Morgan Stanley on Role of Subsidies in Oil Prices

A reader forwarded me a Morgan Stanley fixed income research report wrap, which included a discussion of the role of gasoline and oil price subsidies in certain developing countries. The price gives an good overview of the role these defacto consumer price discounts have played, and argues that they will have to be cut back (India has already reached a crisis point on this issue). To invoke a newly-popular cliche, “the cure for high prices is high prices,” and once these subsidizided customers are increasingly exposed to world price levels, their demand will fall.

One useful aspect of this report is that it considers not just the implications for oil markets but also broader macroeconomc impact. From “Enjoy the Energy Subsidies While You Can,” by Stephen Jen and Luca Bindelli:

A quarter of the world’s gasoline consumption is subsidised, and, in terms of population, half of the world uses energy subsidies.1 This policy has created an important distortion, whereby rising oil prices have been effectively prevented from destroying oil demand. Subsidies have artificially raised inflation in the developed world (through artificially high oil prices) and suppressed inflation in the developing world (inflation would have been even higher in the absence of subsidies). As fiscal pressures mount, some countries will be forced to incrementally remove these subsidies. The net result will be an unwind of these distortions. For currencies, we believe that the net effect will be negative for EM countries, as this process will be stagflationary for them, and ‘Goldilocksy’ for developed countries…

Economists tend to be less well-versed in supply conditions in the energy sector. But the current oil price increases are curious. They are not quite supply driven, and the fact that global demand is decelerating appears to be inconsistent with accelerating oil prices. While the logic behind the increasing structural energy demand from EM makes a lot of sense, it is still difficult to justify how oil prices could more than double in 15 months, or rise by six-fold in seven years, unless one subscribes to the ‘Peak Oil Thesis’, i.e., we are at the steep part of the supply curve.

Without explicitly taking a stand on where the equilibrium price of oil should be, either close to US$200 or US$50 a barrel, in economies, and how they have distorted global energy demand and inflationary pressures in the world. We argue that these subsidies will ultimately need to be rolled back… When these subsidies are rolled back, we believe that the effects will be stagflationary in the EM markets but ‘Goldilocksy’ in the developed countries, with different implications for the EM and developed market currencies.

Right now, half of the world’s population enjoys gasoline subsidies, and a quarter of the world’s gasoline consumption is
subsidised. Exhibit 1 shows the current prices of gasoline in various countries. While many countries have taxes on gasoline, some major oil consumers do not. In China, for example, gasoline costs 64¢ a litre, compared to US$1 in the US, and the equivalent of US$2.16 in the UK. In many of the oilproducing countries, the subsidies are even larger: gasoline costs the equivalent of 12¢ a litre in Saudi Arabia and 5¢ in Venezuela. (However, Norway – another large oil exporter – has the second-highest gasoline prices in our sample.)

While three-quarters of the world’s gasoline consumption is taxed, the level of ‘net taxes’ has actually declined as oil prices have increased, for various reasons. To show this, we compare how Exhibit 1, which is for early 2008, looked at end- 2006, when crude oil was trading at around US$60 a barrel. Back then, only 10.4% of the world’s gasoline consumption was subsidised (compared to 22.2% right now). Essentially, what this means is that the extent to which the world has been subsidising its consumption of gasoline has actually increased, with the rise in crude oil prices.
We have these thoughts:

• Thought 1. Insufficient destruction of oil demand. Demand curves are usually downward-sloping because, all else equal, higher prices should lead to lower quantity consumed. This should be no different for energy products. Particularly when the global aggregate demand may be decelerating, energy prices should not, in theory, rise so rapidly. Large energy subsidies as described above could be one explanation. As international energy prices rose, governments tried to shelter local energy consumers from such a shock through the use of subsidies. Energy demand, therefore, has not been ‘destroyed’ by higher prices. The world’s demand for energy products, as a result, is higher than it should be in the absence of subsidies. Energy prices are overshooting partly because energy demand is overshooting.

• Thought 2. The developed world’s inflation is artificially high, while developing countries’ inflation is artificially low. Food and energy products make up heavier portions of the consumption baskets in developing countries than in developed countries. So, the fact that headline inflation in EM tends to be higher than that in developed nations should not come as a surprise. However, these subsidies – which are concentrated in EM – should bias headline inflation in opposite directions for developed and developing countries.

• Thought 3. These subsidies will be tough to maintain forever. If the energy price shock were transitory, then subsidies should work to smooth out the price shock through the budget. However, if this energy price shock is permanent and if energy prices continue to rise, then it will be quite difficult for governments, especially those with fragile fiscal positions, to maintain these subsidies. Already, Indonesia has announced (on May 21, 2008) a 28.7% fuel price hike, possibly to be implemented in June.2 Malaysia is planning to ease energy subsidies, and Taiwan just announced, earlier today, that it is contemplating a 20% rise in fuel prices.

• Thought 4. This will add to the stagflationary pressures in EM. Governments will reduce energy subsidies by force, not by choice. In other words, they will be forced to 2 Some of these fuel price adjustments will be partly offset through targeted transfers. Specifically, to offset the shock to the very poor, some governments will have a cash compensation programme for the poor. In the case of Indonesia, the government will distribute 14.0 trillion rupiah (US$1.5 billion) in cash, out of the 34.5 trillion rupiah that it should save through the cut in energy subsidies. Taiwan’s gasoline subsidies could be as high as US$250 million a month. In Malaysia, fuel subsidies could total US$16.5 billion this year, according to the Second Finance Minister Nor Mohamed Yakcop. cut back on subsidies precisely when global energy prices rise, and/or the world slows.3 These legacy subsidies effectively flattered EMs’ growth and inflation performance, and the eventual unwind of these subsidies will exacerbate the stagflationary shock in EM. At the same time, the impact on the developed world will be ‘Goldilocksy’, if crude oil prices stabilise as a result of the oil demand destruction in EM. In short, unwinding of these energy subsidies will drive a wedge between the inflation trajectories in the developed and developing worlds.

• Thought 5. Another negative for EM currencies. In previous research, we proposed that there are distinct phases of any financial crisis. The first phase is the pure financial part; the second phase is the real economic adjustments; and the third phase entails significant snap-backs in some asset prices,

During the first phase, EM were seen as the safe havens, primarily because the financial systems in EM were not that exposed to the type of assets that were in trouble. EM equities and currencies outperformed for most of this first phase of the crisis. However, in the second phase, we are turning more cautious on EM currencies, especially in AXJ. The prospective unwinding of fuel subsidies in Asia will add to this negative bias to AXJ currencies, in our view. The world’s oil price inflation should decelerate, as oil demand is destroyed in EM. But faced with a more intense stagflationary shock, EM policy makers will likely opt to protect economic growth, rather than cap inflation.4 Monetary policies in Asia will likely remain easy when hit by this stagflationary shock.

Bottom Line
Half of the world now enjoys fuel subsidies, but this will not last. Fuel subsidies prevent oil demand from being destroyed
by high oil prices, and have exaggerated inflation in the developed world, while understating inflation in the developing world. As these subsidies are rolled back in these EM economies, these distortions will also abate. The key implication for currencies is that most AXJ currencies, and some other EM currencies, will likely experience negative pressures relative to both the USD and the EUR. Risk-reward no longer supports a short USD/AXJ investment posture for the coming weeks, in our view.