Subsidising the oil industry

A recent report showed Egyptian LNG (Liquefied Natural Gas) supplies have suffered due to the government’s program of subsidisation. Before examining why this is happening lets explore the term subsidisation within the petroleum industry. When a government implements a fossil fuel subsidy it will generally produce a lowering of production and consumer costs in the form of tax breaks, price controls and reduced loan agreements. On the face of it, subsidies seem like a good idea especially in new or stagnant markets. However they are not without risk or consequence. In Egypt the result of lowering the cost of gas has resulted in a huge increase in consumer demand. Wonderful I hear you say, customers get a cheap supply of gas, companies make more money on sales and the government acquires a positive image, but when local demand outstrips contractual export requirements then we have a problem.

A government will generally make more money from exporting oil and gas than selling to the local market and as a result may win a number of contracts to supply an amount of petroleum at a certain price for a fixed period, when they fail to deliver it will have an impact on both governmental credibility and potential future investments. Earlier this year the situation became so bad for Eqypt that international arbitration was launched by the Spanish energy company Fenosa because the government suspended exports of its part owned LNG plant. So are the lessons for Uganda as production starts? If the crude oil is efficiently drilled, refined and a competitive contract has been put into place then the requirement for a subsidy should be minimal. If this is not the case then Ugandan oil will not be a competitive product to challenge other more mature competitors.

If Ugandan oil costs more to produce than expected, what remedial measures could the government use to correct the balance? One way is to increase import duty on foreign suppliers. By raising the level of tax the government benefits from having a balanced national market and even a more competitive national product if the tax is high enough. Also the increase revenue could be diverted to aid domestic needs. However the downside to this is that neighbouring countries who directly supply oil or indirectly as part of a distribution network may increase their levies on Ugandan imports to offset the increased costs. This tit-for-tat is annoyingly prevalent with governments who jostle to outdo one another.

Another option is to subsidise the cost of oil and gas at the pumps, giving the customer a cheaper local option. Again this can have many benefits but as we have seen with Egypt if local demand becomes too high then exports suffer as supply runs low. Another alternative is to subsidise at source with the operator. This can be done in the form of interest free loans or tax breaks allowing the operator to ideally pass on the cost savings when delivering to the market. But reducing tax within such a prevalent market can have its drawbacks. The U.S, alone spends a minimum of $10 billion each year to subsidise the local fossil fuel market and internationally governments could be spending up to $1 trillion annually, which I am sure you will agree is an astonishingly large amount of money.

If subsidies were removed how would this impact the national and global markets? A subsidy is born out of a need to deliver petroleum and petrochemical products at a cost effect price that consumers and market forces find attractive, allowing for a continual growth in the national product. Furthermore a subsidy will aid and complement market balancing for International distribution requirements. The problem is that subsidisation is very expensive and will generally add to National debt. Oil Change International a research organisation, say that $21 billion is annually spent in the U.S on production subsidies and that this amount does not include military, health or industry costs. They believe this money is effectively wasted and could be better spent on providing health care for the poor and needy. Therefore to remove subsidies would increase the flow of tax payer money back into the economy.

Also if subsidisation was not in place the true cost of fuel would hit the high street. The cost of production and refining would have to be past onto the consumer resulting in a sharp rise of petrol, diesel and heating oil. Presently oil is wasted on a large scale due to the public perception of a plentiful supply and a sharp rise in prices would curb this especially if pump prices increased in the States. Currently in the UK petrol is the equivalent of $2.20 a litre, while in the U.S it can often be found for around $0.97 a litre meaning many U.S car manufacturers produce vehicles with large powerful engines which are totally unsuitable for day to day commuting. If petrol was so expensive car manufacturers would have to make small highly economical cars as the general public could not afford to run anything else and as a side effect global warming would reduce either because car ownership diminished or because cars became environmentally friendly. Furthermore a poll conducted by Stanford University found that nearly 85% of the pollsters would favour tax breaks for companies that produced hydroelectric power instead of using fossil fuels.

I see there must be a middle road that would allow for growth without over expansion. Oil is a National and International commodity and to pretend otherwise is to be somewhat short sighted. The need for petroleum and petrochemicals is not going to dissipated overnight therefore it would be more than prudent to fully understand how we can apply subsidies in a mature and responsible way to create growth in new markets until such a market has reached maturity would be a logical option. However to use them to prop up a stagnant or artificially high market would be dangerous and could lead to an implosion as the markets destabilise. For the U.S, subsidies should be gradually tapered off but for Uganda I see them as a positive short term option for growth in the future.