The folly of reverting to an oil regulated regime

FOURTEEN YEARS ago, the Philippines acted boldly, embracing oil industry deregulation and bidding goodbye to the oil regulated regime. Overwhelming evidence supports the view that oil deregulation works, that local pump prices behave in sync with world prices, and that oil firms’ profits are reasonable. Reverting to the old, unjust (oil companies made huge profits at consumers’ and taxpayers’ expense), and clearly inefficient, regime will be a monumental mistake.

Formally constituted in March this year, the Independent Oil Price Review Committee (IOPRC) was tasked to determine if oil companies accumulated “excessive profits” and if they were guilty of unfair pricing to the detriment of the public. It focused its study on whether oil prices and the profits of oil companies can be deemed “unreasonable.”

The report approaches this question of reasonableness in three ways.

First, using regression analysis, based on weekly data, the IOPRC evaluated the responsiveness of local pump prices (more specifically unleaded gasoline 93 octane and diesel) to world oil prices (based on Mean of Platts Singapore (MOPS). In addition, the Committee checked the movement of local pump prices compared to a closely situated country (Thailand).

Pump prices are deemed “unreasonable” if they do not closely match the movement of world oil prices, and if movement of local prices is extraordinary compared to Thailand.

The review finds that: “deregulation has resulted in increased responsiveness of local pump prices… [and they] are more responsive to world oil prices now than at any period since regulation.”

“This holds whether one looks at the time it takes for local pump prices to respond to changes in world prices or the amount of variation in local pump prices explained by changes in world oil prices.”

The ratio of local pump prices to world prices is lower and less volatile now than any period, taking account of differences in tax regimes on fuel over time. The ratio of gasoline pump prices to MOPS gasoline has been quite steady at 1.7 over the past two years. Similarly, over the past two years, the ratio of diesel pump prices to MOPS diesel has been quite steady at 1.3.

Conclusion: the IOPRC finds nothing “extraordinary” about the movement of local pump prices in the Philippines. The relationship between local pump prices and world oil prices is generally the same for the Philippines and Thailand, except for periods with price subsidy in Thailand. The spikes in oil price movements have been virtually eliminated and prices have adjusted on weekly basis.

Why not subsidize fuel consumption in the Philippines as in Thailand, Malaysia and Indonesia? The short answer is that it is going to be costly in terms of larger deficit. The estimated cost of fuel subsidies (including for electricity) on Thailand was 2.7% of GDP per year in the past two years.

For the Philippines, that level of subsidy has dire consequences on the country’s prospects for future credit upgrade. It could even lead to credit downgrade.

The second way is to analyze, using project finance modeling, and using annual data, the rates of return of oil companies, compared with returns in other industries as well as government bond rates, and before and after deregulation.

Unreasonableness in profits will show in much higher returns for oil companies compared to returns in other industries.

Conclusion: the IOPRC finds that the oil companies’ profits are reasonable. Major oil firms do much better than independent players. But compared to those in the mining, telecom, power and gaming industries, oil companies’ profits are lower, and slightly higher than in the real estate business.

And here’s a more revealing finding: the average return on equity (ROE) of the three major oil companies (Petron, Shell, Caltex/Chevron) was much higher (estimated at 23%) during the regulated period than during the deregulated period (ROE at 13%).

During the regulated period, oil firms were guaranteed profitability under a regime of “cost + plus” pricing. Under a deregulated regime, the big oil firms have to compete with an increasing number of new independent players. Increasing competition leads to lower oil pump prices.

The third way is to compute, based on monthly data, the oil company’s margin using an Excel-based predictive model of unleaded gasoline and diesel. Pump prices were calculated using MOPS and related information on various fees and taxes on oil products.

Unreasonableness will be manifested in higher actual prices than those predicted by the model.

Conclusion: the IOPRC finds the gross margin as percentage of pump prices for gasoline and diesel to be reasonable. In June 2012, the average oil company gross margin as percentage of pump price is 12.3% (₱6.86 per liter) for gasoline and 1.9% (₱0.88 per liter) for diesel. This gives a weighted average of 5.4% (₱2.88 per liter), assuming that sales proportion are in the order of one-third gasoline sales to two-thirds diesel sales.

Gross margins vary from one period to another depending on market conditions and tax regimes. In 2011, gross margins were no larger than ₱7.45 per liter for gasoline and ₱1.44 per liter for diesel. The larger margins for gasoline indicate that oil firms are cross-subsidizing diesel from their higher gasoline margins to sustain their operations.

Still, the oil company gross margin for gasoline tended to be lower in recent years. During the regulated periods, they were much larger than that during the deregulated period, indicating the level of competition arising from the oil industry deregulation law.

The oil company gross margin for diesel during the regulated period, as well as during the deregulated period, were consistently lower compared to gasoline. Again, this is another evidence of oil firms cross-subsidizing diesel from their higher gasoline margins.

The results of the three approaches converge to one incontrovertible conclusion: deregulation works. Increased competition lead to fair pricing and reasonable, not excessive, profits for oil companies.

The oil market structure has changed sharply since the oil industry was deregulated in 1998. The market share of independent oil companies has increased from 0% in 1998 to 25.7% in 2011.

The number of retail stations has grown from around 3,500, of which 270 were operated by independent oil companies, in 2000 to 4,459 as of end-2011, of which around 800 or 18% of the total were operated by new oil industry players.

The rise in the number of oil industry players has fostered keener competition, which leads to lower oil pump prices. The IOPRC’s statistical analysis supports the hypothesis that oil pump prices are lower where there are more retail stations per capita.

Benjamin Diokno is professor of Economics at the School of Economics, University of the Philippines(Diliman). He was formerly secretary of budget and management in the Estrada administration and undersecretary for budget operations in the Aquino 1 administration. –Benjamin E. Diokno, Businessworld