Fiscal Policy Formulation and Implementation in Oil-Producing Countries
Chapter

17 Domestic Petroleum Price Smoothing in Developing and Transition Countries

Author(s):
Jeffrey Davis, Annalisa Fedelino, and Rolando Ossowski
Published Date:
August 2003
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Author(s)
Giulio Federico, James A. Daniel and Benedict Bingham1 

I. Introduction

This paper examines the case for smoothing retail petroleum prices in the face of volatile international oil prices in developing countries where petroleum prices are regulated by the government. This is an important policy question in many developing countries, given the high volatility of international oil prices, the potentially significant fiscal exposure of many governments to petroleum price changes, and the high political profile of petroleum prices.

In a competitive market economy the case for full and automatic pass-through of international price changes to domestic retail prices is strong, on both economic and institutional grounds.

Full pass-through allows for a correct price signal, which enhances efficiency and does not expose the government to undue fiscal volatility as a result of variable oil prices. However, most of the developing country governments that regulate petroleum prices do not implement automatic and full pass-through mechanisms when setting these prices. A survey of selected developing countries conducted for this paper reveals that most adopt a discretionary approach to changes in petroleum retail prices, which commonly fails to pass through changes in international prices on a consistent basis. This suggests that, at least from a political economy perspective, full-cost pass-through is not a robust policy reform.

This paper seeks to explore whether, and under what conditions, petroleum pricing mechanisms—which provide a degree of insulation to the private sector from international oil price volatility—can offer welfare-enhancing and potentially more politically sustainable alternatives to full-cost pass-through mechanisms. The paper approaches this issue by first considering the consumer-welfare implications of volatile oil prices. It concludes that retail petroleum price volatility is likely to have a negative welfare impact on consumers, and that while the private sector in developing countries is probably able to manage routine variations in oil prices, there may be scope for efficient government intervention to insulate the private sector from sharp shifts in oil prices.

The paper then explores the case for government-managed retail price smoothing. We first consider a number of potential pricing rules that diverge from full pass-through and provide a degree of price smoothing. The price properties associated with these rules and the fiscal implications of implementing such rules for the government are assessed on the basis of historical oil prices. The paper concludes that there appears to be a sharp trade-off between retail price insurance and government fiscal stability in the face of volatile prices, and that most pricing rules leave the government overexposed to oil price risk, especially given the institutional difficulties associated with volatile fiscal revenues.

The paper also briefly considers possible hedging strategies for a government wishing to smooth domestic petroleum prices. This has the advantage relative to pricing mechanisms based on spot prices of relying directly on market-based mechanisms for price insurance. As such, it appears potentially able to deliver significant price smoothing with relatively limited fiscal exposure.

The paper concludes that full pass-through of international price changes may be suboptimal, especially in the face of large shocks. However, governments in developing countries are not well equipped to deal with the significant fiscal risk associated with price-smoothing activities. They should, therefore, introduce relatively limited partial pass-through mechanisms (e.g., short moving averages of past prices) or rely on market-based insurance mechanisms to reduce oil price risk.

II. Current Practice of Petroleum Pricing in Developing Countries

The level of petroleum product retail prices is an important economic variable for both the public and the private sectors in many developing countries, and decisions on the degree of pass-through of changes in international oil prices have significant economic impact on one or both of the sectors.

Domestic taxation of petroleum products is a large source of revenue for many developing countries: it generally accounts for about 7-30 percent of overall revenue, which corresponds to 1−3½ percent of GDP. This is achieved by relatively heavy taxation of petroleum products, which varies by region and petroleum product, reflecting oil availability and distributional and efficiency considerations.

Many developing countries are also significantly exposed to oil prices at a macroeconomic level. This can be illustrated by considering the net oil balance as a percentage of GDP for oil-importing countries. For a sample of 42 net oil-importing developing countries, most countries’ exposure to oil price changes in 19992 was on the order of 1—4 percent of GDP.

The substantial economic impact of changes of both international and retail petroleum prices and of taxes on petroleum products implies that the adjustment of domestic prices to international oil prices is an important economic and political issue in many developing countries. If adjustment is complete (full pass-through) the government is relatively insulated from a fiscal point of view,3 and the private sector bears the volatility in real income. If adjustment is partial, the government would bear some volatility. This trade-off between private and public income volatility poses a difficult policy question because of the high volatility of crude oil prices.4

In spite of often substantial policy focus on the issue, reforms of domestic petroleum pricing mechanisms toward systems of automatic and full pass-through have been slow, and frequently reversed in recent years. This can be seen from the survey of current country practices on petroleum pricing, which shows that most of the 45 transition and developing countries in the selected sample5 appear to both regulate petroleum pricing and use some form of partial and discretionary pass-through mechanism.

The findings of the survey are summarized in Table 17.1, which reveals three key stylized facts about current petroleum pricing policies in selected developing countries:

Table 17.1.Summary of Country Practices on Petroleum Pricing
AreaSurveyedOil

Importers
Regulate

Retail

Petroleum

Prices
Have an

Automatic

Pass-Through

Mechanism
Have Full

Pass-

Through
Have a

Stabilization

Fund
Africa11108321
Asia-Pacific754111
Europe753002
Middle East11611431
Western Hemisphere957323
Total4531331188
Percentage of total1006973241818
Percentage of countries with regulated prices100332424
Source: Authors.
Source: Authors.
  • A significant majority of the countries surveyed regulate petroleum prices (either at the retail or ex-refinery level). Even those governments that have deregulated prices exert pressure on oil companies to moderate their price increases (e.g., as in Thailand and the Philippines during the international price hike of 2000) and still play a role in the price-setting process.

  • Only a minority of countries have an automatic mechanism for adjusting retail prices to changes in international prices. Of these, the majority currently operate a full pass-through mechanism, even though a number of these mechanisms stopped being implemented in the course of 2000, due to the pressure of high international prices.

  • Approximately one-quarter of countries that regulate prices run specific stabilization funds to manage the price-smoothing process. Some countries have recently abolished their funds because of their fiscal implications.

III. Oil Price Volatility and Its Welfare Implications for Consumers

The economic literature on the welfare implications of price volatility shows that there exist three main drivers of cost and benefits to consumers from price instability: (i) arbitrage and substitution possibilities; (ii) risk aversion; and (iii) adjustment costs.

Arbitrage and Substitution

If consumers are able to vary the level of consumption of a good characterized by unstable prices, substituting away from it in highprice periods and consuming more in low-price periods, they may actually benefit from exogenous price instability. This insight is originally due to Waugh (1944), and has subsequently been generalized by others (e.g., Massell, 1969).

Risk Aversion

Risk-averse consumers may prefer stable to unstable prices, given that the marginal utility they gain from high-consumption periods (e.g., periods characterized by low petroleum prices) is lower than marginal utility from low-consumption periods (Newbery and Stiglitz, 1981). This effect works against the substitution effect highlighted above. Turnovsky, Shalit, and Schmitz (1980) examine the nature of this trade-off, combining risk aversion with the “Waugh” effect to show that with a high-income share of the good in question, high coefficients of risk aversion, and low elasticities (both income and price elasticity), consumers prefer price stability and reductions in price volatility.6 As pointed out by Gilbert (1993), these conditions may yield an ambiguous answer as to whether petroleum price stability is desirable: the demand for petroleum products is relatively price-inelastic, and expenditure shares on petroleum tend to be high (both of which point to benefits from price stability) but income elasticities are also high, which suggests price instability may be welfare-improving.

Adjustment Costs

Consumers of petroleum products (both households and firms) may face costs of adjusting their economic activities (consumption and/or production) in the face of volatile petroleum prices.7 This would cause them to prefer stable prices, which do not lead to volatile real incomes (for households) and costs (for firms) and which, therefore, do not require adjustment.

Moreover, depending on the nature of these adjustment costs, consumers will also prefer some unstable price profiles to others. For instance, if adjustment costs are convex (i.e., they display increasing marginal costs), they would prefer gradual price changes to sudden price changes.8 If adjustment costs are mainly fixed, consumers will tend to react only to large and persistent price changes (adopting (S,s) types of rules9).

For both types of adjustment technology (convex and concave), the costs of adjusting may often be effectively sunk (i.e., they cannot be recovered once they have been incurred), which induces “wait and see” behavior by consumers, arising from the option value of deferring adjustment with a volatile price.10

Optimal Consumption Behavior with Volatile Oil Prices

This brief review of welfare effects shows that consumers’ preference for price stability relies crucially on the presence of risk aversion and/or adjustment costs. The high impact of consumption of petroleum products on households’ and firms’ budgets, the relatively low price elasticity of demand for these products, and the likely presence of both risk aversion and adjustment costs all seem to suggest that consumers would prefer to have stable petroleum prices.

In a regime of full spot-price pass-through with volatile oil prices, agents can, therefore, be expected to attempt to engage in risk-coping activities and to try to attain an optimal consumption path.11 This, in turn, will depend on the nature of the price shocks they face, their attitude to risk, and their adjustment technology.

If a price shock is known to be temporary, risk-averse consumers and/or consumers with any kind of adjustment costs will try to stabilize consumption and consume at the permanent level of disposable income. Dissavings would, therefore, occur in low-income/high-oil-price periods, and savings would be made in high-income/low-oil-price periods.

If a shock is known to be permanent (or very long-lasting), optimal consumption behavior will vary with the characteristics of the consumer:

  • A risk-averse consumer with no adjustment costs will adjust to it fully and immediately.

  • A consumer with convex adjustment costs will adjust to it gradually, smoothing the path of consumption or investment (i.e., behaving as if the price path is smoother than it actually is).

  • A consumer with fixed adjustment costs would fully adjust if the shock is large enough and not adjust if it is small, following an (S,s) type of rule.

Hence, given the nature of oil prices, consumers may wish to engage in partial or delayed adjustment behavior and attempt to prevent excessive volatility in consumption due to variable oil prices. This kind of consumption behavior needs to be managed and financed by consumers. For instance, if the oil price increases, a consumer attempting to smooth out consumption will have to increase overall expenditure and will require additional funds to do so. Three options for the management of the consequences of oil price instability are available:

  • Credit markets. Consumers can potentially use credit markets to smooth the path of consumption in the face of volatile oil prices and spread adjustment over time. That is, when prices rise sharply, agents could borrow to finance a gradual adjustment (in the case of convex costs) or no adjustment (in the case of concave costs and insufficiently large price changes) and gradually repay the debt. Conversely, if prices fall, agents could save, or repay old debts. Using credit markets may be an effective option to smooth consumption, but it is likely to be of limited availability, especially in developing countries.

  • Self-insurance. Self-insurance can finance sluggish or impartial adjustment of consumption to current oil prices as an alternative to credit markets. Agents can self-insure by accumulating precautionary savings to draw down in times of “high” (or rising) prices and pay into when prices are “low” (or falling). This option essentially corresponds to the creation of a private stabilization fund and implements an optimal spending-and-saving rule (as derived, for instance, by Hausmann, Powell, and Rigobon, 1993) in the face of price volatility and adjustment costs. For self-insurance to occur it is important, however, that private agents be in a position to accumulate assets that are sufficiently remunerative and liquid. This implies that they need an appropriate macroeconomic environment where the value of liquid assets is not eroded by inflation and where they have access to adequate saving instruments. In many developing countries, the self-insurance option may, therefore, also be limited (Fafchamps, 1999).

  • Hedging. A direct instrument for the management of oil price risk by consumers is provided by hedging markets. These markets provide contracting tools (such as futures and call options) buyers can use to lock in prices and insure against short-run fluctuations. The main limitation of the use of hedging instruments in developing countries for private-consumption-smoothing purposes is access. Small consumers do not have access to financial instruments, given the high transaction costs and the absence of intermediation in most developing countries. Private sector corporations may have better access to these instruments, even if this may still be limited by considerations of default risk and creditworthiness. Hedging instruments may, therefore, represent a “missing market” for many consumers in developing countries.

However, market-failure considerations may affect all three options for managing oil price risk, and therefore consumers may find it hard to finance, and thus implement, otherwise optimal risk-coping behavior.

IV. The Scope for Government Smoothing of Retail Petroleum Prices

It is useful to start the analysis of the case for government-managed petroleum price smoothing by reviewing the standard case for the full and immediate pass-through of changes in international prices.12 This is based on two key considerations:

Efficient pricing. If the government engages in price-smoothing activities and only partially adjusts domestic oil prices to reflect international spot prices, it creates a wedge between consumer prices and the opportunity cost of oil. This entails a basic efficiency cost, that is, a distorted price signal, which creates a deadweight loss. Given the low price elasticity of demand for petroleum products, this loss may be relatively small. It may, however, be magnified by hoarding and smuggling activities13 and should, therefore, not be underestimated.

Institutional considerations.14 A full pass-through rule in the context of petroleum price regulation has a number of appealing institutional properties, such as its transparency and fiscal insulation properties.15 Full pass-through minimizes both the government’s exposure to fiscal risk due to oil price variability and the risk of political interference in the price determination process, avoiding for instance the emergence of hidden price subsidies when prices rise or “stealth” taxes when prices fall.

Any case for government-run smoothing needs to address these positive efficiency and institutional properties associated with full pass-through and demonstrate compensating benefits deriving from partial pass-through. These benefits could result from a market failure deriving from the absence of some consumer risk-management instruments in developing countries, which does not allow private agents to smooth their consumption path adequately. Governments may, therefore, have a role in providing a profile of retail prices that allows consumers to smooth consumption more effectively than in a full pass-through environment and that avoids unnecessary fluctuations.

A second argument against a full pass-through rule based on spot prices is that this may be politically difficult in many countries and, therefore, unstable. Petroleum price rises are very visible government interventions and tend to attract considerable attention. There may, therefore, be “political adjustment costs,” which justify price smoothing. This is particularly so at times of sharply rising international prices, when full pass-through rules can break down and degenerate into ad hoc price adjustments by the government. Such situations took place during the course of 2000 in a number of countries (e.g., Bolivia and Costa Rica).

Indeed, of the countries in our survey that regulate retail petroleum prices, only 24 percent adopt full pass-through rules for adjusting retail prices in response to changes in international prices. Alternative partial pass-through rules may prove to be more sustainable than full pass-through of spot price changes and may, therefore, deserve consideration on “political-economy” grounds, even if they may be second best to full pass-through rules in terms of economic efficiency.

The Scope for Partial Pass-Through of Spot Prices

Governments can smooth the profile of retail petroleum prices by only partially passing through changes in the international oil price. Governments that smooth retail petroleum prices can adopt a discretionary or rules-based mechanism. The survey results presented in Section II indicate that discretionary price adjustments are the dominant mechanism through which governments adjust petroleum prices.

The theoretical advantage of a discretionary approach to price smoothing is that it allows governments to decide when and how much to adjust domestic petroleum prices, without being constrained by a price formula. This gives governments the flexibility to determine the optimal path of retail prices as a function of general market conditions, which may not be fully reflected in the level of spot prices. For instance, if the government is faced with a price spike in the spot market, it can use its discretion to assess whether it should be seen as permanent (or, at least, long-lasting), and thus initiate adjustment in the retail price, or temporary and, therefore, not requiring retail price adjustment.

In practice, however, governments will find it hard to make these kinds of judgments, thus undermining the benefits that may derive from the discretionary approach. There is also a risk with discretionary price smoothing that it will be used for political purposes and prevent desirable adjustment to retail prices, both when international prices rise (to avoid the political cost associated with high domestic petroleum prices) and when they fall (to allow the government to accumulate additional fiscal resources). As a result, governments implementing discretionary price adjustments may tend to adjust prices rarely and, when they are forced to do so, by large amounts (e.g., as was the case in the Philippines during the operation of the now-terminated Oil Stabilization Fund). This is likely to be particularly harmful to consumers, by effectively magnifying both price shocks and price uncertainty.

Automatic price adjustment mechanisms are based on formulas that determine the level of the retail price at regular intervals, on the basis of international prices. The advantage of this approach is that it minimizes political interference in the price-setting process and can shield it from political pressures for low petroleum prices, which at times of rising international prices may have large fiscal implications. On these grounds, price adjustment rules seem superior to a discretionary approach. However, the distinction between the two can become blurred, and automatic mechanisms can collapse into a discretionary approach if they are not always implemented. To avoid this, rules need to be politically robust and, in particular, avoid sharp upward price adjustments when possible.

Partial pass-through rules

Governments can implement three types of partial pass-through rules to allow for domestic price smoothing:

  • moving average rules, which base retail prices on a moving average of past spot prices;

  • trigger rules, by which prices are updated only if spot prices change by more than a predetermined trigger amount; and

  • max-min rules, which place a ceiling and a floor on the level of retail petroleum prices.

This paper’s assessment of these rules is based on simulations of their impact on retail prices and on the government’s fiscal position. Specifically, partial pass-through rules should

  • complement rather than substitute for feasible private sector adjustment; and

  • strike a balance between retail price variability and fiscal risk.

The first criterion implies that pass-through rules should be designed with the main purpose of helping consumers implement their optimal partial (or delayed) adjustment behavior. This means that partial pass-through rules should try to smooth large and sharp price shocks and not necessarily prevent small price shocks, against which consumers should be able to self-insure under most circumstances. By doing so, partial pass-through rules can reduce the negative impact of price volatility for both risk-averse consumers and consumers with adjustment costs and, therefore, enhance efficiency. This will also add to the political robustness of a partial pass-through rule, reducing the occurrence of large discrete price changes and potentially preventing the collapse of the price rule at times of rising prices.

Optimal partial pass-through behavior, however, also implies that the rules should not prevent adjustment to permanent (or persistent) price changes, which need to be passed through to allow consumers to adjust to them. Therefore, any subsidy paid out via the rule at times of high prices needs to be phased out gradually, if the high-price situation persists.

To capture the importance of price shocks for consumer welfare, the paper focuses on the short-run changes16 of the price series simulated with the different partial pass-through rules, measuring both their overall volatility and the frequency of large price jumps relative to a full pass-through rule. This implicitly recognizes that sudden price changes are more costly to consumers than slow and persistent changes (which consumers can gradually adapt to) and should, therefore, be the focus of attention when designing a partial pass-through rule.

The second design criterion recognizes that any price risk from which the pass-through rule shields consumers needs to be borne by the government. As discussed above, this in turn has fiscal implications and can lead to persistent surpluses or deficits associated with the pass-through mechanism. The simulations produce a measure of the magnitude of both the year-on-year fiscal shocks and the cumulative fiscal implications of the partial pass-through rules. These shocks are scaled in percentage of GDP for the typical net oil importer in the sample, based on the 1999 average ratio of net oil balance to GDP (i.e., approximately 3 percent of GDP).

The simulations carried out are based on spot crude prices for the January 1987-June 2000. The price properties and fiscal impact reported for each rule, therefore, abstract from the fact that countries may be importing petroleum products (whose price may be imperfectly correlated with the crude price).17 This is, however, not unduly restrictive given that crude and petroleum product prices tend to move in line with each other except for short-term changes (which may reflect changes in capacity margins in the refinery industry and seasonal demand effects).

It should also be noted that by basing simulations on historical prices, the paper does not claim to be measuring structural properties of the partial pass-through rules. These simulations serve mainly as an illustration of the kind of retail price smoothing and fiscal risk partial pass-through rules can be expected to yield.

Moving average rules

Under a moving average rule, current retail prices are based on a moving average of past spot prices, starting from the current month and moving backwards. The longer the time horizon of the moving average, the more price smoothing this rule achieves.

The theoretical attractiveness of these price rules is that they “follow the market” and do not impose exogenous targets for the level of retail prices, which may prove to be inappropriate in the face of large and persistent shocks. Moving average rules with long enough time horizons can, therefore, provide substantial price smoothing, shielding consumers from transitory price spikes while gradually passing through persistent price changes. These rules, however, do not discriminate between large and small price shocks and do not directly seek to complement private sector self-insurance by focusing on the large shocks.

Simulations show that these rules can achieve substantial price smoothing, both in terms of reduction of the standard deviation of shocks and the frequency of large shocks. The effectiveness of price smoothing rises substantially with the length of the moving average, but even the three-month moving average can achieve a 30 percent reduction in standard deviation and a reduction by more than half in the frequency of monthly shocks in excess of 10 percent, relative to spot prices.

The substantial price smoothing the rules can achieve comes with a significant fiscal risk. For instance, the 12-month moving average leads to large fiscal shocks (on average 0.3 percent of GDP per year, for a typical oil importer) and can also bring about large cumulative deficits (0.6 percent of GDP by 2000, assuming the rule started in 1987). Shorter rules are less risky—the three-month moving average is associated with average shocks of less than 0.1 percent of GDP, and its cumulative impact broadly ranges between +/−0.1 percent of GDP.

Trigger or (S,s) rules

Under trigger rules, a price band is initially determined (e.g., plus or minus 10 percent of the current spot prices), and retail prices are updated to reflect the current spot price only when spot prices reach a level outside the band. When prices are changed, the price band shifts up or down, taking the current spot price as the new central point of the band.

The effect of this pricing rule is to avoid minor fluctuation in retail prices but pass through relatively large changes in international prices. This rule is, therefore, effective in shielding governments from having to bear large price shocks, but by doing so it exposes the private sector to these shocks. This would be optimal in the presence of fixed adjustment costs, but as argued in Section II, consumers with this type of adjustment costs should be able to autonomously implement their optimal adjustment behavior by self-insuring against small shocks. Trigger rules, therefore, do not appear to complement consumers’ risk-coping measures and can only be justified on grounds that do not relate to price smoothing.18

Simulation results show that trigger rules are not effective at providing price smoothing. They actually increase the size and frequency of large price shocks and, in the case of the +/−30 percent trigger, they can increase the overall standard deviation too. This is matched by an overall beneficial fiscal risk profile, but also by large fiscal shocks. Implementing a trigger rule can actually lead to substantial fiscal receipts (as in the case of the +/−30 percent rule). This effect arises from the fact that oil prices are characterized by frequent small price decreases (which are not passed through under this rule and, therefore, lead to fiscal revenue) and less frequent, but large, price increases (which under a trigger rule are passed through).19

Given the poor (or even negative) contribution to retail price smoothing of trigger rules, the main justification for adopting this kind of rule (as opposed to a full pass-through rule) is that it minimizes the transaction costs of continuously updating domestic prices to reflect international spot prices, while insulating governments from excessive oil-related risk. It, therefore, can represent a convenient way of effectively implementing a full pass-through rule (as long as the width of the price band is not too large).

Both Costa Rica and Bolivia implemented trigger rules recently. Costa Rica has had a +/−5 percent trigger rule since 1990, although it has not always been consistently applied. Bolivia also adopted a +/−5 percent trigger mechanism, but it was suspended in July 2000, when retail fuel prices were temporarily frozen for a period of one year.

Max-min rules

Max-min rules specify a price band around a central price, which defines the maximum and minimum level retail prices can reach. If the cost-plus level of retail price is above the band’s ceiling, the government absorbs the difference between the two prices by paying out a subsidy. If the cost-plus retail price is below the minimum price set by the band, the government taxes away the difference and sets retail prices at the minimum level.

This price rule achieves directly the aim of complementing consumers’ risk-coping activities, shielding them from large price shocks and passing through small shocks. It does not, however, automatically pass through large price changes if these are persistent and, therefore, require adjustment. For this to occur, and to avoid excessive fiscal risk to the government, a max-min rule needs to be complemented by a mechanism that updates the position of the max-min band or scales down the additional subsidy (tax) determined by the rule if the cumulative loss (gain) exceeds a given level. Chile recently adopted both of these measures (see Box 17.1) as part of the reform of the mechanism in place since 1991.

This paper simulates three kinds of max-min rules, all broadly based on the Chilean mechanism. These rules have a width of 12½ percent relative to the central price (like the Chilean rule); two of these have a fixed central price (at US$18.50 and US$20 a barrel, respectively), while one has a moving band, which is updated in accordance with the recent updating formula adopted by the Chilean energy regulator.20

The simulations show that fixed band rules are more effective than moving band rules in mitigating price volatility and reducing the impact of large price shocks. This is because the fixed bands, unlike the moving average band, do not move with current prices, which dilutes their shock-absorption properties.

The beneficial price-smoothing effects of fixed band rules are, however, reflected in the higher fiscal risk profile they generate. Both the US$18.50- and US$20-a-barrel rules lead to large absolute fiscal shocks. They differ radically, however, in their cumulative effect, with the US$20-a-barrel rule leading to a substantial surplus over the 1987–2000 period and the US$18.50-a-barrel rule leading to a deficit. This highlights the main weakness of a fixed band approach, that is, the need to estimate an expected level for prices (to set the central level of the band), which may prove to be inappropriate and lead to excess fiscal revenues or losses from price smoothing. The “Chilean” moving band max-min rule, by contrast, led to substantially smaller fiscal shocks and a limited cumulative impact over the 1987–2000 period.

Box 17.1.Chile’s Price Stabilization Mechanism

Chile has operated a domestic petroleum price stabilization mechanism since January 1991 and has recently reformed it.1 The original mechanism was based on a max-min price rule implemented by a Stabilization Fund initially capitalized with US$200 million. Under this mechanism, maximum and minimum prices for each petroleum product were set at +/−12½ percent of a reference price set by the energy authority on a discretionary basis to reflect medium- and long-term market trends. The max-min rule operated asymmetrically: if the (spot) import price was above the ceiling of the band, the fund would pay out a subsidy equal to the difference between the two prices; however, if the import price was below the floor of the band, 60 percent of the difference would be taxed away and deposited into the Fund.

Until mid-1999 this stabilization mechanism worked relatively effectively. The Fund accumulated resources, as import prices were more frequently below the price band than above it. However, the high prices of the second half of 1999 and 2000 led to financial problems for the Fund,2 requiring a total additional injection of US$263 million (paid into the Fund in January and July 2000). The difficulties experienced by the Fund prompted a revision of the rules of the stabilization mechanism, which was passed into law in July 2000.

According to the new Price Stabilization Law, the reference prices that determine the position of the band for each petroleum product are updated weekly, on the basis of a formula that includes historical prices (a weighted average of prices from the past two years), short-term forecasts, and long-term forecasts. The asymmetry in the operation of the price band has been eliminated (so that 100 percent of the difference between the floor of the band and import price is now taxed away), and a contingent tax subsidy rule has been introduced. According to this rule, prices can rise (fall) above (below) the ceiling (floor) of the price band to prevent excessive depletion (accumulation) of the resources of the Fund. This ensures that the Fund never runs out of resources (i.e., as the Fund’s resources converge to zero the subsidy paid out to consumers also converges to zero) and never accumulates more than a set maximum amount.

1The mechanism includes five petroleum products: gasoline, diesel, LPG, heating oil, and kerosene.2This was exacerbated by the fact that in 1999 the reference prices for the max-min band were lowered (in spite of rising import prices) to avoid an increase in domestic prices.

Summary of assessment of partial pass-through rules

The main differences, summarized in Table 17.2, among the three types of rules are

Table 17.2.Summary of Properties of Partial Pass-Through Rules
Simulation Results
Price-Smoothing PropertiesReduction

in standard
Average annual

fiscal shock
Temporary shocksPersistent shocksdeviation1(In percent of GDP)2
Moving averageSmooths out all

shocks
Full pass-through

(with a lag)
30 to 70 percent0.07 to 0.3 percent
TriggerSmooths out only

small shocks
Full pass-through

(if large enough)
2 to 8 percent0.05 to 0.26 percent
Max-minSmooths out only

large shocks
No pass-through

(unless there is an

updating rule)
27 to 45 percent0.08 to 0.17 percent
Source: Authors’ calculations.

Relative to spot prices, based on first difference of the logs of the monthly price series, January 1987 to June 2000.

Based on a 1999 typical oil importer.

Source: Authors’ calculations.

Relative to spot prices, based on first difference of the logs of the monthly price series, January 1987 to June 2000.

Based on a 1999 typical oil importer.

  • max-min rules are more effective at complementing private sector risk coping than both trigger rules (which do not provide price smoothing when the private sector is most likely to need it) and moving average rules (which smooth out all shocks);

  • max-min rules need to be complemented by an updating rule for the position of the max-min price band to ensure that persistent shocks are passed through to the private sector; and

  • the trade-off between retail price insurance and fiscal risk, as measured by historical simulations of the rules, appears sharp.

Given the findings from the simulations, it appears that the most effective partial pass-through rules, and those that strike an appropriate balance between retail price smoothing and fiscal shocks, are short moving-average rules (three-month and, possibly, six-month) and/or a max-min rule with an automatic updating of the max-min price band.21

More ambitious price-smoothing rules appear to leave the government overexposed to oil price-related fiscal risk, especially given the limited availability of effective risk-coping instruments for most developing country governments, as discussed in the next subsection. Therefore, while there is a case for government-led petroleum price smoothing, governments should not attempt to provide excessive price insurance to the private sector, given its fiscal implications. Governments may, on the other hand, find it relatively effective to rely on market-based insurance instruments to implement some retail price smoothing.

Managing the Fiscal Risk Deriving from Partial Pass-Through

It is clear from the historical simulations of partial pass-through rules that implementing a system of partial pass-through of oil price changes automatically transfers some financial risk to the government. The government faces a number of options for managing this risk.

The most immediate option for managing the risk associated with volatile oil revenues is for governments to use their budgets to absorb the shock, either adjusting expenditures or raising additional revenue. This is, however, unlikely to be an efficient option. Changing expenditures in line with oil prices is likely to entail fiscal adjustment costs, which implies that governments should attempt to smooth expenditures over time. Adjusting non-oil taxes is also likely to be inefficient for tax-smoothing considerations.

As in the case of the private sector, governments should try to smooth the budgetary shocks due to the partial pass-through of volatile oil prices. They can potentially do so by making use of credit markets. However, many governments are externally credit-constrained and may not be able to issue domestic debt because of the absence of developed domestic financial markets. Moreover, governments are most likely to be credit-constrained when they most need to borrow (i.e., when hit by negative terms-of-trade shock).

The most accessible risk-coping option for governments is to self-insure by engaging in precautionary saving behavior. The option of self-insurance is, however, not costless. The simulation results for partial pass-through rules presented above show that such saving or dissaving may well be large and very long-lived. A deficit position, in particular, will need to be financed with up-front liquidity, which will have a cost. As shown by Deaton (1991), excessive price (or consumption) smoothing should not be attempted in the face of a combination of liquidity costs and persistent price shocks. Our simulations support this theoretical result. Saving or dissaving for long periods may also be hard to sustain politically.

One option for implementing a self-insurance mechanism in the face of oil-related fiscal risk is to set up a separate domestic oil price stabilization fund.22 This has been a relatively popular option among oil importers. Of the countries in our survey that regulate prices, 24 percent currently run such funds, and a few have had funds for a number of years and only recently abolished them (e.g., Mauritania and the Philippines). In 2000, most of these funds were negatively hit by high oil prices and needed extra resources (Chile) or lost significant sums (Brazil). More generally, recent research indicates that such stabilization funds may complicate, rather than help, fiscal policy in responding to the challenge posed by oil price fluctuations (Davis and others, Chapter 11 in this volume).

Governments in developing countries, like private sector agents, do not seem to be suited to handle large fiscal variability due to oil price risk, given a lack of effective risk-coping instruments. Coupled with the high frequency and persistence of oil price shocks, this implies that any smoothing of spot price variability carried out by the government needs to be limited, and designed to minimize the fiscal shocks it implies for the public sector, as illustrated by the historical simulations presented above.

Hedging

Governments that wish to shield consumers from excessive petroleum price volatility can use financial hedging instruments to reduce oil price risk.23 This has the advantage, relative to partial pass-through rules, of affecting the nature of the price process faced by the country’s consumers directly, potentially removing or mitigating undesirable time-series properties of oil and, therefore, reducing the fiscal risk associated with partial pass-through of spot price changes. It also addresses a crucial market failure, namely the lack of access to hedging instruments for most consumers in developing countries.

Financial markets for oil products are very well developed and are used extensively by producers and consumers in industrialized countries. Crude oil and petroleum product financial contracts are heavily traded (both in New York, on NYMEX, and in London, on the IPE), especially for short maturities (up to 6-12 months).24 This potentially offers substantial scope for risk management activities by oil-consuming countries, especially if they are relatively small oil purchasers.

The Scope for Private Sector Involvement in Petroleum Price Smoothing

Private oil companies may have an important role to play in facilitating or implementing a retail price-smoothing mechanism. The role of the private sector in relation to petroleum price smoothing is not the focus of this paper, but it is briefly discussed here to provide more comprehensive coverage of the subject and to highlight the implications of our analysis of the potential for government-led price smoothing for private sector involvement in this area.

In a regime of price regulation (e.g., in which the government sets a maximum price for petroleum products), the government may be able to delegate to private oil companies risk management activities relating to oil price variability and avoid bearing fiscal risk from price smoothing. It could do so in one of two ways:

  • it could set retail prices according to a partial pass-through rule and fix petroleum excises. This would imply that domestic industry margins would fluctuate with international oil prices; or

  • it could set retail prices on the basis of a “hedging” rule, whereby it presupposes that a given share of oil demand is purchased using financial instruments (e.g., traded futures) and fully passes through the notional purchase cost.

Under both mechanisms, private oil companies will seek to hedge or manage the oil price risk they face, using the range of instruments described above (e.g., financial instruments, credit markets, etc.). This may be superior to government handling of oil price risk, given the technical and political difficulties that may be associated with stabilization funds and the restricted access to financial and hedging markets governments may face. Private companies (especially if they are part of larger international groups) may have better access than governments to effective risk-coping measures.

These delegation mechanisms may, however, suffer from some limitations. In particular,

  • they would render the price regulation of petroleum products harder to manage and require retail prices to take into account the higher cost of capital faced by private companies due to oil price risk;

  • they may lead to suboptimal hedging behavior by the private sector if the government hedging rule is too rigid (or misspecified);

  • governments may be unable to credibly commit to the price-stabilization formulas agreed to with private companies. For instance, in a situation of rising international prices, they may fail to raise retail prices to compensate private companies, even if the pass-through rule allows for a price increase; and

  • given the nature of oil prices and the potential for chronic deficits or gains emerging from a partial pass-through rule, it is likely that there will be a need to renegotiate the risk-transfer arrangements between the government and the oil companies, and political pressure may build up not to compensate companies for low retail prices or to extract the rents from high retail prices. This political risk may, in turn, imply that private companies may be unwilling to manage the risk due to partial pass-through.

A contractually more straightforward alternative to the delegation of risk management activities to private oil companies would be to deregulate prices altogether. This has the advantage of letting market forces determine the appropriate level of retail price smoothing25 and of being a more structural pricing reform than the introduction of partial pass-through rules and, therefore, less liable to be reversed or not adhered to. A number of countries in our survey have opted for deregulating petroleum pricing (27 percent of the countries in the survey).

Under some circumstances, price deregulation, however, may not be a viable strategy. If domestic market conditions are not sufficiently competitive (e.g., the market is too small to allow effective competition to emerge), price regulation may be necessary, which implies that the government needs to assume responsibility for price-smoothing decisions. If this is the case, governments should still consider the option of promoting the involvement of the private sector in managing price-smoothing activities.

V. Conclusions

The level of retail petroleum prices is an important economic variable in many developing countries, affecting both governments’ fiscal revenues and consumers’ disposable income. Consumers may suffer from petroleum price instability, due to risk aversion and adjustment cost considerations. Further, they may not be able to adequately mitigate the negative welfare impact of oil price volatility because of the absence of risk-coping instruments and limited self-insurance possibilities.

There appears, therefore, to be a case for government-led petroleum retail price smoothing in an environment where these prices are regulated. However, given the properties of international oil prices and, in particular, the persistence and high frequency of large price changes, petroleum price smoothing has significant fiscal implications for governments. The simulations of partial pass-through rules based on past international spot prices in this paper suggest that there is a sharp trade-off between price insurance and fiscal stability, and that only limited price smoothing (e.g., in the form of a short moving average rule or a moving max-min price band) is likely to be fiscally sustainable. Market-based price insurance appears to represent a superior alternative for smoothing retail prices—an alternative governments of oil-dependent countries should consider.

Private oil companies may also play an important role in facilitating or implementing a retail price-smoothing mechanism. Price deregulation, although sometimes politically difficult, remains the first-best solution, if competitive conditions are present in the domestic market.

Bibliography

This is a revised and shortened version of “Domestic Petroleum Price Smoothing in Developing and Transition Countries/’ by Giulio Federico, James A. Daniel, and Benedict Bingham (2001).

The average crude oil price in 1999 was US$18.1 a barrel, close to the nominal average for the period 1987–2000. Exposure to oil is defined as the ratio of net oil exports to GDP.

The nature of oil taxes (specific versus ad valorem) and the price elasticity of demand have a bearing on the degree of insulation. Fiscal stability is enhanced with specific taxation of oil products and low elasticities of demand.

See Wickham (1996), and Barnett and Vivanco, Chapter 5 in this volume, for a detailed discussion of the volatility of oil prices.

The countries surveyed were (Africa) Côte d’voire, Guinea, Kenya, Mozambique, Nigeria, Senegal, South Africa, Tanzania, Togo, Uganda, and Zambia; (Asia-Pacific) China, Korea, Mongolia, Philippines, Papua New Guinea, Thailand, and Vietnam; (Europe) Armenia, Azerbaijan, Georgia, Kyrgyz Republic, Moldova, Russia, and Ukraine; (Middle East) Algeria, Egypt, Iran, Jordan, Mauritania, Morocco, Pakistan, Sudan, Tunisia, Turkey, and Yemen; and (Western Hemisphere) Argentina, Bolivia, Brazil, Chile, Colombia, Costa Rica, Mexico, Peru, and Venezuela.

Turnovsky, Shalit, and Schmitz (1980) show that the sign of the benefit (loss) from price stability has the same sign as the following expression: s(R - η)+e, where s is the budget share of the good in question, R is the coefficient of relative risk aversion, η is the income elasticity of demand, and e is the price elasticity of demand (which is negative).

The precise nature of this effect is likely to differ between households and firms. Households may face costs in changing consumption bundles and in adapting to a new level of income. These may take place due to “learning-by-doing” effects and sub-optimal changes in expenditure patterns when disposable income changes rapidly (e.g., expenditure cutting when income falls may hit items that are the easiest, rather than most appropriate, to cut). Firms, on the other hand, may face adjustment costs in the form of the investment required to adapt their production technology to the level of oil prices.

This implies that, if they can, they will only partially adjust when hit by a price shock (see Nickell, 1985).

(S,s) rules describe behavior by which adjustment takes place when the underlying variable that determines the optimality of adjustment is below a given “floor” level (s) or above a “ceiling” level (S).

See, for instance, Dixit (1992).

For simplicity, we refer here only to households that consume petroleum products and to consumption-stabilization or smoothing activities. Similar arguments would apply to firms.

Throughout this section, we assume that the government regulates the price level of petroleum products, which is the norm in developing countries. We briefly touch upon the issue of price deregulation and its potential role in allowing for retail price smoothing later in this chapter.

The former may result if consumers expect that the government will eventually pass through a price increase. The latter may occur if price smoothing creates a price difference between petroleum products across neighboring countries, which consumers try to arbitrage. This would have the effect of increasing demand in the country that implements a partial pass-through rule when international prices rise and depressing demand when they fall.

For a fuller discussion of the political considerations of price subsidy reform and the economics of price subsidy reform more generally, see Gupta and others (2000), and Gupta and others, Chapter 15 in this volume.

We are assuming here, and throughout the rest of this section, that governments levy specific (rather than ad valorem) excises on petroleum products, which implies that the revenues from these excises are largely independent of the oil price (with an assumption of inelastic demand).

We capture this by examining the first difference of the log of the monthly series.

They also abstract from the presence of fixed margins in the final retail price, which reduce its variability relative to crude prices. It is, however, straightforward to gross up the price variability measures we report into retail price variability figures by making assumptions on the size of the various fixed margins in the value chain.

Moreover, by reducing the frequency of price adjustments and increasing their magnitude, trigger rules may be politically fragile and more likely to be violated than rules that allow for continuous adjustment.

This is consistent with the findings of Deaton (1992) for non-oil commodities. This effect arises from the asymmetry in storage opportunities, resulting from the fact that negative storage is not possible, so that the constraint on large price increases is weaker than on large price falls. Cashin, McDermott, and Scott (2002) find a similar effect for oil.

The current Chilean formula updates the max-min price band according to historical prices, short-term projections, and long-term forecasts. For the purposes of our simulation, we have assumed that the short-term projection component of the price band formula is equal to the current spot price and that the long-term forecast is US$20 a barrel.

A hybrid of these two rules (i.e., a max-min rule for which the band is updated according to a relatively short moving average of past prices) may also be appropriate.

For a full discussion of oil savings and stabilization funds, see Davis and others, Chapter 11 in this volume.

See Daniel, Chapter 14 in this volume.

For instance, NYMEX crude oil open interest (the number of outstanding contracts that have not yet been closed) averages about one billion barrels a day, which is equivalent to 27 percent of global crude exports. Of this open interest, 75 percent is for six months forward or less, and about 5-10 percent for 24 months and beyond.

In countries where petroleum pricing is deregulated, private oil companies engage in some price smoothing. In the United States, for instance, the Department of Energy estimates that average gasoline retail prices fully reflect the variation in spot prices after three months, with 50 percent of the change passing through within four weeks (U.S. Department of Energy, 1998).

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