May 17, 2013

The strange dynamics of energy pricing

The price of natural gas, coal and biomass is somehow correlated with the international price of oil which in turn is manipulated by a few countries.

The rise in Brent price of crude oil from $22-28 a barrel in the year 2000, to a peak of $145 in 2008 was attributed to many factors – increased demand from developing countries like China and India, higher cost of production due to “peak oil” phenomenon, political instability in the Middle East, etc. Today, with reports of plentiful availability and supplies from different parts of the world, and no evidence of peaking of oil, the trend should have reversed and oil price cooled off considerably. This has not happened and oil price continues to rule in the range of USD 100-120 a barrel.  The question to be asked is, why?


As Bloomberg News reported recently, quoting a senior consultant at the Arab Petroleum Investments Corp (Apicorp), “Oil prices must average $99 this year for the 12 members of the Organization of Petroleum Exporting Countries to be able to balance their national budgets. Saudi Arabia, OPEC’s largest producer, needs an average price of $94 to balance its budget, according to Apicorp estimates. Iran requires oil at $125 to break even, or almost double the level needed by Qatar. The break-even level represents the price sought by the government, not the actual cost of producing oil.” If price falls close to break-even level, OPEC countries will need to cut down on production to shore up the prices.

The Union Budget of India, for the financial year 2013-14, assumes an annual average price of $110 a barrel while making allocation for the petroleum subsidies. This is realistic and is indexed to the price budgeted by OPEC with the transportation costs added on.

Why must OPEC control the price at a high level? Apart from the obvious profit motive, there are other reasons. In an interesting piece titled “The first law of petropolitics” written in 2006, Thomas Friedman had posited that there was an inverse correlation between crude oil price and democratic freedom. Quoting Michael L Ross, a political scientist at UCLA, he wrote, “Oil-rich governments tend to use their revenues to relieve social pressures that might otherwise lead to demands for greater accountability from, or representation in, the governing authority… When oil revenues provide an authoritarian state with a cash windfall, the government can use its newfound wealth to prevent independent social groups — precisely those most inclined to demand political rights — from forming. A massive influx of oil wealth can diminish social pressures for occupational specialisation, urbanisation, and the securing of higher levels of education — trends that normally accompany broad economic development and that also produce a public that is more articulate, better able to organise, bargain, and communicate, and endowed with economic power centers of its own.” So, from the standpoint of the OPEC rulers, it would be suicidal to let the oil prices fall as it could lead to erosion of their authority.

What about the price of natural gas? Though the production is distributed over a wider geography than in the case of oil, the price of gas, especially in the Asian market, closely follows the price of oil. Why should this be so? Although oil-derived products and gas are not readily fungible, there are many applications where either could be used. For example, fertiliser plants that use naphtha as feedstock could change over easily to natural gas. Metal melting furnaces that burn oil could switch to gas. LNG imported into India tends to follow the 6-to-1 rule. The gas price in $/MMBTU is around one-sixth the price of a barrel of crude oil. If crude is at $100 a barrel, gas price hovers around $16-17/MMBTU.

The price of the other major source of primary energy — coal — should be independent of crude oil price but, in reality, it is not. While India has adequate domestic reserves of coal, for a variety of reasons, the production does not keep pace with demand. We need to import about 30 percent of our coal needs — and this percentage is expected to increase in the future. Unlike in the case of oil, there is no cartel, and the pricing can be based purely on fundamentals of supply and demand. But coal traders keep track of oil pricing as it provides them a good sense of the willingness of the user to pay a higher cost. This gives them the cue to increase the coal price. Thus, when oil prices rose from 2005 to 2008, thermal coal prices also went up by 300 percent, before some sanity was restored.

Even suppliers and aggregators of biomass for boilers stay tuned to the oil price. Biomass is a cheaper alternative to furnace oil or gas, and when the price of oil increases, an arbitrage opportunity is immediately sensed. Cost of woody biomass has gone up in the last few years from an average of Rs 800-1000/ton to Rs 2500-3000/ton, mimicking the increase in oil price .

Clearly, whatever is the form of energy, there is some correlation with the price of oil which, in turn is manipulated by a few countries. When India imports 80 percent of its oil and has no control whatsoever over the pricing, the only sensible thing that it can do is pass on the burden to all the users, instead of trying to under-recover the costs or extend unsustainable subsidies. The gradual increase in the price of diesel was a good move. The under-recovery has come down from Rs 10-12/litre to Rs 3-4/litre in the last few months. Similarly, the decision to allow Adani Power and Tata Power to pass on the coal price increase to the distribution companies and its consumers is to be welcomed. This violates the fixed-price stipulation in the contracts and can be viewed as a mockery of the bidding process, but it is sensible to recognise the impracticality of the clause and move on, rather than allowing the power plants built at huge cost to be closed down due to unviable pricing. Energy management requires a pragmatic approach and not a dogmatic one.

Photo: José Luís Agapito 

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