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Oil Prices History and Trends

History of Oil Prices in India

18

Economics of Oil Price

23

Policy Making with Oil Prices

33

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
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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 20032004. 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 (16.5106 m3/d) from 86 million barrels (13.7106 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.
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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 19962006. 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 (790103 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.
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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.
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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

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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.

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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.
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In contrast, non-OPEC production increased from 25 million barrels per day to 31

million barrels per day.

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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

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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
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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

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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
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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.
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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

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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.

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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 countrys 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
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the discovery of several new oil fields most notably the off-shore Bombay High field
which remains by a long margin Indias 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, Indias main trading partner. The bailout was done on the condition that the
government initiate further reforms, thus paving the way for Indias 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.
Indias 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 Indias strong economic links with Iran, India voted with the
US when Irans 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 wasnt exactly a level playing field which prompted Arthur D Little, a consultancy
firm, to suggest that IOCs huge market share be reduced to ensure that other players in
the PSU space get a fair share of the pie.
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The international consultant had prepared an exhaustive report of Indias downstream

industry and mooted a merger of Madras Refineries and Cochin Refineries. A portion of
IOCs 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 BRPLs 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 Petroleums 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
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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. HPCLs 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.
IOCs 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, Indias 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.
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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 countrys 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.

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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. Thats 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 worlds 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 Irans 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, Irans 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

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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: Todays oil isnt flowing from the same places it did yesterday. More
importantly, its not flowing at the same cost.
Conventional oil production, the easy-to-get-at stuff from the Middle East or west Texas,
hasnt increased in more than five years. And thats 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 worlds oceans and even oil shales, 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. Its 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.

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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)

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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 cant 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.
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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%
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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.

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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 worlds economies. The countries guzzling the most oil are
taking the biggest hits to potential economic growth. Thats 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. isnt 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
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an economy cant 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.

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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. Its 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.

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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.

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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.
Whats 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.
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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 Feds 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.

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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 energy prices, quantitative easing must impact physical supply or demand.
Expansionary monetary policy can change physical supply and demand of commodities,
including oil, through several channels. One such channel is through expectations of
higher inflation or strong growth. Still, if market participants interpret announcements
of quantitative easing instead as signalling more problems in terms of lower growth
prospects or more risk, then an announcement of quantitative easing might easily lead
to a fall (rather than a rise) in prices. A second mechanism is through the interest rate
channel. Low interest rates due to expansionary monetary policy may increase prices of
storable commodities: by reducing the opportunity cost of carrying inventories, thereby
increasing inventory demand; by reducing the cost of holding reserves underground,
thereby decreasing oil supply; and by increasing the demand for oil in non-dollar
economies, whose prices are denominated in a now weakened dollar.
Empirical evidence on the impact of quantitative easing on oil prices is so far mixed. On
the one hand, Kilian (2009a, 2009b) argues that the only episodes in which monetary
policy regime shifts caused major oil price increases dated back to the 1970s. He argued
that increases in global liquidity in the early and mid-1970s fostered a global output
boom and surge in inflation, thereby driving up the prices of oil and other industrial
commodities. Kilian further argues that it would take concerted regime shifts in many
countries to exert enough demand pressure to drive global commodity prices. However,
his analysis does not look into the period after 2008, where we observed the
widespread introduction of unconventional monetary-policy measures by major central
banks. On the other hand, Anzuini, Lombardi and Pagano (2012) find that conventional
monetary policy (associated with a change in the short-term interest rate) had a limited
effect on the oil price surge between 2003 and 2008 and that those effects were tied to
the expected growth and inflation channels. However, their analysis also did not
provide any evidence for the impact of unconventional monetary policy (associated
with forward policy guidance and large-scale asset purchases) on commodity prices.
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Still, they suggest that the extraordinary monetary policy easing at a time when the
lower bound on the interest rate has already been reached might push prices up, albeit
to a small extent.
There are very few empirical studies of whether unconventional monetary policies have
any effect on commodity prices. Glick and Leduc (2011), using an event study
methodology, find that commodity prices tend to fall following the announcement of
such policy measures. However, their analysis only covers 11 observations, which
precludes drawing conclusions at any conventional level of statistical significance.
Some anecdotal evidence regarding the effects of unconventional monetary expansion
on commodity prices can be gleaned by looking at the impact of monetary easing on
inflation expectations, interest rates, and aggregate economic activity. We find a strong
positive correlation between oil prices and expected inflation, measured by the
difference between the interest rate on ordinary ten-year government debt and tenyear inflation-protected Treasury debt. Expected inflation surged following the
announcement of the first two rounds of quantitative easing, but started to fall while
QE1 and QE2 were still in progress, though it is worth noting that the decline in
expected inflation would likely have been higher without the asset purchase. Several
extant papers find that QE1 and QE2 increased the ten-year expected inflation by a
range of 0.96-1.5% and 0.05-0.16%, respectively (see, e.g., Krishnamurthy and VissingJorgensen (2011) and Farmer (2012)). It seems that QE1 had a bigger impact than QE2
in terms of affecting expected inflation although it is important to note that QE1 was
implemented when expected inflation was close to zero.

The empirical research to date shows that the Feds large-scale asset purchases lowered
the ten-year interest rate. Point estimates vary between 13-100 basis points, however,
with most estimates between 15-20 basis points see, e.g., Hamilton and Wu (2011)
and Williams (2011).

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While related research papers also find some minor positive impact on GDP and
employment, it is very difficult to identify and measure the effect of quantitative easing
on real economic activity due to the response time of the latter as well as difficulties in
separating the effect of the Feds action from other factors affecting aggregate demand.
Hence, these extant estimates at the most suggest that oil prices might have been
affected by quantitative easing, but the extent of the impact might be very limited as
suggested also by Anzuini, Lombardi and Pagano (2012).
The impact of the latest round of quantitative easing on oil prices will again be
determined by its effect on inflationary expectations and aggregate demand. Although
expected inflation rose from 2.38% to 2.64% on the day following QE3s announcement,
it had fallen by 0.14% (to 2.50%) as of 20 September 2012. At the same time, WTI
prices declined from $98/bbl to $92/bbl. One interpretation is that oil market
participants may have seen the latest round of quantitative easing as a sign of worsethan-originally-perceived conditions of the economy in the coming months. Put
differently, it is still too early to make any predictions on the possible impact of the
recent quantitative easing on commodity prices.
Inflation rates are rising in the world's major economies. The consumer price index rose
by half a percent in the United States in February, equivalent to an annual rate of 6.2
percent. Consumer prices rose at a 4.4 percent annual rate in the UK and a 2.4 percent
rate in the euro area. All three central banks have explicit or implicit inflation targets of
2 percent or less.
In all three economies, rising oil prices accounted for a big part of the increase of
inflation. That fact poses a dilemma for monetary policy. Should central banks tighten
monetary policy to counteract the effects of oil price increases and prevent general
inflation? Or should they instead accommodate oil price increases with easy monetary
policy, in order to maintain growth of output and employment? Two problems make the
choice a difficult one.
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The first problem is that nothing central bankers can do, will prevent an increase in
world oil prices from harming an oil-importing economy. It must either be left with
fewer other goods and services after paying for the oil it imports, or learn to live with
less oil, or go deeper in debt, or do a little of each. Monetary policy, at best, can only
determine what form the damage takes.
The second problem is that central banks have little direct control over the real
economy, as manifested in variables like real GDP and employment. By and large,
monetary policy can only control the growth of nominal GDP. If it applies its policy
instruments correctly, a central bank could, for example, cause nominal GDP to grow at
four percent per year rather than 0 percent per year. However, it cannot do much to
determine whether that four percent nominal growth will consist of 4 percent greater
output of real goods and services, without inflation; 4 percent inflation without growth
of real output; or some combination of inflation and real output change that adds up to
four percent.
Putting these two problems together leaves the central bank of an importing country
with limited options when an oil price shock hits:
1. It can tighten policy to keep inflation from rising. Doing so will cause real GDP to
decrease, or at least to lag behind the growth of potential real GDP. The resulting
negative output gap will cause the unemployment rate to increase.
2. It can use expansionary monetary policy to try to offset the impact of oil prices
on real output and employment. However, doing so will cause nominal GDP to
grow faster. Given the negative impact of the oil shock on real GDP, inflation will
accelerate.
3. It can compromise by doing nothing, that is, hold the rate of growth of nominal
GDP to its previous path, despite the oil price shock. The result will be
intermediate between Cases 1 and 2, that is, there will be some increase both in
inflation and unemployment.
None of these options is completely satisfactory. None of them fully neutralizes the
harm done by the oil price increase. The choice among them depends on the phase of
the business cycle at the time oil prices spike, the preferences of the monetary
authorities,the legal framework they work in, and the need to coordinate monetary
policy with fiscal policy. Those factors play out somewhat differently for the central
banks of the United States, the UK, and the EU, so we should expect different policy
decisions.
The situation in the UK is shaped by the aggressive program of austerity being followed
by the Conservative-Liberal Democrat coalition government that was elected last year.
The program proposes reducing government spending by nearly a fifth and cutting half
a million government jobs. Austerity is not limited to cuts in discretionary spending.
There are cuts to entitlements, including a scheduled increase in the retirement age,
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cuts to a health-care system that is already relatively austere by European standards,

decreases in defense spending, and tax increases.
A case can be made for the UK's austerity program, considering that the budget deficit in
2010 was among the largest of all developed economies. However, it came at a time
when the British economy was just beginning to recover from recession. In the fourth
quarter of 2010, real GDP actually decreased. That left monetary policy with the burden
of preventing a full-blown double-dip recession. The Bank of England, which had
already lowered its main policy interest rate to 0.5 percent, undertook further
expansionary policy with a program of quantitative easing. The combination of low
interest rates and QE was expected to restore real GDP growth in 2011, but only at 1.7
percent, not enough to keep up with the growth of potential GDP.
Given the circumstances, the Bank of England, so far, has opted for accommodation.
Despite January and February inflation more than twice the bank's target rate of 2
percent, six of the nine members of its rate setting committee voted to keep rates low at
their most recent meeting. To try aggressively to bring down inflation at this point
would not only undermine already-weak economic growth, but would also risk failure
for the fiscal austerity plan itself, which depends for its success on a growing tax base
and a falling unemployment rate.
In the euro area, circumstances would also appear to favor accommodating the oil
shock, or at least taking a neutral stance. Real output growth in the euro area, as in the
UK, is expected to be weak this year, just 1.6 percent. Inflation in February was less than
half a percent above the 2% target rate, a smaller overshoot than in the United States or
the UK. The ECB's policy interest rate, unlike those in the UK and the United States, was
never cut below 1 percent. Several euro area economies, notably Greece, Ireland, and
Portugal, are in the midst of stringent fiscal austerity programs, which could be derailed
by a tightening of monetary policy.
Nonetheless, it appears that the ECB will soon raise interest rates. One reason is the
uneven pace of euro area growth. Although peripheral members of the euro are
struggling, growth in the core economies of Germany and France is strong. More
importantly, the ECB is more inflation averse than the Fed or the Bank of England. The
treaty that brought the ECB into existence gives the central bank a strong mandate to
focus single-mindedly on inflation. Willingness to take that mandate seriously has been
a litmus test for appointments to its executive board.
As one token of its hard-line approach to inflation-fighting, the ECB focuses exclusively
on headline inflation, which includes all goods and services. Other central banks pay
more attention to core inflation, which excludes volatile food and energy prices, and is
currently running well below headline inflation. As a result, the ECB's official inflation

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target of 2 percent, although nominally on a par with those of the United States and the
UK, is effectively more stringent.
Also, the ECB appears to give more weight to the issue of credibility. It seems to fear
that the slightest sign of weakness would call its inflation-fighting credentials into
doubt. Policy makers at all three central banks would agree, in principle, that credibility
is important. None of them want to see the emergence of long-term inflationary
expectations on the part of firms and households. However, the Fed and the Bank of
England are more willing to gamble on public understanding that any present
departures from strict inflation targeting are driven by circumstances, and do not justify
an increase in long-run inflation expectations.
Last, we come to the Fed. In some ways, the case for accommodation seems weaker in
the United States than in the UK or the euro area. US GDP growth in the fourth quarter
of 2010, at a revised 3.1%, was stronger than in the UK or the euro area, and forecasts
for 2011 growth, running at 3% or better, are also higher. January and February
inflation, as measured by the month-to-month increase in the headline CPI, was the
most rapid of the three economies. The Fed's policy interest rate, set at a range of 0 to
0.25 percent, was the lowest of the three. Finally, as in England, the Fed had gone
beyond low interest rates to engage in a vigorous program of quantitative easing.
What is more, the Fed, unlike the Bank of England, does not face the need to maintain
easy monetary policy as an offset to tight fiscal policy. On the contrary, US fiscal policy,
especially after December's new round of tax cuts, remains strongly expansionary.
Neither the administration's budget, nor any actions taken to date by Congress, comes
close to dealing seriously with a budget deficit that continues at record levels.
Yet, despite these circumstances, the Fed seems least likely of any of the big three
central banks to tighten its policy in response to rising oil prices. As in the case of the
ECB, both legal and attitudinal factors come into play. Unlike the ECB, the Fed, by law, is
tasked with balancing price stability against the need to fight unemployment, which
remains very high. Also, the Fed, more than other central banks, focuses on core
inflation, and on measures of expected inflation, neither of which is rising as rapidly as
the headline CPI.
Unless some strong indications of higher inflation emerge, for example, a sharp increase
in long-term interest rates, it seems almost certain that the Fed will keep interest rates
low and carry its current program of quantitative easing through to its scheduled
completion in June. At that point, if oil prices are still on an upward trajectory, if
Congress has still done nothing about the deficit, and if there are signs that headline
price increases are spilling through into core inflation and indicators of expectations, a
turn to a less accommodative policy becomes likely.

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Bibliography:

http://www.wtrg.com/prices.htm
http://www.fuelfreedom.org/the-real-foreign-oil-problem/oil-economics/
http://oilprice.com/Energy/Oil-Prices/How-Closely-are-Oil-Prices-Tied-toEconomic-Activity.html
http://www.bloomberg.com/news/2012-09-23/how-high-oil-prices-willpermanently-cap-economic-growth.html

CIA World Fact book, Refined Petroleum Consumption, 2011 estimates

http://buyuksahin.blogspot.in/2012/11/monetary-policy-and-oil-prices.html
http://www.clevelandfed.org/research/policydis/no10apr05.pdf
http://www.clevelandfed.org/research/commentary/2005/july.pdf
http://www.nipfp.org.in/media/medialibrary/2013/04/wp_2012_99.pdf
http://oilprice.com/Energy/Oil-Prices/Oil-Price-Shocks-And-MonetaryPolicy.html

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