Law of One Price defeats oil subsidy
Fuel shortages are spreading across Indonesia like an ominous red flag signaling that we have systemic problems. Long gasoline lines are everywhere, even as government subsidies grow to all-time highs with the recent approval of a massive 35 percent increase in fuel subsidies. Where is all of our low-cost gasoline and diesel fuel going?
Between 10 and 15 percent is stolen, according to the downstream regulating authority (BPH Migas). The cheap subsidized fuel is diverted, transported to a full-price market, and then resold; bigger subsidies give bigger illegal profits.
State oil and gas company Pertamina executives say they are struggling to stop these illegal fuel diversions that occur at all points along the distribution system and cost the government a shocking US$2 billion annually.
These fuel subsidies place a serious burden on the government budget and it is sad to see its good intentions thwarted to such an extent. Although the fight against fuel smuggling may be noble, an economics theory makes it look like a losing battle: the Law of One Price says you can’t stop it.
The Law of One Price says the same gasoline should have the same price anywhere (with transportation costs factored in) and that particular price is set by sellers flocking to the highest price. In an efficient market, this activity leads to equilibrium as supply and demand constantly respond to ongoing conditions.
But smugglers hijack these market principles while stealing the fuel. They steal subsidized oil and flock to a full-price market as the price differential and market boundaries create an opportunity.
Conducted legally, the process of redirecting materials from more-to-less abundant markets is called arbitrage and is important for the economy. But done illegally, as in the case of fuel diversion and smuggling, all the government’s good intentions are cashed in and the benefits to citizens evaporate.
Several years ago, the Indonesian Navy detained nearly a dozen vessels carrying 80,000 barrels of gasoline and kerosene intended for illegal export. At one point, oil analysts estimated that roughly 100,000 barrels per day were smuggled out of the country. I doubt the number was actually that high. But it emphasizes the power of the Law of One Price in giving big profit incentive for smugglers to risk being caught.
Indonesia is not alone in facing the Law of One Price when it comes to oil subsidies; smuggling is an international problem. From the Mekong Delta region of Cambodia and Vietnam to the mountainous jungles dividing Malaysia and Thailand and the vast expanses of Indonesia’s territorial waters, smugglers are earning tens of millions of dollars — with profit margins climbing as crude prices rise.
For instance, China officially exports a large amount of subsidized gasoline to Vietnam, which does not have any refineries. The heavy subsidy leads to an active smuggling market that sends fuel from Vietnam back to China where it can be sold profitably at prices that are below market.
The official retail price of ultra-low sulfur diesel in Hong Kong is almost double of the price of smuggled Chinese light diesel oil.
The police and military guard many gas stations to prevent oil diversions. But eventually the Law of One Price will dominate the game plan, as long as there is a huge subsidy resulting in a price differential.
The Indonesian government seemed to be at its wits end when it sought help from the Ulema Council (MUI) to declare an edict (fatwa) that prohibits the illegal use of subsidized oil.
As international oil prices climb, the costs keep mounting for the Indonesian government to keep consumer fuel prices down through subsidies, which is creating a bigger price wedge. Big windfalls are reaped by people who siphon off the subsidized gasoline and diesel to sell at a higher price, both domestically and abroad.
The way to stop smuggling is to remove the root cause — huge subsidies. And any move to further increase fuel subsidies will strengthen the domination of the Law of One Price. That means that smugglers are likely to keep smuggling, and subsidized oil will keep disappearing. Unfortunately, our government and Pertamina will keep scratching their own heads — helpless in defying the nature of “the Law of One Price”.
The writer is an economist at the Nicholas Institute for Environmental Policy Solutions, Duke University, Durham, North Carolina, the US.