The subtle shifts in UAE’s fuel pricing dynamic

This article appeared originally in Gulf News: link to original article

So fuel subsidies in the UAE are finally removed … or so has been announced.

When the announcement first came out, I couldn’t hide my enthusiasm at the fact that what I was advocating as the right thing to do has finally been done. At the point, I was making all sorts of calculations and predictions on what would be the price of a litre of gasoline at the pump.

The only indication then was what the Minister of Energy’s announcement that prices in the UAE will better reflect international prices, and that the price of diesel will drop while that of gasoline will increase slightly. “Slightly” was the key word here and for one main reason: how could it be slightly when the same announcement says that the price will be benchmarked with worldwide prices?

And then, how efficient is it to meet every month to set next month’s prices? This report will explore the change in policy further, benchmarking the UAE’s data with that of Japan and Russia to calculate previous and current subsidy rates.

I argued in a report published in April last about how now is the optimal timing to remove the UAE’s fuel subsidies. Nevertheless, it happened now and the timing is still good. As the announcement stated that the price will be as per the international benchmark, I had every single reason to believe that it will be close enough to the global average pump price for gasoline as provided by the World Bank.

That stood at $1.3 for the year 2013 in comparison to $0.47 for the UAE before the change in fuel subsidy. The average takes into account the lowest price per litre for gasoline being $0.02 in Venezuela and the highest being $3.33 in Eritrea.

It would have been wrong to assume that the price in the UAE would be exactly at par with the world’s average because the UAE is an oil producing country — among the Top 10 worldwide. Also, fuel prices in other countries might be higher due to import duties, taxes, and so on which would lift the average.

My assumption was before August’s fuel prices are announced on July 28, the gasoline price per litre would be $0.8-$1.00 compared to the global average of $1.3. My assumption was wrong.

The gasoline price per litre quoted for August is $0.58 for the ‘Special 95’ gasoline which I am using as the benchmark here. The price in the UAE is not just far off from the prediction I had in mind, but it is in fact less than half the world’s average.

If anything, this means that the subsidy has been perhaps substantially reduced but not completely removed. Moreover, and even though the price quoted by the Ministry of Energy as the minimum price per litre, distribution chains supposedly would need to chip in their operational costs which would have pushed prices even higher than their current level. That isn’t the case, and price at the pump for Special 95 is $0.58.

So what is the previous subsidisation rate and what is it now? According to the International Energy Agency (IEA), the UAE’s average subsidisation rate is 65 per cent which is inclusive of oil, gas, coal, and electricity.

So, to calculate the subsidisation rate for oil only, I used the gasoline price per litre in Japan, which is a net importer of oil and as a country with no fuel subsidies — $1.4 per litre of gasoline in 2013.

Working out the math resulted in a subsidy rate of approximately 65 per cent. There is one setback here which is that fuel sold to Japan would incur transportation and other costs which inflates the price to $1.4.

To calculate the subsidy rate more accurately and the change in it, I used data for Russia, which is the world’s second largest producer exporter of oil, and where oil is not subsidised domestically. (But gas and electricity are.)

The gasoline price per litre was $0.8 in 2013. Applying the same calculation method, UAE’s oil subsidy rate would have been somewhere around 42 per cent before the change in subsidy policy. Taking August’s figures into account, the UAE’s oil subsidy rate is probably around 28 per cent now.

I mentioned earlier that this is the optimal time to remove fuel subsidies. Judging from the calculations above, one would conclude that the price quoted for August is more likely to be the price for some time unless something happens in the oil markets and cause prices to decline significantly. Even then, my assumption would be that the subsidy rate will be reduced further with the price being maintained at more or less the same level.

So what if prices go significantly up?

I am wondering here if it would have been better to remove the subsidy altogether and then allowing the market to adjust. However, there are three concerns here that must be discussed.

First, the reaction of people to the higher prices. Assuming the price became similar to the one in Japan, or even the one in Russia, you would be paying much more that what you used to pay for each tank refuel before changing the subsidy for gasoline.

Even though the price did not increase much, debates were taking place everywhere on the change in policy that took place. It is most likely for these debates to take place again if the subsidy rate was lowered further at any point in the future. So in such a scenario, a one-time increase would have been better.

The second concern is that of smuggling. The fuel price gap between the UAE and its neighbours would only widen, encouraging smuggling across borders.

If actions are taken to stem such activities, then again, it would have been more beneficial for this to be done once and for all. The third concern is that of inflation.

It has been feared that many retailers and services providers would be using the change in subsidy policy as basis to increase the prices of their products and services. That will happen anyway due to the not very efficient checks and balances of customer protection.

For those doubting this, make a call to report an increase on a product price and see how long it will take for the call to be answered and then for the issue to be resolved. Anyway, whether the subsidy is reduced or fully removed, the ground will be laid for higher prices in the future and hence inflation.

Such a scenario is unescapable, but would need effective regulations in the market itself to ensure that the price hikes are justifiable.

To conclude, the change in subsidy policy is good and the full removal of it would have been even better. It will lead to zeroing out a major government’s expenditure — estimated by IEA at $5.7 billion in 2013.

Such an amount could be then used to subsidise areas that the government would like to see growing, research and innovation being one example. Assuming the base price quoted by the Ministry of Energy would barely fluctuate unless a major shock in oil prices occurs, it would have been more efficient to adopt a more realistic approach than reviewing the prices on monthly basis.

For instance, a final subsidy rate could have been agreed on and maintained at all times — let’s say at 25 per cent. Then, an average of five years, as in Chile, is used as the basis for fuel prices for each year with the government subsidising the rate up to a maximum of 25 per cent when the price goes up and then reducing the subsidy to zero when it drops.

That would have at least reduced the amount spent on subsidising fuel by a great percentage, as it’s not completely eliminated anyway. Not only that, government spending on infrastructure could be reduced now due to higher prices for gasoline and hence, hopefully, less cars on roads. Presumably, high prices will reduce the number of cars owned per household, encouraging carpooling and higher utilisation rate of public transport.

The last thought that I want to leave you with: why not remove now the subsidy for electricity? (Note: UAE’s electric power exceeds 10,100 kWh per capita while that of Russia, which is subsidised at a lower rate, is around 6,617 kWh per capita).