WHITHER THE OIL PRICES?

What does the oil price has to do with business? The answer: a lot! Oil is the main source of energy, and presents more than 95% source of energy for transportation. And in terms of transportation, 2/3 of it are for purposes of transporting people, and another 1/3 are used for transporting goods. The price of goods, in turns, have about 20% to 30% component attributed to costs of transportation, and may consume anywhere from 10% to 50% of it’s production costs in form of energy, which is of course come mainly from petroleum and petrochemicals. Therefore, the total energy component in the price of any goods purchased can be anywhere from 30% to 70%, in terms of costs. No wonder when oil price increase, the costs of goods and services also increase in some proportions. Anyone doing business and pays no regards to oil price will be doomed. But the question is what drives world oil prices anyway? Can we understand it? Is it easy to predict what the oil price will be say three months from now? One year? Or for that matter 10 years from today?

The truth is forecasting future price of oil is an extremely futile effort: it is almost impossible to predict and forecast with any precision. The best people in the fields, namely the big oil companies are struggling with it, so you can imagine the same tasks that are faced by any arm chair economists or bureaucrats. If you ask traders and speculators, they will come with varying forecasts, some bullish while the others are bearish, depending on their view, as well as the time frame that they are looking at. In fact if you take all their forecasts together and summed them up, very likely you will learn almost nothing from it; there are tremendous forecasting variations and noise. One example that come to my mind were forecasts made one big investment firm in New York about two years ago, which publish its forecast of oil price for ten years forward. In their forecast, they predict that oil price will rise to USD50 per barrel by year 2015 (when at that time the price was about USD30 per barrel). We know that today oil price hovers around USD120 and 130 per barrel.

If we can’t forecast and predict, then what should we do? My answer is: first let us understand what is going on, because understanding the subject is in fact the first and paramount subject that is necessary to prepare us better (recall my discussions on Known Unknown: understanding what are generally unknown is very important). To delve in this subject, I have to start with a bit of background and I will attempt to explain using bit of technical jargon (of which I am almost a novice), and some economical terms. I also need the readers’ indulgence in the sense that I will try to be brief and simple, and hence avoid very accurate data as well as detail references, by using some heuristic measures, which in my view is easier to comprehend. I will try to do this by establishing certain facts, and in turns answers the opposite fallacy related to it.

Fact No. 1: Almost all world oil’s “proven and probable reserves” are KNOWN. When I say almost, it is about 75% or more. Which means that regardless of how much more efforts are done, we will not be able to discover a lot more oil than what is already found. The total proven and probable reserve that has been discovered up to date is about: trillion barrels. Based on world consumption of xx barrels per year…that means by 2050, the oil will be totally depleted. This gives an answer to Fallacy no 1: The world has unlimited supply of oil and it’s supply can last a very long time on, say 100 years on until the year 2100. Explanations: Since many years all geologists and experts has been studying the earth crust and every plate or cracks has been understood, and with today’s seismic technology, they have drawn 3-D and 4-D pictures of the earth crust on every corner of the earth and left nothing unturned. In fact all the major finds has been made since 1970s, and until then the subsequent findings were all of minor in nature. The balance of 25% or so, that are still not found are in fact, in the proper word, have been guessed to be there, it is just that they are small in size hence not enough resources being spent on to confirm it. That’s all. Any announcement of “newly” discovered oil is not a surprise by itself, it is just a confirmation.

Fact No 2: Not all proven and probable reserves will actually turns into “production oil”, and in fact the likelihood is only about half of it can be extracted and becomes crude oil. This brings in another subject called “Peak Oil”, originally brought to attention by Hubbert, an American geologist and oil expert, in 1956. To explain this, first let us understand the distinction between proven and probable reserves. Proven reserves means that the field has been drilled and proven “estimates” has been made on how much oil the field contains. Probable on the other hands means that the field has been discovered and some estimates has been made on the quantity of oil available, but in no certain terms the estimates are correct until drilling has been made and hence can be categorized into “proven” status. Another fact is also important: not all of the proven reserves can be extracted; the extraction ratio ranges from some low percentage up to 70-80%. Why? A simple fact of gravity: not all of the oil underground can defy the gravity; there won’t be enough pressure to bring it up. So what happen is so much oil are still left under the earth after pumping, and depending on the exact geological built, much are left in the rocks and will remain there forever (until and unless new technologies can undo such matter, which is very highly unlikely). Due to the low quality of so many fields (save for the one in the Middle East and some places like Russia), the extraction ratio can be on average about 50%. In another word, only half of the proven reserves coverts into production oil. And the same logic goes to probable reserves. Since most of the probable reserves known to date are of later discoveries, they all falls into the “low quality” category, and hence it is doubtful that it can beat the same ratio; and furthermore not all probable reserves will convert into proven reserves. This is what “peak oil” tries to explain: that in actuality, the oils that has been discovered (and also yet to be discovered) suffers a very important shortcoming: the actual peak for the oil production is very much shorter than what most estimates. In another word: the production of oil depletes faster than what we thought we have. This is very scary. If we go back to what I said earlier, say that based on what we know in terms of proven and probable reserves (plus some more discoveries to come), we may run out of oil much faster than we thought. It can be as early as 2030! That is well within our lifetime (and definitely our children or grandchildren). This answer Fallacy No. 2: That oil production is still in good shape, and should cater for our immediate needs at least to some foreseeable future.

[For the third discussion, I will start with the fallacy, and conveys some answers, because the facts are not as obvious, and I do not have clear answers to them.] Fallacy No. 3: That the (recent and) current oil price increase is due to speculators, but not because of the laws of supply and demand (or economic factors). What actually happen is that most peoples (all of us included), have been living happily with oil (just like the Turkey that I have explained earlier). Nobody thought that the oil issue becomes so serious and so sudden. Why? Because all economists, oil companies, governments, have been reporting about oil supplies (based on proven and probable, as explained), and the forecasts has been very good and brings everyone to the conclusion that: we will have oil for at least next 300 years, despite the growing demand from China and India! This is very assuring. Until one day, suddenly, everyone starts to question this wisdom, right after two hurricanes swept through southern United States (the Katrina and after that Rita), which disrupt production and refinery activities in the Gulf of Mexico – everything went haywire. The vulnerability of supply shows its face, and everyone started to recalculate their views, and more discussions took place: and suddenly, many people realized that we have been living in complacency out of the assumptions that (fallacy 1 and 2 above) oil will be there for long while. This is when oil prices started to surge. It rises from USD30 per barrel to USD70 per barrel after Katrina. Then after that the rise has been on the upswing since then as more and more realization come to place. The next question is then: if the price went up so much, is it because the “current” supply is insufficient to meet the current demands? The answer is: No! In fact the situation is such that all oil being produced today (about 85 million barrels per day) is more than sufficient to meet the current use of 80 million barrels per day. For that matter, all crude oils produced are being refined, such that if you pump more oils, you have no place to refine it, and it will end up in storage (which is non-economical). The same thing goes for the refined petroleum: all of them are being consumed and sufficiently meets the use, and hence excess refined products have to be stored (which is non-economical as well). Therefore, there is no use, save for political ploy, to ask producers to produce more (as evident from President Bush asking Saudi Arabia to increase production to stem the oil price increase in his recent visits to Saudi Arabia). For those who understands economics 101, will ask: if supply meets the demands, then why the oil price increased dramatically? Because, under the law of supply and demand, price increase either due to shortage of supply or excess of demands: If everything is in “equilibrium” price should be stable (say at USD30 per barrel)? This is a good example of failure of simple classical economics: In the case of crude oil, we do not have a straight line supply and demand curve; in fact the curve might look like as S curve, as in the graph below. What we can see from the Graph, there are so many possible meeting points between supply and demands, and hence the many possibilities of points of equilibrium for oil price.

Can we then forecast the price of oil in the future? I would say that it is going to be very hard. Only one thing is certain: it won’t go down, and it might go up more than what we see today. I would call the current state as a point of “inflexion” in the state of the world economy. A point of inflexion, is where a new realization has begun which sets a new level of prices (in this case oil, which in turns feeds into the rest of other goods and commodities), and a global inflation will creeps in, a lot of unrest and unsettling things will happen, until everyone adjusts to this new reality. As the word “inflexion” means, it is very hard to predict, what will be the next state of affairs will be, as these complex interactions and adjustments are taking place simultaneously. It might take us to another level, and another inflexion point, or it will settle on a new plateau for a while until other new events take place – I can’t tell, and for that matter if anyone offers you or me another “theory”, I would view them with a lot of suspicion and caution, as these forecasters are as good as any fortune tellers or soothsayers. Therefore, let me leave this subject of price here with just one conclusion: be aware and always on the lookout (to avoid being a Turkey!).

Now let me turn into other matters related to oil (and energy): should we then focus on alternative solutions such as bio-fuels, wind energy, solar power, hydrogen fuels, nuclear energy, hydro power, etc? The answer is yes, and the time is now, before it is even too late. We may not realize it that Malaysia is blessed with one thing (God given, and we must thank Him for that), we are in the equator -with much sunshine and rain, as well as (somewhat) fertile soil (and not bad size of land mass). Out of many solutions, it is clear that the more practical one should take priority, namely with what we are endowed with naturally (except oil): which is Bio-Fuels and hydro power. Why this instead of others: most of the other solutions are very much under experiments and the costs (as well as controversies) are very high and require much R&D. We still have sizable uncultivated land, and despite the controversies by environmentalists and naturalists, we should come up with national policies and serious implementations on the matter. These people (the one against these policies, mostly come from the West) which I believe where they should focus on, as they are the worst pollutants and have exterminated their forests and natural environment long ago, and we cannot fall into their trap: our children future is at stake. From much that I understand about bio-fuel, is for us to avoid anything that are edible, in order not to drive prices of food higher, and with careful management of the land use (in order not deprive food cultivation) then it should be fine. A good example that came to me is Jatropha. There are also other cellulose based conversion to bio-fuels, as well as microbe based solutions are also available, and some other research also discovers some algae and sea-weeds that also plausible. I am not an expert, but what I understand is that all of these make sense and are practical solutions.

On another note as well (in regard to how to overcome fuel price increase), is about what I called as “natural hedge” for the public: namely agriculture. As the price of fuel increase, the prices of “goods” produced also increase, but the most important area (which requires the least fuel input, save for the fertilizers – which can also be replaced with non petrochemicals sources) is agricultural output. Farmers and producers of agricultural products should gain in these increase and hence increase their income as well to cover the increase in the costs of living as the oil price increase. In fact, the people who are most hit are the urban population, as they are the consume energy by far greater amount then the rural people, and they have the least ways of hedging themselves against the fuel price increase. (May be on this note: we should start to encourage a reversal of trend that has gradually increased our problem over the years: urban migration, by getting people to move back to the rural areas, and encourage cultivation of unused lands).

Last but not least, let me get into this debate about fuel prices that are going on in Malaysia today. First let us understand the fuel subsidy issue: In order to keep the fuel prices low (compared to world prices), the Government need to pay for this difference, in what we call as fuel subsidy: which in turns maintain a low level of price at the fuel stations. At the current price of oil say USD100 per barrel (why USD100? even though the spot price is USD120, the actual prices that are being traded and done between major oil companies, Petronas included, are still at a much lower prices. My friends from one of the oil company in the Gulf informed me that the effective price they are selling is still at about USD70 per barrel): the total amount of subsidy the Malaysian Government has to spend is about USD2 billion per year. Of course this is a big amount and a very serious issue. It will deplete our Federal government budget (as it become about 5% of the annual budget). What it does is that it will “crowd out” other investments and expenditures by the Government. This is probably the main reason that the Government lifts part of the subsidy which translates into our petrol price today to be at RM2.55 per liter. Even at this price, the Government is still subsidizing us, and it claims that this is in line with the following arguments: that our petrol prices are still the lowest in the region (compared to Singapore, Indonesia and Thailand – which is true), subsidy is bad for economy as it encourages unchecked consumption and conservations (which is also true); and furthermore subsidy is unsustainable business practice and crowd out other productive purpose of peoples money, vis-à-vis government budget (which is not true, and is clearly political answer – on this issue later); And the opposing arguments that goes as follows: that subsidy should continue because we can afford it (which is true – but it can only be a temporary solution); that we cannot compare our self to Singapore and other developed countries since even though their prices are higher, their purchasing power (parity) is also high, and hence the impact on fuel prices won’t be as significant, and we cannot compare with Thailand or Indonesia, because it is unwise to compare bad with worst (which is true); that there are too much wastage in the government expenditures and there enough pockets of savings that can be used to append the subsidy (which is also true – but only to some extent); And so on and so forth, as arguments and counter arguments will be forwarded as time goes on.

The main issue that is missing in all is as follows: Subsidy cannot last forever, as the oil price will continue to be high (and may even go higher), therefore it is a serious issue that need to be tackled, the sooner the better. The prices of fuels is the base price for all other prices (since it is the price of energy), therefore, tinkling with the prices (I.e. allowance for increase) is not at all trivial matter and can just be decided without clear and well thought solutions. We have to weigh the total economic impact against the costs of managing such impact. What I have seen is that the Government never deliberate this issue well and articulate the subject thoroughly (despite all the claims, I cannot see any exposit deliberation and answers, save for the above). The economic impact of petrol increase is so dramatic and serious: take an example of a household take home earning say RM3000 per month. The total petrol costs for family per month is between RM700 to RM1000, that is close to 30% on take home moneys, not counting the increase in price of foods and services, what more moneys required for paying housing and car loans, etc In economic terms, the amount of subsidy that the Government has let go, translates into a “direct” taxation into households regardless of income, on a one to one basis (every dollar saves by the government, is extra every dollar spent on the petrol by the public). So it is the same as applying a direct to tax to every population of the country. Then we have to consider the extra money to be spent due to increase in prices of other goods and services – which is hard to measure, but can be in a big multiplier say 5 times. Therefore, one billion saved, will translates into 5 billion indirect costs (on top of the petrol costs, which are direct costs) to the consumers. This is not counting yet the broad inflationary effects on the country which is also going be a direct result of fuel price increase. My point is (which is in congruent with the views of people opposing the measures), why are we so hasty in hiking up the fuel price (by removing some of the subsidy)? Has it been thoroughly thought and considered? I have a lot of doubts on this. Even the announcements were made in haphazard manner. Is it because our federal budget is under such tremendous pressure? Or is it the case that the Government is running out money (under impending danger of such, so soon)? It raises a lot more question than answers. By making announcements from Petronas and publishing its accounts is just a “red-herring” and detraction from the reality. Petronas is just an “oil company”, as its CEO correctly said; it is not the culprit, it just manages our oil, not the Federal Budget. The budget is under the Finance Minister, who is also the Prime Minister. In my view, there are many other ways to achieve the results with lesser impact on the public, but they need to be calculated very carefully. Political ploy such as giving back rebates (and similar measures) are not only inefficient and ineffective, but also hazardous, as any sound economists will agree by increasing the tax (as I explained, due to direct price increase in fuel) to be followed by transfers (rebates etc), are the worst kind of economic policy that any government can do (and this argument holds true if the transfers are real, but in our case the transfers are just clear political ploy, nothing more than that, which makes it worse since it is a deception). I don’t intend to debate and bring forth various ideas and possible solutions in this writing as it requires more data, as well as detailed technical discussions. So let me just leave with this conclusions: In my view, the Government are mismanaging the issue and are clearly do not have any long term solution, as well as comprehensive solutions, to the problem. What I can clearly foresee, are more and more crisis will happen in the near future, unless and until this issue is clearly taken as national priority. The opposition on the other hand, has clearly sided with the public, even though I cannot see anything that are convincing as far as the long term future is concerned. But at least, they are sincere about it and willing to take a serious look into the matter in the interest of the common public. What clearly the country needs is leadership at highest level with vision and ability to steer the country forward, which today is clearly lacking.

As for the business and businessman: the economic environment will be much more challenging. We will see more Turkeys are sacrificed; Inefficiencies will be rooted out, those who can compete will not thrive, those who are more prepared will be less affected, those who use better sense will have better chance at surviving, and so on.

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