Anatomy of the fall

It is simplistic to assume that oil prices are sliding only because of falling
demand. The reality is that the plunge is due to a complex interplay of
several factors, including, of course, lower demand.

The inability, or unwillingness rather, of the Organisation of Petroleum

Exporting Countries (OPEC), which accounts for about 40 per cent of global oil
output, to cut production to match the demand is a major factor.

OPEC members are caught in a difficult spot as cutting down production will
mean loss of revenue. They are also conscious about holding on to their
market shares; cutting output will mean a loss of market share, especially if
the U.S. shale gas producers continue to pump away. Yet, every barrel that
they are unable to cut is adding to market surplus and depressing the price.

Saudi Arabia, which dominates the cartel with the highest share, appears
determined to stay in a race to the bottom along with U.S. shale oil
producers.

The kingdom is gambling that shale oil will become economically unviable to
produce if it already has not as prices head below the $50 a barrel mark.
First signs of that gamble paying off are just beginning to appear on the
horizon. Drilling activity for shale oil is beginning to slow down as producers
begin to feel the pinch of unremunerative prices. Americas oil output may
now be at a three-decade-high but 2015 will be a crucial year as shale oil
producers begin to cut down on output.
Demand-supply equations

If basic demand-supply equations are one factor for sliding oil prices, the
other is financial market equations. The oil market was funded in a major way
in the last few years by cheap dollars flowing out of the Federal Reserves
quantitative easing programme. With interest rates at near zero, surplus
funds flowed into the commodity markets, notably crude oil, driving their
prices upwards.

With the Fed winding up its stimulus programme and an interest rate hike in
the U.S. possibly just round the corner, funds are now flowing out of
commodities, driving their prices down. It is not a coincidence that oil prices
started falling at around the same time that the Fed first indicated the
possibility of a rate hike in the near term.

Oil prices are likely to stay soft for at least the rest of this year though
periodic minor spikes cannot be ruled out. This is, as said at the beginning of
this piece, good news for the world economy and also Indias. Cheaper fuel
prices will put more money in the hands of consumers which will, in turn, be
either invested or spent elsewhere.

According to Moodys chief economist, Mark Zandi, quoted in a recent

Bloomberg report, if oil stayed at $60 a barrel, American consumers would
save a whopping $150 billion on their fuel bills which, according to him, will
be spent elsewhere driving economic growth. This would hold true for other
countries as well, including India.

Of course, we are assuming here that governments across the world pass on
the benefit to consumers and not appropriate it as taxes. So far as India goes,
a lot depends on how well the government exploits the low oil price scenario.
For one, it should use the chance to clean up its subsidy act once and for all,
mainly in cooking gas and fertilizers. It should push for transparency in
pricing of fuel by the oil companies, something that is now absent.

The government should also ensure market prices for the oil producing PSUs
ONGC and OIL so that they can invest in exploration and production.

It should resist the temptation to raise taxes excise duty has gone up
thrice in the last two months depriving consumers of the benefit of lower
prices. To the contrary, the government should pass on the benefit to
consumers who can then either spend the surplus elsewhere or save.

Costs across the economy would also drop acting as a stimulus by itself if the

government cuts fuel prices. The benefits from a larger macro economic
perspective in the long-term would be bigger than the resources raised from
fresh taxes in the short-term. We missed the opportunity to do all this the last
time when oil prices were at similar levels. We cannot afford to miss it again.