Oil price hike: it’s institutional

How conflicting responsibilities of the regulator make sudden changes inevitable.


Farooq Tirmizi November 08, 2010

Billed as the biggest fuel price increase in years, last week’s rise in oil prices has attracted considerable ire amongst consumers and the media. Less well understood, however, are the conflicting interests that regulators must balance when deciding these matters.

Much of the problem in oil prices is structural. Unlike developed economies, oil prices in Pakistan are set by government fiat through the Oil and Gas Regulatory Authority (Ogra), which has the dubious distinction of being an organisation that is simultaneously responsible for ensuring that consumers do not face sudden price increases while also ensuring that profitability in the energy sector remains substantial enough to attract the necessary investment – local and foreign.

These are two diametrically opposed goals in the short run, although they do at least partially converge in the long run. Higher short-term profitability of the energy sector is likely to spur more investment, which will reduce consumer prices over the long-run. However, it is the short-run that usually grabs the government’s immediate attention.

Oil prices change every minute of the day, but Ogra can change prices only once every month. The regulator is essentially caught between the slow pace of the bureaucracy to which they are legally bound and the lightning speed of trading on global energy exchanges, where the international price of oil is set.

This institutional structure ensures that instead of small daily increases or decreases, price changes are almost always sudden jumps.

It was an attempt to correct this discrepancy that led the government to allow some discretion to the oil companies in pricing petroleum products at retail petrol stations across the country. Yet, even this move was greeted with sharp criticism, with several observers particularly peeved by the government’s alleged secrecy in the matter. The government is damned if it does and damned if it does not.

The 9.2 per cent rise over last month’s prices is at least partially justified. The prices for Arabian Light Sweet Crude Oil, the benchmark used by Ogra, have risen by as much as 6.9 per cent over the past month and are expected to go up even further.

Oil futures contracts trading on the New York Mercantile Exchange (Nymex) suggests a further 3.5 per cent rise within the next three months. Futures contracts are traded on exchanges and determine the price of a given delivery at a specified date in the future.

Most oil marketing companies make their purchases between one and six months in advance, with three months being the most common period of advance purchase. This makes the three-month futures (contracts that specify a price for delivery three months in the future) highly relevant to current pricing decisions. Ogra will undoubtedly use this data to justify the price increase and not unreasonably.

Nonetheless, critics argue that there are other factors at play and that perhaps Ogra is likely to be less forthcoming about those. For instance, despite all sorts of price volatility in the international markets – where prices move in both directions – prices rarely ever go down for domestic consumers. The occasional decreases are often not of the same magnitude as global price declines.

While it is true that Ogra often does not substantively decrease oil prices, it does not always increase domestic prices in line with global price hikes either. For example, during the first two quarters of 2008, global oil prices shot up by over 90 per cent, yet the corresponding price increase in Pakistan was nowhere near that number.

Indeed, it was the government’s failed attempt at subsidising fuel that eventually led to the problem of inter-corporate circular debt. With the government unable to pay sufficient subsidies to energy companies, they were in turn unable to pay their own bills, creating a vicious cycle of unpaid bills that has crippled the energy sector.

The recent IMF-driven push by the government to deregulate the energy sector is designed to solve this problem by getting the government out of energy pricing altogether, focusing its regulatory attention instead on preventing fraudulent and collusive activity. The most recent attempt by Ogra to hand over pricing decisions to oil companies is part of that effort.

While the consumer is unlikely to see any substantial declines in fuel prices in the near future, deregulation will ensure that their ire is directed at oil companies, not the government.

In the long run, of course, more developed domestic energy sources are likely to help consumers have access to affordable energy. It is unclear, however, whether the populist passions of both commentators and ordinary citizens can be contained long enough not to derail that process.

The writer is a financial and management consultant based in Karachi

Published in The Express Tribune, November 8th, 2010.

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