Economy, Business And Markets

Upside of Low Oil Prices

Post-Doc and Teaching Fellow at Alzahra University
Upside of Low Oil PricesUpside of Low Oil Prices

With the benefit of hindsight, it should be said that oil prices plummeting to historic lows is not all gloom and doom.

The declining pattern that started from the summer of last year has had some benefit for the government in Tehran, which is long struggling to balance its books, and helped it reach some of its targets.

With declining oil revenues having almost emptied state coffers, the government has been deprived of the largesse to spend at will, which is usually followed by ballooning deficits.

Less money to spend has noticeably translated into one of the reasons behind the government’s success in taming inflation and curbing the people’s expectations of lower prices in the wake of the nuclear agreement with the six world powers in July.

Moreover, for the first time in contemporary Iranian history, revenues from taxes have overtaken oil export receipts. Add to this the fact that as international gasoline prices have also decreased drastically, the President Hassan Rouhani administration has achieved the oft-mentioned goal of restructuring gasoline prices at the pumps at par with Persian Gulf free-on-board rates.

From January 2011 and as per the Subsidy Reform Plan, the government is obliged to comply with the law to reform energy prices. Change in energy prices should be such that domestic prices of oil derivatives gradually increase by the end of the Fifth Five-Year Economic Development Plan (March 2016) and are not less than 90% of the  FOB prices and not above FOB prices.

The highly controversial subsidy plan has been putting 450,000 rials per month in the individual bank accounts of an estimated 74 million Iranians. What is worse is that the value of this understandably meager amount has declined due to growing inflation and forex rates—when it started it was equivalent to about $45 but today it is hardly worth $13.

Now domestic gasoline prices are also higher than the FOB price, in view of the official exchange rate. At market rates, gasoline prices are about 93% of the FOB price. As of now, gasoline is traded at $1.13 per gallon that makes it 30 cents per liter.

Each liter of gasoline is sold at a unified price of 10,000 rials, which is equivalent to $0.33 at the official exchange rate. This is primarily due to the 50% decline in FOB prices for gasoline over the past five months.

Subsidy reforms, the pet project of former president, Mahmoud Ahmadinejad, was designed to also raise energy prices with the one declared aim of curbing energy consumption in Iran that has long reached crisis proportions. Hence, while the targeted price adjustment is here, the reform program has seemingly failed to discourage prohibitively high and unsustainable energy consumption.

One area where this claim can be seen visibly is the agonizing increase in traffic congestions in all our major cities, not to mention the pattern of high consumption of gas, water and electricity both by households and manufacturers. Data from the World Bank show an increasing trend of energy consumption after the launch of the Subsidy Reform Plan.

This evidence suggests that it is not the target that matters; rather it is the desired effect that the target is seeking. Thus, it is not only gasoline prices that determine consumption levels but also its price relative to other things, especially the substitutes, complements and their price changes. The reform plan lacks, among other things, a clear mandate for improving and expanding public transport and reducing the use of private cars.

The reform agenda was meant to adjust prices and it was believed that real prices would eventually lead to the desired results. The perceived change in consumption patterns was used as a platform for selling the regressive reform plan to the public that was satisfied with the cash handouts as it was too generous during its launch–amounting to about 50% of per capita expenditure of the poorest 10% of the population in 2011.

A group of economists and pundits are recommending higher gasoline prices, as they compare the Persian Gulf FOB prices with those in the developed countries. These experts have called for another round of increase in prices, saying that under record low oil prices, now is the best time to do so. This line of reasoning carries little if any logic because of reasons like transaction costs and trade barriers. The same good does not sell for the same price in all locations.

The sizable difference between prices across countries is due to varying purchasing powers. Hence, if we compare the average monthly wage to the price of gasoline across countries, we get a sense of the difference across countries as it is the price relative to income that matters and not the price itself.

Comparing Iran and the UK, which have the most expensive gasoline, the ratio of average monthly wages to gasoline prices is 1,462 in Iran and 1,448 in the UK.

This implies that an average Iranian monthly salary can buy 1,462 liters of gasoline, while the UK average monthly salary can buy 1,448 liters. Hence, if we express prices in relative terms, the misleading international comparisons by using market exchange rates will be minimized.

Although energy prices have been adjusted without much government effort, it has curbed the purchasing power as is evident from the loss of value of the cash subsidy payments to the vast majority of the people.

For this reason, the government decided to distribute a free food basket to the needy that strangely included many non-poor groups and excluded many, if not most, poor families who found out later that they were not among the nine million needy households.

As the government has failed to determine the needy, economists and social scientists have dismissed the food aid program as a fiasco. It is for this primary reason that the government is having a tough time trying to delete the relatively well-off from the monthly $1.1 billion cash subsidy scheme—an undertaking it simply will not be able to afford in the not-too-distant future.