Friday, October 17, 2008

Grasping the oil price, inflation linkage

Hindu Businessline-Racy Cases, 28.09.08 , Co-author: Arindam Mahato, IBS Hyd, Class of 2009

“Are the economic principles of demand and supply still valid?” asked a friend. We are at a loss for words for we are staunch supporter of economics. He continues, “I am scared to buy a car, for fear of oil prices touching the roof. Obviously the demand-supply position of oil has not changed drastically in the past one year, but the oil prices have more than doubled in one year and about quadrupled in the past five years. Now once again they are on the way down, and are now at around $100 per barrel! What’s the reason? Has the entire world economy become the playground of speculators? Are the prices purely driven by speculation?"

He was angry. Angry at everything around him. Angry at the policymakers for letting it all happen. Angry at the helplessness of the common man. We had no answers for all these questions. We too keep wondering about disillusionment cast by the entire financial and economic system around the world. However, his outburst did result in us taking a closer look at the oil prices.

Oil price drivers
A few macroeconomic factors which are said to be responsible for driving world crude oil prices are inflation, exchange rates, gold prices and OPEC’s decision on supply. These have an impact on oil prices either directly or indirectly.

Plotting the last five years’ data for all four of them along with the crude oil prices, we notice that gold and crude oil prices seem to have a very high correlation (0.9166). Oil and gold have been priced in US dollars since 1975.

Up to 1971 the dollar could be converted into gold by central banks. The price of gold was fixed at $35 an ounce and oil was steady at $3 a barrel. When the convertibility was removed, some of the oil producing countries converted the dollars into gold (this means that the demand for dollar went down and demand for gold went up). This had an impact on both oil and gold prices. Even today, an increase in the price of oil results in an increase in the price of gold and a decline in dollar value.

The euro-dollar exchange rates also seem to have a very high correlation with oil prices (0.8847). This could be due to the following: first, oil exporters have some price setting capacity; second, oil exporters receive a substantial share of their imports from Europe, particularly from euro area countries; third, oil invoicing takes place in US dollars; and, fourth, the US is itself a major importer of oil.

The OPEC supply has a much lower correlation of 0.7265. The supply of oil has remained more or less stable during the past five years. However, we can assume that the demand has been increasing due to the increasing appetite of emerging countries such as China and India. Also, oil is a finite resource and this has been recognised long back.

Depleting stock
According to a study, global oil resources are depleting at an annual rate of 6 per cent while demand is growing at an annual rate of 2 per cent. Thus, scarcity premium will continue to rise over time. This justifies the increase in prices. But what it does not justify is the sharp price rises and falls.

An increase in oil price results in inflation, which affects oil-importing countries. It also affects the cost of the finished products and prices in the economy. According to a research done by LeBlanc and Chinn of the University of California, Santa Cruz, oil price increases of as much as 10 percentage points will lead to direct inflationary increases of 0.1-0.8 percentage points in the US and the EU.

The correlation between world inflation and oil prices are the lowest amongst the four variables that we have considered (0.6879).

After doing this analysis, we went back to our friend to explain our findings. The response we got was “this is all very good and sounds logical too. But how does this have an impact on the common man? When the oil was $142 per barrel, I was paying Rs 56.60 per litre of petrol. Today, oil is around $100 a barrel and I am still paying around Rs 56 for a litre of petrol.

Unanswered questions
“The entire media quoted learned analysts and economists saying that inflation is going up because of oil prices. Now oil prices have fallen drastically but inflation has not come down. Do you have an answer for that?”

No we don’t. Now, with financial sector biggies such as Lehman Brothers and AIG collapsing, the general public is perplexed about the sanctity of the financial and economic systems, the acumen of analysts who slash the credit ratings of companies only after they actually collapses, and of the regulators who wake up only when such crises actually arise.