Flawed fuel pricing formulae unlikely to succeed
A fuel price hike is on the horizon. Sounds too familiar? Petrol price hikes in Sri Lanka are not driven by external factors. In the past it has not been and guaranteed in the future too, that is going to remain the trend. In the past regular price hikes and sporadic revisions were precipitated by a short-lived political agenda.
Crude oil is more than a commodity that drives the global economy. Let’s acknowledge that the reader and the writer both live in an era that has converted crude oil to a giant crude monster. It will not stop here.
Consumption and production-driven economic growth model converts this primary base to secondary goods and regards energy (oil) as an infinite commodity. We are mere converters and in the process we siphon off this limited commodity at maximum throttle. Last time the seven sisters (the USA based oil majors) started to produce crude at maximum throttle that resulted in the energy crisis and lead to the formation of OPEC.
We use oil as “Capital” and have designed our life styles based on a misguided belief. Flawed thinking: We must design a life style on Income and not on Capital. This can be abstract or philosophical.
Incremental Capital Output Ratio
The Incremental Capital Output Ratio (ICOR) reflects a relationship of “investment” to “growth”. Or from a layman lingo, this reflects as to how efficiently the capital has been utilised to reach growth projections. The lower the number the better it is.
I am using the concept of ICOR given that oil continues to be abused as Capital in Sri Lanka for the production of electricity and for transportation. As an economy, if we envision becoming an export oriented economy we must then be sensitive to this one component commodity: “Oil”.
Sri Lanka as an agro economy is trying to dabble in industry endeavouring to lead the economy towards a market economy; looks good on paper. If we fail to have a competitive and a sustainable solution to our oil crisis, as converters, we will not be able to convert these wonderful market economic theories from paper to palpable realties.
Our oil imports while being politicized and corrupt to the core, is a strain on our coffers. Oil is a commodity that is subject to international politicisation and now also local politicisation.
Prices adjusted for political advantages
In the process we continue to be exposed to spot market price volatility. While prices drop, the spot prices are volatile. When we envisage the creation of an export oriented economic model, in a competitive global market space we will not be able to compete if we do not properly address our energy problem with a sustainable medium term (5 – 10 years) solution.
Energy is central to production in growth. Energy as it remains is used as Capital. While being so, as for a commodity it is sensitive to adverse price swings. Now the more it is used to ramp up our export projections our ICOR keeps moving up in random.
We should try to have a business model/policy for economic growth whilst ICOR is managed properly.
Problems and the solution
Solutions must have a definable relationship to the problems we strive to resolve. If the potential solution leads to a bigger problem mid stream then what good would be the solution? In the past solutions were developed in a vacuum. Solutions were diamerically opposite to the problem. A case in point is, as a measure of reducing poverty in Sri Lanka consecutive governments since the middle-East boom advocated our village girls and mothers to seek “nanny-opportunity” in these countries. Nannies were a many but so were the direct and indirect social problems. The crux of the problem is that as a nation we lack policies. Policies are formulated by politically-appointed individuals who got no comprehension of the problem and fail to see the whole problem. Solutions are offered to fragmented pieces of the bigger problem.
International fuel pricing:
The current low prices are mainly too due manipulations to leverage as I stated herein.
Among the factors contributing to these low prices are:
. Fracking
. Return of Iran Oil
. Russian factor
. Excess Production
To summarise, there are three opposing factors: Russia, Middle East and the US working under different agendas that is driving the prices down and the production up. As I write, there is an excess production of approximately 1 million barrels of crude oil daily and they are being stockpiled. At the rate the global production and consumption patterns are shaping up the per barrel prices will remain low in the high US$50 to low $60 and the average prices for the next 12 months will be in the $60s range with periodic spikes driven by worker, weather and freight related issues.
Price formula
Any price model that will pass on the spot market price to the consumer is a failed model.
In the past we have had a kerosene subsidy where the low income strata were expected to be the beneficiary but it was not to be the case.
A review of the fuel prices in Sri Lanka would reveal that many versatile persons at policy making level came up with pricing formulas. They were to address the national energy crisis. As always they were shortlived and failed to fix the problem. Why they failed in the past was because the approach was wrong. Only theoretically they were good.
This time too, the proposed convoluted Oil + Energy price formula is guaranteed to fail. Initially these theories will work on a trial basis. The more complex any model is, the effectiveness of the model gets compromised as it becomes increasing difficult to monitor. We saw this happen with the complex derivatives instrument the banks sold to the Ceylon Petroleum Corporation. They came up with fancy names and complex structures (target redemption swap!)
As a solution to the volatile spot market prices, the energy industry developed energy derivatives and hedging strategies. The rest of the world used these instruments and strategies with success. Unfortunately in Sri Lanka, hedging was a total failure not because the mechanism was wrong but because the banks had a concealed agenda to mislead the policy makers and the policy makers were playing ball.
Yes, we had a bad experience once with energy hedging but we had numerous failures with these wonderful energy pricing formulas. Why then do we expect a different result from a more complex formula?
Crude oil hedging offers a sustainable solution to the energy price volatility. As stated earlier, hedging as a solution has a definable relationship to the energy problem. If we fail to take a comprehensive approach to our energy situation and continue to offer fragmented solutions (like a pricing formula), our lot will remain “wishful thinking” and a convoluted formula that will look good on paper.
(The writer, based in Canada, is a specialist on oil industry issues and is a regular columnist for the Business Times. He could be reached at upularunajith@gmail.com)