Middle East Economic Survey
VOL. L
No 50
10-Decem
IRAN
Gasoline Markets in Iran: An Economic Perspective On Issues And Solutions
By Cyrus H Tahmassebi
Dr Tahmassebi, who wrote this article for MEES, was Ashland Inc’s Chief Economist and Director of Market Research before his retirement from that company in 1996. He is now an independent consultant.
Iran’s gasoline shortage and growing dependency on imports of this fuel have been widely discussed inside and outside Iran. The problem, which began as a result of the 1980-88 Iran-Iraq war, has continued to this day and its resolution has become much more complicated due to the failure of successive post-war administrations to address the issue boldly and decisively. Today, the gasoline shortage and the enormous amount of subsidy, estimated at about $40bn a year, that the government pays for this and other fuels is a huge economic burden; and because of Iran’s controversial stance on certain international political issues, it has also become an important national security concern. Recognizing the gravity of this situation, President Mahmoud Ahmadinejad recently launched a new initiative that not only raised the price of gasoline but also for the first time introduced an elaborate rationing system.
Iran’s Gasoline Problem
The key contributing factor to Iran’s gasoline problem is the government’s ownership of the downstream assets and its intervention in a process that should function through free market mechanism rather than by state controls. Iran is not unique in this respect. In almost all OPEC countries government ownership of energy-related assets and intervention in markets is prevalent and, for the same reason, almost all of them face similar issues. However, owing to its large industrial base, rapid growth, large population, unique demographic profile and controversial stance on international political issues, Iran’s case is much more complicated.
Over the last three decades, the country’s population has more than doubled from about 34mn in 1979 to over 70mn today, and nearly half of it is 30-years-old or younger. Vehicle numbers (now estimated at over 4mn) and industrial activities have grown at a rapid rate. Improvements in fuel efficiency in almost all sectors, particularly transportation, have been limited. Meanwhile, the price of gasoline and other fuels was kept artificially low, resulting in an astronomical growth in consumption, and even of smuggling to neighboring countries.
Iran’s ability to produce crude oil and petroleum products was severely undermined by the 1980-88 war and by a series of trade constraints and economic sanctions imposed on the country since the 1979 Revolution. The war with Iraq inflicted heavy damages on oil fields and refineries, resulting in considerable declines in the country’s ability to produce crude oil and refined products. The post-1979 trade restrictions and economic sanctions imposed by the US and others made it much more challenging to restore or expand refining and oil production capacity. Whereas the decline in oil production led to lower exports and revenues, the damage to refineries forced the country to meet its rising fuel consumption by costly imports.
In a market-based economy, a circumstance of this nature would have led to rapid increases in petroleum products prices, thereby discouraging consumption and generating cash for investments in refineries. But in Iran, the nominal prices of products – particularly gasoline – either remained unchanged or rose slowly and with considerable lag. Even in a state-run enterprise such as a national oil company, one would expect a government to raise petroleum product prices, at least in tandem with inflation or with the increase in the opportunity cost of crude oil, ie what it could fetch if exported. Again, for numerous reasons, some clearly political, until recently none of the post Iraq-war administrations took the initiative to address this problem boldly. Consequently, rather than generating revenue and income for NIOC and the government, all refineries in the country operated with huge losses and gobbled up a considerable portion of the funds generated from oil exports.
Some believe the root of this hesitation to raise gasoline prices goes back to 1964 when there was an attempt to raise the price of gasoline from IR5/liter to IR10/l. According to those who were at the time in decision-making positions, the purpose was to generate additional revenue rather than discourage consumption. This initiative was short-lived, however, and the price of gasoline was lowered to IR6 due to public opposition and the assassination of the prime minister at the time. Although there is no convincing evidence that this assassination was related to the gasoline price increase, some believe it was a continuing factor in the hesitation to raise gasoline price in subsequent years.
Nostalgia For “Cheap” Gasoline
Although a large percentage of drivers in Iran are of the post-revolutionary period, the “cheap” gasoline era of the 1960s and 1970s still evokes nostalgia in the minds of many. The “cheap” gasoline price of that era is often mentioned in discussions criticizing the government’s energy policy. It is important, however, to note that gasoline at IR6/l (or at IR10/l for a subsequently introduced higher octane grade called “Super”) or about IR23/gallon in the 1960s, was not really cheap. In fact it was either close to or higher than international prices. At the then prevailing exchange rate of IR70 to $1, IR23/g translated to $0.33/g. The average retail gasoline price in the US at the time was about $0.25-30/g, substantially lower than Iran. Today, gasoline prices in the US are the lowest among all industrial countries, including Canada which is a major oil exporter, and yet IR1,000/l in Iran is only a small fraction of the current US prices.
A comparison of gasoline price to crude oil is even more revealing about the folly of this nostalgia. In the 1960s, crude oil was around $1.60/B. At about $0.33/g or $13.86/B, the retail gasoline price in Iran in the 60s was about nine times the price of crude oil. At today’s exchange rate of about IR9,300 to $1 and crude oil price at $85/B, retail gasoline price at even IR4,900/l (five times the IR1,000 price that has been in effect since April 2007) would only cover the opportunity cost of the crude, leaving NIOC to absorb refining and distribution costs. Moreover, it is a well known fact that the Iranian rial is grossly overvalued. At a more realistic exchange rate between the rial and the dollar, Iran’s domestic gasoline prices could easily top IR10,000/l liter if parity with international prices was the real objective.
Deteriorating Refining Economics
Although there are no accurate reliable figures for the amount of subsidy provided to consumers of gasoline and other fuels in Iran, it is obvious that it is huge by any standards. Iran now consumes some 1.5-1.7mn b/d of petroleum products. Thus the annual subsidy, even at the artificially inflated exchange rate, could easily top $40bn. The weight of these subsidies is not only on the shoulders of the government, but also on NIOC’s downstream operations. The government has had the luxury of continuing the operations of these money-losing refineries only because of huge cash flows generated from crude oil exports. The multi-fold increase in crude oil prices over the last few years has provided the government with the financial wherewithal not only to continue operating these refineries at great losses but also to add to capacity and upgrade them. But obviously this trend is not sustainable. Most observers believe that eventually the government will be forced to follow a free market model in pricing its gasoline and other petroleum products and gradually phase out its subsidies program. According to these observers, procrastination, as happened in the past, would only make the task of tackling this problem progressively more difficult.
Ahmadinejad’s Initiative
Over the last year or so, Iran’s high degree of dependency on imported gasoline has been the subject of numerous discussions, editorials and analyses in the West and has been identified as the government’s Achilles’ heel. Accordingly, it has been asserted that the economic damage and hardship resulting from a successful attempt by the West to halt gasoline exports to Iran could cause enough unrest that might undermine Mr Ahmadinejad’s presidency. In reaction to these potential threats and the damaging impact of the highly subsidized gasoline prices on the overall economy and NIOC, President Ahmadinejad recently launched a plan that included both a price increase and a rationing program. The gasoline price was raised by 25% from IR800/l to IR1,000/l – a small amount in comparison to what was really needed to effectively address the problem. The plan also includes a rationing scheme through the use of a ration-card called a “smart card”.
This initiative, the efficacy of which is yet to be determined, triggered small-scale unrest, with a number of gas stations set on fire. The scheme, which consists of different ration allowances for different types of vehicles and uses, is reported to be now firmly in place and fully implemented. However, it is worth noting that by adding this rationing system to the price increase, the government in effect seems to indicate that it does not have much confidence in the demand-reduction impact of its 25% price increase, and its hope of reducing demand rests largely on the rationing scheme. The goal of the combined price increase and rationing is to reduce gasoline consumption from some 75mn l/day to about 39mn l/d, a 47% reduction.
There is much skepticism among analysts and other observers on the plan’s prospects for success. Most believe that issues surrounding gasoline and other fuels, such as heating oil and natural gas, that enjoy huge subsidies are far from over. The reason is clear: rather than opting to tackle the gasoline challenge through large and systematic price increases, thus creating incentives to reduce consumption and bringing the domestic price of gasoline closer to international levels to prepare for the eventual privatization of downstream operations, the government has opted primarily for a method that has been tried many times in other parts of the world and has almost always failed to achieve a long-lasting tangible result.
President Ahmadinejad reportedly favored a combination of a relatively small (ie small relative to what was needed) price increase and adoption of a strict rationing scheme for two reasons. First, he believes that too big an increase in price could not only be inflationary, but also would be unfair to the low income and middle class. Second, he considers rationing as a “catch-all” device, distributing pain and hardship equally and fairly to all consumers.
Most experts, however, would argue that rationing is a form of “command and control”, the implementation of which requires a huge bureaucracy; and it almost always fails to achieve its goal. Even if it initially succeeds on a limited basis, success will be short-lived. Moreover, rationing, by its nature, carries a huge stigma because its adoption signifies the failure of or lack of trust in earlier measures. Critics also expect the rationing plan to fail because it is prone to manipulation, cheating and emergence of black markets, despite its high administrative cost. In fact anecdotal evidence suggests that black markets have already emerged, with abundant cheating and abuses of the system. The perpetrators use different schemes, including the use of very old and decrepit light trucks and pick-up vehicles that are entitled to higher allocations to obtain allowances, only to turn around and sell them directly or through gas station attendants for more than three times the subsidized price. There is also anecdotal evidence that some taxi drivers sell their entitlements at fat profits rather than use the fuel. Whether or not the government will be able to prevent these abuses by adding new features to its smart cards is not yet clear. But it is obvious that if the rationing system is not followed up by rapid price increases and a gradual phasing-out of the subsidy system, abuses, in one form or another, are certain to continue.
Pragmatic Approach
Despite repeated calls for action from different circles within the country, no-one seems to suggest that either a huge price increase, to raise fuel prices to international levels in a very short period, or complete privatization of downstream operations is feasible now. Such initiatives would be radical, impractical and extreme. Yet, suggestions abound for galvanizing the rationing scheme or making it more effective. Some have suggested replacing the single price in the rationing scheme by a new progressive pricing mechanism where the price would rise with the level of each vehicle owner’s consumption. Others have suggested a combination of rationing and a quasi-free-market approach, with the present rationing system continuing, but with consumers given the choice of purchasing unlimited quantities of gas at the quasi-free-market price. As an initial step, one or two pumps in each gas station would be set aside to sell gasoline at a much higher price with no limitations on the quantity. The price in these pumps targeting well-to-do consumers would rise much faster until it approached parity (or near parity) with international prices. Meanwhile, the price in other pumps would also rise, but at a much slower pace to allow other consumers to adjust to the higher prices more gradually. Within a few years, the prices for the rationed and non-rationed gasoline would converge. Such a plan would gradually prepare the public for much higher prices and thus pave the way for the eventual privatization of all downstream activities.
Twin Questions Of Inflation And Fairness
Inflation, fairness and affordability are issues that are frequently brought up in discussions regarding the need to raise fuel prices in Iran. Having been accustomed to unrealistically cheap fuel prices for too long, the public reaction to any proposal seeking to reduce or eliminate the subsidies has been understandably very negative. Rather than being assertive and launching an all-out effort to educate the public about the dire consequences of the status quo continuing, the government has succumbed to public opposition to the elimination of fuel subsidies. As a result, every administration in the past two-to-three decades has failed to face the issues head on. Instead, they have opted for a “muddle through” approach, adopting half-hearted measures. This continuing failure to face the subsidy challenge boldly has exacerbated the problem.
Most experts argue that inflation, fairness and affordability are issues that merit close examination and analysis. However, their adverse impacts seem to have been grossly exaggerated. Inflation is a monetary phenomenon and, with a proper monetary policy, the spillover from higher fuel prices can be small and manageable. Moreover, the resulting inflation can not be long lasting if it is not fueled by uncalled for expansion in money supply. It is interesting to note that countries keeping their fuel prices low through huge subsidies are almost invariably among those with very high inflation rates. And the reverse is also often true. For example, as a result of rising crude oil prices in recent years, gasoline prices in the US have more than doubled and EU countries have seen their fuel prices rise sharply. Yet inflation has remained in check because of their measured monetary policies. On the other hand, inflation in Venezuela, one of the two countries with gasoline prices below those in Iran, averaged 39.3% in 1990-2004.
The argument for fairness and affordability also collapses under close examination. Fuels of all kinds are used much more by affluent citizens than by the poor or middle class. Therefore, rich people are the biggest beneficiaries of the fuel subsidies. In an efficient economy, the problems of fairness and affordability are not tackled by market interference, but are remedied by such measures as income subsidies or tax relief. Thus markets are allowed to function with minimum distortion and government interference.
Finally, national ownership of an industry’s production and operation is almost certain to result in unrealistic public expectations. For example, sharp increases in crude oil prices over the last few years have raised substantially subsidies on gasoline and other fuels because of higher opportunity costs of the crude oil used in domestic refineries. Yet the public’s expectations for subsidies have become even more extensive. They believe that when the government’s revenue goes up as a result of higher oil prices, so should the subsidies. Here again one can clearly see the disadvantages of a government getting involved in a business activity that should be owned and operated by the private sector.
Prospects For Success
If history is a guide, one must be skeptical about the prospects for President Ahmadinejad’s plan. Combining a price increase with a rationing system makes his approach bolder than others, so on the surface it may seem to have a better chance of success. But if rationing fails in implementation, as many observers and experts expect to happen, then Mr Ahmadinejad’s initiative will not be significantly different from those of previous administrations. People, who believe that rationing is a panacea, would argue that the previous administrations failed because they only resorted to price increases. But in reality, their plans failed to stem the problem because the price increases were insufficient, as is the case with President Ahmadinejad’s initiative.
Some observes say President Ahmadinejad would have a greater chance of success if he treated his rationing plan as a temporary measure, lowered his expectations of its success, completely precluded it from long-term planning, and pursued his demand-reduction goals by resorting to price increases only. These observers also believe his chances of success would improve considerably if he coupled his price increases with a well-planned and executed financial-assistance program to mitigate the hardship of higher fuel prices on low-income consumers. Resolving the gasoline problem is a major challenge that has defied the will and the wit of the previous administrations. Only time will tell if President Ahmadinejad is the man to succeed.