Fluctuating Crude Oil Prices: A crises brewing!

Crude oil for January delivery ended down $2.85, or 6.5%, at $40.81 a barrel on the New York Mercantile Exchange this Friday, the lowest closing level since December 2004. Oil lost 25% during the week, the largest drop since the week ended Jan. 18, 1991. Having fallen over $100 from the July 2008 peak of $147 a barrel, questions are being asked about the 'Fair Value' of Crude Oil.

Saudi Arabia’s King Abdullah has said $75 is a “fair price". Saudi Arabia has the world’s largest oil reserves and is OPEC’s biggest producer. When the king talks about a “fair price”, perhaps what he is referring to is a price which keeps afloat the Saudi treasury, not the state oil company. Citigroup Inc. estimates that Saudi Arabia, the world’s largest holder of crude reserves, must sell oil for an average of about $70 a barrel next year to finance its imports and domestic projects. The United Arab Emirates also requires $70 next year to balance its current account and fiscal spending, while Kuwait and Qatar both need $55 a barrel to break even.

How do we determine the Fair Price for oil? A fair price is one that gives producers an incentive to continue investing but does not compromise consuming countries’ economic growth. Global demand for oil is expected to climb from its present level of 82 million barrels a day, to 120 million barrel a day in 2025. For a matching increase in supply to occur, oil prices have to go up to encourage further investment. Europe and newly industrialized Asia (Including China and India ) import as much as 30 to 60% of their Oil needs. Japan is worst placed, where almost all of its Oil is imported. Let us turn to a bit of history: In 1971, an agreement between OPEC and oil companies recommended a gradual rise in oil prices of 2.5 per cent to keep up with inflation. The price of a barrel of oil then was only about $2, but the idea of adjusting prices to inflation was a reasonable. At present, a fair price for oil, after correction for inflation, is anywhere between $40 and $50 a barrel. And this price needs to be adjusted annually to compensate for inflation and to stimulate investment in the industry.

Let us find out what speculators have to say about Crude prices. "Crude oil prices could fall to as low as $20 a barrel in 2009 as falling U.S. demand outstrips Chinese growth", Hedge fund manager Jacques Mechelany told Reuters this week. Having already profited handsomely from the steep decline in crude prices, Mechelany intends to continue to take short positions in crude oil futures and selected oil-related stocks. "When oil prices begin falling leveraged investors have to unwind positions, further depressing prices," he said.

It is uncertain times ahead. In the short run it may benefit net oil importers like India, but falling oil prices leave little incentive for new oil exploration and it also reduces the political will to push through costly renewable energy initiatives. This may be detrimental for the global economy in the long run. All we require is stable crude oil prices, for which global steps need to be taken like curbing excessive speculation in commodity markets. The last round of global crises (market turmoil) was triggered by ballooning oil prices, the next round will perhaps be triggered by the falling oil prices.