With crude oil prices under $50 per barrel this is an historic opportunity for Saudi Arabia and other countries to eliminate energy subsidies.
Low crude oil prices are making the impossible possible. Back in August, the United Arab Emirates (UAE) rolled back gasoline and diesel subsidies, leading prices to increase by 25%. UAE’s energy minister, Suhail Al-Mazrouei, said the change was about “building a strong economy that is not dependent on government subsidies.”
This is a stunning change for one of the world’s largest crude oil producers. Cheap gasoline has long been a permanent fixture throughout much of the Middle East, so when the second-largest OPEC producer increases gasoline prices this is big news.
And it is not just UAE. The World Bank recently released new data on global gasoline prices and several major economies have increased gasoline prices since the last data release two years ago.
Indonesia, for example, increased gasoline prices by $1.75/gallon. These are even larger price increases than would initially appear because global spot prices decreased by $0.75/gallon during this period. So compared to the opportunity cost of gasoline, Indonesia’s $1.75 increase represents a whopping $2.50/gallon reduction in subsidies. The economic waste from fuel subsidies goes up with the square of the gap between the price at the pump and global spot prices, so even countries with small nominal increases like Iran implicitly took large steps to improve economic efficiency.
The two biggest movers were Egypt and Indonesia. Gasoline prices in Indonesia increased from $1.78 in November 2012 to $3.52 in November 2014, while prices in Egypt increased from $1.70 to $3.33. Both countries made these reforms to curb rising budget deficits and both have pledged to use some of the fiscal savings from reforms to target health, education, and social protection measures (see here, here, here, and here).
Mexico took a slow but steady approach to rolling back subsidies. Gasoline and diesel prices in Mexico continue to be set by PEMEX, the state-owned petroleum monopoly. But after holding pump prices well below global spot prices for more than a decade, the decision was made to steadily increase them during 2013 and 2014. The monthly “gasolinazos” were each relatively small in magnitude, but cumulatively have now completely eliminated fuel subsidies in Mexico.
Cutting fuel subsidies is good for the economy. Why? Economic efficiency requires that prices be set equal to marginal cost. Cutting fuel subsidies eliminates “deadweight loss” (economist-speak for “waste”) and ensures that the benefits exceed the costs for all gasoline and diesel sales.
Cutting fuel subsidies is also good for the environment. We are less than 1 month away from the 2015 UN Climate Change Conference in Paris where participants will be discussing all types of creative approaches for reducing carbon dioxide emissions. Few are as simple and effective, however, as increasing energy prices. Indonesia’s recent reforms, for example, could eventually reduce Indonesian oil consumption by 30%, or half a million barrels per day. This is equivalent to more than 75 million tons of carbon dioxide emissions annually, a significant part of Indonesia’s entire proposed commitment for COP 21.
Why is this subsidy reform happening now? Low crude oil prices reduce government revenue in oil producing countries, increasing budget deficits and making fuel subsidies harder to afford. This fiscal urgency was a major part of the motivation in most of the countries where subsidy reform has occurred. The situation was particularly desperate in Egypt and Indonesia, where the governments combined reforms with public-education campaigns aimed at explaining just how costly the subsidies had become from a fiscal perspective.
Low crude oil prices also reduce the size of the subsidy, making it an opportune time to allow prices to rise to international levels. Had UAE attempted to liberalize prices last year, it would have meant much larger price increases and more public backlash. When Yemen tried to liberalize prices in August 2014, it led to large protests and violence, in part because global spot prices were so much higher than they are today.
The true test is going to be whether countries like the UAE can maintain the reform in the future when global oil prices increase. Although the term “deregulation” is being used to describe the reforms in UAE, prices in UAE are not truly deregulated. They continue to be set by a “Fuels Prices Committee”, which meets on the 28th of each month. You have to worry when crude prices increase, this committee is going to come under huge political pressure to freeze retail rates.
UAE’s reform nonetheless provides a clear roadmap for countries that continue to have large gasoline subsidies like Venezuela (where retail prices are $.06 per gallon), Saudi Arabia ($.61), Kuwait ($.83), Turkmenistan ($.83), and Qatar ($.87). The UAE reform suggests that there may be a changing culture around fuel subsidies.
The next big change may be in Saudi Arabia. Two weeks ago the Saudi oil minister Ali Al-Naimi made news when he said that Saudi Arabia was considering reducing fuel subsidies. One report even suggested that the Saudi government had asked the UAE government for advice. Ali Al-Naimi backed away from these suggestions last Wednesday, however, saying that such steps are only, “when you are in dire need, and fortunately Saudi Arabia isn’t today in such dire need.” Given Saudi Arabia’s historic leadership in the Persian Gulf region and long tradition of steep subsidies, any reform there would be huge news and could lead the remaining countries that subsidize fuels to do the same, slashing economic waste and external costs.
Lucas Davis is an Associate Professor of Economic Analysis and Policy at the Haas School of Business at the University of California, Berkeley. His research focuses on energy and environmental markets, and in particular, on electricity and natural gas regulation, pricing in competitive and non-competitive markets, and the economic and business impacts of environmental policy.