Just about everybody has now thrown in the towel on oil prices. Despite many observers believing that we are in the midst of an oil bubble, oil prices refuse to come down on a sustained basis.
Prices seem Teflon-coated, and despite global economic weaknesses, chances of rising interest rates, attempts to talk up the dollar, etc. oil prices refuse to cool down.
The bull case is very clear -- constrained supplies, strong demand from the large emerging markets and geo-political tensions. The bears are equally clear that this is another price bubble, and will end as all such financial market spikes ultimately do.
Whatever be the arguments, the bulls are clearly winning. Most market participants accept that we are in a new era for oil prices and it is very unlikely that prices will come down anywhere near the pre-2005 levels.
As is the norm, just when everyone capitulates, the seeds of a reversal get sown. In the case of oil, there are steps being taken and they will cool down this red-hot commodity, but they are being ignored by the markets.
First, all the major Asian consumers of oil have now hiked retail prices. India, Indonesia, Malaysia, Taiwan and now even China have hiked retail prices by 12-40 per cent. This is a major break in pattern as these governments have now seemingly accepted the unsustainability of continuing to subsidise consumption.
Having bitten the bullet, all now have plans to reduce oil subsidies further in the coming months. Once prices are hiked in these countries, they will not be reduced, independent of oil price movements, and thus consumers in these countries will now have to adjust to permanently higher fuel prices.
Given the income profile in these countries, the impact on consumption should be far steeper than price hikes in the OECD economies. Already demand for petroleum products is shrinking in the OECD, with gas demand in the US dropping by 6 per cent year-on-year.
Demand growth in the Asian countries should begin to stall as price hikes cascade through the system. Today's high oil prices are justified not on the basis of current shortages, but on the expected sustained growth in future demand.
If the major Asian consuming nations, which account for all the incremental demand growth today, are on a clear path to remove subsidies and force energy efficiency, this has to have an impact on the trend incremental demand. As consumers accept that they will have to ultimately pay near global prices, demand and behaviour will adjust.
Secondly, there seems to be a serious mood change in the US towards energy security. The fact that John McCain has openly come out and suggested a revival of the US nuclear programme, and that the Governor of Florida has talked of re-examining the ban on offshore drilling, are just straws in the wind, pointing to a change in political mood.
The US consumer is now feeling the pain of higher gas prices and the country will I think become more pragmatic in balancing environmental and energy security concerns.
Who would have thought that the Americans can ever be weaned away from their gas-guzzling SUVs? But that is exactly what is happening.
As consumers adapt to high petroleum prices, this adaptation will soon manifest in policy change as well. One cannot rule out tax changes designed to reduce the carbon intensity of the economy.
There is also, to my mind, a high probability of some type of legislative changes designed to reduce speculation in the commodity futures markets. It could be as simple as imposing, on institutional investors, the same prudential and disclosure norms that currently govern ordinary commodity speculation.
The loophole that currently allows investment banks to be treated as commercial hedgers, rather than financial participants, could easily be plugged. The governments in the US and Europe could reconsider the tax-free status of investments in commodities by endowments and pension funds, etc.
There is too much pressure on US lawmakers to be seen to be doing something, and this is an area where there is limited political opposition. Given the fiasco of laissez-faire regulation in the structured products and sub-prime arena, it will be difficult to resist the move to increase legislative oversight in these futures markets.
Any moves in this direction are bound to have an impact on positions sizes and the number of participants in the commodity futures markets, and will reduce volumes and speculative activity.
The fourth factor is the gradual realisation among the large OPEC producers, viz. Saudi Arabia (with huge reserves still in the ground), that it is seriously damaging its own long-term prospects by letting oil prices get out of hand today.
It is unprecedented for the Saudis to call a meeting of producers and consumers, which, even though not successful, underlines the growing sensitivity of Saudi Arabia to global calls to stop this parabolic rise in oil prices.
The Saudis must be afraid of serious policy action in the major oil-consuming countries designed to reduce dependence on imported oil.
Oil prices have now become the single-biggest issue facing the global economy. The long-term negative impact of the sharp surge in oil prices far exceeds any effects of the sub-prime crisis. High oil prices affect the poor disproportionately, and will increase global poverty. Unlike the credit crisis, it is not investment bankers but the man on the street who will feel the pinch.
The rise in prices from $70 to near $140 a barrel will alone transfer in excess of $2 trillion from oil consumers to producers. Countries and politicians can no longer wait for or afford the luxury of markets finding their own equilibrium.
We will see action of the type outlined above and more as policymakers are forced to try and engineer a reduction in oil prices. Current prices are causing too much political and economic damage across too many countries and the beginnings of action to reverse this rise are now visible.
I think we have crossed the limits and the world will act through all the policy levers at its command, both obvious and unconventional.
Oil prices will come down; it is only a matter of time and this will be a huge positive for global markets, especially Asia. They may not go much below $100, but even a move from $135 to sub $100 is huge in today's context.