Money October 2005

Money

Oil prices and government responses

Florin Citu
October 2005

The latest increases in the international price of oil, which continue to show up in higher petrol prices in Romania, has created a minor hysteria among journalists, analysts and even politicians. Price increases were reversed in less than 48 hours when the Romanian president threatened to revisit the purchase agreement of OMV’s privatisation of Petrom. An unorthodox threat, if ever there was one.

Why are we so scared of rising oil prices? Higher oil prices are neither inflationary nor deflationary. Their effect on an economy and its level of prices depends on the response of monetary policy – and possibly fiscal policy – to increases.

Theoretically, an increase in the price of oil raises the input costs of firms, so that they produce less at any given price. If aggregate demand is unchanged, this translates into higher prices and lower output. Headline inflation is increased by higher fuel prices almost immediately. If higher inflation then results in higher wages, then the core, or underlying, rate of inflation will also rise. Thus, according to the theory, Romanians – and everyone else – should have expected higher petrol prices as the price of crude oil rose on the world market.

But oil prices have been rising internationally for several years now, at a faster pace than domestic energy prices. Since 2001, we have not seen the same direct correlation between domestic petrol prices and international oil prices. Due to the price of petrol being heavily subsidised by the government, Romanians did not experience the same increase in petrol prices as might have been expected from higher crude oil prices.

So why does everyone in Romania see the latest increase in gasoline prices as unwarranted? First, the Romanian currency has appreciated throughout 2005 and second, petrol prices at the pump have risen to levels similar to those of other European economies.

Regarding the currency, the conventional thinking was that because the RON has appreciated against the euro and the dollar gasoline prices should fall, not rise. This is partially true. The first problem with this argument is that crude oil is priced internationally in dollars and the RON has only appreciated by 1.4 per cent against the dollar since December 2004. The second problem is that during the same period world oil prices have increased by 48 per cent – an increase that has only translated into a 6.6 per cent petrol price rise, of which more than half is due to higher excise taxes.

As for comparing prices with other European countries, analysts looked at the fairness of having similar prices. Again, this is misleading. Petrol uses an input that is traded internationally and thus a petrol producer (ie a refinery) will have to pay the same price for crude oil as would any another producer elsewhere. Even if the oil is extracted domestically, it would be bad business for a refinery to sell it at a lower price than in the international markets. Thus, the difference in petrol prices derives from production costs and taxes.
My point is that there is more to petrol prices than exchange rates and also being fair does not have anything to do with maximising profits. But if a government is worried about higher oil prices it should use tools that do not contradict the spirit of free markets.

One of the principles of market economics is that the right policy will be a direct response to a specific problem. If the problem is that higher prices will show up in higher inflation then it is the task of monetary policy to respond appropriately. If the problem is that petrol prices do not reflect their cost on society then it is the job of fiscal policy to respond. And if the problem is that prices are set in a non-competitive environment then it is the job of the competition council to respond.

Any other market interventions that are not in the spirit of a free market will lead to further volatility and uncertainty. And that is just poor economics.

Florin Citu is Managing Director of BAC Romania, and investment bank.