From October 1998 to February 2005, crude oil prices have increased from $12 to over $65 a barrel. As demand keeps increasing for fast-growing economies such as China and India, we can expect that the price at the pump will keep rising.
Indeed, a recent forecast by energy economists at Ixis-CIB, an investment bank, had crude prices rising to $380 a barrel by 2015, or six-fold of current prices. This doesn't seem implausible given the six-fold increase over seven years from 1998 to 2005. This increase in price has been driven by demand, rather than an increase in cost to producers.
In 1998, the average worldwide cost to producers for producing a barrel of oil (which includes exploration and extraction costs) has risen from about $12 to $15 from 1998 to 2005. The rise in price from 1998 to 2005 means India currently pays over $30 billion extra each year for its crude imports.
India is the worst placed among the major economies of the world, with oil imports accounting for over one-third of total imports and expected to grow rapidly. No other country, not even energy-poor Japan or Germany, have such a large fraction of oil in total imports.
With India's projected growth, oil imports will only accelerate. The natural question to ask is whether anything can be done about this wealth transfer, or is the India helpless? The answer fortunately is that India is not helpless, as I will explain.
Suppose you have five neighbours. Two of them produce petroleum, whereas you and three other consume petroleum. The price to the producers is $15 a barrel, but the demand by the four consumers leads them to compete against each other resulting in a price of $65 a barrel.
Sometimes the two producers even form a cartel and restrict supply so that the price is higher. You take a step back and think about it: the producers are spending $15 to produce the petroleum but selling it to you for $65, what can you do about it?
Economic analysis (common sense really) says you can do one of two things. First, you can form a buyers' cartel with the other consumers. The four of you stop competing, but rather band together. You offer the producers a certain take-it-or-leave-it price, say, $25 a barrel.
As the price for the producers is only $15, they still make a profit at $25, so they may very well accept your offer. Of course, the price will be determined by negotiations, but it will almost certainly be significantly below $65.
The buyers' cartel can then sell the oil to its members, and the price will be $65. However, the profits of the buyer's cartel ($40 a barrel if the buying price is $25) can be distributed among you and the neighbours and your effective price becomes $25.
Alternatively, you can come to an agreement with your neighbours that the consumption of petroleum will be taxed. These taxes will be pooled and distributed among the consumers. The effect of this will be to reduce the demand for petroleum, thus causing the price charged for petroleum to drop.
Though the consumers face apparently higher petroleum prices (because of the tax), the total effect is less money paid from consumers to producers after taxes are returned to the consumers. This refund of taxes has to be lump sum rather than proportional to consumption, so as not to negate the effect of taxes.
Now substitute the US, China, Japan, Germany, South Korea, Italy and France for your oil importing neighbours and Saudi Arabia, Russia, and Iran as your oil exporting neighbours, and you have the current global oil market. India needs to form a cartel or arrive at a tax understanding with the other oil importing countries.
Of the two solutions, which is better? They both have their advantages. The first solution of a buyers' cartel that resells to importing nations would probably result in larger gains for the importing countries. However, it would entail a major restructuring of the way the international oil market works and would meet serious resistance from oil exporting countries. The latter solution would be easier to implement but would cause higher prices at the pump for consumers (though in the net they would come out ahead as this scheme is "revenue neutral" to the government).
At late 2005 prices, the wealth transfer out of the India due to the excess over costs was about $54 billion a year. The capitalised value of this excess over cost (being paid by India) ranges from $5 trillion to $20 trillion.
China's consumption is growing even faster. If in the next 10 years, its per capita oil consumption reaches even one-third of current per capita US consumption, the capitalised value of the excess price over cost paid by China could hit $15 trillion to $60 trillion.
For the US, it would range from $12 trillion to $50 trillion, for Japan, it could be $5 trillion to $20 trillion, and about $2.5 trillion to $10 trillion apiece for South Korea and Germany, and $2 trillion each for France, Spain and Italy.
The capitalised value of the excess paid by all importing countries adds up to about $50 trillion to $200 trillion.
To overcome the huge wealth transfer to foreign producers taking place due to increasing demand, coordination is necessary between the governments of petroleum importing countries. Tax policy by their governments is one feasible method of attaining this coordination. Such a policy has the promise of cutting the effective petroleum expense for consumers by more than half.
As additional benefit of this policy would be the cut in consumption of petroleum that would alleviate serious environmental problems such as global warming.
I can only end this article by reiterating: there is free lunch worth about $5 to $20 trillion for India lying on the table. Whether India and other oil importing countries' citizens get nothing or a share depends upon the competence of their governments.
To say we shouldn't try it is accepting a zero share for sure.
The author is Professor of Business at Nevada State UniversityDo you want to discuss stock tips? Do you know a hot one? Join the Stock Market Investments Discussion Group