Oil price strength and its ramifications for Indonesia

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.