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Michael McDonald

Michael McDonald

Michael is an assistant professor of finance and a frequent consultant to companies regarding capital structure decisions and investments. He holds a PhD in finance…

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How The Oil Price Crash Will Make Markets More Efficient

How The Oil Price Crash Will Make Markets More Efficient

BP CEO Bob Dudley recently came out making an interesting point regarding the silver lining from the fall in oil prices. Dudley notes that as a result of low oil prices, subsidies have been cut on many petroleum products around the world. This is important in that it creates a more even playing field and a freer market internationally for many oil products.

There are more than 800 fossil fuel subsidies around the world, and these subsidies distort markets, often in favor of inefficient local producers. These subsidies are costly for governments and often for the people the subsidies are actually intended to help. Even within the country that often complains most loudly about restrictions on international trade, America, there is a hidden subsidy in the form of the export ban which helps certain domestic industries at the cost of other domestic industries. Related: Downturn Hits Bottom But High Oil Storage Could Delay Recovery

In particular, of the $500 billion annually that the IMF says subsidies cost, about half is spent by countries in the Middle East and North Africa. These subsidies are primarily to suppress local fuel costs and help ensure a happy populace. As oil prices have swooned, many oil exporting countries have seen a huge hole blown in their budgets which those countries have struggled to close as much as possible, any way they can. That has put a big target on fuel subsidies.

Even outside the Middle East though, Dudley cited India and Indonesia as examples of where fuel subsidies are being slashed. These are huge countries and to the extent that oil markets become less subsidized, it should help create a more balanced and fluid oil market where prices are dictated by supply and demand rather than government fiat. That helps oil producers broadly and even indirectly helps domestic U.S. producers (who still cannot export crude for the most part). Related: Canadian Oil Industry On Edge Ahead Of Election Outcome

Even mighty Saudi Arabia is considering following the UAE’s lead and starting to cut subsidies, though reports on the move also indicate that the country will likely be cautious and ramp up subsidies on food and other goods to help avoid inflation surprises as a result of any subsidy cuts and the ensuing price increases.

The UAE’s decision to cut oil subsidies is evidence for just how big a distortion these decisions can have. Manufacturing and industry in general across the UAE have benefited from the low cost of gasoline there which runs $0.50 a liter versus roughly $0.84 a liter in the U.S. Those subsidies cost the UAE $29 billion annually or about $3,200 per person in the country. Saudi Arabian subsidies run to nearly $107 billion annually while Qatar’s subsidies are valued at close to $6,000 per person. Related: Russia Could Gain A Stranglehold On This Market

These subsidies encourage excess consumption of fuel in the UAE and elsewhere and distort the local economy. To some extent, fuel in the UAE should be cheaper than elsewhere simply given the logistics of moving it and the proximity of oil in the area. But subsidies in excess of those cost efficiencies create artificial incentives to consume more oil than needed and contribute to less economically efficient industries. As the UAE and other countries slowly move away from those subsidies, local industries will learn to be more economically efficient and, in the long run, the country will have a stronger economy as a result. The same principle holds across the globe. And that’s indeed a silver lining in the oil price collapse.

By Michael McDonald of Oilprice.com

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  • Lee James on October 19 2015 said:
    It's easy for Americans to wonder about high fuel subsidies for consumers in foreign countries. We get it. These subsidies distort signals for shoppers in the marketplace.

    It's harder for Americans to see a subsidy when you do not directly see it. If you see solid waste in a river, you know, "uh-oh, somebody's gonna pay." But we do not directly see CO2 and other forms of pollution in the air and water. We do not directly see that we are paying less for oil at the pump because we are paying more to protect oil shipping lanes in the Mideast.

    So, this article is very American. What North Americans are having a hard time seeing is what foreign countries often point out to us. We have our own ways of not seeing the full and true cost of extracting, transporting and burning fossil fuel.

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