Oil has become the driving factor that swings the economies around the world and changes the political and strategic faces of the government in almost all the countries. With the oil prices in abeyance, it becomes yet important a factor. On one hand are the countries where all the profit and loss statements are driven by the price of oil, and on the other hand are the countries where oil becomes a detrimental factor of the quality of life it is able to provide to its citizens.
Oil has become such a major factor in the last few decades that there are organizations that are formed to look after the regulations in this. One such organization is the Organization of Petroleum Exporting Countries (OPEC). According to the statistics of the year 2013, OPEC’s share of world crude oil reserves is a little over 81%. This share is sufficient to regulate the flow of oil export in the world map. According to the current estimates, almost 81% of the world’s proven oil reserves are located in OPEC member countries, with the bulk of OPEC oil reserves in the Middle East, amounting to 66% of the OPEC total. OPEC Member Countries have made significant additions to their oil reserves in recent years, for example, by adopting best practices in the industry, realizing intensive explorations and enhancing recoveries. As a result, OPEC’s proven oil reserves currently stand at 1,206.17 billion barrels. The major exporters of oil in the OPEC nations are Venezuela, Saudi Arabia, Iran, Iraq and Kuwait. In a world where the interests are driven by the oil prices, there are nations like Venezuela, where the entire economy is based on oil.
How the price of oil varies
The oil price in the international markets is driven by the demand and supply ratio. If one factor, say the demand, is kept constant, and the other factor, the supply increases, the price of oil in the international market is tend to fall. On the other hand, if the supply is kept constant and the demand of the oil increases, the price of oil goes high in the international market.
The supply of the crude oil in the international market is dependent on the production of crude oil by the OPEC member nations and the non-OPEC oil exporters. According to the agreement between the OPEC nations in December 2011, they agreed to maintain a production of 30 million barrels per day.
In the recent scenario, the prices of crude oil are dropping due to several reasons. This is not good for many OPEC nations like Venezuela where the decrease in oil prices may trigger an internal instability as its economy is majorly dependent on the oil. Such nations have been pushing for a cut in the daily production of crude oil in order to boost the price, but Saudi Arabia, the largest producer of crude oil among the OPEC nations favoured maintaining the oil production at its current level.
Reasons for falling oil prices
The major reason for the falling oil prices in the International market is again the principal of demand and supply ratio. The supply has increased while the demand has dropped steeply.
Reasons for the increase in supply:-
- Increase of crude oil production in the United States: In the last three years, the United States has been producing over 3 million barrels of crude oil daily. United States of America is the third largest producer of crude oil in the world. It is now quickly catching up with the Saudi Arabia, which stands at second position in crude oil production. Horizontal drilling and hydraulic fracturing in the hydrocarbon-rich underground shale layers have helped the US oil production grow by over 65% in the last 5 years.
- High OPEC output: Libya, despite its domestic turmoil, has outdone itself in the oil production. It has tripled its production since June, to about 9,00,000 a day. Similarly, the war in the Iraq has not stopped it from producing oil. It is producing around 3.1 million barrels a day.
- Russia’s production: Russia, the largest producer of crude oil in the world, was already on the verge of creating a production record before the Ukraine fiasco.
Reasons for decrease in demand:-
- China, which is one of the biggest consumers of fuel in the world, is witnessing a record decline in the demand due to its sluggish economy. China’s economic growth eased to its weakest since the 2008/2009 global financial crisis as a slumping property market dragged on manufacturing and investment.
- Japan, due to its economic condition, is undergoing a similar slowdown.
- The oil demand in the US is almost less than the average demand in the last 5 years.
The United States of America is increasing its oil productions and is looking forward to Asian markets such as India and China for exporting oil. At this time, the OPEC does not want to budge. Hence, OPEC is letting the prices slide down to test if the US can withstand low prices. The Saudi Arabia is concerned with the production cost of the shale supply by the US. About 2.6 million barrels or 2.8% of the world’s output requires a cost of over $80 per barrel to be profitable. However, it has been reported that only about 4% of the total US shale output needs prices above that level.
India and the oil
The top three importers of oil are the USA, China and India. A lot of India’s foreign exchange reserves are used to buy oil. When the oil prices are higher, the prices of diesel, petrol and LPG start to sour in the nation. Whenever the price of diesel sours, it is bound to result in higher price of almost all consumer commodities such as vegetables and fruits as diesel is the main fuel required to transport these commodities. This results in inflation and price-rise which directly hits the common man. As Indian society is majorly made up of the middle-class, higher prices negatively impact the quality of life. To compensate against this factor, government puts up various subsidies, such as that for LPG gas cylinders. Subsidies are never good for India in the long run, as they result in even greater deficit for the government’s finances.
For a country like India, which imports over 80% of its oil, the lower the prices of oil in the international market, the better it is.
Oil pricing in India
Let us see the different factors that get involved between the International Oil supplier and the Indian oil consumer and how the pricing adds up:-
- An Indian oil company, say IOCL or BPCL will pay a Free On Board Price (FOB Price) to a counterpart in an oil exporting nation. This is the price which is paid to deliver oil at a nearby international port.
- The oil company will now incur a price of transportation (Ocean Freight) of oil from this international port to an Indian port. This Ocean Freight price and FOB Price are together called Cost and Freight Price (C&F Price).
- Once reaching an Indian port, there would be three prices that will come into picture:-
- Insurance charges, which would be the premium paid to the Insurance Company for the insurance cover provided to the crude.
- Port Dues, which would be the fee paid to the port for its services and facilities.
- Ocean Losses, which is the compensation for the losses incurred during transportation.
- These charges, collectively, are called the Import Charges.
- A Customs charge would be imposed on the imported crude oil by the Government of India. This is called Customs Duty. It would be 2.5% of the C&F Price.
- The total price of the crude oil paid at the Indian port would be called Import Parity Price (IPP). It would be the sum of C&F Price, Import Charges and the Customs Duty.
- Export Parity Price (EPP): It is a hypothetical terms which is the price of the crude oil if an Indian company would have exported it to the international market.
- Trade Parity Price (TPP): It is the weighted average of IPP and EPP. In India, TPP is used.
- TPP = (0.8 x IPP) + (0.2 x EPP)
- Refinery Transport Price (RTP): Once the crude oil has been refined into Diesel, Petrol, etc. this term comes into picture. This is the price that the Oil Marketing Companies (OMCs) pay to the refineries. In case of Diesel, RTP is equal to the TPP.
- The refined Diesel/Petrol is now transported to the retail outlets via Rail and Road. The price incurred in this transportation is called the Inland Freight. Marketing costs also add up on top of this. Hence, we get another term called the Total Desired Price (TDP).
- TDP = RTP + Inland Freight + Marketing Costs
- But OMCs sell Diesel at the retail outlet at a price less than the TDP. This price is called the Depot Price.
- Once the Diesel has reached a retail outlet, the Central and state Governments impose taxes on it. The Central Government imposes Excise Duty, while the state Government imposes Value Added Tax (VAT).
Thus, we get the price of Petrol and Diesel. There might be a burning desire as to why they are priced differently in different cities and towns. Well, that is because of the variation in Inland Freight based on the distance from the refineries and the variable VAT in various states.
As of today, there is a difference between the prices incurred by the OMCs and price of sale. This difference is balanced by the subsidies given by the Central government, which in turn, is a part of the taxes paid by the citizens to the Central Government. Hence, for India, if the prices of crude oil drop in the international market, it would be able to decrease the difference borne by the subsidies, which would be good in the long run.