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Solution to the Global Petroleum Crisis

posted on: June 26, 2008 | about stocks: OIL / USO    

Raju Agarwal

Rising petroleum prices may plunge the world into a global recession. Here’s what to do about it.

In my view, financial speculators are largely responsible for the recent surge in the price of petroleum. Indeed, this is yet another case of “irrational exuberance”, similar to the previous technology and real estate bubbles. Of course, as in previous bubbles, financial speculators will provide many seemingly convincing arguments to rationalize their actions.

However, at the end of the day, we must recognize that petroleum has become an essential asset class for institutional investors. And, given the unabated growth of institutional capital from pension funds, insurance companies, university endowments and sovereign wealth funds, petroleum prices are likely to continue their upward trajectory.

So what can be done to stem the rise of petroleum and avert a global recession?

First, the U.S. in coordination with other major economies must create a new Petroleum Speculation Tax which would be levied on financial investors that buy and sell petroleum assets but do not take physical possession of petroleum. Previous proposals have largely called for a windfall tax on energy producers. However, energy producers do not set the price of petroleum; they are price takers. The price of petroleum is set by financial investors which trade in petroleum assets. Therefore, my proposal is likely to more directly influence the price of petroleum.

Second, emerging market economies (i.e. Brazil, Russia, India and China) must accelerate their efforts to substitute petroleum with alternative fuels. For example, Brazil and Pakistan have made significant progress in substituting petroleum with sugar-based ethanol and Compressed Natural Gas [CNG] respectively.

In particular, India, which is a major sugar producer along with Brazil, must accelerate the adoption of sugar-based ethanol. To that end, India must move towards mandatory blending of twenty-five percent ethanol with petroleum as against the current five percent. Moreover, India should also liberalize the import of ethanol from Brazil until domestic producers are able to meet demand for twenty-five percent blended ethanol. The advantages of substituting petroleum with ethanol are obvious. General inflation within India would moderate while sugar cane farmers would receive higher prices.

In short, the U.S. must curb excessive speculation in petroleum and India must accelerate the substitution of petroleum with ethanol to rein in surging petroleum prices and bolster the global economy.

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