View from McLeod Road: Deregulated prices could have prevented petrol crisis

Rigidity in pricing mechanism is part of the cause for acute shortages.

CHICAGO:

This was supposed to have been a good month. Lower global oil prices were finally starting to be felt in Pakistan’s energy supply chain.

Prices of petrol and cost of power production were all supposed to go down. Power production should have gone up. Blackouts should have decreased. Industrial and commercial activity should have picked up just as inflation started decreasing.

But what we got instead were massive lines running for miles waiting for fuel, a severe gas shortage, and continued power outages. Did I mention that power outages are about to get a lot worse? How did all of this happen? The short answer would be government interference.

There are several causes that led to the current, acute phase of the much longer chronic energy crisis we face. Everything from a truck collision on a highway outside Karachi to fog in Punjab to delays in ships arriving at the port were immediate causes of the crisis. But the real, long-run reason is that our energy supply chain is extremely brittle, and it has become that way because the government owns most of it and wants to promise the people magic.

The crisis is complex and interconnected, so it is helpful to talk about it in segments. Let us focus with the part of the energy chain that is currently the most visibly affected — retail petrol pumps.

About 65% of all petrol pumps in Pakistan are either directly owned by or supplied fuel by Pakistan State Oil (PSO), the government-owned company that dominates the country’s energy sector. The remainders (and a growing percentage) are owned by the private sector.



These people are required by law to have 20 days’ worth of fuel in reserves at all times. Most of these companies and petrol pumps have nowhere near that level of capacity to hold inventories, let alone actually have that much fuel in reserves. So is that the problem? Not really.

The real problem for the oil companies is the way the government mandates that prices are determined. The Oil and Gas Regulatory Authority (Ogra) determines what the price should be, based on the weighted average cost, every month. It also mandates that oil companies make a fixed profit per litre of fuel sold. Ordinarily, I would argue that fixed margins are a bad idea, but when one company (PSO) has so much market power, I can see the logic.

However, when you combine fixed profit margins with sudden price changes, the incentive to hold large inventories vanishes, particularly in times of rapidly declining global prices such as the situation we face today. Here is why. Let’s say I buy oil from the international market at Rs90 and the government allows me to sell at a Rs5 profit. I buy a million litres and sell half of that in two weeks and have the other half left over.

Suppose the international price falls and the government mandates that I sell my new fuel at Rs80. For the new fuel I buy, that is no problem. I am buying cheaper fuel from the international market and making a Rs5 per litre profit. But what about the half million litres that I bought at Rs90. I still have to sell that at Rs80, which is a Rs10-per-litre loss that I have to book that all but wipes out my profit from the new oil. So why would I keep any reserves if I know that prices are falling?

The solution to this little conundrum is to deregulate prices, but keep government rules on profit margins. If oil companies do not have to face sudden, government-mandated prices, they can gradually adjust prices downwards based on the average cost of oil in their inventories. That would then remove the disincentive to have inventories during falling prices, and the effect of global prices would more smoothly be passed on to consumers.

Of course, this would also mean that the prime minister would not get to address the nation and announce oil prices as though he made them happen. However, I suspect, this is the reason we have the current system in the first place.

The writer is a staff correspondent

Published in The Express Tribune, January 19^th,  2015.

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