The dilemma in hiking oil prices

By David E. Sumual

JAKARTA (JP): The price of oil is of critical importance to today's Indonesian economy, given that oil is the largest traded commodity, both in volume and value terms. It is generally known that we depend on a "hydrocarbon economy".

In addition, the prices of energy-related goods and services are linked to hydrocarbon prices, of which oil makes up the single most important share.

Finally, the price of oil is linked to some extent to the price of other fuels -- even though oil is not a full substitute for natural gas, coal, and electricity, particularly in the transportation sector.

For these reasons, abrupt changes in the price of oil have wide ranging ramifications for both Indonesian oil production and consumption.

The sharp decline in world oil prices from late 1997 through early 1999 certainly qualifies as an abrupt and significant change that made the Indonesia economy plunge further.

This significant effect can be clearly seen by the woeful budgets of 1983 and 1986 that forced the government to devaluate the rupiah, caused inflation, a deficit trade balance and stagnant growth of the economy as a whole.

The current high price is predicted to be temporary due to several factors. First, the Organization of Petroleum Exporting Countries (OPEC) will be forced to raise output quotas to avoid market disruptions.

Second, there is concern from Asian producers such as China, Indonesia, Brunei, and Malaysia, that if prices continue at present levels, the nascent economic recoveries in Asia could be cut short. Moreover, OPEC also depends heavily for demand growth from this region.

Third, there is also concern about the impact of high oil prices on the sustainability of the North American expansion and on emergent growth in Europe.

And OPEC certainly does not want to prompt a situation where governments of the Organization for Economic Cooperation and Development (OECD) are forced to use strategic reserves to avoid market disruptions.

Finally, historical prices have exceeded US$30 per barrel only twice -- in response to non-economic phenomenon such as the Iran- Iraq war from 1980 to 1982, and conflict in the Middle East (the annexation of Kuwait by Iraq).

It can then be inferred that historically high oil prices have never lasted long in the face of political pressures by developed countries on oil producers to rise supply.

So how should the Indonesian economy best accommodate this volatility in oil price, especially with regards the budget and subsidy problems? This turbulence raises a sticky situation, since oil is highly correlative to inflation as an economic and political indicator.

The fluctuation of international oil price apparently has not directly affected the domestic oil price, since the government has administered the strategic energy prices, especially oil, and has provided an oil subsidy.

The government realizes that people here have relatively low political and social tolerance for the pain caused by an increase in oil price.

Meanwhile the government has gradually been pushed to the edge of the ravine by defending the domestic price with subsidies.

It now has plans to raise the oil price by an average of 12 percent after previously pushing the domestic oil price by 43 percent. This led the transportation figure of the consumer price index to jump from 119 to 126 in April 1997.

We will have to wait and see how our inflation will be affected by the planned oil price hike.

In view of all the consequences of a policy to protect the poor, several facts must be taken into account to visibly assess the current development. Wisdom, not a myopic consideration, must be a priority to settle this problem.

The monopoly of the state run oil company Pertamina has been blamed for the source of the inefficient and underdeveloped oil industry.

It is very hard to find a local company that can handle exploration and exploitation in the oil sector due to their deliberately underdeveloped status. Most domestic companies lack the required technological experts.

Pertamina is also rife with corruption and collusion; the State Auditor Agency reported there were 159 cases of corruption and collusion in Pertamina.

Inefficiency (in Pertamina), as reported by international auditor PricewaterhouseCoopers, has also led to huge losses of government revenues, resulting in almost US$ 4.3 billion in leakages -- not to mention lost opportunities because of weak management.

One other problem in the oil industry that has become a main concern to foreign investors is legal assurance, especially regarding Production Sharing Contract (PSC) regulations.

PSCs, so far handled by Pertamina, have proven to be the source of reluctance of foreign investment because of the many loopholes open to bribery.

All costs spent by Pertamina to produce and distribute petroleum is replaced by government with additional fees.

When petroleum sales are lower than the procurement cost, the government pays a subsidy.

On the contrary, the government could gain from what is termed a petroleum net profit. In the last 20 years petroleum prices have always been lower than its cost of goods sold, causing the need to provide subsidy, except in 1995/1996, which led to the petroleum net profit.

It can be concluded that it is this system which has made Pertamina face no risk, inducing its inefficiency.

Furthermore, the efficiency of Indonesians to use oil energy is lower compared to other countries.

One such measure is the amount of oil consumed to produce a dollar's worth of gross domestic product. The amount of oil required to generate a dollar of output reached 0.60 liters in 1999. In comparison, the efficiency of the United States in using oil energy is 0.16 liters or nearly four times more efficient than Indonesia.

In general, Indonesians seem to be more wasteful than US inhabitants; this is probably due to relative lack in technological ability to use oil energy efficiently.

However, having the cheapest oil price compared to other countries can be blamed as the source of problem.

Subsidies are aimed to help low income households, but in practice, middle to high income households, commercial and industrial sectors have benefited from the petroleum subsidy.

Likewise, it has also been proven that the oil subsidy tends to be both urban and Java-biased.

As is generally known, most of the oil here comes from outside of Java, from mostly rural areas; but unfortunately most of the people enjoying the subsidy are in Java and in urban areas.

Kerosene and diesel oil contribute the most to petroleum subsidy. Diesel oil is used for transportation, or 45.3 percent of total petroleum consumption, and industry uses 23 percent of total consumption; whereas kerosene for households is now 23.2 percent of total consumption.

Clearly most of the subsidies end up in the transportation sector and for industrialists.

The subsidy has spoiled industrialists, as they still lose out in competition with China, Vietnam and other developing countries which do not have subsidies for energy.

A mounting petroleum subsidy also reduces the government's ability to finance crucial programs -- health, education, civil servant salaries and poverty alleviation programs.

The facts reveal that the oil subsidy comprises the largest share of the total subsidy in the current budget.

After revising the price of oil to $20, the subsidy was raised to Rp 22.4 trillion or about 64 percent of total subsidies; compare this with about Rp 2 trillion for desperately needed food subsidies.

Furthermore, petroleum subsidies also cause oil prices to be far below its economic price -- again, the price here is the world's cheapest -- resulting in smuggling, squandering and blending the expensive oil with the cheap.

One important thing to note here is that the Indonesian government budget concept is only a one-year budget plan instead of emphasizing the inter-temporal budget allocation with more stress on future interest. Therefore, future generations will have to tolerate higher oil prices.

As oil subsidies increase with higher oil prices, and the government has limited resources to allocate to other crucial sectors, reducing the subsidy becomes an urgent consideration. The direct subsidy to the needy using public transportation, although introduced a little late, deserves support.

With the prevailing pricing system, energy diversification will be confined. While the government wants to reduce its dependency on oil, petroleum is still subsidized; resulting in the loss of attractiveness for alternatives.

Petroleum subsidies also do not promote energy conservation efforts, as people are not stimulated to use energy wisely.

It would be a very good policy, in the short term, to have reduced fuel subsidies, because a complete removal would shock the economy, yet to fully recover from the crisis.

However a hike in prices, sooner or later, is as certain as the sun rising tomorrow.

The writer is a Jakarta-based energy analyst.