Economy of Oil Price

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Information about Economy of Oil Price
Business & Mgmt

Published on March 2, 2014

Author: prasant26

Source: slideshare.net

Oil Prices History, Trends, Economics and Policies Submitted By: Group 8_Sec B Achintya PR Manish Watharkar Nandana SS Pallavi Ghandat Prashant Patro Uttara Chattopadhyay 1|P ag e 13020841062 13020841083 13020841085 13020841092 13020841094 13020841114

Index Sl No 1 Oil Prices History and Trends 3 2 History of Oil Prices in India 18 3 Economics of Oil Price 23 4 Policy Making with Oil Prices 33 5 2|P ag e Content Page No Bibliography 41

Oil Price History and Trends: The EIA (Energy Information Administration) provides the average annual price for a barrel of WTI crude oil since 1986: Oil Price/Barrel Oil Price/Barrel Oil Price/Barrel 1986 $15.05 1995 $18.43 2004 $41.51 1987 $19.20 1996 $22.12 2005 $56.64 1988 $15.97 1997 $20.61 2006 $66.05 1989 $19.64 1998 $14.42 2007 $72.34 1990 $24.53 1999 $19.34 2008 $99.67 1991 $21.54 2000 $30.38 2009 $61.95 1992 $20.58 2001 $25.98 2010 $79.48 1993 $18.43 2002 $26.18 2011 $94.88 1994 $17.20 2003 $31.08 2012 $94.05 The trend can be plotted in the following graph as shown below. This has shown an overall high increase in the oil price in the past years. The price rose highly during initial year of 2001, and saw the only dip during the year 2008-09. $120.00 $100.00 $80.00 $60.00 $40.00 $20.00 1986 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 $0.00 Oil Price/Barrel Crude Oil Price Trends: Oil prices usually go up in the summer, driven by high demand for gasoline during vacation driving times. Sometimes it will drop further in the winter, if there is lower 3|P ag e

than expected demand for home heating oil, due to warmer weather. During 2008, there was fear that economic growth from China and the U.S. would create so much demand for oil that it would overtake supply, driving up prices. However, most analysts now realize that such a sudden increase in oil prices was due to increased investment by hedge fund and futures traders. In addition, oil prices seem to be rising earlier and earlier each spring. In 2013, prices started rising in January, reaching a peak of $118.90 in February. In 2012, oil prices started rising in February. The price for a barrel of WTI (West Texas Intermediate) crude broke above $100 a barrel on February 13, 2012. In 2011, prices didn't break $100 a barrel until March 2, and didn't peak until May at $113 a barrel. Fortunately, none of these peaks were as high as the June 2008 all-time high, when the price of WTI crude oil hit $143.68 per barrel. By December, it plummeted to a low of $43.70 per barrel. The U.S. average retail price for regular gasoline also hit a peak in July 2008 of $4.17, rising as high as $5 a gallon in some areas. By December, it had also dropped to $1.87 a gallon. Demand for oil: The demand side of peak oil over time is concerned with the total quantity of oil that the global market would choose to consume at various possible market prices and how this entire listing of quantities at various prices would evolve over time. Total global quantity demanded of world crude oil grew an average of 1.76% per year from 1994 to 2006, with a high growth of 3.4% in 2003–2004. After reaching a high of 85.6 million barrels (13,610,000 m3) per day in 2007, world consumption decreased in both 2008 and 2009 by a total of 1.8%, despite fuel costs plummeting in 2008.Despite this lull, world quantity-demanded for oil is projected to increase 21% over 2007 levels by 2030 (104 million barrels per day (16.5×106 m3/d) from 86 million barrels (13.7×106 m3)), due in large part to increases in demand from the transportation sector. According to the IEA's 2013 projections, growth in global oil demand will be significantly outpaced by growth in production capacity over the next 5 years. The world increased its daily oil consumption from 63 million barrels (10,000,000 m3) (Mbbl) in 1980 to 85 million barrels (13,500,000 m3) in 2006. Energy demand is distributed amongst four broad sectors: transportation, residential, commercial, and industrial. In terms of oil use, transportation is the largest sector and the one that has seen the largest growth in demand in recent decades. This growth has largely come from new demand for personal-use vehicles powered by internal combustion engines. This sector also has the highest consumption rates, accounting for approximately 68.9% of the oil used in the United States in 2006, and 55% of oil use worldwide as documented in the Hirsch report. Transportation is therefore of particular interest to those seeking to mitigate the effects of peak oil. 4|P ag e

United States crude oil production peaked in 1970. In 2005, imports were twice as great as production. Although demand growth is highest in the developing world, the United States is the world's largest consumer of petroleum. Between 1995 and 2005, US consumption grew from 17,700,000 barrels per day (2,810,000 m3/d) to 20,700,000 barrels per day (3,290,000 m3/d), 3,000,000 barrels per day (480,000 m3/d) increase. China, by comparison, increased consumption from 3,400,000 barrels per day (540,000 m3/d) to 7,000,000 barrels per day (1,100,000 m3/d), an increase of 3,600,000 barrels per day (570,000 m3/d), in the same time frame. The Energy Information Administration (EIA) stated that gasoline usage in the United States may have peaked in 2007, in part because of increasing interest in and mandates for use of bio fuels and energy efficiency. As countries develop, industry and higher living standards drive up energy use, most often of oil. Thriving economies, such as China and India, are quickly becoming large oil consumers. China has seen oil consumption grow by 8% yearly since 2002, doubling from 1996–2006. In 2008, auto sales in China were expected to grow by as much as 15– 20%, resulting in part from economic growth rates of over 10% for five years in a row. Although swift, continued growth in China is often predicted, others predict China's export-dominated economy will not continue such growth trends because of wage and price inflation and reduced demand from the United States. India's oil imports are expected to more than triple from 2005 levels by 2020, rising to 5 million barrels per day (790×103 m3/d). The EIA now expects global oil demand to increase by about 1,600,000 barrels per day (250,000 m3/d). Asian economies, in particular China, will lead the increase. 5|P ag e

1947-2011: Like prices of other commodities the price of crude oil experiences wide price swings in times of shortage or oversupply. The crude oil price cycle may extend over several years responding to changes in demand as well as OPEC and non-OPEC supply. We will discuss the impact of geopolitical events, supply demand and stocks as well as NYMEX trading and the economy. Throughout much of the twentieth century, the price of U.S. petroleum was heavily regulated through production or price controls. In the post World War II era, U.S. oil prices at the wellhead averaged $28.52 per barrel adjusted for inflation to 2010 dollars. In the absence of price controls, the U.S. price would have tracked the world price averaging near $30.54. Over the same post war period, the median for the domestic and the adjusted world price of crude oil was $20.53 in 2010 prices. Adjusted for inflation, from 1947 to 2010 oil prices only exceeded $20.53 per barrel 50 percent of the time. (See note in the box on right.) Until March 28, 2000 when OPEC adopted the $22-$28 price band for the OPEC basket of crude, real oil prices only exceeded $30.00 per barrel in response to war or conflict in the Middle East. With limited spare production capacity, OPEC abandoned its price band in 2005 and was powerless to stem a surge in oil prices, which was reminiscent of the late 1970s. 6|P ag e

Post World War II Pre-Embargo Period From 1948 through the end of the 1960s, crude oil prices ranged between $2.50 and $3.00. The price oil rose from $2.50 in 1948 to about $3.00 in 1957. When viewed in 2010 dollars, a different story emerges with crude oil prices fluctuating between $17 and $19 during most of the period. The apparent 20% price increase in nominal prices just kept up with inflation. From 1958 to 1970, prices were stable near $3.00 per barrel, but in real terms the price of crude oil declined from $19 to $14 per barrel. Not only was price of crude lower when adjusted for inflation, but in 1971 and 1972 the international producer suffered the additional effect of a weaker US dollar. OPEC was established in 1960 with five founding members: Iran, Iraq, Kuwait, Saudi Arabia and Venezuela. Two of the representatives at the initial meetings previously studied the Texas Railroad Commission's method of controlling price through limitations on production. By the end of 1971, six other nations had joined the group: Qatar, Indonesia, Libya, United Arab Emirates, Algeria and Nigeria. From the foundation 7|P ag e

of the Organization of Petroleum Exporting Countries through 1972, member countries experienced steady decline in the purchasing power of a barrel of oil. Throughout the post war period exporting countries found increased demand for their crude oil but a 30% decline in the purchasing power of a barrel of oil. In March 1971, the balance of power shifted. That month the Texas Railroad Commission set proration at 100 percent for the first time. This meant that Texas producers were no longer limited in the volume of oil that they could produce from their wells. More important, it meant that the power to control crude oil prices shifted from the United States (Texas, Oklahoma and Louisiana) to OPEC. By 1971, there was no spare production capacity in the U.S. and therefore no tool to put an upper limit on prices. A little more than two years later, OPEC through the unintended consequence of war obtained a glimpse of its power to influence prices. It took over a decade from its formation for OPEC to realize the extent of its ability to influence the world market. 8|P ag e

Middle East Supply Interruptions Yom Kippur War - Arab Oil Embargo* In 1972, the price of crude oil was below $3.50 per barrel. The Yom Kippur War started with an attack on Israel by Syria and Egypt on October 5, 1973. The United States and many countries in the western world showed support for Israel. In reaction to the support of Israel, several Arab exporting nations joined by Iran imposed an embargo on the countries supporting Israel. While these nations curtailed production by five million barrels per day, other countries were able to increase production by a million barrels. The net loss of four million barrels per day extended through March of 1974. It represented 7 percent of the free world production. By the end of 1974, the nominal price of oil had quadrupled to more than $12.00. Any doubt that the ability to influence and in some cases control crude oil prices had passed from the United States to OPEC was removed as a consequence of the Oil Embargo. The extreme sensitivity of prices to supply shortages became all too apparent when prices increased 400 percent in six short months. From 1974 to 1978, the world crude oil price was relatively flat ranging from $12.52 per barrel to $14.57 per barrel. When adjusted for inflation world oil prices were in a period of moderate decline. During that period OPEC capacity and production was relatively flat near 30 million barrels per day. 9|P ag e

In contrast, non-OPEC production increased from 25 million barrels per day to 31 million barrels per day. 10 | P a g e

Crises in Iran and Iraq In 1979 and 1980, events in Iran and Iraq led to another round of crude oil price increases. The Iranian revolution resulted in the loss of 2.0-2.5 million barrels per day of oil production between November 1978 and June 1979. At one point production almost halted. The Iranian revolution was the proximate cause of the highest price in post-WWII history. However, revolution's impact on prices would have been limited and of relatively short duration had it not been for subsequent events. In fact, shortly after the revolution, Iranian production was up to four million barrels per day. In September 1980, Iran already weakened by the revolution was invaded by Iraq. By November, the combined production of both countries was only a million barrels per day. It was down 6.5 million barrels per day from a year before. As a consequence, worldwide crude oil production was 10 percent lower than in 1979. The loss of production from the combined effects of the Iranian revolution and the IraqIran War caused crude oil prices to more than double. The nominal price went from $14 in 1978 to $35 per barrel in 1981. Over three decades later Iran's production is only two-thirds of the level reached under the government of Reza Pahlavi, the former Shah 11 | P a g e

of Iran. Iraq's production is now increasing, but remains a million barrels below its peak before the Iraq-Iran War. OPEC Fails to Control Crude Oil Prices: OPEC has seldom been effective at controlling prices. Often described as a cartel, OPEC does not fully satisfy the definition. One of the primary requirements of a cartel is a mechanism to enforce member quotas. An elderly Texas oil man posed a rhetorical question: What is the difference between OPEC and the Texas Railroad Commission? His answer: OPEC doesn't have any Texas Rangers! The Texas Railroad Commission could control prices because the state could enforce cutbacks on producers. The only enforcement mechanism that ever existed in OPEC is Saudi spare capacity and that power resides with a single member not the organization as a whole.With enough spare capacity to be able to increase production sufficiently to offset the impact of lower prices on its own revenue; Saudi Arabia could enforce discipline by threatening to increase production enough to crash prices. In reality even this was not an OPEC enforcement mechanism unless OPEC's goals coincided with those of Saudi Arabia. During the 1979-1980 periods of rapidly increasing prices, Saudi Arabia's oil minister Ahmed Yamani repeatedly warned other members of OPEC that high prices would lead to a reduction in demand. His warnings fell on deaf ears. Surging prices caused several 12 | P a g e

reactions among consumers: better insulation in new homes, increased insulation in many older homes, and more energy efficiency in industrial processes, and automobiles with higher efficiency. These factors along with a global recession caused a reduction in demand which led to lower crude prices. Unfortunately for OPEC only the global recession was temporary. Nobody rushed to remove insulation from their homes or to replace energy efficient equipment and factories -- much of the reaction to the oil price increase of the end of the decade was permanent and would never respond to lower prices with increased consumption of oil. Higher prices in the late 1970s also resulted in increased exploration and production outside of OPEC. From 1980 to 1986 non-OPEC production increased 6 million barrels per day. Despite lower oil prices during that period new discoveries made in the 1970s continued to come online. OPEC was faced with lower demand and higher supply from outside the organization. From 1982 to 1985, OPEC attempted to set production quotas low enough to stabilize prices. These attempts resulted in repeated failure, as various members of OPEC produced beyond their quotas. During most of this period Saudi Arabia acted as the swing producer cutting its production in an attempt to stem the free fall in prices. In August 1985, the Saudis tired of this role. They linked their oil price to the spot market for crude and by early 1986 increased production from two million barrels per day to five million. Crude oil prices plummeted falling below $10 per barrel by mid-1986. Despite the fall in prices Saudi revenue remained about the same with higher volumes compensating for lower prices. A December 1986 OPEC price accord set to target $18 per barrel, but it was already breaking down by January of 1987 and prices remained weak. The price of crude oil spiked in 1990 with the lower production, uncertainty associated with the Iraqi invasion of Kuwait and the ensuing Gulf War. The world and particularly the Middle East had a much harsher view of Saddam Hussein invading Arab Kuwait than they did Persian Iran. The proximity to the world's largest oil producer helped to shape the reaction. Following what became known as the Gulf War to liberate Kuwait, crude oil prices entered a period of steady decline. In 1994, the inflation adjusted oil price reached the lowest level since 1973. The price cycle then turned up. The United States economy was strong and the Asian Pacific region was booming. From 1990 to 1997, world oil consumption increased 6.2 million barrels per day. Asian consumption accounted for all but 300,000 barrels per day of that gain and contributed to a price recovery that extended into 1997. Declining 13 | P a g e

Russian production contributed to the price recovery. Between 1990 and 1996 Russian production declined more than five million barrels per day. OPEC continued to have mixed success in controlling prices. There were mistakes in timing of quota changes as well as the usual problems in maintaining production discipline among member countries. The price increases came to a rapid end in 1997 and 1998 when the impact of the economic crisis in Asia was either ignored or underestimated by OPEC. In December 1997, OPEC increased its quota by 2.5 million barrels per day (10 percent) to 27.5 million barrels per day effective January 1, 1998. The rapid growth in Asian economies came to a halt. In 1998, Asian Pacific oil consumption declined for the first time since 1982. The combination of lower consumption and higher OPEC production sent prices into a downward spiral. In response, OPEC cut quotas by 1.25 million barrels per day in April and another 1.335 million in July. The price continued down through December 1998. Prices began to recover in early 1999. In April, OPEC reduced production by another 1.719 million barrels. As usual not all of the quotas were observed, but between early 1998 and the middle of 1999 OPEC production dropped by about three million barrels per day. The cuts were sufficient to move prices above $25 per barrel. With minimal Y2K problems and growing U.S. and world economies, the price continued to rise throughout 2000 to a post 1981 high. In 2000 between April and October, three successive OPEC quota increases totalling 3.2 million barrels per day were not able to stem the price increase. Prices finally started down following another quota increase of 500,000 effective November 1, 2000. Russian production increases dominated non-OPEC production growth from 2000 to 2007 and was responsible for most of the non-OPEC increase since the turn of the century. Once again it appeared that OPEC overshot the mark. In 2001, a weakened US economy and increases in non-OPEC production put downward pressure on prices. In response OPEC once again entered into a series of reductions in member quotas cutting 3.5 million barrels by September 1, 2001. In the absence of the September 11, 2001 terrorist attacks, this would have been sufficient to moderate or even reverse the downward trend. In the wake of the attack, crude oil prices plummeted. Spot prices for the U.S. benchmark West Texas Intermediate were down 35 percent by the middle of November. Under normal circumstances a drop in price of this magnitude would have resulted in another round of quota reductions. Given the political climate OPEC delayed 14 | P a g e

additional cuts until January 2002. It then reduced its quota by 1.5 million barrels per day and was joined by several non-OPEC producers including Russia which promised combined production cuts of an additional 462,500 barrels. This had the desired effect with oil prices moving into the $25 range by March 2002. By midyear the non-OPEC members were restoring their production cuts but prices continued to rise as U.S. inventories reached a 20-year low later in the year. By year end oversupply was not a problem. Problems in Venezuela led to a strike at PDVSA causing Venezuelan production to plummet. In the wake of the strike Venezuela was never able to restore capacity to its previous level and is still about 900,000 barrels per day below its peak capacity of 3.5 million barrels per day. OPEC increased quotas by 2.8 million barrels per day in January and February 2003. On March 19, 2003, just as some Venezuelan production was beginning to return, military action commenced in Iraq. Meanwhile, inventories remained low in the U.S. and other OECD countries. With an improving economy U.S. demand was increasing and Asian demand for crude oil was growing at a rapid pace. The loss of production capacity in Iraq and Venezuela combined with increased OPEC production to meet growing international demand led to the erosion of excess oil production capacity. In mid 2002, there were more than six million barrels per day of excess production capacity and by mid-2003 the excess was below two million. During much of 2004 and 2005 the spare capacity to produce oil was less than a million barrels per day. A million barrels per day is not enough spare capacity to cover an interruption of supply from most OPEC producers. In a world that consumes more than 80 million barrels per day of petroleum products that added a significant risk premium to crude oil price and was largely responsible for prices in excess of $40-$50 per barrel. Other major factors contributing to higher prices included a weak dollar and the rapid growth in Asian economies and their petroleum consumption. The 2005 hurricanes and U.S. refinery problems associated with the conversion from MTBE to ethanol as a gasoline additive also contributed to higher prices. One of the most important factors determining price is the level of petroleum inventories in the U.S. and other consuming countries. Until spare capacity became an issue inventory levels provided an excellent tool for short-term price forecasts. Although not well publicized OPEC has for several years depended on a policy that amounts to world inventory management. Its primary reason for cutting back on production in November 2006 and again in February 2007 was concern about growing OECD inventories. Their focus is on total petroleum inventories including crude oil and petroleum products, which is a better indicator of prices that oil inventories alone. 15 | P a g e

In 2008, after the beginning of the longest U.S. recession since the Great Depression the oil price continued to soar. Spare capacity dipped below a million barrels per day and speculation in the crude oil futures market was exceptionally strong. Trading on NYMEX closed at a record $145.29 on July 3, 2008. In the face of recession and falling petroleum demand the price fell throughout the remainder of the year to the below $40 in December. Following an OPEC cut of 4.2 million b/d in January 2009 prices rose steadily in the supported by rising demand in Asia. In late February 2011, prices jumped as a consequence of the loss of Libyan exports in the face of the Libyan civil war. Concern about additional interruptions from unrest in other Middle East and North African producers continues to support the price while as of Mid-October 400,000 barrels per day of Libyan production was restored. Recessions and Oil Prices: It is worth noting that the three longest U.S. recessions since the Great Depression coincided with exceptionally high oil prices. The first two lasted 16 months. The first followed the 1973 Embargo started in November 1973 and the second in July 1981. The latest began in December 2007 and lasted 18 months. Charts similar to the one at the 16 | P a g e

right have been used to argue that price spikes and high oil prices cause recessions. There is little doubt that price is a major factor. The same graph makes an even more compelling argument that recessions cause low oil prices. 17 | P a g e

History of Oil Prices in India Colonial Rule, 1858-1947 The first oil deposits in India were discovered in 1889 near the town of [Digboi] in the state of Assam This discovery came on the heels of industrial development. The Assam Railways and Trading Company (ARTC) had recently opened the area for trade by building a railway and later finding oil nearby. The first well was completed in 1890 and the Assam Oil Company was established in 1899 to oversee production. At its peak during the Second World War the Digboi oil fields were producing 7,000 barrels per day. At the turn of the century however as the best and most profitable uses for oil were still being debated, India was seen not as a producer but as a market, most notably for fuel oil for cooking. As the potential applications for oil shifted from domestic to industrial and military usage this was no longer the case and apart from its small domestic production India was largely ignored in terms of oil diplomacy and even written off by some as hydrocarbon barren. Despite this however British colonial rule laid down much of the country’s infrastructure, most notably the railways. Independence, 1947-1991 After India won independence in 1947, the new government naturally wanted to move away from the colonial experience which was regarded as exploitative. In terms of economic policy this meant a far bigger role for the state. This resulted in a focus on domestic industrial and agricultural production and consumption, a large public sector, economic protectionism, and central economic planning. The foreign companies continued to play a key role in the oil industry. Oil India Limited was still a joint venture involving the Indian government and the British owned Burma Oil Company(presently, BP) whilst the Indo-Stanvac Petroleum project in West Bengal was between the Indian government and the American company SOCONYVacuum (presently, ExxonMobil). This changed in 1956 when the government adopted an industrial policy that placed oil as a “schedule A industry” and put its future development in the hands of the state In October 1959 an Act of Parliament was passed which gave the state owned Oil and Natural Gas Commission (ONGC) the powers to plan, organise, and implement programmes for the development of oil resources and the sale of petroleum products and also to perform plans sent down from central government. In order to find the expertise necessary to reach these goals foreign experts from West Germany, Romania, the US, and the Soviet Union were brought in The Soviet experts were the most influential and they drew up detailed plans for further oil exploration which were to form part of the second five-year plan. India thus adopted the Soviet model of economic development and the state continues to implement five-year plans as part of its drive towards modernity. The increased focus on exploration resulted in 18 | P a g e

the discovery of several new oil fields most notably the off-shore Bombay High field which remains by a long margin India’s most productive well Liberalization 1991-at present The process of economic liberalisation in India began in 1991 when India defaulted on her loans and asked for a $1.8 billion bailout from the IMF. This was a trickle-down effect of the culmination of the cold war era; marked by the 1991 collapse of the Soviet Union, India’s main trading partner. The bailout was done on the condition that the government initiate further reforms, thus paving the way for India’s emergence as a free market economy. For the ONGC this meant being reorganised into a public limited company (it is now called for Oil and Natural Gas Corporation) and around 2% of government held stocks were sold off. Despite this however the government still plays a pivotal role and ONGC is still responsible for 77% of oil and 81% of gas production while the Indian Oil Corporation (IOC) owns most of the refineries putting it within the top 20 oil companies in the world. The government also maintains subsidised prices. As a net importer of oil however India faces the problem of meeting the energy demands for its rapidly expanding population and economy and to this the ONGC has pursued drilling rights in Iran and Kazakhstan and has acquired shares in exploration ventures in Indonesia, Libya, Nigeria, and Sudan. India’s choice of energy partners however, most notably Iran led to concerns radiating from the US. A key issue today is the proposed gas pipeline that will run from Turkmenistan to India through politically unstable Afghanistan and also through Pakistan. However despite India’s strong economic links with Iran, India voted with the US when Iran’s nuclear program was discussed by the International Atomic Energy Agency although there are still very real differences between the two countries when it comes to dealing with Iran IOC, HPCL and HP In the early 1990s, all roads virtually led to the Indian Oil Corporation, which was the monarch of all it surveyed with half a dozen refineries in its portfolio. In contrast, Hindustan Petroleum Corporation and Bharat Petroleum Corporation had only one facility each in Mumbai (HPCL was also co-promoter of the three million tonne Mangalore Refinery & Petrochemicals). Madras Refineries, Cochin Refineries and the smaller Bongaigaon Refinery & Petrochemicals were standalone entities processing petrol, diesel and LPG, but did not have exclusive retail outlets. They depended on the Big Three to sell their products. On the other hand, IBP was a standalone marketing entity whose job was to sell petrol and diesel produced by these refiners. It wasn’t exactly a level playing field which prompted Arthur D Little, a consultancy firm, to suggest that IOC’s huge market share be reduced to ensure that other players in the PSU space get a fair share of the pie. 19 | P a g e

The international consultant had prepared an exhaustive report of India’s downstream industry and mooted a merger of Madras Refineries and Cochin Refineries. A portion of IOC’s market share (equivalent to the volumes it retailed on behalf of MRL and CRL), could be set aside for this merged entity. This would include its retail outlets as well as terminals and bottling plants. Arthur D Little then proposed that IBP take over the marketing of BRPL’s products (which was being done by IOC), akin to the MRL-CRL model, and get its share of retail assets in the process. The report created quite a flutter in oil industry circles and, perhaps, paved the way for a restructuring exercise some years later. By this time, the Government had given its go-ahead to new refineries which its public sector units would commission jointly with global players. While Oman Oil would team up with HPCL and BPCL for two separate projects in Maharashtra and Madhya Pradesh, Kuwait Petroleum Corporation would join hands with IOC for a coastal refinery in Orissa. Nobody reckoned with the delays that would accompany these ambitious projects. HPCL called off its venture with Oman Oil because there were environmental concerns in Ratnagiri — the proposed location for the refinery. BPCL also faced similar issues in Bina which had attracted the attention of exploration giant, Oil & Natural Gas Corporation keen on entering the fuels marketing arena. The delays prompted Oman Oil to exit the project while a determined BPCL hung on. Kuwait Petroleum’s participation in Paradip with IOC continued to be uncertain, and the latter decided to go on its own. HPCL had in the meantimeopted for a new refinery in Punjab in which big names such as Saudi Aramco and Exxon were keen to participate. EXPERT COMMITTEES It was also around this time in the mid to late-1990s that the Government set up expert committees to look into the issue of freeing petrol, diesel and LPG prices which were part of the subsidy basket. A panel headed by BPCL Chairman & Managing Director U. Sundararajan submitted its report in 1995 and advocated complete deregulation of prices. It was quite a radical suggestion for a system where subsidies were the order the day. The Government, of course, was in no hurry to implement these recommendations because any dramatic price hikes would hit a section of society really hard. Yet, it was beginning to realise that it made little sense not to revise prices when global prices were heading upwards. The first signs of trouble were evident in 1997-98 when refiners were strapped for cash and some like IOC resorted to short-term borrowings from the wealthier ONGC. There were other interesting dynamics panning out in the downstream space. The Government decided that BPCL would now take charge of CRL while MRL and BRPL 20 | P a g e

would go to IOC (which would eventually add IBP to its portfolio). This move put an end to the problem of these standalone entities while ensuring additional capacity for BPCL. Private players had also entered the landscape with Reliance commissioning its gigantic refinery in Jamnagar, Gujarat. Essar Oil was also on course to getting its own facility ready in the same State. The other big news concerned HPCL which refused to buy out the stake of its partner, the AV Birla group keen on exiting MRPL. It was a costly decision, something that the top management regrets even today because it resulted in ONGC getting majority control of the refinery. HPCL’s stake was down to less than 20 per cent when it could have easily tilted the scales otherwise by paying virtually nothing to take charge of a coastal facility. ONGC could not have asked for a more cushy entry into the downstream space except that its bosses in the Petroleum Ministry were categorical that it focused on its core activity of exploration. It still has not been able to realise its vision of setting up a host of retail outlets (under its brand name) across the country. IOC and ONGC had, also around this time, explored the idea of coming together and pooling their expertise in refining, marketing and exploration as well as getting into new areas like power and petrochemicals. It was an ambitious partnership that promised to deliver the moon except that practical realities were quite different. The mega dream fell apart in some years with each company choosing to go on its own. However, HPCL and BPCL had cause for cheer when their long overdue projects in Punjab and Madhya Pradesh finally saw the light of day. The former got a strong partner in the Lakshmi Mittal group, while Oman Oil wasted little time in heading back to the Bina project with BPCL. What was particularly impressive was that both refineries were commissioned at a time when HPCL and BPCL were in the midst of a severe liquidity crunch. This was the time crude prices had spiralled out of control and the oil companies had their backs to the wall. Yet, they continued to invest because these refineries were critical to their growth going forward especially in North India where their presence was little to write home about. IOC’s Paradip refinery is still some months away. It continues to be the largest player but competition has become more intense. Private players like Reliance and Essar have realised that marketing of fuels is a tough task when prices continue to be subsidised. However, with petrol out of the administered pricing net and diesel rapidly following suit, these companies are expected to be back in the local arena with a bang. Their public sector rivals — IOC, BPCL and HPCL — are also gearing up for the challenge in what promises to be a high voltage script in the coming years. Refining capacity From a little over 50 million tonnes in 1993, India’s refining capacity is now nearly 220 million tonnes. IOC leads the fray with 55 million tonnes with BPCL at 30 mt and HPCL at 24 mt. Reliance has the single largest refining capacity of 62 mt with Essar at 20 mt. 21 | P a g e

The next three years will see HPCL increase capacity at Visage and Bhatinda by nine mt and BPCL following suit in Mumbai, Numaligarh, Bina and Kochi (14 mt). IOC will add 20 mt which will include a new refinery at Paradip, Orissa. Essar will see its capacity increase by 18 mt, while MRPL will be up a tad at three mt. The 6 mt Nagarjuna Oil refinery is also expected to be commissioned which means the country’s overall refining capacity will be comfortably over 300 million tonnes by 2016. Recessions and Oil Prices It is worth noting that the three longest U.S. recessions since the Great Depression coincided with exceptionally high oil prices. The first two lasted 16 months. The first followed the 1973 Embargo started in November 1973 and the second in July 1981. The latest began in December 2007 and lasted 18 months. Charts similar to the one at the right have been used to argue that price spikes and high oil prices cause recessions. There is little doubt that price is a major factor. The same graph makes an even more compelling argument that recessions cause low oil prices. 22 | P a g e

Economics Oil Prices Oil provides more than a third of the energy we use on the planet every day, more than any other energy source. And you can draw a straight line between oil consumption and gross-domestic- product growth. The more oil we burn, the faster the global economy grows. On average over the last four decades, a 1 percent bump in world oil consumption has led to a 2 percent increase in global GDP. That means if GDP increased 4 percent a year -- as it often did before the 2008 recession -- oil consumption was increasing by 2 percent a year. At $20 a barrel, increasing annual oil consumption by 2 percent seems reasonable enough. At $100 a barrel, it becomes easier to see how a 2 percent increase in fuel consumption is enough to make an economy collapse. Fortunately, the reverse is also true. When our economies stop growing, less oil is needed. For example, after the big decline in 2008, global oil demand actually fell for the first time since 1983. That’s why the best cure for high oil prices is high oil prices. When prices rise to a level that causes an economic crash, lower prices inevitably follow. Over the last four decades, every time oil prices have spiked, the global economy has entered a recession. When we consider the first oil shock, in 1973, when the Organization of Petroleum Exporting Countries’ Arab members turned off the taps on roughly 8% of the world’s oil supply by cutting shipments to the U.S. and other Israeli allies. Crude prices spiked, and by 1974, real GDP in the U.S. had shrunk by 2.5%. The second OPEC oil shock happened during Iran’s revolution and the subsequent war with Iraq. Disruptions to Iranian production during the revolution sent crude prices higher, pushing the North American economy into a recession for the first half of 1980. A few months later, Iran’s war with Iraq shut off 6 percent of world oil production, sending North America into a double-dip recession that began in the spring of 1981. There are many ways an oil shock can hurt an economy. When prices spike, most of us have little choice but to open our wallets. Paying more for oil means we have less cash to spend on food, shelter, furniture, clothes, travel and pretty much anything else. Expensive oil leaves a lot less money for the rest of the economy. Worse, when oil prices go up, so does inflation. And when inflation goes up, central banks respond by raising interest rates to keep prices in check. From 2004 to 2006, U.S. energy inflation ran at 35 percent, according to the Consumer Price Index. In turn, overall inflation, as measured by the CPI, accelerated from 1 percent to almost 6 percent. What happened next was a fivefold bump in interest rates that devastated the 23 | P a g e

massively leveraged U.S. housing market. Higher rates popped the speculative housing bubble, which brought down the global economy. Triple-digit oil prices will end the lofty economic hopes of India and China, which are looking to achieve the same sort of sustained growth that North America and Europe enjoyed in the post-war era. There is an unavoidable obstacle that puts such ambitions out of reach: Today’s oil isn’t flowing from the same places it did yesterday. More importantly, it’s not flowing at the same cost. Conventional oil production, the easy-to-get-at stuff from the Middle East or west Texas, hasn’t increased in more than five years. And that’s with record crude prices giving explorers all the incentive in the world to drill. According to the International Energy Agency, conventional production has already peaked and is set to decline steadily over the next few decades. New reserves are being found all the time in new places. What the decline in conventional production does mean, though, is that future economic growth will be fueled by expensive oil from nonconventional sources such as the tar sands, offshore wells in the deep waters of the world’s oceans and even oil shale’s, which come with environmental costs that range from carbon-dioxide emissions to potential groundwater contamination. And even if new supplies are found, what matters to the economy is the cost of getting that supply flowing. It’s not enough for the global energy industry simply to find new caches of oil; the crude must be affordable. Triple-digit prices make it profitable to tap ever-more-expensive sources of oil, but the prices needed to pull this crude out of the ground will throw our economies right back into a recession. What Affects Oil Supply? OPEC is an organization of 12 oil-producing countries that produce 46% of the world's oil. In 1960, they formed an alliance to regulate the supply, and to some extent, the price of oil. These countries realized they had a non-renewable resource. If they competed with each other, the price of oil would be so low that they would run out sooner than if oil prices were higher. OPEC's goal is to keep the price of oil at a stable price. A higher prices gives other countries the incentive to drill new fields which are too expensive to open when prices are low. The U.S. stores 700 million barrels of oil in the Strategic Petroleum Reserves. This can be used to increase supply when necessary, such as after Hurricane Katrina. It is also used to ward off the possibility of political threats from oil-producing nations. 24 | P a g e

The U.S. also imports oil from non-OPEC member Mexico. This makes it less dependent on OPEC oil. NAFTA is a free trade agreement that keeps the price of oil from Mexico low, since it reduces trade tariffs. What Affects Oil Demand? The U.S. uses 21% of the world's oil. Two-thirds of this is for transportation. This is a result of the country's vast network of Federal highways leading to suburbs built in the 1950s. This decentralization was in response to the threat of nuclear attack, which was a great concern then. As a result, the country has not developed the infrastructure for a national mass transit system. The European Union is the next biggest user, at 15% of the world's oil production. China now uses 11%, as its use has grown rapidly. What Else Affects Oil Price Futures? Oil futures, or futures contracts, are agreements to buy or sell oil at a specific date in the future at a specific price. Traders in oil futures bid on the price of oil based on what they think the future price will be. They look at projected supply and demand to determine the price. If traders think demand will increase because the global economy is growing, they will drive up the price of oil. This can create high oil prices even when there is plenty of supply on hand. That's known as an asset bubble. This happened in gold prices during the summer of 2011. It happened in the stock market in 2007, and in housing in 2006. When the housing bubble burst, it led to the 2008 financial crisis. How has oil prices behaved in recent decades? The graph below shows the history of the price of oil since the early 1950s. The price shown is the monthly average spot price of a barrel of West Texas intermediate crude oil, measured in U.S. dollars. The gray bars in this and all the following figures represent recessions, as defined by the National Bureau of Economic Research. Spot Oil Price ($ Barrel) 25 | P a g e

As it can be seen, a long period of oil price stability was interrupted in 1973. In fact, the 1970s show two distinct jumps in oil prices: one was triggered by the Yom Kippur War in 1973, and one was prompted by the Iranian Revolution of 1979. Since then, oil prices have regularly displayed volatility relative to the ’50s and ’60s. The graph on the right shows the real oil price, calculated by dividing the price of oil by the GDP deflator. This removes the effect of inflation and thus gives a more accurate sense of what is happening to the price of the commodity itself. In essence, the “real” measure allows you to compare oil prices over time in a way that you can’t when inflation is also part of the change in price. You can see that real oil prices have varied a lot over time, and large fluctuations tend to be concentrated over somewhat short periods. You can also see that by the spring of 2008, as this posting was prepared, the real price of oil has easily exceeded that of the late 1970s. How closely is Oil Prices Tied to Economic Activity? Recent developments in oil markets and the global economy have, once again, triggered concerns about the impact of oil price shocks around the world. The economists have started wondering whether the fuss is really necessary. Increases in international oil prices over the past couple of years, explained partly by strong growth in large emerging and developing economies, have raised concerns that high oil prices could endanger the shaky recovery in advanced economies and small oilimporting countries. The notion that oil prices can have a macroeconomic impact is well accepted and the debate has centered mainly on magnitude and transmission channels. Most studies have focused on the US and other OECD economies. And much of the discussion has related to the role of monetary policy, labour markets, and the intensity of oil in production. The manner in which oil prices affect emerging and developing economies has received surprisingly little attention compared with the large body of evidence for advanced economies. The researchers have completely ignored the impact of oil prices and the facts involved with it that characterize the relationship between oil prices and macroeconomic aggregates across the world. The big picture It is no surprise that import bills go up when oil prices increase. It is more surprising that GDP often goes up too. The graph below depicts the correlation between oil prices and GDP for 144 countries from 1970 to 2010. 26 | P a g e

More precisely, it shows the cyclical components of oil prices and GDP, with long-term trends excluded. The set includes 19 oil-exporting countries, represented by red bars, and 125 oil-importing countries, represented by blue bars. A positive correlation indicates that when oil prices go up, GDP goes up, and when oil prices go down, GDP goes down. Through this, we can say that in more than 80% of the countries, the correlation between oil prices and GDP is positive, and in only two advanced economies – the United States of America and Japan – it is negative. One of the main contributing factors to this pattern is that in 90% of these countries, exports tend to move in the same direction as oil prices. Anatomy of oil shock episodes Given that periods of high oil prices have generally coincided with good times for the world economy, especially in recent years, it is important to disentangle the impact of oil price increases on economic activity during episodes of markedly high oil prices. There have been 12 episodes since 1970 in which oil prices have reached three-year highs. The median increase in oil prices in these years was 27%. During this period, there is no evidence of a widespread contemporaneous negative effect on economic output across oil-importing countries, but rather value and volume increases in both imports and exports. It is only in the year after the shock that negative impact on output for a small majority of countries was found. (In the graph, we can see the Real GDP growth in oil shock episodes less median growth from 1970-2010) Small effects for oil importers Taking into account the fact that higher oil prices are generally positively associated with good global conditions, studies have shown that the effect becomes larger and more significant as the ratio of oil imports to GDP increases. To trace out the full impact of an oil shock, the below graph which gives the results indicate that the typical oil importer can expect a cumulative GDP loss of about 0.3% 27 | P a g e

over the first two years, with little subsequent impact. For countries with oil imports of more than 4% of GDP (i.e., at or above the average for middleand low-income oil importers), however, the loss increases to about 0.8% – and this loss increases further for those with oil imports above 5% of GDP. In contrast to the oil importers, oil exporters show little impact on GDP in the first two years but then a substantial increase consistent with the positive income effect, with real GDP 0.6% higher three years after the initial shock. To put these numbers in perspective, it is useful to think of an economy where oil accounts for 4% of total expenditure and where aggregate spending is determined entirely by demand. If the quantity of oil consumption remains unchanged, then a 25% increase in the price of oil will cause spending on other items to decrease and, hence, real GDP to contract by 1% of the total. From this reference point, one would expect the possibility of substituting away from oil to reduce the overall impact on GDP. At the same time, there could also be factors working in the opposite direction, via, for example, confidence effects, market frictions, or changes in monetary policy. With our estimates of the GDP loss at only about half the level implied by the direct price effect on the import bill, the results presented here suggest the size of any such magnifying effects, if present, is not substantial across countries. Are oil price increases really that bad? Conventionally, the researchers have it that oil shocks are bad for oil-importing countries. It is also consistent with the large body of research on the impact of higher oil prices on the US economy, although the magnitude and channels of the effect are still being debated. Recent research indicates that oil prices tend to be surprisingly closely associated with good times for the global economy. Indeed, we find that the US has been somewhat of an outlier in the way that it has been negatively affected by oil price increases. Across the world, oil price shock episodes have generally not been associated with a contemporaneous decline in output but, rather, with increases in both imports and exports. There is evidence of lagged negative effects on output, particularly for OECD economies, but the magnitude has typically been small. 28 | P a g e

Controlling for global economic conditions, and thus abstracting from the findings that oil price increases generally appear to be demand-driven, makes the impact of higher oil prices stand out more clearly. For a given level of world GDP, it is found that oil prices have a negative effect on oil-importing countries and also that cross-country differences in the magnitude of the impact depend to a large extent on the relative magnitude of oil imports. The effect is still not particularly large, however, with our estimates suggesting that a 25% increase in oil prices will typically cause a loss of real GDP in oil-importing countries of less than half of 1%; spread over 2 to 3 years. These findings suggest that the higher import demand in oil-exporting countries resulting from oil price increases has an important contemporaneous offsetting effect on economic activity in the rest of the world, and that the adverse consequences are mostly relatively mild and occur with a lag. The fact that the negative impact of higher oil prices has generally been quite small does not mean that the effect can be ignored. Some countries have clearly been negatively affected by high oil prices. Moreover, it cannot be ruled out that more adverse effects from a future shock that is driven more by lower oil supply than the more demanddriven increases in oil prices that have been the norm over the past two decades. In terms of policy lessons, our findings suggest that efforts to reduce dependence on oil could help reduce the exposure to oil price shocks and hence costs associated with macroeconomic volatility. At the same time, given a certain level of oil imports, strengthening economic linkages to oil exporters could also work as a natural shock absorber. How High Oil Prices Will Permanently Cap Economic Growth ? For most of the last century, cheap oil powered global economic growth. But in the last decade, the price of oil has quadrupled, and that shift will permanently shackle the growth potential of the world’s economies. The countries guzzling the most oil are taking the biggest hits to potential economic growth. That’s sobering news for the U.S., which consumes almost a fifth of the oil used in the world every day. Not long ago, when oil was $20 a barrel, the U.S. was the locomotive of global economic growth; the federal government was running budget surpluses; the jobless rate at the beginning of the last decade was at a 40-year low. Now, growth is stalled, the deficit is more than $1 trillion and almost 13 million Americans are unemployed. And the U.S. isn’t the only country getting squeezed. From Europe to Japan, governments are struggling to restore growth. But the economic remedies being used are doing more harm than good, based as they are on a fundamental belief that economic growth can return to its former strength. Central bankers and policy makers have failed to fully recognize the suffocating impact of $100-a-barrel oil. Running huge budget deficits and keeping borrowing costs at record lows are only compounding current problems. These policies cannot be long-term substitutes for cheap oil because 29 | P a g e

an economy can’t grow if it can no longer afford to burn the fuel on which it runs. The end of growth means governments will need to radically change how economies are managed. Fiscal and monetary policies need to be recalibrated to account for slower potential growth rates. How do high oil prices affect the economy on a “micro” level? As a consumer, it can be understood the microeconomic implications of higher oil prices. When observing higher oil prices, most of us are likely to think about the price of gasoline as well, since gasoline purchases are necessary for most households. When gasoline prices increase, a larger share of households’ budgets is likely to be spent on it, which leaves less to spend on other goods and services. The same goes for businesses whose goods must be shipped from place to place or that use fuel as a major input (such as the airline industry). Higher oil prices tend to make production more expensive for businesses, just as they make it more expensive for households to do the things they normally do. It turns out that oil and gasoline prices are indeed very closely related. So, when oil prices spike, you can expect gasoline prices to spike as well, and that affects the costs faced by the vast majority of households and businesses. Is the relationship between oil prices and the economy always the same? The two aforementioned large oil shocks of the 1970s were characterized by low growth, high unemployment, and high inflation (also often referred to as periods of stagflation). It is no wonder that changes in oil prices have been viewed as an important source of economic fluctuations. However, in the past decade research has challenged this conventional wisdom about the relationship between oil prices and the economy. As Blanchard and Gali (2007) note, the late 1990s and early 2000s were periods of large oil price fluctuations, which were comparable in magnitude to the oil shocks of the 1970s. However, these later oil shocks did not cause considerable fluctuations in inflation, real GDP growth or the unemployment rate. 30 | P a g e

A caveat is in order, however, because simply observing the movements of inflation and growth around oil shocks may be misleading. Keep in mind that oil shocks have often coincided with other economic shocks. In the 1970s, there were large increases in commodity prices, which intensified the effects on inflation and growth. On the other hand, the early 2000s were a period of high productivity growth, which offset the effect of oil prices on inflation and growth. Therefore, to determine whether the relationship between oil prices and other variables has truly changed over time, one must go beyond casual observations and appeal to econometric analysis (which allows researchers to control for other developments in the economy when studying the link between oil prices and key macroeconomic variables). Formal studies find evidence that the link between oil prices and the macro economy has indeed deteriorated over time. For example, Hooker (2002) suggests that the structural break in the relationship between inflation and oil prices occurred at the end of 1980s. Blanchard and Gali (2007) look at the responses of prices, wage inflation, output, and employment to oil shocks. They too find that the responses of all these variables to oil shocks have become muted since the mid-1980s. Why might the relationship between oil prices and key mac roeconomic variables have weakened? Economists have offered some potential explanations behind the weakening link between oil prices and inflation. Gregory Mankiw suggests increases in energy efficiency as one explanation. Indeed, as shown in the graph, energy consumption per dollar of GDP has gone down steadily over time. This means that energy prices matter less today than they did in the past. It’s also found that increased flexibility in labor markets, monetary policy improvements, and a bit of good luck (meaning the lack of concurrent adverse shocks) have also contributed to the decline of the impact of oil shocks on the economy. Finally, how monetary policymakers treated the economic shocks caused by rising oil prices also may have played a role in the impact of the shocks on economic growth and the inflation rate. Specifically, some have argued policymakers tended to worry more about output than inflation during the oil shocks of 1970s and did not adequately take into account the inflationary aspect of the oil shocks when fashioning a policy response to them. In the case of the U.S., since households and firms sensed that the Fed was not going to pay a lot of attention to inflation, they probably realized that the oil shocks would lead to substantially higher future inflation and adjusted their expectations accordingly. By contrast, the Fed in the 2000s is more committed to fighting inflation, the public knows it, and the result has been that, even though headline inflation has risen noticeably because of the direct effects of oil and commodity shocks, core inflation and inflation expectations remain contained. 31 | P a g e

The lack of major output effects of oil price shocks since the 1970s calls into question what role they played during the two recessions of that period. In other words, one possible reason why oil shocks seem to have noticeably smaller effects on output now than they did in the 1970s is that the world has changed. Another is that the effects of oil shocks were never as large as conventional wisdom hold, and that the slow growth of that decade had to do with other factors. 32 | P a g e

Policy Making with Oil Prices The US Federal Reserve did not cause the recessions of the 1970s and early 1980s by raising interest rates in response to unexpectedly higher oil prices. Moreover, the oil price ‘shocks’ contributed comparatively little to the output and inflation swings of those decades. These are among the conclusions of research by Professor Lutz Kilian and Logan Lewis, published in the September 2011 issue of the Economic Journal. The researchers note that the effects of monetary policy responses to oil price shocks in the 1970s and early 1980s should not be only of interest to economic historians. The issue is central in modern day analysis of the transmission of oil price shocks, with some observers suggesting that the Fed may have been too passive in dealing with the drivers of high asset and oil prices after 2005. What’s more, as the world economy recovers from the crisis, the question of how to respond to higher oil prices is likely to take on a new urgency. In a policy environment that resembles the beginning of the 1970s, understanding the monetary policy regimes of that era – to what extent they were successful and to what extent they can be improved – is crucial for monetary policy-makers. Oil prices since 1970 have been volatile and the subject of both media and academic attention. But while they are important for businesses and consumers alike, even large oil price swings on their own are unable to generate major booms and busts in the overall economy. This led some economists to propose that in addition to the direct effect of oil price increases, the Fed might raise interest rates to fight the inflationary effects of oil price shocks. This policy reaction would amplify the direct effects of the oil price increases – and together these effects would cause a recession. Kilian and Lewis show that the evidence for this channel rests largely on using only oil price increases, rather than both increases and decreases in the price of oil. By ignoring oil price decreases, the statistical estimate of the effects of unexpected changes in oil prices is overstated. Without this questionable transformation, their research shows, oil price shocks did not significantly contribute to the inflation and output movements of the 1970s and early 1980s, even when the monetary policy response is included. Monetary policy responds to many economic variables, most notably inflation and real economic activity. Kilian and Lewis estimate and decompose the response to an unexpected 10% increase in the real price of oil. They find that the overall Fed Funds rate rises about 0.6% after six months. 33 | P a g e

Most of this response is directly triggered by the oil price increase itself, indicating that the Fed was indeed responding to oil price shocks. But relative to other shocks in the economy, these oil price shocks are too small to cause the booms and busts seen in past decades, and the monetary policy response does not substantially amplify these effects. Moreover, Kilian and Lewis caution that all oil price changes are not alike. Some are caused by supply disruptions, including wars and decisions by OPEC. Others are the result of shifts in worldwide demand for energy, undermining the rationale for a mechanical policy response to oil price shocks. In addition, there is evidence that the monetary policy response to oil price shocks has changed since the 1980s. Future models of oil and monetary policy should analyse the underlying sources of oil price changes, with monetary policy responding to those causes rather than the resulting price effects. The debate over the impact of quantitative easing by major central banks has again intensified, especially following the announcement of another round of quantitative easing by the US Federal Reserve on 13 September 2012. Some commentators have argued that, in a world in which commodities constitute an asset class, there ought to be a positive relationship between quantitative easing and commodity prices via ‘portfolio effects’– even if quantitative easing does not affect the demand or the supply of physical oil. There is scant empirical evidence, however, to support the claim that financial investment in commodities affected commodity prices. Other commentators therefore point instead to the positive correlation between the Fed’s Treasury-bond purchases and oil prices as evidence that quantitative easing is pushing commodity prices higher. Yet, the only observable positive correlation between bond purchases and oil prices coincided with the recovery of global economic activity in early 2009, when the latter led to an increase in the demand for oil. Therefore, it is in all likelihood misleading to argue that quantitative easing pushes commodity prices higher by just looking at such short-term correlations. 34 | P a g e

Monetary policy, of course, does have the potential to affect commodity prices. However, it is important to understand the transmission mechanism of how quantitative easing could affect commodity prices. The physical oil market is a highly competitive market, with physical prices determined by supply and demand. Hence, to impact

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