International oil prices remained well below $ 50 per barrel in the 1980s and 1990s. The figure shows this for Brent. But they’ve gotten excessively volatile since the mid-2000s – Brent hovered between $ 132 in mid-2008 and $ 30 in January 2016, with swings in between. A lower high of $ 81 in October 2018, as well as a crash to $ 18 with Covid-19, both didn’t last long.
This volatility was one reason for slow global growth in the 2010s. Spillovers from losers to winners reduce net profits.
For example, while commodity exporting nations were in dire straits after the 2014 oil price crash, India’s profits were lower than expected as the slowdown in global export growth dampened profits.
As a produced raw material, the price of oil depends on the supply-demand balance, stocks, oil production capacity and costs. When stocks are low, supply or demand shocks can lead to large short-term price fluctuations. Over time, the rise in prices reduces demand and increases supply.
When administrative pricing mechanisms were abandoned in the physical market, deep and liquid futures markets were developed that combine different views to facilitate pricing. These should make the oil market more future-oriented. As a financial asset, the price of oil depends on the structure of markets, expectations of oil fundamentals and the news that affects them. In the 1990s, investors began taking positions in commodity futures as part of a diversified portfolio.
As the figure shows, the average price levels and their volatility increased sharply after 2000, which indicates persistent deviations from the fundamentals. This followed the US Commodity Futures Modernization Act passed in 2000, which, among other things, eased the position limits. “Swap dealers”, who enable over-the-counter investments in exchange-traded funds that track commodity indices, have been exempted from position limits. Thereafter, the open interest in oil derivatives more than tripled and the number of traders doubled between 2004 and 2008. When pension funds diversified their portfolios after the dotcom crash, extensive index-based investments were made.
Deregulation increased procyclical waves of optimism or pessimism. Even oil producers consider oil futures to be too volatile. They prefer a price range around $ 60 that will keep production constant. The G20 should adopt uniform prudential regulation of the futures markets. Position limits could be reintroduced.
The size of the cycles decreased after 2015 as the entry of shale oil made the delivery response easier and faster. As OPEC’s market share fell, so did its pricing power. But the cycles remained larger than they were before 2000.
However, the sharp slump due to the unprecedented Covid-19 shock caused many over-indebted shale oil producers to go bankrupt. This made it easier for OPEC to regroup and regain market power with an agreement on production cuts.
However, if the price of oil rises above $ 70, shale oil will be highly profitable again. The restructuring had brought costs down and the lessons of more disciplined expansion had been learned. It is dangerous for OPEC to let the oil price rise. Countries are trying to break the cartel. Green substitutes are also getting a boost. Your most recent meeting again shows difficulties in reaching an agreement. Consumer countries like China will take advantage of large oil supplies that have been built up when prices have fallen, reducing demand. If an agreement is reached on sanctions, Iran’s large oil reserves could come into the market. When prices peaked at $ 81 in October 2018, they had fallen to $ 64 the next month. History can repeat itself this year.
It is unclear whether the recovery will generally fuel excess demand and inflation, or whether supply chains will recover and secular stagnation will re-emerge. Markets seem to be leaning towards the idea that inflation will be temporary. US bond yields have fallen.
The local tangle
Indian fuel taxes were hiked sharply during the oil price slump in 2020 to offset the sharp slump in tax revenues from the lockdown. However, they were not reversed, despite the rebound in both tax revenues and international oil prices.
Unfortunately, the center and the states both compete for space, each fearing that withdrawing would allow the other to interfere. State taxes are levied on value added and automatically increase with prices. Incorporating energy into the GST provides a solution to this impasse.
Mid-State Shares could be accounted for under the GST Principles established by the 15th Finance Commission (FC) based on relative spending responsibility. Even taxing a maximum luxury class of 28 percent of the GST would lead to a double-digit reduction in fuel prices per liter. It would also reduce the cascading cost-driving inflation and improve export competitiveness and household consumer demand.
The graph shows both rising and falling international fuel prices. Indian prices continued to rise during their administration. Even after being determined by the market, taxes tend to rise more when international prices fall, but decrease less when prices rise. As a result, Indian fuel prices are rising faster than international ones.
The persistence thus imparted to domestic oil prices undermines flexible inflation management. Monetary policy can withstand volatile commodity price shocks, as firmly anchored inflation expectations are passed.
But if politics makes the price hike permanent, inflation expectations cannot be anchored after a shock. The upward ratchet keeps inflation going. The second round of the wage increase and long-term bond rates follows. If policy rates have to rise, so will the cost of borrowing for central and state governments.
In the era of gasoline price administration, loud political battles made it difficult to raise domestic prices as international prices rose. Now oil marketing companies are changing prices smoothly with international ones. However, the political challenge has shifted to the taxes imposed.
This discretion allows for arbitrary distortions of prices and resources and causes enormous indirect economic costs. Removing it will leave you free to focus on more rewarding topics. But will the governments be ready? The relentless public struggle for more hides the fact that the states have not lost with the GST; 14 percent of the compensation was generous and set the nominal income growth rates prevailing at the time, but remained in place even with declining growth. Now that loopholes are partially closed and the economy is recovering, there is a surge in revenue that needs to be shared.
Incentive reforms with the 15th Finance Commission open up new sources of income for states. An increase in user fees and property tax can be combined with better services.
Relations between the center and states were strained in part because the constitution gave the center more powers to hold the nation together. A cooperative federalism works if the functions are divided according to the capacity at different levels.
It is clear that there are advantages in centralizing certain functions – buying vaccines, borrowing, some types of taxation, ensuring the homogeneity of public services while the services must be provided locally.
States want GST compensation to continue beyond the agreed date – it could be more modest and tied to the injection of energy into the GST. The revenue neutrality results from the resulting higher efficiency and higher growth, supplemented by an additional CO2 tax, which would also promote green alternatives and lower India’s oil bill. Domestic surcharges would then not exacerbate the international oil shocks.
The author is Professor Emeritus, IGIDR. Views are personal