Why aren’t we paying R5.29 for fuel?

Government’s shakedownThe US government (and popular media) has a long history of blaming oil companies for “excessive profits” when the oil price is high. They don’t particularly care that when the oil price is low, oil companies risk huge losses, or that massive, long-term industrial investment projects can only be justified by future profits. No, every time Americans suffer at the pump, or think they do, oil companies are hauled before Congress to testify about their “price gouging”.

Turns out that they make less profit than you’d think, as Sterling T. Terrell shows eloquently in an article here. It’s a must-read, because it makes the price of fuel at the pump really, really simple. Taking into account inflation and tax, and despite higher demand from growing economies, higher demand from countries buying in currencies other than dollars, and restricted supply because of draconian environmental restrictions on exploiting domestic oil resources in the US, it turns out Americans aren’t paying all that much at all. Of the excess over base costs, two thirds goes to the government in the form of taxes. The “record profits” of billions of dollars that you hear about on TV might sound like a lot, but once you work it out in terms of the value of a typical oil company’s asset base, the volumes of product supplied, the cost base, and total revenues, they’re not “record profits” at all. Even water utilities make more profit, as do many other industries.

He argues, correctly, that price caps will lead, inevitably, to shortages. But that doesn’t stop politicians, here and abroad, from expressing grave concern about the impact of the high oil price on consumers. Smoothing the political path for intervention, no doubt.

I did a crude (haha) calculation myself, using various data obtained from Stats SA and the Department of Minerals and Energy Affairs. Starting with a 1998 base price of R2.28, which is what a litre of 91-octane unleaded used to cost inland, I compared the actual price to the inflation-adjusted price. For actual price I stuck to the highest octane available, as new levels (93 and 95) were introduced. If R2.28 is adjusted by inflation (average annual CPIX), the average fuel price in 2007 would have been R4.45. The average price in 2007 was actually R6.75. For the sake of simplicity, let’s put all of that disparity down to the steep oil price rise of recent years.

But we are a global leader in the production of synthetic fuel from coal. Sorry, says Sasol, we can’t give it to you cheaper than the government price. As a result, Sasol’s after-tax net profit margins, at 17%, are much higher than the 9.5% profit margin of US oil companies. Synfuel, however, accounts for only 30% or so of its business, but generates about 55% of the company’s profits. So the profit margin of the synfuels division alone is almost twice as high again, just because its costs are independent of the oil price, but its prices are determined by government and rise as the oil price goes up. So in reality, Sasol’s synfuel makes 3.3 times the profit that a typical US oil company makes. And the US companies are the ones being hauled before public hearings!

Fuel price composition (click to enlarge)Profits would not be an issue in a free market, but they are an issue when they are made by a private monopoly in a highly-regulated, price-controlled sector. Worse than government-sponsored profits for Sasol, however, is that more than 20% of the fuel price goes towards unnecessary taxes (as opposed to the Road Accident Fund, which for all its bureaucratic chaos and mismanagement, is a more defensible levy). Take that arbitrary tax away, and the inflation-adjusted fuel price at the end of 2007 could have been R3.73, or if you account for the disparity between the inflation-adjusted price and the actual price — reflecting, in my simplification, the recent oil price rise — it could have been R5.29. (Disclaimer: So says the back of my envelope; corrections or refinements to this rough calculation would be welcome.)

Instead of R6.75 on average for 2007, we could have paid R5.29, and that’s without any change to the Sasol price policy or reduction in the price of oil. What effect might such a massive saving in transport cost have on food prices and general price inflation? Why does the government think it’s a good idea to tax fuel, and to keep raising those taxes?

Some might argue that fuel taxes discourage consumption, and therefore they are good for the environment. But fuel demand is notoriously inflexible. Face it, you’ve got to get to work, and producers have got to get bread and milk to the supermarket, no matter what the fuel price is. So the effect of taxation on demand is fractional. If you’re going to incur costs in the economy by using the fiscus to fund environmental improvement, almost any other investment would get you higher returns than fuel taxes.

So we have the absurd situation that on one hand, the US is holding hearings in populist efforts to claw back money from companies whose prices aren’t regulated, whose operations are bound by a myriad laws, and whose profits are by no means excessive. On the other, South Africa is doing nothing about sky-high monopoly profits that are a direct gift from the government, and which raise costs for every industry sector, limit economic growth, reduce our ability to alleviate poverty and create jobs, and limit our options in dealing with the energy crisis. And neither country has considered that of all the idiotic tax ideas a rapacious government can think of, slapping 20% taxes on fuel is possibly the worst. [Correction: that should read “27.2% taxes”. 27.2% tax results in a 21.4% share of tax in the final price, which I rounded to 20% here.]

Some economists say that South Africa is not headed for recession, despite the worldwide financial crisis, the weakening global economy, the critical shortage of electricity, and the rising oil price. I’m fairly pessimistic, however. I think the electricity crisis alone will be enough to cause a recession, because its effects permeate the economy. But even if the Bolt Effect, as I like to call it, is not as bad as I surmise, I’d be far more inclined to believe the optimists if the government were less keen to skim the cream off what’s left of the economy by taxing a basic commodity such as fuel.

Meanwhile, you have until this Friday, 25 April 2008, to comment on price cap proposals (Government Gazette link in PDF) on liquified petroleum gas. I’ve written about this before. If you want to know why you can’t find that nice cheap LPG at your local petrol station, look no further than government’s insistence on regulating every price in sight.

And every time we get shortages, or price inflation, or both, we wonder why. It’s because (and Mandy de Waal’s comment yesterday is a case in point) we simply don’t trust the profit motive as a driver of efficient capital allocation. We simply don’t trust the price mechanism to regulate supply and demand. In the end, we don’t trust our people with their freedom.

But really, do go read Terrell’s article. Evidence once more that Economics 101 is, well, elementary.