by: kei
From: Economic Times (Reuters), on how India's decision to cut oil subsidies could bring economic stability to the world economy.
Volatility in Crude - how subsidies brought the world down!
Market analysts remain fiercely divided about what caused the doubling of crude oil prices between Q1 2007 (when they averaged $58 per barrel) and Q2 2008 ($124). But three factors were crucially important:
Extensive price controls and subsidies on refined product prices across most of Asia and the Middle East ensured households and firms were insulated from the rise in oil prices. Price controls broke the “invisible hand” and meant regional consumers faced no real pressure to reduce consumption or switch to alternative fuels despite the doubling in crude costs.
The entire burden of adjustment therefore fell on households and firms in the advanced industrial economies. Prices had to surge high enough to force deep cuts in the western world’s oil consumption to offset supply shortages and unrestrained demand growth in emerging markets.
Oil producers were unwilling or unable to materially increase supply in response to soaring prices. In the short term, supply is fairly fixed.
Those producers holding spare capacity (mostly Saudi Arabia) either had the wrong sort of crude (heavy, sour) or doubted that adding additional barrels to the market would make much difference, given inventories already appeared to be at reasonable levels and there was no sign of physical shortages.
Hedge funds and other “managed money” participants built up a (then record) net long position in oil futures and options on the assumption that although prices were already high, they would need to rise even further to “choke off” demand and balance the market.
In particular, many investors seem to have concluded that neither emerging market demand nor crude supply would be very responsive to prices unless they spiked to exceptionally high levels.
The interval between mid-May and early July 2008, when prices started peaking, saw two significant developments which probably convinced many participants the market was turning: China announced huge increases in state-controlled gasoline and diesel prices to take effect from June 20, and Saudi Arabia said at the Jeddah summit in June it would increase output to 9.7 million barrels per day.
By the start of September — well before the collapse of Lehman Brothers brought on a liquidity crisis — crude prices had already fallen almost a third to around $100 per barrel.
