Rising Oil Prices Pose a Threat to Energy Subsidy Reforms

Many countries have reduced fuel subsidies as part of economic reform packages, but crude’s rebound risks a reversal in this policy trend.


For economists who complain about the distortions and deficits caused by energy subsidies, 2014 was a godsend. Last year at least 27 countries curtailed their fuel subsidy programs, or considered doing so, in favor of aligning domestic prices with global prices. But the recent rebound in oil prices threatens to undo much of that good work.

“The staying power of governments with regards to fuel subsidy reforms depends on the trajectory of international oil prices,” says Stephen Bailey-Smith, head of Africa research at Standard Bank Group in London, and his research colleagues.

Global crude oil prices fell by more than 50 percent in the six months between July 2015 and this January, making it possible for governments to remove costly energy subsidies without hitting consumers’ pocketbooks. Many countries took advantage of that window of opportunity. Ghana, an oil exporter, began raising domestic fuel prices in July 2014 and announced plans this month to eliminate subsidies by September. In oil-importing Indonesia, President Joko Widodo eliminated fuel subsidies in January.

“There’s a good argument for subsidy reform for both oil exporters and oil importers when the price falls,” says Jim Krane, fellow in energy studies at the Baker Institute for Public Policy at Rice University in Houston. Exporters can point to lower oil revenues to justify the need to tighten public spending and require consumers to pay a little more for gasoline and electricity, he contends. “They need to reform subsidies,” adds Krane, “to send price signals to domestic consumers to reduce their consumption.” For oil importers, savvy governments can capitalize on the tumbling cost of crude oil to trim energy subsidies without the public perceiving steep price hikes.

The savings can be substantial. The International Monetary Fund estimates that governments have reduced energy subsidies by a total of $190 billion a year since 2011. Trimming such largesse can rejuvenate economies by reducing budget deficits and freeing up funds for public expenditure on things the economy urgently needs, such as infrastructure, education and poverty-reduction programs. Indonesia’s Widodo plans to use the government’s subsidy savings to ramp up infrastructure spending by about 60 percent over the next five years. He hopes the shift will boost the country’s growth rate to 7 percent a year from last year’s 5 percent pace.

Although subsidies are often justified as helping the poor, most of the benefits actually go to well-off consumers, who are more likely to drive cars and consume more electricity in their large homes. “It’s a very expensive way of reaching the poor, because there is so much that leaks out to the middle class,” says Franziska Ohnsorge, chief economist of the World Bank’s Development Prospects Group. India removed diesel fuel subsidies in October 2014 and is trimming petroleum subsidies by 50 percent in the fiscal year that began April 1; it is providing cash transfers to low-income households to compensate. Such reforms have already boosted investor confidence and triggered capital inflows, the bank said in its flagship forecast, Global Economic Prospects, published this month.

Subsidy reform is facing a growing challenge from the recent rebound in oil prices, though. Since bottoming out in January at $45 a barrel, Brent crude oil has already risen to about $66. “That’s the real breaking point,” says Ohnsorge. As prices climb, she adds, “there is a risk that some of these reforms slip.” Indonesia has already delayed a price increase on fuel sold by state-owned oil company Pertamina that had been scheduled for May, to match the global oil price rise. It’s not yet clear whether the delay will prove to be temporary or whether it marks a return to subsidization.

“It’s a clever policy tool to hide your subsidy reform in a falling commodity price, by allowing the price to free-float with the global oil price,” says the Baker Institute’s Krane. “But with net price rebounds, as will likely happen sooner or later, the public starts to figure out what you’ve done.”

If oil prices continue to rise sharply, as they did in 2009, governments will be more inclined to reintroduce subsidies or shelve plans to reduce them, contends Standard Bank’s Bailey-Smith. “The reintroduction of subsidies will further tie down funds governments might have otherwise used in providing a structural framework that can foster longer term economic growth,” Standard Bank says.

Of the major oil-producing economies in Africa, only Nigeria has not removed subsidies. The government’s subsidy bill is estimated at about $3.4 billion a year, or roughly 10 percent of public spending.

Energy subsidies are particularly heavy in the oil-rich Middle East. Electricity in Kuwait, for example, costs about seven tenths of a U.S. cent per kilowatt hour, versus about 12 cents in the U.S., according to Krane. In Qatar electricity and desalinated water are free for citizens. Iran is perhaps the worst offender. The government spent nearly $84 billion on oil and gas and electricity subsidies in 2013 (the latest year for which data are available), according to the International Energy Agency.

Politicians often trade subsidies for political support, which makes their removal so difficult, says Krane. “There’s a long-term political gain and short-term political hit,” he says. If a government can survive the short-term hit to its popularity, the removal of subsidies should provide economic and political dividends in the long run, he reckons. Some countries, notably Yemen and Nepal, faced public unrest following fuel price hikes in 2014. Yemen partially restored subsidies last September, whereas Nepal modified its scheme to be based on international price trends. Many populations simply don’t trust their governments to implement other programs that benefit the poor in place of the subsidies, like cash transfer programs.

Subsidies are dangerous because they create a political constituency for maintaining them, says Krane. “When you introduce them, you basically sow the seeds of future political opposition to their removal,” he concludes.