil supply than the more demand-

driven increases in oil prices that have been the norm over the past two decades. In

terms of policy lessons, our findings suggest that efforts to reduce dependence on oil

could help reduce the exposure to oil price shocks and hence costs associated with

macroeconomic volatility. At the same time, given a certain level of oil imports,

strengthening economic linkages to oil exporters could also work as a natural shock

absorber.

How High Oil Prices Will Permanently Cap Economic Growth ?

For most of the last century, cheap oil powered global economic growth. But in the last

decade, the price of oil has quadrupled, and that shift will permanently shackle the

growth potential of the world’s economies. The countries guzzling the most oil are

taking the biggest hits to potential economic growth. That’s sobering news for the U.S.,

which consumes almost a fifth of the oil used in the world every day. Not long ago, when

oil was $20 a barrel, the U.S. was the locomotive of global economic growth; the federal

government was running budget surpluses; the jobless rate at the beginning of the last

decade was at a 40-year low. Now, growth is stalled, the deficit is more than $1 trillion

and almost 13 million Americans are unemployed.

And the U.S. isn’t the only country getting squeezed. From Europe to Japan,

governments are struggling to restore growth. But the economic remedies being used

are doing more harm than good, based as they are on a fundamental belief that

economic growth can return to its former strength. Central bankers and policy makers

have failed to fully recognize the suffocating impact of $100-a-barrel oil. Running huge

budget deficits and keeping borrowing costs at record lows are only compounding

current problems. These policies cannot be long-term substitutes for cheap oil because

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an economy can’t grow if it can no longer afford to burn the fuel on which it runs. The

end of growth means governments will need to radically change how economies are

managed. Fiscal and monetary policies need to be recalibrated to account for slower

potential growth rates.

How do high oil prices affect the economy on a “micro” level?

As a consumer, it can be understood the microeconomic implications of higher oil

prices. When observing higher oil prices, most of us are likely to think about the price of

gasoline as well, since gasoline purchases are necessary for most households. When

gasoline prices increase, a larger share of households’ budgets is likely to be spent on it,

which leaves less to spend on other goods and services. The same goes for businesses

whose goods must be shipped from place to place or that use fuel as a major input (such

as the airline industry). Higher oil prices tend to make production more expensive for

businesses, just as they make it more expensive for households to do the things they

normally do. It turns out that oil and gasoline prices are indeed very closely related. So,

when oil prices spike, you can expect gasoline prices to spike as well, and that affects

the costs faced by the vast majority of households and businesses.

Is the relationship between oil prices and the economy always the

same?

The two aforementioned large oil shocks of the 1970s were characterized by low

growth, high unemployment, and high inflation (also often referred to as periods of

stagflation). It is no wonder that changes in oil prices have been viewed as an important

source of economic fluctuations. However, in the past decade research has challenged

this conventional wisdom about the relationship between oil prices and the economy.

As Blanchard and Gali (2007) note, the late 1990s and early 2000s were periods of large

oil price fluctuations, which were comparable in magnitude to the oil shocks of the

1970s. However, these later oil shocks did not cause considerable fluctuations in

inflation, real GDP growth or the unemployment rate.

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A caveat is in order, however, because simply observing the movements of inflation and

growth around oil shocks may be misleading. Keep in mind that oil shocks have often

coincided with other economic shocks. In the 1970s, there were large increases in

commodity prices, which intensified the effects on inflation and growth. On the other

hand, the early 2000s were a period of high productivity growth, which offset the effect

of oil prices on inflation and growth. Therefore, to determine whether the relationship

between oil prices and other variables has truly changed over time, one must go beyond

casual observations and appeal to econometric analysis (which allows researchers to

control for other developments in the economy when studying the link between oil

prices and key macroeconomic variables).

Formal studies find evidence that the link between oil prices and the macro economy

has indeed deteriorated over time. For example, Hooker (2002) suggests that the

structural break in the relationship between inflation and oil prices occurred at the end

of 1980s. Blanchard and Gali (2007) look at the responses of prices, wage inflation,

output, and employment to oil shocks. They too find that the responses of all these

variables to oil shocks have become muted since the mid-1980s.

Why might the relationship between oil prices and key mac roeconomic

variables have weakened?

Economists have offered some potential explanations behind the weakening link

between oil prices and inflation. Gregory Mankiw suggests increases in energy

efficiency as one explanation. Indeed, as shown in the graph, energy consumption per

dollar of GDP has gone down steadily over time. This means that energy prices matter

less today than they did in the past. It’s also found that increased flexibility in labor

markets, monetary policy improvements, and a bit of good luck (meaning the lack of

concurrent adverse shocks) have also contributed to the decline of the impact of oil

shocks on the economy.

Finally, how monetary policymakers treated the economic shocks caused by rising oil

prices also may have played a role in the impact of the shocks on economic growth and

the inflation rate. Specifically, some have argued policymakers tended to worry more

about output than inflation during the oil shocks of 1970s and did not adequately take

into account the inflationary aspect of the oil shocks when fashioning a policy response

to them. In the case of the U.S., since households and firms sensed that the Fed was not

going to pay a lot of attention to inflation, they probably realized that the oil shocks

would lead to substantially higher future inflation and adjusted their expectations

accordingly. By contrast, the Fed in the 2000s is more committed to fighting inflation,

the public knows it, and the result has been that, even though headline inflation has

risen noticeably because of the direct effects of oil and commodity shocks, core inflation

and inflation expectations remain contained.

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The lack of major output effects of oil price shocks

since the 1970s calls into question what role they

played during the two recessions of that period. In

other words, one possible reason why oil shocks

seem to have noticeably smaller effects on output

now than they did in the 1970s is that the world

has changed. Another is that the effects of oil

shocks were never as large as conventional wisdom

hold, and that the slow growth of that decade had

to do with other factors.

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Policy Making with Oil Prices

The US Federal Reserve did not cause the recessions of the 1970s and early 1980s by

raising interest rates in response to unexpectedly higher oil prices. Moreover, the oil

price ‘shocks’ contributed comparatively little to the output and inflation swings of

those decades. These are among the conclusions of research by Professor Lutz Kilian

and Logan Lewis, published in the September 2011 issue of the Economic Journal.

The researchers note that the effects of monetary policy responses to oil price shocks in

the 1970s and early 1980s should not be only of interest to economic historians. The

issue is central in modern day analysis of the transmission of oil price shocks, with some

observers suggesting that the Fed may have been too passive in dealing with the drivers

of high asset and oil prices after 2005.

What’s more, as the world economy recovers from the crisis, the question of how to

respond to higher oil prices is likely to take on a new urgency. In a policy environment

that resembles the beginning of the 1970s, understanding the monetary policy regimes

of that era – to what extent they were successful and to what extent they can be

improved – is crucial for monetary policy-makers.

Oil prices since 1970 have been volatile and the subject of both media and academic

attention. But while they are important for businesses and consumers alike, even large

oil price swings on their own are unable to generate major booms and busts in the

overall economy.

This led some economists to propose that in addition to the direct effect of oil price

increases, the Fed might raise interest rates to fight the inflationary effects of oil price

shocks. This policy reaction would amplify the direct effects of the oil price increases –

and together these effects would cause a recession.

Kilian and Lewis show that the evidence for this channel rests largely on using only oil

price increases, rather than both increases and decreases in the price of oil. By ignoring

oil price decreases, the statistical estimate of the effects of unexpected changes in oil

prices is overstated. Without this questionable transformation, their research shows, oil

price shocks did not significantly contribute to the inflation and output movements of

the 1970s and early 1980s, even when the monetary policy response is included.

Monetary policy responds to many economic variables, most notably inflation and real

economic activity. Kilian and Lewis estimate and decompose the response to an

unexpected 10% increase in the real price of oil. They find that the overall Fed Funds

rate rises about 0.6% after six months.

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Most of this response is directly triggered by the oil price increase itself, indicating that

the Fed was indeed responding to oil price shocks. But relative to other shocks in the

economy, these oil price shocks are too small to cause the booms and busts seen in past

decades, and the monetary policy response does not substantially amplify these effects.

Moreover, Kilian and Lewis caution that all oil price changes are not alike. Some are

caused by supply disruptions, including wars and decisions by OPEC. Others are the

result of shifts in worldwide demand for energy, undermining the rationale for a

mechanical policy response to oil price shocks.

In addition, there is evidence that the monetary policy response to oil price shocks has

changed since the 1980s. Future models of oil and monetary policy should analyse the

underlying sources of oil price changes, with monetary policy responding to those

causes rather than the resulting price effects.

The debate over the impact of quantitative easing by major central banks has again

intensified, especially following the announcement of another round of quantitative

easing by the US Federal Reserve on 13 September 2012. Some commentators have

argued that, in a world in which commodities constitute an asset class, there ought to be

a positive relationship between quantitative easing and commodity prices via ‘portfolio

effects’– even if quantitative easing does not affect the demand or the supply of physical

oil.

There is scant empirical evidence, however, to support the claim that financial

investment in commodities affected commodity prices. Other commentators therefore

point instead to the positive correlation between the Fed’s Treasury-bond purchases

and oil prices as evidence that quantitative easing is pushing commodity prices higher.

Yet, the only observable positive correlation between bond purchases and oil prices

coincided with the recovery of global economic activity in early 2009, when the latter

led to an increase in the demand for oil. Therefore, it is in all likelihood misleading to

argue that quantitative easing pushes commodity prices higher by just looking at such

short-term correlations.

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Monetary policy, of course, does have the potential to affect commodity prices.

However, it is important to understand the transmission mechanism of how

quantitative easing could affect commodity prices. The physical oil market is a highly

competitive market, with physical prices determined by supply and demand. Hence, to

impact energy prices, quantitative easing must impact physical supply or demand.

Expansionary monetary policy can change physical supply and demand of commodities,

including oil, through several channels. One such channel is through expectations of

higher inflation or strong growth. Still, if market participants interpret announcements

of quantitative easing instead as signalling more problems in terms of lower growth

prospects or more risk, then an announcement of quantitative easing might easily lead

to a fall (rather than a rise) in prices. A second mechanism is through the interest rate

channel. Low interest rates due to expansionary monetary policy may increase prices of

storable commodities: by reducing the opportunity cost of carrying inventories, thereby

increasing inventory demand; by reducing the cost of holding reserves underground,

thereby decreasing oil supply; and by increasing the demand for oil in non-dollar

economies, whose prices are denominated in a now weakened dollar.

Empirical evidence on the impact of quantitative easing on oil prices is so far mixed. On

the one hand, Kilian (2009a, 2009b) argues that the only episodes in which monetary

policy regime shifts caused major oil price increases dated back to the 1970s. He argued

that increases in global liquidity in the early and mid-1970s fostered a global output

boom and surge in inflation, thereby driving up the prices of oil and other industrial

commodities. Kilian further argues that it would take concerted regime shifts in many

countries to exert enough demand pressure to drive global commodity prices. However,

his analysis does not look into the period after 2008, where we observed the

widespread introduction of unconventional monetary-policy measures by major central

banks. On the other hand, Anzuini, Lombardi and Pagano (2012) find that conventional

monetary policy (associated with a change in the short-term interest rate) had a limited

effect on the oil price surge between 2003 and 2008 and that those effects were tied to

the expected growth and inflation channels. However, their analysis also did not

provide any evidence for the impact of unconventional monetary policy (associated

with forward policy guidance and large-scale asset purchases) on commodity prices.

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Still, they suggest that the extraordinary monetary policy easing at a time when the

lower bound on the interest rate has already been reached might push prices up, albeit

to a small extent.

There are very few empirical studies of whether unconventional monetary policies have

any effect on commodity prices. Glick and Leduc (2011), using an event study

methodology, find that commodity prices tend to fall following the announcement of

such policy measures. However, their analysis only covers 11 observations, which

precludes drawing conclusions at any conventional level of statistical significance.

Some anecdotal evidence regarding the effects of unconventional monetary expansion

on commodity prices can be gleaned by looking at the impact of monetary easing on

inflation expectations, interest rates, and aggregate economic activity. We find a strong

positive correlation between oil prices and expected inflation, measured by the

difference between the interest rate on ordinary ten-year government debt and ten-

year inflation-protected Treasury debt. Expected inflation surged following the

announcement of the first two rounds of quantitative easing, but started to fall while

QE1 and QE2 were still in progress, though it is worth noting that the decline in

expected inflation would likely have been higher without the asset purchase. Several

extant papers find that QE1 and QE2 increased the ten-year expected inflation by a

range of 0.96-1.5% and 0.05-0.16%, respectively (see, e.g., Krishnamurthy and Vissing-

Jorgensen (2011) and Farmer (2012)). It seems that QE1 had a bigger impact than QE2

in terms of affecting expected inflation – although it is important to note that QE1 was

implemented when expected inflation was close to zero.

The empirical research to date shows that the Fed’s large-scale asset purchases lowered

the ten-year interest rate. Point estimates vary between 13-100 basis points, however,

with most estimates between 15-20 basis points – see, e.g., Hamilton and Wu (2011)

and Williams (2011).

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While related research papers also find some minor positive impact on GDP and

employment, it is very difficult to identify and measure the effect of quantitative easing

on real economic activity due to the response time of the latter as well as difficulties in

separating the effect of the Fed’s action from other factors affecting aggregate demand.

Hence, these extant estimates at the most suggest that oil prices might have been

affected by quantitative easing, but the extent of the impact might be very limited – as

suggested also by Anzuini, Lombardi and Pagano (2012).

The impact of the latest round of quantitative easing on oil prices will again be

determined by its effect on inflationary expectations and aggregate demand. Although

expected inflation rose from 2.38% to 2.64% on the day following QE3’s announcement,

it had fallen by 0.14% (to 2.50%) as of 20 September 2012. At the same time, WTI

prices declined from $98/bbl to $92/bbl. One interpretation is that oil market

participants may have seen the latest round of quantitative easing as a sign of worse-

than-originally-perceived conditions of the economy in the coming months. Put

differently, it is still too early to make any predictions on the possible impact of the

recent quantitative easing on commodity prices.

Inflation rates are rising in the world's major economies. The consumer price index rose

by half a percent in the United States in February, equivalent to an annual rate of 6.2

percent. Consumer prices rose at a 4.4 percent annual rate in the UK and a 2.4 percent

rate in the euro area. All three central banks have explicit or implicit inflation targets of

2 percent or less.

In all three economies, rising oil prices accounted for a big part of the increase of

inflation. That fact poses a dilemma for monetary policy. Should central banks tighten

monetary policy to counteract the effects of oil price increases and prevent general

inflation? Or should they instead accommodate oil price increases with easy monetary

policy, in order to maintain growth of output and employment? Two problems make the

choice a difficult one.

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The first problem is that nothing central bankers can do, will prevent an increase in

world oil prices from harming an oil-importing economy. It must either be left with

fewer other goods and services after paying for the oil it imports, or learn to live with

less oil, or go deeper in debt, or do a little of each. Monetary policy, at best, can only

determine what form the damage takes.

The second problem is that central banks have little direct control over the real

economy, as manifested in variables like real GDP and employment. By and large,

monetary policy can only control the growth of nominal GDP. If it applies its policy

instruments correctly, a central bank could, for example, cause nominal GDP to grow at

four percent per year rather than 0 percent per year. However, it cannot do much to

determine whether that four percent nominal growth will consist of 4 percent greater

output of real goods and services, without inflation; 4 percent inflation without growth

of real output; or some combination of inflation and real output change that adds up to

four percent.

Putting these two problems together leaves the central bank of an importing country

with limited options when an oil price shock hits:

1. It can tighten policy to keep inflation from rising. Doing so will cause real GDP to

decrease, or at least to lag behind the growth of potential real GDP. The resulting

negative output gap will cause the unemployment rate to increase.

2. It can use expansionary monetary policy to try to offset the impact of oil prices

on real output and employment. However, doing so will cause nominal GDP to

grow faster. Given the negative impact of the oil shock on real GDP, inflation will

accelerate.

3. It can compromise by doing nothing, that is, hold the rate of growth of nominal

GDP to its previous path, despite the oil price shock. The result will be

intermediate between Cases 1 and 2, that is, there will be some increase both in

inflation and unemployment.

None of these options is completely satisfactory. None of them fully neutralizes the

harm done by the oil price increase. The choice among them depends on the phase of

the business cycle at the time oil prices spike, the preferences of the monetary

authorities,the legal framework they work in, and the need to coordinate monetary

policy with fiscal policy. Those factors play out somewhat differently for the central

banks of the United States, the UK, and the EU, so we should expect different policy

decisions.

The situation in the UK is shaped by the aggressive program of austerity being followed

by the Conservative-Liberal Democrat coalition government that was elected last year.

The program proposes reducing government spending by nearly a fifth and cutting half

a million government jobs. Austerity is not limited to cuts in discretionary spending.

There are cuts to entitlements, including a scheduled increase in the retirement age,

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cuts to a health-care system that is already relatively austere by European standards,

decreases in defense spending, and tax increases.

A case can be made for the UK's austerity program, considering that the budget deficit in

2010 was among the largest of all developed economies. However, it came at a time

when the British economy was just beginning to recover from recession. In the fourth

quarter of 2010, real GDP actually decreased. That left monetary policy with the burden

of preventing a full-blown double-dip recession. The Bank of England, which had

already lowered its main policy interest rate to 0.5 percent, undertook further

expansionary policy with a program of quantitative easing. The combination of low

interest rates and QE was expected to restore real GDP growth in 2011, but only at 1.7

percent, not enough to keep up with the growth of potential GDP.

Given the circumstances, the Bank of England, so far, has opted for accommodation.

Despite January and February inflation more than twice the bank's target rate of 2

percent, six of the nine members of its rate setting committee voted to keep rates low at

their most recent meeting. To try aggressively to bring down inflation at this point

would not only undermine already-weak economic growth, but would also risk failure

for the fiscal austerity plan itself, which depends for its success on a growing tax base

and a falling unemployment rate.

In the euro area, circumstances would also appear to favor accommodating the oil

shock, or at least taking a neutral stance. Real output growth in the euro area, as in the

UK, is expected to be weak this year, just 1.6 percent. Inflation in February was less than

half a percent above the 2% target rate, a smaller overshoot than in the United States or

the UK. The ECB's policy interest rate, unlike those in the UK and the United States, was

never cut below 1 percent. Several euro area economies, notably Greece, Ireland, and

Portugal, are in the midst of stringent fiscal austerity programs, which could be derailed

by a tightening of monetary policy.

Nonetheless, it appears that the ECB will soon raise interest rates. One reason is the

uneven pace of euro area growth. Although peripheral members of the euro are

struggling, growth in the core economies of Germany and France is strong. More

importantly, the ECB is more inflation averse than the Fed or the Bank of England. The

treaty that brought the ECB into existence gives the central bank a strong mandate to

focus single-mindedly on inflation. Willingness to take that mandate seriously has been

a litmus test for appointments to its executive board.

As one token of its hard-line approach to inflation-fighting, the ECB focuses exclusively

on headline inflation, which includes all goods and services. Other central banks pay

more attention to core inflation, which excludes volatile food and energy prices, and is

currently running well below headline inflation. As a result, the ECB's official inflation

40 | P a g e

target of 2 percent, although nominally on a par with those of the United States and the

UK, is effectively more stringent.

Also, the ECB appears to give more weight to the issue of credibility. It seems to fear

that the slightest sign of weakness would call its inflation-fighting credentials into

doubt. Policy makers at all three central banks would agree, in principle, that credibility

is important. None of them want to see the emergence of long-term inflationary

expectations on the part of firms and households. However, the Fed and the Bank of

England are more willing to gamble on public understanding that any present

departures from strict inflation targeting are driven by circumstances, and do not justify

an increase in long-run inflation expectations.

Last, we come to the Fed. In some ways, the case for accommodation seems weaker in

the United States than in the UK or the euro area. US GDP growth in the fourth quarter

of 2010, at a revised 3.1%, was stronger than in the UK or the euro area, and forecasts

for 2011 growth, running at 3% or better, are also higher. January and February

inflation, as measured by the month-to-month increase in the headline CPI, was the

most rapid of the three economies. The Fed's policy interest rate, set at a range of 0 to

0.25 percent, was the lowest of the three. Finally, as in England, the Fed had gone

beyond low interest rates to engage in a vigorous program of quantitative easing.

What is more, the Fed, unlike the Bank of England, does not face the need to maintain

easy monetary policy as an offset to tight fiscal policy. On the contrary, US fiscal policy,

especially after December's new round of tax cuts, remains strongly expansionary.

Neither the administration's budget, nor any actions taken to date by Congress, comes

close to dealing seriously with a budget deficit that continues at record levels.

Yet, despite these circumstances, the Fed seems least likely of any of the big three

central banks to tighten its policy in response to rising oil prices. As in the case of the

ECB, both legal and attitudinal factors come into play. Unlike the ECB, the Fed, by law, is

tasked with balancing price stability against the need to fight unemployment, which

remains very high. Also, the Fed, more than other central banks, focuses on core

inflation, and on measures of expected inflation, neither of which is rising as rapidly as

the headline CPI.

Unless some strong indications of higher inflation emerge, for example, a sharp increase

in long-term interest rates, it seems almost certain that the Fed will keep interest rates

low and carry its current program of quantitative easing through to its scheduled

completion in June. At that point, if oil prices are still on an upward trajectory, if

Congress has still done nothing about the deficit, and if there are signs that headline

price increases are spilling through into core inflation and indicators of expectations, a

turn to a less accommodative policy becomes likely.

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permanently-cap-economic-growth.html

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