Chapter

IV. The Implications of Rising Oil Prices

Author(s):
International Monetary Fund. African Dept.
Published Date:
May 2006
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Pass-Through of Higher Oil Prices to Domestic Prices, 2003-06

Since 2003 most countries in SSA have allowed a high degree of pass-through of higher gasoline prices to domestic retail prices (Figure 4.1).20,21 The pass-through, which averaged about 105 percent for all countries, was 148 percent for countries with liberalized price systems, 71 percent for countries with formula-based systems, and 53 percent for countries with ad hoc administered price adjustment. The pass-through was 100 percent in countries that recently qualified for debt relief under the MDRI. The high pass-through to retail gasoline prices in part reflects both the use of ad valorem rather than specific taxes and the impact of higher fuel prices on the cost of transporting petroleum products from seaports. The pass-through for oil-exporting countries—many of which subsidize fuel prices—averaged slightly over half that for oil importers.

Figure 4.1.Pass-through of Higher Gasoline Prices, 2003-06

(Ratio of change in retail price to change in import price)

Source: IMF, country desk data.

In other parts of the world, the pass-through to retail prices has also varied by country and region. For all countries in the Middle East and Central Asia the average was about 50 percent for 2002-06, but for oil exporters it was only 18 percent. For emerging market economies, the pass-through averaged about 80 percent.22 Industrial countries allowed a full pass-through, reflecting their liberal pricing systems.

The pass-through in SSA is lower for kerosene than for diesel and gasoline (Figure 4.2). Governments have sought to mitigate the impact of higher world prices on retail prices of kerosene because it has a relatively high share in the consumption basket of poor households.

Figure 4.2.Pass-Through of Higher Gasoline, Kerosene, and Diesel Prices, 2003-06

(Ratio of change in the retail price to change in import price)

Source: IMF, country desk data.

With rising prices, the average tax rates on petroleum products have fallen (Figure 4.3). In many oil-importing countries fuel taxation is dominated by specific duties that do not adjust automatically to higher prices. Twenty-three oil importers in SSA levy specific excise taxes on fuel products, and five also impose specific import duties. In Sierra Leone and Tanzania, drivers are charged a specific levy on gasoline and diesel. For gasoline, the decline in average tax rates (total taxes as a percent of the pretax price) is most notable in landlocked oil-importing countries, but average gasoline taxes have also declined in exporting countries.

Figure 4.3.Taxation of Gasoline, 2003-06

(Percent of pretax prices)

Source: IMF, country desk data.

Despite a high degree of pass-through, some SSA countries continue to subsidize petroleum products. This is because most countries rely on ad hoc price adjustments, which often result in a misalignment between domestic prices and import costs. This is particularly true of kerosene in a number of countries where domestic prices (pretax) are significantly lower than international prices (Figure 4.4). Among fuel exporters, Angola’s subsidies exceeded 3 percent of GDP in 2005, Gabon’s were 1.6 percent, and the Republic of Congo’s were 1.5 percent. Cameroon and Equatorial Guinea also provide subsidies. Some oil importers subsidize domestic petroleum products; in Cape Verde, the subsidy exceeded 5 percent of GDP in 2005.23 In Ghana, Rwanda, and Senegal, subsidies are smaller.24

Figure 4.4.Selected SSA Countries: Pretax Prices for Kerosene, 2006

High prices make it more pressing to address inefficiencies in oil importing and distribution. While SSA has made considerable progress in reducing distortions due to state ownership in oil distribution, supply disruptions due to mismanagement have sometimes exacerbated the impact of high prices. For example, in Benin mismanagement at the main distributor, SONACOP, caused significant shortages in the retail petroleum market. Zambia’s economy was affected in 2005 by a prolonged shutdown at the country’s only oil refinery, Indeni, because it had not invested enough in the refining sector due to controls on petroleum prices in the past. This shows the pitfall of making the oil distribution sector bear the burden of high oil prices instead of passing them on to the consumers.

Oil price pass-through offers both microeconomic and macroeconomic benefits. It provides a clear price signal that the relative scarcity of petroleum products has risen, encouraging users to adjust accordingly. This promotes greater efficiency and environmental sustainability in energy usage. Pass-through also protects the limited fiscal space of low-income countries and averts the risk of open-ended subsidies on petroleum products (Dudine, 2006). Even when not on the budget, quasifiscal costs can be incurred from incomplete pass-through via implicit subsidies or contingent liabilities in the oil refining or distribution sector. Nevertheless, safety nets will be necessary to mitigate the adverse impact of pass-through on the poor; policy options for this are discussed below.

Social Impact of Higher Oil Prices

Rising oil prices can have severe consequences for the poorest population groups. For SSA, the estimated impact varies considerably by country depending on the size of the price increases and the shares of petroleum products in household expenditures.25 Kerosene is a dominant component of the energy budget for low-income households; it accounts for over 67 percent of the total energy budget in Ghana and Mali.26

Price increases affect different groups in different ways. In Ethiopia and Mozambique, urban groups are more affected than rural. Some occupational groups (e.g., artisanal fishers, maize millers, small traders, urban commuters, and small businesses that rely on generators) may be hit particularly hard.

Oil price rises may have other social and environmental costs. For many households, higher prices for kerosene could lead to its replacement for cooking by fuel wood, which increases deforestation and damages the environment. Cooking with fuel wood is also detrimental to health because it increases the incidence of respiratory disorders, one of the factors contributing to child mortality.

When petroleum product prices are not adjusted to international price changes, the benefits of subsidies or tax reductions accrue largely to the better-off. In Gabon, for example, it is estimated that the richest 10 percent of households capture 33 percent of the subsidy, while the poorest 30 percent, which are below the poverty line, receive merely 13 percent (El-Said and Leigh, 2006). In Ethiopia, the highest-income 20 percent of the population captures 44 percent of the subsidy, while the lowest-income 20 percent gets less than 9 percent of it.27 In Ethiopia, even the subsidies for kerosene, the product most used by the poor, are skewed toward the better-off: 62 percent of the benefit from kerosene subsidies accrues to the richest 40 percent of the population, and only 22 percent to the poorest 40 percent. These subsidies divert resources from other productive or social ends: in Gabon, for example, the cost of subsidies is larger than the entire health budget. Moreover, subsidies on petroleum products tend to be nontransparent and foster smuggling and rent-seeking activities.

While petroleum price subsidies are poorly targeted, there is a welfare case for compensating the poorest for income losses as a result of oil price increases. The first-best policy is to replace subsidies with direct income support for the affected poor. However, weak administrative capacity in SSA countries has limited the ability of governments to both identify the population groups affected and reach them through income transfers (Smith and Subbarao, 2003). Some governments are instead using indirect means to compensate the poor more generally. For these measures to be worth adopting, they must target those affected better than the oil subsidies they replace. Such mechanisms have been found to be more effective where the public was consulted during their design because that enables mitigation measures to be tailored to specific circumstances and capacities. Among second-best compensatory measures are:

  • Maintaining subsidies for kerosene. Given the importance of kerosene for the poor and the lack of instruments for direct income support, maintaining these subsidies has been a policy option for many SSA countries. Only eight SSA countries fully passed through higher international kerosene prices between 2003 and 2006, but even these price increases did not eliminate all subsidies for kerosene. Reliance on subsidies preserves the inefficiencies that result from smuggling and product substitution.

  • Subsidizing public transportation. This is appropriate to the extent that the urban poor use public transport. Ghana, Eritrea, and Mauritius are doing it. This option has positive effects on the environment and traffic congestion.

  • Reducing or eliminating charges for public services, such as health and education. Gabon, Ethiopia, and Ghana have plans to improve access to basic services. Ghana has explicitly linked fuel price rises and improvements in services, including abolition of school fees, as part of a public information campaign on the need to increase fuel prices. Ethiopia implemented a partial pass-through of oil price increases in May but is delaying further increases until basic service delivery is improved.

  • Increasing expenditure on other social transfers that benefit the poor. Food transfers have been proposed in Mali, and expansion of the safety net program in rural Ethiopia. Comoros has reduced import tariffs on basic food stuffs.

The Impact of Rising Commodity Prices on GDP in Oil Importers—Simulations

In oil-importing countries higher oil prices can affect real GDP through three channels: worsening terms of trade, rising production costs, and the central bank’s monetary policy response (IMF, 2000). Declining terms of trade indicate a decline in the real income of a country; this would have a demand-induced contractionary effect on economic activity unless there is no pass-through to domestic fuel prices and the government has resources to finance the additional oil bill without fiscal tightening.28 Because oil is an important input for production, profit margins in non-oil industries are squeezed, and their output declines. The central bank may need to tighten monetary policy to contain the inflationary impact, adding to the contractionary response. Other asset prices, such as the exchange rate and equity prices, may also respond.

The impact of higher oil prices on the GDP of low-income countries has been typically proxied by their short-run impact on the current account,29 though that approach overstates the GDP impact because it overlooks adjustments economic agents make in production and consumption. The UNDP and the World Bank (2005) estimate an output decline of about 0.5–1.5 percent for low-income countries from a 72 percent increase in the oil price spread over two years. SSA oil importers tend to be in the upper range of output losses because energy intensity in SSA is rising compared with that in Asia and OECD countries (IMF, 2005c).

To better assess the impact of higher oil and other fuel prices on GDP, several simulations were conducted using the Global Trade Analysis Project (GTAP) model (Box 4.1).30 For the nine countries studied, the rising prices for oil, gas, and coal were found to lower real GDP by 0.2 to 1.0 percent. These estimates are smaller than those proxied by the direct (first round) impact on the current account. Separate simulations show that for some countries the positive GDP of higher prices for nonfuel commodities fully or more than fully offset impact on the negative impact of higher fuel prices. However, countries that import nonfuel commodities suffer large additional GDP losses as their terms of trade worsen.

Box 4.1.Simulated Impact of Higher Fuel Prices on GDP

The fuel price increases simulated are those observed during 2002-05.1 Consistent with the practice in most SSA countries during this period, the simulations assume a full pass-through of world prices to domestic prices. In real terms—nominal price increases deflated by the average price of world merchandise exports—the price of oil increased by 90 percent, of gas by 85 percent, and of coal by 68 percent.

Simulation results show that GDP declines in all nine countries identified in the model. Contractions in economic activity range from 0.2 percent of GDP in Uganda to over 1 percent in South Africa and Zambia (Figure 1). The large variations in output losses are a result of differences among countries in production and trade structure. In particular, GDP losses tend to be larger in countries that are more dependent on fuels because higher fuel prices raise production costs throughout the economy. If it were assumed that countries could not finance the higher import bill, output losses would be larger by an average of 0.2 percent of GDP.

Figure 1.Changes in Real GDP Arising from Higher Fuel Prices

(Percent)

The trade account would worsen by 1.0 to 1.5 percent of GDP in all nine countries. These estimates are less than the increase in the import bills because domestic production (where it exists) expands, and consumers and producers adjust demand in response to higher world prices. Without such adjustments, the trade account would have worsened by 3.1 percent of GDP on average for the nine countries and 3 percent of GDP for all SSA oil-importing countries. Had this deficit been financed by a drawdown of reserves, it would have lowered the reserve cover for oil-importing countries by 1.3 months, to 2.7 in 2005.

A separate simulation indicates that in some countries the impact of higher fuel prices on GDP would be more than offset by rising prices for nonfuel commodities.2 Of the nine countries in the sample, three (South Africa, Mozambique, and Zambia) are large net commodity exporters; three (Botswana, Tanzania, and Zimbabwe) are small net commodity exporters; and three (Malawi, Madagascar, and Uganda) are net commodity importers. For the large net exporters, higher world nonfuel commodity prices raise GDP by 1 to 2 percent—two to three times their losses from higher fuel prices (Figure 2).

Figure 2.Changes in Real GDP Arising from Higher Fuel and Commodity Prices

(Percent)

In contrast, the net importers lose significantly from higher nonfuel commodity prices. Their GDP contractions are either equal to or greater than those from higher oil prices. For Malawi, the contraction is six times that from fuel price increases. Among the small exporters, Botswana gains, and Tanzania almost breaks even. Zimbabwe loses despite its significant net exports of commodities because it is more dependent on agricultural and manufactured exports—sectors that contract because of the resources drawn to the booming sector and rising commodity input costs.

1 Prepared by S. Gupta, Y. Yang, and K. Carey.2 The simulated increases in commodity prices correspond to those observed during 2002-05. They range from 30 percent (mineral products) to 82 percent (minerals).

These results highlight the importance of commodity price developments for SSA. Higher commodity prices further increase production costs in the agricultural, manufacturing, and services sectors. As a result, economic activity in these sectors falls significantly. Thus, Malawi, for example, has to absorb cost increases from commodities on top of those stemming from higher fuel prices. Moreover, Malawi faces lower prices for agricultural products, of which the country is a large net exporter.

Maintaining the competitiveness of agriculture and manufacturing in the face of higher fuel and commodity prices will be a challenge. In oil- and commodity-exporting countries, booming extractive industries draw resources from the agricultural and manufacturing sectors. In oil-importing countries, agriculture and manufacturing face unfavorable terms of trade and the rising costs of fuel and commodities. Unless these countries improve their productivity, they could see further downward pressures on employment and output as industry profit margins are reduced. Given the role of agriculture in generating income for the poor, the squeeze on that sector also has adverse implications for reducing poverty, (Pattillo, Gupta, and Carey, 2006).

Prepared by Sanjeev Gupta, Yongzheng Yang, Arto Kovanen, Kevin Carey, Paul Francis, and Kirsty Mason.

Pass-through is calculated as the ratio of the absolute change in the retail price to the absolute change in the import price (as opposed to the ratio of percentage changes in each price). Because both are calculated in local currency terms, the import price incorporates the effect of changes in the exchange rate.

However, Cape Verde has recently eliminated fuel subsidies for electricity and water generation in an effort to move toward a system of automatic adjustments of the tariffs on these services.

Ghana’s subsidy is provided to the oil refinery company (Tema). The government introduced a new pricing mechanism for petroleum products starting in May 2006; prices are now adjusted monthly.

This section draws upon poverty and social impact analysis (PSIA) studies undertaken for Angola, Ethiopia, Gabon, Ghana, Mali, and Mozambique. For example, in Mali a 34 percent across-the-board price increase for petroleum goods is associated with a 1.8 percent decrease in real income for the poorest income quintile; in Ghana a differentiated increase in prices reduces income for the poorest quintile by 8.5 percent. The increases required in Ghana to eliminate subsidies were: 17 percent for petrol, 49 percent for kerosene, 67 percent for diesel, 50 percent for fuel oil, and 108 percent for LPG (Coady and Newhouse, 2005).

The share of kerosene in total consumption for the poorest quintile of households in Ghana is 5.9 percent and in Mali 2.0 percent (Coady and others, 2006).

Similarly, in Mali, the nonpoor constituted 32 percent of the population and captured 69 percent of the benefit of lowering taxes, while the poor, accounting for 68 percent of the population, obtained only 31 percent (Coady and Newhouse, 2005).

The transfer is also contractionary globally, to the extent that oil exporters have a higher marginal propensity to save than do oil importers.

Estimating the impact of oil price increases on GDP typically requires techniques that are demanding of data that are generally available only for industrial countries. The simplest econometric approach uses a small-scale statistical model linking the oil price to GDP, inflation, and other macroeconomic variables. A more detailed structural model can be used to simulate the impact of the shock. Using such a model, the IMF (2005a) estimated that industrial country output would decline by 0.6 percent for a temporary increase in the oil price from $45 to $80 per barrel. The output losses are 0.3 - 0.5 percent higher if prices stay high, with further large losses if consumer confidence is adversely affected.

GTAP is a multiregion, multisector, computable general equilibrium model. It can capture the effects of adjustments of economic agents to oil price increases as well as track structural changes through input-output linkages. For more details about the model, see Hertel (1997) and about its database, see Dimaranan (2006, forthcoming). GTAP is solved using GEMPACK (Harrison and Pearson, 1996). The current model base year is 2001.

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