As OPEC+ meets in Vienna this week, one of the motivating factors pushing certain members to favor an increase in oil production is the concern that the sharp increase in oil prices over the past six months has strained emerging market economies and is beginning to test the limits of what consumers will tolerate. Oil prices have fallen back slightly over the past month, but at $75 per barrel, Brent is up nearly 40 percent from the 2017 average.
Higher fuel prices combined with a strengthening dollar have significantly raised the cost of fuel for consumers around the world, threatening to undermine robust oil demand forecasts.
Higher fuel prices combined with a strengthening dollar have significantly raised the cost of fuel for consumers around the world, threatening to undermine robust oil demand forecasts. However, a growing number of emerging market governments are stepping in with fuel subsidies or price controls to prevent costs from rising too high. These actions may keep demand elevated despite stronger global oil prices.
Subsidies make a comeback
Fuel subsidies can result in numerous negative consequences. Artificially suppressing prices leads to over-consumption, increased air pollution, and more congestion. They also drain scarce public dollars, which could be used for other critically important societal goals.
In the years following the 2014 oil market downturn, a series of countries took the opportunity provided by low oil prices to begin phasing out pricey fuel subsidies, a windfall for governments that no longer had to suppress market prices at great expense. A study from the IMF found that global fossil fuel subsidies topped $5.3 trillion annually. Indonesia removed most of its fuel subsidies in 2015, while keeping in place some price supports for low income households. The reforms were widely hailed as a success—Indonesia spent more than 3 percent of GDP on fuel subsidies in 2014, a figure that declined to less than 1 percent in 2016.
But the policy success might have been temporary. The rally in oil prices since the start of 2018 has strained household budgets in different markets, spread consumer discontent, and forced some governments to roll back some of the subsidy reforms begun several years ago. In March, Indonesia said it would increase its per-liter subsidy for diesel and gasoline from the equivalent of around USD$0.35 per gallon to $0.49-$0.70 per gallon. Motorists would see no change in the price at the pump, putting much of the increase in oil prices on the government’s tab.
The damage to public finances has been magnified by the recent strength of the U.S. dollar.
The damage to public finances has been magnified by the recent strength of the U.S. dollar. Crude oil is priced in dollars, so a strengthening greenback makes oil even pricier in local currencies. The U.S. dollar is down from a year ago, but has strengthened since early 2018, coinciding with substantial gains in crude oil. The dollar and oil do not typically move in tandem, but the Bloomberg Dollar Index is up more than seven percent since February, during the same period Brent crude rose by 10 percent.
Rising oil prices and a weaker local currency tend to result in sharp increases of prices at the pump, which could weaken oil demand growth. The danger to emerging markets is even greater in countries with large debt. Dollar-denominated debt becomes difficult to pay back when the local currency depreciates, bond prices falter as investors lose faith, and central banks use up their tools trying to defend their currencies. Moreover, a hike in interest rates intended to keep the currency from falling can also bring on an economic downturn. For example, Argentina had to turn to the IMF just weeks ago to secure a financial lifeline after the peso collapsed, a development at least in part influenced by higher interest rates from the U.S. Federal Reserve and the ensuing capital flight from emerging markets.
“In effect, the double whammy of a strong dollar and rising oil prices could easily start to negatively impact oil demand across a range of emerging economies,” Bank of America Merrill Lynch wrote in a report in early June.
Subsidies could support demand growth
Higher oil prices should, in theory, curtail oil demand, but governments have become skittish about the economic and political fallout from a spike in fuel prices. That has led to a phasing back in of subsidies in several countries.
India, no stranger to public outcries over expensive fuel, slashed gasoline and diesel prices, with the ruling party eyeing next year’s presidential election.
Brazil was recently rocked by crippling protests by truckers and oil workers angered by expensive fuel. Workers demanded an end to market-based pricing for fuels, forcing the government to return to regulated prices. Brazil is not alone. India, no stranger to public outcries over expensive fuel, slashed gasoline and diesel prices, with the ruling party eyeing next year’s presidential election. Thailand, Indonesia, and Argentina have also proposed or implemented fixed fuel prices. Mexico’s leading presidential candidate has hinted that he would do the same if he wins the upcoming election.
In China, there has been less help from the government to keep prices down, and the country has been hit with strikes by truckers protesting high fuel prices. The IEA predicts that China’s oil demand growth will slow to 270,000 b/d year-on-year in the second quarter, down from 460,000 b/d y-o-y growth in the first quarter.
But the return of subsidies in several emerging market countries could actually keep oil demand growth on track, muting the price effect on consumer behavior. “[R]rigidities are building across the board with a large number of emerging economies trying to mitigate the impact of rising oil prices on the consumer,” wrote BofA Merrill Lynch. “Many countries took the opportunity afforded by falling oil prices to ease fuel subsidies and increase fuel taxes, but as oil prices have rebounded, fuel price regimes are set reverse course.” Emerging market economies account for most of the growth in oil demand, so policy support could have global ramifications for the market.
“With EM governments intervening to mitigate the rise in local prices, we continue to project global oil demand to grow by 1.5mn b/d this year and 1.4mn b/d next year.”
“With EM governments intervening to mitigate the rise in local prices, we continue to project global oil demand to grow by 1.5mn b/d this year and 1.4mn b/d next year,” said Bank of America Merrill Lynch. In its June Oil Market Report, the IEA kept its oil demand forecast largely unchanged after downgrading it a month earlier by 100,000 barrels per day. The agency noted that the price rally might have run out of steam, but “demand might also receive support from measures under consideration in some countries, e.g. Argentina, Brazil, India, Indonesia, Russia and Turkey, to help consumers cope with higher prices.”