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June 09, 2008

Oil Prices & Global Investors

Today's Economic Times had articles by two well known fund managers - Ruchir Sharma and U R Bhat - on the topic of oil prices.

From Sharma's article:
The parallels are indeed striking between the late stages of the tech mania and the current oil boom. Both mega trends were rooted in a powerful economic shift; while the tech boom was associated with several technological breakthroughs and new ‘killer applications’ for mass use, the oil-led commodity boom is attributed to the rapid industrialisation of emerging markets.

At some point, however, investor imagination begins to overstate reality. With oil prices doubling since mid-2007, without any major corresponding change in the supply-demand dynamic, there are now widespread signs that the myth has again transcended the truth. While it’s hard to predict exactly when the deeply entrenched uptrend will reverse, it’s important to be fully aware that psychology rather than fundamentals is currently spurring oil prices.

...Myth 2: Emerging market demand is main determinant of oil prices. Unlike most other commodities, where China is indeed the price-setter, OECD demand is still the most relevant factor when it comes to oil. The US consumes 25% of global oil compared to 9% for China. US oil demand has contracted by 5% so far this year, as demand destruction is in the works.

From Bhat's article:
The status of oil as just another commodity changed dramatically in the early 1970s when the oil producers got together and quadrupled the price of oil. Most of the countries reliant on imported oil responded sensibly by using the price mechanism to reduce oil consumption by imposing heavy doses of taxation on the commodity before it reaches the consumer. In India, petrol and diesel are subjected to various kinds of government taxes and levies — right from customs duty on imported crude, to excise duty, sales tax, entry tax, octroi, etc. As a result, even after the recent price hike without factoring in any prospective reduction in state sales tax, at current crude oil prices just under half of the retail price of petrol and just under a third of the price of diesel are accounted for by taxes and levies of the government.

However, given that taxing petroleum products is one of the main sources of revenue for the government, it is unlikely that the incidence of taxation on these products can come down significantly further. Moreover, the hike in retail prices is not just about passing on the increase in crude prices but more importantly, about moderating consumption.

...The status quo where the oil companies are made to bleed — though a bit less than the Rs 650 crore per day they were losing till last week — is clearly a sub-optimal solution for want of decisive policy action. Despite all the talk of excessive subsidies on petroleum products, the government has been indulging in some inelegant financial engineering where taxes, duties and levies on petroleum products are collected from the consumers in cash and a part of this amount is returned to the oil companies in the name of subsidies as illiquid bonds — which are inappropriately referred to as off-balance sheet items.

Arun Natarajan is the Founder & CEO of Venture Intelligence, the leading provider of information and networking services to the private equity and venture capital ecosystem in India. View free samples of Venture Intelligence newsletters and reports.