Unlocking Demand Elasticity

Among the factors contributing to higher oil prices, energy subsidies in developing countries are finally attracting the attention they deserve. As noted in this week's Economist, fuel subsidies and price controls are prevalent in many developing countries, and they play an important role in keeping demand--and thus global oil prices--high by short-circuiting the price elasticity of demand. That forces even larger adjustments on the part of developed countries such as the US and EU members, which quickly see the impact of higher oil prices reflected at their gas pumps. A report in this morning's Wall Street Journal indicates that India, Malaysia and several other countries have just reduced their subsidies. That is good news for consumers elsewhere.

I've been hearing about the problems in India from a friend and former colleague who grew up in India and spends part of the year there. Thus far, the government's "administered price" program has forced refiners, including the private and state-run oil companies, to absorb the impact of higher crude oil prices. The Journal estimates this cost at $5 billion for the current fiscal year. Although the government was ultimately going into debt over this policy, because it finances the refining companies' deficits with government bonds, raising prices to world levels appeared to be political suicide. Apparently American consumers aren't the only ones who feel entitled to cheap fuel. The consequences of this logjam were starting to mount, according to my friend. Companies were rationing dealers to the previous year's volumes, and several companies, including Reliance Petroleum and Essar, closed thousands of service stations, many of them new. The latest reduction of subsidies has pushed the gas price to the equivalent of over $4.00 per gallon, and the protests have begun.

Malaysia is in some respects an even more interesting situation, because unlike India, it is a net exporter of oil. Although its oil consumption is modest, in global terms, the government's decision to move retail prices closer to world levels could be influential with other producers, including Middle Eastern countries that have kept their domestic prices very low, and that have experienced an explosion of demand in recent years--in aggregate rivaling the growth of petroleum demand in China. A few years ago, Malaysia exported nearly twice as much oil as it does now, and the growth of domestic demand threatens to turn the country into a net importer within a few years, a shift that Indonesia has already experienced. There's a lesson here for those who think that energy independence and cheap energy are inherently synonymous, a lesson that the UK has already learned.

If we're looking for US diplomacy to have an impact on the price American consumers pay for gasoline, the elimination of market-distorting fuel subsidies around the world looks like a better target than exhorting oil producers to increase their output to drive prices down. It would also be more consistent with US policy in other areas, in contrast to our schizophrenic approach to oil drilling.