The tale behind rise in oil prices

China, India and the United States are the most affected by the rising oil prices. (AFP)

The rise in the price of oil has many reasons attached to it and each one has been so backed by flawless statistics that we are persuaded to believe there is probably no reason for crude prices to recede.

The world has – painfully – started to realise how the scenario has started to erode its earnings, and erode pretty quickly at that.

As the oil market applauds and leaps on every bullish report of oil being released to the market, most economies are going at least three steps back, and that is harmful for oil as a long-term trend.

The most affected are the major consumers of oil such as China, India, the US, etc. Studies point out that a $10 increase in the crude oil price reduces India's GDP growth by about 0.3-0.5 percentage points and increases the consumer price index (inflation) by at least 1.2 percentage points.

The US based Energy Information Agency estimates that a sustained 10 per cent increase in the price of oil results in a loss of real US GDP in the range of 0.05 to 0.1 per cent. And so is the case with the emerging economies.

Most of these reasons, on which analysts have achieved consensus – be it Iran's stubbornness on nuclear issues, Nigerian militant attacks, refinery bottlenecks in the United States, speculative fund flow or the dollar's weakness – surprisingly ignores the possible drop in demand for oil on account of this astronomical price rise. The basics of economic laws are applicable to crude oil, too, ie demand is inversely proportional to price.

True, oil price is highly inelastic: even a substantial increase in price does not alter the consumption pattern. To put this more clearly, lack of direct alternatives force us to continue to consume oil irrespective of the price rise. But will this continue to remain so?

Recent reports from the International Energy Agency (IEA), the adviser to 27 industrialised economies, reveals that global oil demand will rise at its slowest pace in six years during 2008. In its monthly oil report, IEA detailed that global consumption will rise by only 800,000 barrels per day (bpd) this year, 230,000 bpd less than its previous forecast.

On similar lines Energy Information Administration (EIA), in its June 2008 report, revealed that global oil consumption is projected to grow by only one million bpd in 2008. Though this is higher than IEA figures (by 200,000 bpd) at the global level, the decline in the US is most important in the EIA's data. US consumption of liquid fuels and other petroleum is expected to decline by about 290,000 bpd in 2008 because of higher petroleum prices and slower economic growth. Adjusting for increased ethanol use, US petroleum consumption is projected to fall by 440,000 bpd in 2008.

A recent public poll by US-based Ipsos Public Affairs revealed that when gas hits $4 a gallon 74 per cent of Americans change driving habits, while hitting $5 a gallon forces 85 per cent of Americans to change driving habits.

That's not all. Many workers and executives in industrial nations are reported to be shifting to four-day weeks to save gasoline. The idea is that by allowing employees to work four 10-hour days, it will save them 20 per cent on their commuting costs and ease the financial pinch of filling up their cars. Greater utilisation of public transport, car-pooling and other travelling methods are on the increase globally. The trend may soon percolate to other nations if prices continue to remain firm.

Most oil bulls are betting the surge in demand on Asian economies, which could negate the possible demand drop from the developed world, especially the US. But it is a must to remember that the Asian economies are more price-sensitive than the western developed world. Changes in consumption and living habits in emerging economies are swifter.

The sharp unidirectional price rise is also detrimental to the oil producing nations as it might force consumers to shift to alternative energy sources such as bio-fuels or electric/battery driven vehicles.

The perfect example is Brazil, where more than 80-85 per cent of cars have flexi-fuel engines – which can use either petrol or alcohol, or a combination of the two. This south-American nation has substantially reduced its dependence on imported oil in this process. The US, China, India, Japan, and the European Union countries are steadily attempting to duplicate the Brazilian model to reduce the impact of oil on their economies.

In a nutshell, it seems what's going on now is simple bidding and not necessarily smart or intelligent investing; there is a lot of money chasing the liquid commodities and crude oil has unfortunately caught the eyes of speculators. Their bull faith has been well rewarded until now and there is evidence that the trend could spring further spikes. But sustainability would be the key issue from here on.

It is pivotal to remember that, just like the rally, any crash from here on could also be equally brutal and one-sided. Often the force of gravity is stronger and the markets have a tendency to fall on their weights.

'Returning to mean averages' on a timely basis is the special attribute of every commodity and oil is not immune to this. This does not mean an end of the bull run in commodities or oil once and for all, but in the near term there could be reversals leading to a more balanced global growth.

The author is assistant vice-president of research and trading at Vision Commodities.