The Rise in Fuel Prices: Impact, Government Response, and the Potential Effects on Decarbonization

2023-10-17 04:13:02

October 17, 2023

The increase in fuel prices has become a serious headache for the government, eager to act to protect consumers. The French authorities are not the only ones struggling. In Japan, where the depreciation of the currency adds to the rise in the price of petroleum products, the authorities have decided to extend the subsidies at the pump put in place in January 2022. May the rise in fossil fuel prices help decarbonize our economies by reducing the kilometers traveled and shifting demand towards vehicles that emit less CO2 carries little weight in the face of polls and political risks. In reality, the authorities of the importing countries do not control the origin of the shock caused mainly by the rise in crude oil. To think regarding an appropriate political response, we must first question the causes of the increase.

The main upward factor comes from the crude oil market, for which the reason is clear: the rise in the price of oil is the result of a deliberate strategy by Saudi Arabia. With a production capacity greater than 11 million barrels per day (mb/d), a level exceeded in September 2022, the kingdom has reduced its production to less than 9 mbd as part of the OPEC+ agreements with Russia and its own strategy. Last June, OPEC confirmed that the reduced quotas would be extended. Saudi Arabia added more, announcing an additional reduction (1 mb/d) in its production. The United States Energy Information Administration (EIA) recently confirmed that Saudi production had indeed fallen to 8.7 mb/d in August. As a result, the price of the variety exported by SA, light Arabic, approached $100/bbl at the end of September, bringing that of Brent to $95, an increase of almost 30% in the space of three months. Since then, the price of Brent has fallen to $85/bbl, still 15% more expensive than in June, before rising to $90, following the Hamas attack on Israel.

The reasons for the Saudi strategy are not as clear as the OPEC communication indicates. Officially, this involves supporting prices in a context of anticipated weakening of demand, even if this is not what is anticipated by the International Energy Agency which, in its September reportforecasts a 1% increase in global demand in 2024.

Lessons from 1986

Attempting to prop up prices by reducing one’s own production has historical precedent. After the almost tripling of the price of crude oil between 1978 and 1980 (+163%), a consequence of the Iranian revolution and the outbreak of war with Iraq, the OPEC countries agreed on a reference price ($34 for light Arabic, or regarding $110 today). As Western economies plunged into recession following the oil shock and the US Federal Reserve’s anti-inflation monetary policy, the only way to maintain the price was to lower supply. However, only Saudi Arabia was able to modulate its production to support prices, due to its dominant position and its financial reserves. The other OPEC producers, while declaring solidarity, were not prepared to lose revenue for the common objective, so pressing were their domestic needs. This strategy resulted in a drastic fall in Saudi production, its global market share falling from 18% in 1981 to only 6% in 1985, as well as a collapse in its revenues. The only actor to play the role of marginal producer – the one capable of balancing the market – Saudi Arabia had not only given way to other members of OPEC such as Nigeria, but had involuntarily accelerated investments in the search for oil, resulting in a sharp increase in non-OPEC production. In 1986, the Saudi strategy took a radical turn, with a 50% increase in production which caused the price of crude to fall, but allowed the kingdom in the years that followed to regain lost market share and rebuild its market power. In 2022, its global market share was around 14%.

It’s not 1985, but…

There is no shortage of parallels with the current situation. For example, Saudi Arabia is practically alone in respecting the OPEC+ agreement. Russia’s promise to reduce its production by 0.5 mb/d and its exports by 0.3 mb/d only binds those who believe it. In reality, every barrel produced and exported, by whatever means and route, is so valuable to finance the war once morest Ukraine that not only is Russia pumping everything it can, but, to circumvent the ban European Union to insure ships carrying Russian oil purchased at more than $60/bbl, it mobilized through front companies a fleet of “shadow” tankers, well documented in this article from Le Monde, a fleet that it insures itself. Furthermore, Iran and Venezuela took advantage of the situation to increase their own production, to the detriment of Saudi Arabia. A second parallel with the 1980s is the policy of the Federal Reserve, determined to regain its anti-inflation credibility by pushing interest rates higher.

There are of course big differences with the 1980s. Western economies have, until now at least, resisted monetary potions well, moreover infinitely less bitter than those administered by Paul Volcker in 1980, they are much less oil-hungry than they were, and the price increase is an order of magnitude lower than then.

It prevents. Wanting to support prices by limiting production can certainly work in the short term, as we observed in August and September, but, in the long term, can only cause a serious backlash. Indeed, the rise in prices, if it were to continue, would reduce demand even more due to its depressive effect on the global economy, itself amplified by the reaction of the Fed, which might not ignore the consequences of the oil inflation on wage demands – American auto unions are demanding wage increases of 35 to 40%! With weaker demand, Saudi Arabia would have to cut production even further to maintain prices. Others would take advantage of high prices to increase their production, starting with American shale oil producers. Ultimately, the kingdom would see its market share (and therefore its power) erode and its revenues fall. For its income to increase, prices must increase by more than 25%, to compensate for the 20% drop in its production.

Who was wrong with MBS to give Putin such a gift?

As we have certainly not forgotten in Riyadh the setbacks of the price support strategy of the 1980s, we must probably look elsewhere for the motivations of those in power. Let’s risk some hypotheses.

First of all, the bane of Gulf producers is not Russia, which has little room for maneuver and with which we can discuss state to state. The enemy is rather the American producers of “tight” oil (extracted from shale thanks to technological innovations) which appeared in the 2000s, but which only began to weigh on the global balance ten years later. Highly flexible and responsive to price fluctuations without regard for politics, they have shaken Saudi Arabia and its allies from their pedestal as marginal producers. However, the producers of Spraberry, Bakken, Wolfcamp and Bonespring, these champion districts of tight oil, are financed by bank credits or on the junk bond markets. They are therefore very sensitive to interest rates, which have become unfavorable for them. Aramco strategists may therefore have thought that these competitors would not be able to take advantage of the windfall of higher prices to regain market share. In fact, tight oil production has only increased slightly since the start of the year (0.3 mb/d). And if higher interest rates for longer forces some into bankruptcy, that would be a point gained, even if the respite would only be short-lived, as the oil in the ground is still there.

Second, Crown Prince and de facto ruler of Saudi Arabia Mohammed Bin Salman (MBS) is aware that the main beneficiary of a restrictive oil policy is President Putin. The rise in world prices brought with it that of the Urals, which rose from $60/bbl, the sanctions ceiling, to $84 at the end of September, a discount of only 12% compared to Brent, while it exceeded 30% six months ago. According to already cited IEA report, Russian export income increased by almost $2 billion in August. It certainly grew even more in September. Over a full year and if its effects were to last, the Saudi strategy would bring in $20 to $30 billion more for Russia. The advantage that Russian leaders can gain in their attempt to subjugate Ukraine is considerable.

But what benefit do we think Riyadh will get from this gift to Putin, other than making it clear to the United States that the time when they might dictate their conditions to the Saudis is well and truly over? We will not venture into this area, but would like to observe that, since the argument of an economic advantage for Saudi Arabia is unconvincing, we must look to the geopolitical side for the deeper reasons for this strange game.

So what if there’s not much we can do?

For importing countries having little influence over Saudi decisions, which is the case of France and Japan, what can be done to limit the damage and not enter into the game of billiards with an indeterminate number of bands played by MBS?

Should we follow the Japanese tactic, that is to say extend the measures to reduce the price at the pump through direct subsidies? Many voices are pleading in this direction, whether it is a question of “blocking prices” (NUPES), of reducing taxes on products (rebate requested by Eric Ciotti of the Republicans, reduction of VAT for the National Rally, TICPE floating for Richard Ramos of Modem…). Freezing prices would be the worst measure, because, unless it is at a level higher than that of the market, which is obviously not the idea pursued, it would immediately lead to rationing of supply, refiners and distributors unable to satisfy demand at the price set by the State. Queues at stations would form immediately.

Proposals for tax reductions or rebates, which the government had also put in place for all energy sources during the price explosion in 2022, are no better. If we think regarding it carefully, this would amount to transferring tax resources from France to Saudi Arabia or Russia, depending on the origin of the imported products. Let us imagine that all importers follow the same policy of eliminating increases by reducing taxes. Saudi Arabia’s Malthusian strategy would then be rewarded, since the rise in oil prices would have no effect on demand. The oil producer’s revenue surplus would be equal to the importers’ tax losses due to rebates. There would be no other way to encourage producers to push their prices even higher, since they would have the assurance that this would not diminish consumers’ appetite for their products.

In the case of France, the only economic justification for the shield strategy put in place in 2022 was to smooth out the shock of imported inflation caused by Russian aggression, so as to limit the increases in low wages inherent to our system. minimum wage over-indexed to inflation. This was to reduce the risk of a loss of competitiveness that would be difficult to reverse. But the remedy was only justified by the magnitude of the shock and was only valid if it was temporary. It made it possible to avoid inflation significantly above 10% as in some of our neighbors. Continuing the perfusion, while the increase in imported prices is much more limited than following the outbreak of the war, seems all the less justified since, as the previous analysis shows, Saudi Arabia’s strategy does not is not sustainable. Sooner or later, MBS will decide that eroding its market share is fundamentally once morest its interests, and the price of oil will fall.

Playing Saudi Arabia’s crooked game and subsidizing the CO2 emissions inherent in the use of fossil fuels until then is not in our interest.

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