Towards Oil Industry Liberalization

July 1995 - The current debate over oil prices provides us a timely and important opportunity to view the issue in the context of a deregulated oil industry. When Congress passed the bill creating the Department of Energy in December 1992, the DOE was mandated to submit a program for deregulation by the end of 1996, now only 18 months away.

The public interest would be best served by gradually liberalizing and deregulating the industry over the next 9 to 12 months.

Why?

1. This is consistent with an overall policy thrust to liberalize other key sectors of the economy, most notably industry, banking, power generation, and telecommunications among others.

2. An automatic price-setting mechanism based on a formula which accounts for publicly-known world crude oil prices and the peso-dollar exchange rate insulates the government from having to bear the political burden and pressure of setting prices.

The problem with the current mechanism is that a politically-driven solution is at times applied to an economic problem. Prolonged debate and other factors tend to delay decision-making with respect to price adjustments. Thus, any adjustments to cost trends tend to become more substantial to make up for delays rather than more graduated to reflect market realities as they happen. The net result is infrequent – but larger – price changes which consumers find difficulty adjusting to rather than more frequent, but smaller, changes.

3. Over this time horizon, we expect world oil prices and the peso-dollar rate to remain fairly stable and within a narrow range which would in turn result in gradual changes in the pump price if an automatic price-setting mechanism was introduced to replace the Oil Price Stabilization Fund (OPSF).
Price stability within a narrow range for world crude prices will present us with a window of opportunity within which a deregulated environment can be created without adverse impact on the public.

4. Competition introduced into the market through liberalization will create pressure on the oil companies and dealers to keep prices low and service-levels high. This competition can take the form of new entrants into the market, more gas station locations (currently regulated), direct importation of product by large users and traders, and open competition for gas station services to motorists.

5. While liberalization and deregulation will benefit the public, controls should remain firmly in place to ensure fair competition, steady availability of oil supplies, safety and health of oil industry workers as well as the public, and strict environmental standards.

It is useful then to view the anticipated oil price structure in the context of a liberalized oil industry and to begin to adjust pump prices accordingly in that direction.

How?

The following steps must be taken in the sequence described below.

1. Enabling legislation should be passed in the next few months to introduce price-setting automaticity. The formula will necessarily include oil price and forex movements, both of which data are readily available to users. The automatic price-adjusting scheme should allow for frequent and small upward or downward changes as opposed to the infrequent and large changes we see today.

2. Changes in pump prices today should reflect the market realities of direct cost recovery and should build up the OPSF back to zero balance or, at most, to a moderate balance of no more than one million pesos. This balance should then be slowly phased out to zero by end of 1996 at the latest. This may entail a moderate increase in the current prices of oil products at the pump.

3. Enabling legislation should be passed to realign the tax structure for oil products which are currently taxed on an ad valorem basis. This should now be switched to specific taxes based on the volume of refined oil products imported by any user or reseller. Moreover, this specific tax should be collected at the time of importation which in effect would make it a form of sales tax collected in advance. In this way, enterprises which declare importation for their own use but end up reselling the fuel will already be taxed in advance. The government would not lose tax revenue under this arrangement. At the same time, legitimate resellers who pay their sales tax would not be faced with unfair competition in the form of technical smuggling.

4. At the same time that the tax structure is realigned, cross subsidies on the different oil products should also slowly be removed over a publicly-known timetable so that consumers will be able to anticipate price changes over time.

In making this recommendation, we are cognizant of the fact that prices for such products as LPG and diesel fuel are a sensitive issue with consumers. In the case of LPG, there may need to be a continued subsidy in order to keep LPG prices affordable and encourage its use as opposed to other methods of cooking (e.g., electric ranges, charcoal, wood, etc.) for environmental and other reasons.

5. There should be a full liberalization of the construction and installation of new service stations and storage facilities in preparation for full deregulation.

6. After the automatic price setting mechanism has been established, the OPSF been brought into balance, tax structure realigned, and cross subsidies removed, then the Oil Price Stabilization Fund (OPSF) may be abolished by an act of Congress. The deregulation of the oil industry will have been completed and prices will now reflect global market realities.

It must be stressed that the OPSF nor the cross subsidies cannot be removed immediately without the other steps taking place first as this would have adverse and sudden impacts on the prices of oil products.

What would the impact of liberalization be?

1. Prior to full deregulation, in the short-term, prices for some petroleum products may rise moderately. It would not be advisable to “load” the increase on only one or few products because this would further distort pricing (creating more cross-subsidy) and take us away from the long-term objective of deregulated prices. It would also not be advisable to place a disproportionate burden of the increase on fuel oil as this will raise the cost of power generation and have the effect of increasing electricity rates.

2. In the long-term, oil prices would reflect the world crude oil price trends. If prices were to rise, it would be far better to absorb them as they happen through pump prices rather than through any government appropriation or industry subsidy into a stabilization fund. A government appropriation would only exacerbate the public sector deficit while an industry subsidy would discourage future investment.

Conversely, a downward trend in world crude oil prices would likewise be immediately felt at the pump, assuming moderate or no depreciation of the peso against the dollar.

In any event, competition within the market would create downward pressure on prices as well as force suppliers and dealers to provide more value-added services.

3. Automatic price-setting would impose a market discipline against unnecessary use of fuel resources and in fact create a positive impact on the environment.

4. Since the market would determine the prices, the government would be insulated from having to make a politically-colored decision (or at least a publicly-perceived political decision). This would reduce the political fallout created by public clamor to hold prices when global realities indicate otherwise.

We would argue that it would be far better to begin the liberalization and deregulation move now, considering the outlook for the Philippine economy (continued growth), oil prices (stable), and the foreign exchange rate (stable). It would not make sense to further delay the entire deregulation program, which is mandated by law and policy to take place anyway.

We would further urge that the move towards deregulation be accompanied with a strong public information campaign to inform consumers about the ramifications of such a shift.