Parsing the pain at the pump
8 Jul, 2022

Petrol stations across the country were jam-packed on Tuesday as motorists waited in line to fill up ahead of the following day’s record increase in the petrol price. Even with the government temporarily cutting the fuel levy by R1.50 per litre, the petrol price still jumped by R2.33 to R24 per litre.

The main culprit is of course the Russian invasion of Ukraine and associated sanctions against the aggressor. European countries look set to implement a ban on Russian oil imports as well as banning European insurers from covering ships carrying Russian crude. The latter is important, since European (including British) firms dominate global maritime insurance and, without cover, many ports will not allow a ship to dock.

Russian oil exports to Europe and North America have already fallen substantially, and its firms had to find new customers, notably in China and India. As a result, Russian oil trades at a historic discount of around $30 per barrel to other grades of crude such as Brent. The country’s oil output has declined by about 10% since the outbreak of the war to nine million barrels per day, according to Reuters.

Although a meeting of members and associates of the OPEC cartel agreed to raise output by 648 000 barrels a day in July and August, the market is still very tight, and fears of shortages persist. The price of crude still hovered well above $110 per barrel last week.

The rand has clawed back some of its recent losses against the dollar, but for now, the price of oil in rand remains close to record highs (unlike the dollar price, which is still below its 2008 peak).

Chart 1: oil price in rand and dollars

Refinitiv Datastream

No one knows how the war will play out. While the uncertainty persists, the oil price is likely to remain elevated, but the risk premium is already large and it won’t necessarily move significantly higher unless something drastically changes. Meanwhile, a slowdown in global economic activity could dampen oil demand in the coming months. High prices always incentivise consumers to economise or find alternatives, while producers are induced to increase output. That is the importance of price signals in a market economy. However, the adjustment doesn’t always take place immediately, and in the case of oil, the supply response is impeded by the fact that a large portion of output is in the hands of a cartel.

How much pain?

How much pain will this inflict on the domestic economy, and is there anyway to get around it? For the first part of the question, it depends a lot on how long the petrol price stays this high. This we don’t know. We do know that there are predominantly three channels through which high fuel prices impact the economy: the balance of payments, purchasing power and the impact on interest rates as inflation.

The good news is on the balance of payments side. Though the oil price has shot up, the coal price has increased even more. Faced with concerns over Russian gas supplies, European utilities have been burning more coal. Other key commodity prices such as iron ore and platinum group metals are also higher than over the past few years, though they are off their recent peaks.

The net effect is that South Africa continues to run a trade surplus. The devastating flooding in KZN distorted the April trade numbers as reported by SARS, but they still show a surplus of R15 billion, albeit smaller than March’s R47 billion. A positive trade surplus has a number of positive spill overs for the broader economy, but it also means the country is easily earning the hard currency needed to buy fuel (and other items) abroad. That is not something all developing countries can say.

The second channel is the impact on purchasing power. Simply put, a household or business that spends more on fuel will have less money to spend on other items unless they manage to drive less, increase their income somehow or borrow money to maintain spending. In terms of the former, it is easier for some people to drive less in this era of work from home, but not for everyone. Still, over time one sees evidence of economising in the face of price shocks. Stats SA produces data on the value of fuel sold at petrol stations (latest data point is for March). It lags the petrol price over time, indicating that people sensibly tend to burn less fuel when it is very expensive. Vehicles have also become more fuel efficient over time.

Chart 2: SA fuel sales and the petrol price

Source: Stats SA and the Central Energy Fund

Income growth, meanwhile, is rarely in anybody’s direct control. Strong businesses can maintain their margins and pass on some of the input cost increases to customers, but this also depends on the ability of customers to absorb such increases. Though a number of contentious wage negotiations are underway locally – including a few strikes – most workers cannot raise their wages as they wish. It is only a minority of workers whose wages are set through a formal bargaining arrangement. For most it is a case of take it or leave it.

Finally, borrowing can work for a month or two but is clearly not sustainable.

This means there is likely to be a hit to consumer spending as the fuel price jumps, especially on discretionary items. As always, it is lower income earners who are hardest hit. They have less of a financial cushion in terms of savings and investments (or access to cheap credit) and spend a greater portion of their income on basic goods like food and fuel. Low-income workers are also least likely to be able to work remotely.

Inflation and interest rates

Higher fuel prices also raise headline inflation rates, since petrol is about 5% of the consumer price index. It is also the most volatile component of CPI. It is worth remembering that there is a difference between “inflation” and “expensive”. If the petrol price stays at the current record-high levels for 12 months, its inflation rate will eventually fall to zero. That is cold comfort, perhaps, but it illustrates why price spikes usually only have a “transitory” impact on inflation.

Chart 3: SA consumer price index changes, %

Source: Stats SA

The more important question from an inflation point of view concerns the so-called second- round effects where companies pass on higher fuel prices to consumers.

The Reserve Bank always notes, rightly, that it doesn’t respond to higher prices but only to the risks of second-round inflation emerging. It can do nothing about global oil markets but can put downward pressure on those second-round effects by raising interest rates that dampen domestic demand.

In other words, it works with a very blunt tool that can cause lots of collateral damage. By raising rates as inflation rises, the local consumer experiences a double whammy. This is understandably hard for consumers to swallow but maintaining stable inflation over the long term has major economic benefits. And part of achieving stable inflation over time is to have a central bank that is perceived as “credible”, in other words willing to do unpopular things if necessary. Setting the level of interest rates that guarantees such credibility is more art than science, however. Central banks will point to elaborate models and theories but ultimately it is very much in the eye of the beholder and very dependent on the global mood. And currently the global mood is one of rising rates to combat inflation.

South African inflation, for once, is quite subdued by current global standards and lower than prevailing rates in Europe and the US. Local consumer inflation was unchanged at 5.9% in April. It will probably breach the upper end of the Reserve Bank’s target range in the next few months as the petrol price spikes are reflected in the data.

However, core inflation, which excludes food and fuel prices, was 3.9% in April and comfortably below the midpoint of the range. The passthrough from higher fuel prices to core inflation remains low, indicative of companies’ lack of pricing power. This is in contrast to the US and some other developed countries where companies have maintained very high margins.

The Reserve Bank’s response has been to front-load some of its interest rate hikes. The May Monetary Policy Committee meeting resulted in a 50 basis points increase, in contrast to the usual 25 basis point increments. With the US Federal Reserve putting in 50 basis points hikes, the MPC cannot fall too far behind especially since other emerging market central banks started hiking aggressively last year already. However, the repo rate is still likely to settle at a lower peak than the previous cycle.

In summary, the impact on the economy – and indeed on most economies – is net negative. However, South Africa is shielded somewhat by the fact that our export prices have increased in tandem with the oil price.

Do something!

What can be done about surging fuel prices? This is something that politicians around the world are furiously grappling with, but there are no simple short-term solutions. Last week, Parliament’s Portfolio Committee on Mineral Resources and Energy called on the government to undertake a “comprehensive review” of South Africa’s fuel pricing regime.

The petrol price consists of three components: the basic fuel price, fixed margins for various players in the value chain, and levies (most notably the general fuel levy and the Road Accident Fund levy).

Chart 4: Contributors to the price of 93 unleaded petrol

Source: Central Energy Fund (total R23.94/l in June)

National Treasury gave us all breathing room by cutting the fuel levy by R1.50 per litre over the past three months (and 75c/l in July). The first two months were funded by sales from the strategic fuel reserves. The extension will cost the fiscus an estimated R4.5 billion. There is some room to do so now because tax revenues have been robust due to the commodity price windfall, but it is not sustainable. Continuing with this subsidy will mean a combination of raising other taxes, cutting spending or borrowing.

Moreover, subsidies are generally a bad idea since they tend to lead to excessive and wasteful use. We want people to use as little fuel as possible since it is mostly imported, and it causes pollution. Moreover, subsidies in the fuel price will tend to favour people who own cars at the expense of people who don’t. It will be better to subsidise public transport, increase social grants temporarily or reduce VAT to soften the blow of higher fuel prices. But the blow will remain.

As a rule, deregulation and competition are generally better but in the case of the fuel price it presents certain problems. It can lead to lower prices in cities where there is steep competition, but the opposite is likely to be true in the countryside and smaller towns. Some places could end up with no petrol stations. It would certainly result in pump attendants losing their jobs as in Europe and North America.

Deregulation would also lead to even more volatile prices, perhaps changing weekly or even daily. Currently, in America, fuel prices at the pump are being pushed higher not only by crude oil prices but also record high “crack spreads” (refinery margins).

Deregulation might therefore help somewhat but it’s not a panacea.

Longer-term, the solution is not to try to massage the fuel price down, but to invest in public transport and encourage the growth of the electric vehicle market. From an environmental point of view, a high fuel price is mostly good since it should encourage efficiency of use – smaller cars, fewer trips, better technology. One of the questions policymakers worldwide should therefore engage with is whether retail fuel prices should be allowed to fall if the war in Ukraine eventually ends.

Final thoughts

But for the time being, the pain at the pump remains. While oil prices have a global macro-economic impact, it is also important to remember that the petrol price probably plays a bigger-than-warranted role in the popular imagination. It is a very visible price and one we pay often. It is also a price that evokes the idea of individuals facing powerful malignant forces: warlords, geopolitical schemers, environment-destroying corporations, greedy traders, tax-hungry governments and so on. But it is best to not overreact to such feelings, especially not when it comes to your portfolio. People will also be surprised how much fuel you can save when you really try.



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