Oil Prices and Futures Market By Dr. Bobby Srinivasan and Dr. Sudhakar Balachandran

This is an ongoing conversation between the student and the professor.

Student: Professor, I read in the papers that the price of Brent Crude oil has touched 115 dollars a barrel. Will it hurt India?

Professor: Of course it will. The main reason for this price hike is because of the civil insurgency in Iraq. The price of crude oil went up 4.5 percent ($5 a barrel) in just one week. The Sunny insurgents (ISIS) have already taken over Mosul, the second largest city in Iraq. The Baiji refinery that provides diesel and gasoline to Iraq is also under siege. A scarcity is in the making.

Student: Will there be a ceasefire soon?

Professor: Very unlikely. You see the Sunnis want to carve a separate state. (They call it Caliphate) where all the Sunnis could live and practice their Shariat law. This is their dream similar to that of Martin Luther King of US who wanted the black and the white to live and work together in harmony and Nelson Mandela of South Africa who wanted the abolition of apartheid. The Shia’s are providing the opposition and willing to fight to death to kill their dreams. So there is a blood bath going on.

Student: Professor, every time a crisis develops of this nature, the oil prices go up. Why?

Professor: For 2 reasons. (1) The production of oil could be hampered by the war and so an artificial scarcity is created which will push up the oil prices. (2) The oil futures market where hedgers and speculators are there to seek protection and to profit respectively from the volatile market. The hedgers for example may be importers of oil and they buy the oil futures to ensure availability of oil and at a price they are comfortable with. The speculators on the other hand want to push the price sky high to reap speculative profits. These 1000 barrel Brent crude and WTI contracts are traded in the ICE and CME markets in the US. The volume of trade is very huge revealing the intensions of the traders and speculators.

Student: Why should the retail market be affected?

Professor: When the traders see the prices moving up in the futures market they know that the price will eventually move up in the retail market. It is this expectation that results in the price changes in the retail market.

Student: Can anyone prevent the prices of oil from moving up?

Professor: That is why you should study macroeconomics. For example, in the case of oil you will know who are the producers and consumers in the world and how political and economic events play a big role in the price movement. For example in the last Iraq war, the oil pipeline going through the Kurds territory was blown and this caused the price of crude oil to spiral up. The speculation took the price to $ 146 a barrel before the bubble burst.

Student: Now let me ask you a question about India. Will the events in the middle-east affect us?

Professor: You bet your last dollar it will affect us seriously. We import large quantities of oil from Iraq. If there is an interruption in supply, the price will shoot up. Also all flows through the gulf of Hormuz will stop creating scarcity. If the insurgency spreads through Iran, the gulf-shipping will be affected badly. With every dollar of price hike per barrel our oil bill jumps up by several thousand crores. To protect the consumer, if the subsidy in increased, then the budget deficit will increase significantly. On the other hand, if the cost is passed on to the ultimate consumer, prices at the petrol pump will jump higher and so this will push the inflation rate higher.

Student: What really can government do?

Professor: They can perhaps hedge. Hedging costs are sometimes quite prohibitive and this discourages them from hedging. Look, when things are not in your control what can the government do.

Student: Professor I will go and read up about oil and oil future. Thanks for the conversation.

Professor: Let me caution you. When you read some of these reports, check who has written it. Some really wish the price could go higher. It is a zero sum game. For example, Russia and Saudi Arabia will be celebrating because they are the big exporters of crude oil and also will want the price to go up. Countries like India are major importers and so we have to pray to the lord almighty that the civil war should end soon and that the prices revert back to its normalcy. But you see we don’t have a choice. As they say “Beggars cannot be chosers. Take it or leave it”.

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