52115 No. 17 Petroleum Sector Briefing Note August/September 2009 Rockets and Feathers? Petroleum Product Price Movements "Shooting up like a rocket, drifting downward like a feather in the wind," or so goes the perception of petroleum product prices. This became the focus of public attention world over in 2008, when the international price of oil surged in the first six months, only to fall dramatically to a third of its peak value in the following five months. This briefing note discusses factors influencing the relationship between the prices of petroleum products on the world market and the domestic retail market. Increased like the jump of a rabbit but now falling like does not generally translate to the same percentage reduc- the walk of a turtle," complained a taxi driver about gasoline tion for retail prices. First, crude oil and petroleum product prices in Cambodia in October 2008 [1]. Do petroleum prod- prices are governed by different supply and demand forces. uct prices rise rapidly in times of rising world oil prices and Headline news is usually about the price of a benchmark fall slowly when world prices come down? If so, is this be- crude oil, and over a short span of time crude oil prices cause of legitimate physical supply issues, such as inven- could rise while spot (net-of-tax) prices of refined products tory adjustment costs? Or is such an uneven pattern a result fall, and vice versa. Second, exchange rate fluctuations af- of uncompetitive market behavior (in which case govern- fect domestic prices even if the world oil prices remain con- ment intervention may be called for)? "Rockets and feath- stant, although the Cambodian economy is highly dollarized ers" have been the subject of much debate and study in the and the riel-dollar exchange rate has been stable. Third, last two decades. This briefing note reviews the evidence in retail petroleum product prices include taxes, which are not other countries and possible explanations for such a price always set in percentage terms. In Cambodia, reference prices movement pattern. for petroleum products have been frozen since 2004, thereby converting, in effect, various taxes, set nominally in per- centages, to specific taxes--constant in riel and conse- Price Lag quently independent of the world oil price movement. Because there are several stages in the supply chain Fourth, the costs of shipping, railing, and trucking petro- before petroleum products are sold to consumers, it takes leum products--which are included in retail prices--de- time before a change in the price of crude oil is fully transmit- pend only in part on the price of fuel, and again do not ted to the retail market. In the case of Cambodia, as explained halve if the world oil price halves. in [2], the issue is the lag between the time a change in the price of a refined product occurs in Singapore, Thailand, or Comparison of net-of-tax free-on-board prices in any other country from which Cambodia imports petroleum Singapore and retail prices (inclusive of taxes) in Phnom Penh products, and the time that change is reflected in the prices for gasoline and diesel is shown in Figure 1. Cambodian re- at the retail shops in Cambodia. tail prices are smoothed and exhibit less volatility than the prices in Singapore. As explained above, the tax component One important determinant of price lags is the rate of in Cambodia is essentially fixed and does not fluctuate inventory turnover. Most firms follow the first-in, first-out throughout the period shown in the figure. The diesel price accounting rule. When prices are falling, the first in stock came down by the same amount from the peak in 2008 to of refined products would have been purchased when prices April 2009 in Singapore and Phnom Penh, but came down were higher, and conversely when prices are rising, the first more for gasoline by about US$0.08 a liter in Phnom Penh. in stock would have been purchased when prices were lower. There is no obvious evidence of rockets and feathers If the inventory turnover is faster when prices are rising than when they are falling--a fast inventory turnover can Reaction in 2008 occur if the initial inventory is low, if sales volume is high, or both--that would produce the phenomenon of rockets Consumers the world over became alarmed at the pace of and feathers. oil price increases in the first half of 2008. Even in a market as large and competitive as the U.S. gasoline market, a poll taken A percentage reduction in the world crude oil market in July 2008 found that more than half of those surveyed 2 Petroleum Sector Briefing Note August/September 2009 Figure 1 Monthly Prices of Gasoline and Diesel in Singapore and Phnom Penh 1.40 Retail gasoline 1.20 Phnom Penh 1.00 Gasoline US$ per liter Singapore 0.80 0.60 Retail diesel 0.40 Phnom Penh 0.20 Diesel Singapore 0.00 Jan-04 Jan-05 Jan-06 Jan-07 Jan-08 Jan-09 blamed price gouging by oil companies and producing coun- to lower prices [4]. tries, as well as a lack of effective action by government, for high oil prices [3]. These reactions suggest that many consumers per- ceived the movement of retail prices for petroleum products In Kenya, where prices are determined by market forces, in 2008 to be governed by factors other than market forces, the energy minister announced in September 2008 that his and believed that government intervention would be justi- ministry would launch a campaign through the media to com- fied. If there has indeed been some collusive behavior, then pel fuel marketers to lower prices by more 10 Kenyan shil- this becomes a regulatory issue. If, on the other hand, there lings (576 riel) a liter. In October 2008, the energy minister has not been price collusion for the most part, government said that he was not satisfied with the oil companies' re- interventions could even make the matter worse. sponse to the government's request to lower prices, and tabled the possibility of re-introducing price control [4]. Defining and Explaining the Problem Closer to home, the government of the Philippines in The question asked by researchers who have examined 2008 announced that a joint task force of the Departments this topic is three-fold: of Energy and of Justice would be investigating if cases of unfair market practice and overpricing could be filed against (1) How long does it take for a change in the price of the top three oil companies with a combined market share crude on the world market to be transmitted to the of 83 percent. Calls were made in the senate to "act upon" domestic retail price? the oil companies' pricing practice. In September 2008, when small oil companies reduced prices but the major oil compa- (2) Are changes in prices passed on fully to consum- nies did not immediately follow, both the energy secretary ers? and President Arroyo asked the oil companies for an expla- nation and the energy secretary held a meeting with the (3) Is the lag for response the same whether prices are parties concerned. In January 2009, the task force submit- going up or down? ted a report, clearing the oil companies of monopolistic prac- tices and cartelization. In Cambodia, the government formed Most studies concern the movement of retail gasoline a special ministry committee in June 2008 to monitor prices prices, and are part of a larger body of literature on the im- with a view to assessing if there might be price gouging. pact of changes in the prices of inputs (used to manufacture Prime Minister Hun Sen has called upon oil companies to finished products) on the retail prices of finished goods. lower prices on several occasions, and in September 2008 One study examined price changes of 77 consumer and 165 instructed the finance ministry to meet with fuel marketers producer goods, and found that prices tend to increase fast August/September 2009 Petroleum Sector Briefing Note 3 and decline slowly. It found that the immediate price response lowest price. Consumers may try harder to find better to an increase in input cost is twice the price response to a deals when prices are increasing than when prices are decrease in input cost. The study also argued that the more decreasing, potentially reinforcing the phenomenon of intermediaries there are in the supply chain, the greater the rockets and feathers. If the cost of searching for sellers difference in speed between price increases and decreases. with lower prices is high--for example, if prices are not However, the study also found that the greater the price displayed clearly--then it becomes easier for sellers to volatility, the smaller the differences in the speed of price maintain high prices. In contrast, wholesalers can be response [5]. sophisticated buyers. Particularly in regions with futures markets, information about prices is readily available and In the petroleum sector, a number of studies--mainly in changes in the prices of crude oil and refined products developed countries--have found that retail prices catch up are transmitted rapidly to spot prices at various parts of more quickly with crude oil price increases than with de- the supply chain upstream of retail. creases. Given sufficient time, price changes appear to be fully passed on to consumers eventually. However, a few Hoarding. If consumers buy more in anticipation of studies have also arrived at the opposite conclusions: either further price increases when prices are rising, then in- that prices rise as fast as they fall, or, in a couple of studies, ventories are run down faster and prices rise more prices fall faster than they rise. Different analytical techniques quickly. Panic buying in recent years has indeed caused and different data sets used account for the differences in fuel shortages in the countries where governments con- the conclusions. One author used the same datasets in the trol prices, resulting in fuel shortages and sending prices United States and applied two different methods, and found high on the black market. If, on the other hand, consum- that entirely different conclusions were reached depending ers postpone purchase when prices are falling--because on which method was used [6]. In studying this phenom- they expect that the longer they wait, the lower the prices enon, the price movements have been sub-divided further will be--then the inventory turnover is slowed and prices into various stages in the supply chain. correspondingly decrease more slowly. In situations where researchers believe they have found Inventory adjustment. Oil companies will do whatever faster price increases than decreases, several explanations they can to avoid running out of fuels altogether. A re- have been offered. duction in supply (which causes price increases) could prompt a firm to increase selling prices to slow down Lack of competition. An explanation that has raised the sales and avoid running out of refined products, espe- greatest concern is that arising from a handful of oil cially if their own inventories are running low. If sup- companies dominating the market and tacitly agreeing plies are plentiful (causing prices to fall), and if running not to follow price decreases rapidly. Consider a coun- an inventory above normal levels carries relatively little try with no refineries. When world prices of refined prod- additional cost, there is less incentive to lower prices ucts rise, oil marketing companies increase retail prices rapidly. to ensure that their profit margins do not fall--that is, they may stand to lose if they do not adjust prices quickly. Recovering losses. When prices rise steeply--because When prices of refined products fall on the world mar- of physical disruptions to supplies, demand rising faster ket, however, oil marketing companies' profit margins than supply, and so on--refiners and wholesalers may do not decrease, and for profit maximization it would make a loss. A period of falling prices provides an op- make sense to keep prices high until one or more compa- portunity to recover commercial losses caused by price nies start undercutting the retail prices of the remaining shocks by maintaining prices high and sustaining higher firms. In a highly competitive market, someone would profit margins. start cutting prices immediately to expand the market share, and others follow. In a market with only a limited number of firms and not enough competition, it is pos- Response sible to have an unspoken and unwritten agreement not Despite highly sophisticated statistical analysis, re- to undercut, and prices could remain high for much searchers in the United States and other developed econo- longer and come down much more slowly than the time mies have found it difficult to arrive at a consensus view on it takes for prices to rise in times of rising world prices. whether prices rise faster than they fall. This may be an indi- cation that limits on market competition, if they exist at all, Limits on consumer knowledge of price movements. are small in these countries, in part because of tight regula- Firms can also exploit consumers' incomplete knowledge tion governing anti-competitive behavior. There is stronger about who is charging how much when and where. It evidence that price changes are eventually fully passed on takes time and effort to visit several shops or filling sta- to end users. Consumers can have perceptions of rockets tions, compare prices, and choose the seller with the and feathers even when the phenomenon does not exist, 4 Petroleum Sector Briefing Note August/September 2009 because a price lag is inevitable in all markets and because, pany [10]. Posting historical prices is invaluable--consum- after a period of exceptionally high prices, consumers are ers can see historical patterns--and should not be difficult anxious to see prices come down. It is important to have because it entails merely retaining information already col- public awareness campaigns so that wrong perceptions do lected. For Cambodia, posting spot prices of gasoline, die- not lead to misguided policies. sel, and kerosene in Singapore, both in U.S. dollars and after conversion to riel, might also be informative. An important step is empowering consumers by provid- ing them with price information. In this way, the cost of search- ing for lower prices can be reduced. The first priority is to Observations require that all filling stations display prices on display boards Although the perception of uneven price changes de- using letter sizes that are clearly visible from the road, and pending on whether oil prices are rising or falling is wide- enforce that rule. Vehicle drivers can obtain information about spread, it is difficult to demonstrate rigorously that such a prices as they drive, even when they are not looking to refill pattern exists. And even where such a pattern can reason- their fuel tanks. ably be shown to exist, demonstrating that it was caused by a market failure--firms colluding to keep prices high--is even Another step is to make historical price information more challenging. publicly available. One example of how a government has come about publishing prices is Tanzania. The government Cambodia's oil market is relatively small, making price liberalized the petroleum sector in 2000. In 2007, the Energy competition inherently more difficult to achieve. But even in and Water Utilities Regulatory Authority of Tanzania such a market, empowering consumers with information about (EWURA) conducted an inquiry--soliciting comments prices, current and historical, and explaining mechanisms through mass media and holding a public hearing--into the for price transmission specific to the Cambodian market goes circumstances leading to a uniform price increase that oc- a long way to promoting competition, while helping to dis- curred on July 1, 2007. The inquiry did not find clear evi- pel misperceptions about legitimate price lags. dence of price collusion. However, the report on the find- ings of the inquiry cited several areas of inefficiency in the supply chain. One recommendation was to require all filling References stations to "publish on clearly visible boards prices charged [1] Cambodia Daily. 2008. "For some, oil price decrease for petroleum products on sale" on their premises. To pro- is not enough." October 23. mote more effective competition, EWURA began publish- [2] World Bank. 2009. "Getting Petroleum Products to ing, on its website, "indicative" retail prices--prices con- Market" Petroleum Sector Briefing Note No. 16, sidered reasonable based on import-parity price levels--as MONTH. well as price ceilings, set 7.5 percent above indicative prices, [3] Gallop. 2008. "U.S. Congress, gouging blamed equally in different parts of the country [4]. for gas prices." August 6. [4] Masami Kojima. Forthcoming. "Government Response Among Cambodia's neighbors, Thailand's Energy Policy to Oil Price Volatility: Experience of 49 Developing and Planning Office (EPPO) posts the price buildup of each Countries." petroleum product in Bangkok daily. Ex-refinery, wholesale, [5] S. Peltzman. 2000. "Prices rise faster than they fall." and retail prices, as well as all taxes and charges are shown The Journal of Political Economy, 108(3): 466­502. separately for a total of 11 products [7]; the effort involved in [6] D. Shin. 1992. "Do product prices respond symmetri- collecting so much information would be considerable. In cally to changes in crude prices?" American Petro- addition, monthly average wholesale and retail prices, and leum Institute Research Study #68. taxes collected are posted on EPPO's website [8]. [7] www.eppo.go.th/petro/price/index.html. [8] www.eppo.go.th/info/index_prices.html. Posting prices is clearly easier if prices are controlled. If [9] http://tonto.eia.doe.gov/dnav/pet/pet_pri_gnd_ prices are uniform throughout the country and are changed dcus_nus_w.htm. only once a month, then the government can easily post [10] www.doe.gov.ph/OPM/Pumpprices.htm. prices for the entire country. This approach to pricing, how- ever, almost never makes for efficient market operations. If For more information contact: prices are determined by market forces, as in all developed Mr. Bun Veasna countries, a survey of retail prices will have to be carried out Infrastructure Officer regularly. The U.S. Department of Energy surveys gasoline Email: vbun@worldbank.org or (approximately 115,000) and diesel outlets throughout the Masami Kojima country and posts weekly retail prices [9]. The Philippine Lead Energy Specialist Department of Energy conducts price surveys in three cities Email: mkojima@worldbank.org once a week and posts prices for seven products by com-