Oil price strength and its ramifications for Indonesia

David E. Sumual Jakarta

Soaring oil prices have again been creating headlines in the economic sections of most newspapers. After climbing about 40 percent last year, oil prices have continued to gyrate widely over the past two weeks.

Crude oil on the New York commodity market breached the psychologically significant level of US$40/barrel to hit a 13- year high of $41.70/barrel at the beginning of this week. With crude prices now hovering around the $40/barrel mark, fears of another oil-incited crisis, having a similar impact as the 1973 Arab oil embargo, are now tangible.

As a leading indicator, many global bourses, including the Jakarta stock exchange (JSX) have moved down in the past two weeks due to fears that high oil prices would push up inflation and thus curb the world's economic growth. In the near future, if oil prices continue to rise to $45 per barrel or even approach $50 per barrel, the world economic recovery may turn sour.

Given the continued chaos in Iraq, the scenario that a quick war in Iraq would bring the Iraqi oil reserves back into the market and lead to a sharp fall of oil prices has not materialized. Besides Iraq, some analysts also point to the short-term conditions such as an insufficient supply of OPEC produced oil and seasonal shortages as the main causes.

However, other than the notions of sentiment-led or seasonal movements, there is a signpost that the recent leaps in oil prices signaled that the world oil market equilibrium has been gradually shifting.

Even if the quagmire in Iraq is finally resolved, it may not however give the world sustainably cheap oil in the foreseeable future. Oil prices may tend to move upward over the next couple of years given the strong economic growth in some emerging and industrialized countries, leading to greater demand for the limited oil supply.

In general, unless there have been any political crises or wars, oil prices since the early 1980s have tended to move in accordance with changes in OPEC producers' capacity utilization. When production is high, producers have been unable to sustain high prices. And when production falls, oil prices usually move higher.

OPEC has in part supported this long-term trend. The organization is following a strategy of deliberately moderate prices and high market share that will maximize their returns over time. This strategy would also allow non-OPEC economies to grow and prosper, whereas excessive energy prices would lead to reduced economic activity and thus to lower oil consumption and, of course, would affect their economies.

However, there is a strong tendency that world oil production is already at or near its peak. This phenomenon, which is also known as the Hubbert Peak, is a moment when worldwide demand for oil outstrips the global capacity to produce it, which signifies the end of the age of cheap oil.

Dr. King Hubbert is a geophysicist who predicted in 1956 that American production would peak in 1970 and then he proved the phenomenon as predicted.

On a world scale, a consulting firm in Geneva (Petroconsult) has created a Hubbert Peak analysis based on the most complete computerized database of world oil exploration results, and has concluded that the world Hubbert Peak will arrive shortly around the year of 2010. A more optimistic scenario by the International Energy Agency places the peak of oil production somewhere between 2010 and 2020.

Given the emerging economies' (especially China's) thirst for imported oil, world excess demand may nevertheless, arrive sooner than 2010. According to the IEA (International Energy Agency), the daily world consumption of oil is 14 million barrels higher than it was a decade ago and although China only consumes 8 percent of the world's oil, it accounted for 37 percent of the growth in world oil consumption over the last four years.

So even if the Iraq war is resolved quicker than expected, the around 250 billion barrels of Iraqi oil reserves may only give the world lower oil prices for more than a couple of years at most.

Oil prices may temporarily fall back toward $22 a barrel but the recovery in the U.S and Asia's growing demand for oil may push the oil price upward. Moreover, the specter of terrorism - although transient - may also be a wild card that affects oil prices. Speculation on the geopolitics situation in the Middle East and fears of terrorist attacks on oil infrastructure in major oil exporting countries still spooks the oil market.

Beside those reasons, soaring oil prices have also been determined by the rational expectations of big oil investors. Even right now while oil prices have risen to over $40 a barrel, vast reserves of oil that exist in the deep sea cannot be extracted profitably although many big oil firms keep signing deals to try to exploit the high-cost oil reserves.

Their calculation is a long term one: Either advances in technology will slash the cost of getting at this crude oil or prices will soar before they do. Within this scenario, the advanced technological progress and high oil prices would allow the further exploitation of known sources in the deep sea and would allow output to rise for another decade or two.

So how should Indonesia react given the current situation? The most important thing is that Indonesia must adapt promptly given that the nation is now actually a net oil importer.

According to Pertamina, Indonesia needs to import up to 20 million kiloliters of oil products this year as it may only produce 44 million kiloliters of fuel, while demand is estimated at 63.3 million kiloliters this year.

Due to large fuel subsidies and the obligation to distribute the additional income to regional governments, higher oil prices would also not even contribute any gains to the state budget. For instance, windfall profits of higher oil prices for the state budget stood at Rp 16 trillion ($1.8 billion) in 2003, but the government had to pay additional subsidies amounting of Rp 12.82 trillion in that year.

Adaptation also means that the government should prepare a contingency plan to deal with the higher oil prices. Our newly elected legislators and our soon-to-be-elected president should see this issue as one of their top priorities.

As long as Indonesia is dependent on a dwindling supply of oil, the threat of an economic downturn will remain. The soon-to- be-elected administration should undertake a major campaign to bring about a radical change in the way oil energy is used.

The government could also begin to promote investment in alternative energy sources and support greater energy conservation measures. The next administration could also consider encouraging domestic industries to use oil energy efficiently by reducing oil subsidies.

Boosting foreign investment, particularly in underexploited natural resources and mining products such as coal and natural gas would also help keep the Indonesian economy afloat.

We know that the Indonesian government for now at least is still focused on the exploitation of oil that will actually only last for the next decade. Meanwhile, the greater potential of a huge reserve of natural gas and coal that could last one more century remains neglected.

The writer is analyst of Danareksa Research Institute. This article is a personal view.