Why oil control freaks are wrong - I

The report of the group chaired by Kirit Parikh, on ending the system of administered pricing for petroleum products, is an outstanding one and well worth reading. What could go wrong when the prices of petroleum products are decontrolled? Three kinds of arguments can be made:

1. Some believe that it’s important to subsidise the fuel purchases of poor people, either because it makes economic sense or because it makes political sense.

2. It could be argued that world oil prices are subject to short-term shocks. It could then be claimed that government can help by absorbing short-term fluctuations and giving the private sector a more stable environment.

3. It could be argued that floating rates for petroleum products will generate inflation or inflation volatility.

Fuel for poor people

The first argument is easy to dispose of. If a Prime Minister wants to subsidise fuel purchases of poor people, the direct way to do this is to deliver cash subsidies to them (eg, as is being done using NREG) or to give poor people vouchers entitling them to purchase fuel at a discounted price. The retail outlet that sells fuel at this reduced price would carry these vouchers to the government and get reimbursed.

There are implementation issues in ensuring that vouchers or cash transfers get to poor people only. NREG has made some fair progress: the rich are unlikely to do uncomfortable physical labour in order to get paid by NREG. The UID will help in improving the targeting of these kinds of schemes.

As an example, every BPL family can be given a voucher that buys 100 litres of kerosene a year. Assuming 20% of India is below the poverty line, and assuming there are five individuals per family, there are 43 million BPL households. Hence, this voucher system corresponds to a government purchase of 4.3 billion litres of kerosene a year. At a world price of Rs 36 a litre, this corresponds to an expenditure of Rs 15,480 crore or 0.3% of GDP. In other words, the existing system of distortions of the petroleum market can be replaced by a system of delivering 100 litres of kerosene to every BPL household per year at the cost of 0.3% of GDP. This argument is not new, but it bears repeating because of the long history of policy mistakes in India on this subject. The other two arguments are more interesting.

Smoothing over short-term fluctuations

Suppose the world crude oil market works as follows: There is a deeper price movement that changes very slowly, and then there is short-term noise on top of this. Sometimes prices go up and sometimes prices go down, but they tend to return to the long-run price.

If this were the case, you could make an argument that a government adds value by absorbing these short-term price fluctuations and only modifying domestic product prices to reflect the deeper price movements. This would help reduce noise in the decision making of the private sector. The private sector would adapt its technological choices (eg, what energy source should be used for what application?) based on the deeper price changes, but not have to scurry around responding to day-to-day movements of prices.

Even if this story is true, we’d need to demonstrate that the cost of the government’s actions in achieving this stability is outweighed by the gains. So the existence of such patterns in price movements does not immediately justify an administered price system. But before we get into that, the key question is: Is this how the price of crude oil behaves? Does it have a component of short-term fluctuations which tend to be reversed? This is the same as asking: Does the price tend to mean-revert? That is, when it goes up, on average does it tend to come back down, and when it goes down, on average does it tend to go back up? Are there negative correlations in price fluctuations in the short run?

Most prices in the financial market exhibit little such behaviour. Financial prices tend to be well approximated by the ‘random walk’. The random walk never forgets. Every change is permanent. Changes are not reversed. The autocorrelation function of percentage changes (i.e. returns) shows near-zero values for autocorrelations.

I focus on monthly data after January 1983, which is when Opec’s administered price system broke down. The time-series of the price of oil is depicted in Figure 1.

So is this more like a random walk or is it a mean-reverting process? Figure 2 shows the autocorrelations of prices. This looks a lot like a random walk, with very big autocorrelations at the short end. In a random walk, the best predictor of the price of oil next month is the price of oil this month—there is no return to a ‘long-term level’. The ADF test has a prob value of 0.4. That is, the null hypothesis of a random walk is not rejected. Figure 3 shows the autocorrelation function of the monthly percentage changes.

We see a little bit of momentum at the short end. There’s a 0.25 correlation of the change in the oil price at month t against the change in the oil price at month t+1. That is, this is mean aversion, not mean reversion. The price of oil isn’t going back to a deeper stable level. It’s mostly like a random walk.

If we believe that the price of oil is a random walk, then there is no case for a government to help the economy by stabilising the price. Trying to hang on to last month’s or last year’s price is pointless because in a random walk, the only thing to focus on is today’s price. The world oil price isn’t going to go back to what it was last year or last month. Every change is permanent, and we get new shocks starting from where we are.

A government that tries to hang on to a number will generally find that the market moves away from that number, with explosive fiscal consequences. One does not have much of a basis for claiming that any price is the ‘right one’ and is more right than what the market is saying right now.

If the price of oil was mean reverting, we could then ask whether the costs of administered pricing were outweighed by the benefits. But since the price of oil is mostly a random walk, there are no benefits. It is best if the private sector is constantly shown the current price so that it is able to think about how to adapt technology and the capital stock to today’s prices. We actually do damage by showing the private sector a stale price. We discourage the technological adaptations that the private sector should be onstantly undertaking.

One variant of this story that we sometimes hear is: Floating rates are fine for normal times but in extraordinary times, it is better to have administered prices. The great boom and bust of oil prices in the recent few years is held up as an outlandish set of events. This raises the question: Was oil volatility exceptionally large in the recent few years? Figure 4 shows the volatility of the world oil price with a rolling window width of 24 months.

So in the recent period, oil volatility has been running at values of 40% to 50% annualised. These values are not exceptional when compared with the historical experience. Odds are we will see such volatility in coming decades also. The recent few years were not just an outlandish set of events.

Source : Financial Express


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