An Equation with One Unknown

Not long ago I was asked why the oil price had fallen by more than half while the gasoline price had fallen nowhere near as much. There are several reasons, and they are worth understanding:

1. The cost of gasoline consists of the cost of oil on the domestic market plus the costs of refining and delivery. So when the oil price falls, the gasoline price cannot fall proportionally.

2. The state sets maximum prices for oil. When oil cost more than $100 per barrel, it was sold on our domestic market not at the market price but at a much lower one. By law, subsoil users must sell 30% of their output on the domestic market. If gasoline has a maximum price, then oil on the domestic market also has a maximum price, above which no one will buy it. At a gasoline price of KZT 128 per liter, that oil price was roughly equal to $80 per barrel. In other words, domestic prices converged with market prices only when Brent fell below $80. So we have to look at what the domestic oil price was during that period in order to calculate the proportion.

3. The progressive scale of rent tax for subsoil users. Our exporters pay on a progressive scale: the higher the price, the higher the rate. If the rate is 19% at a price of $100 per barrel, it is 7% at $50. So when the oil price falls, the domestic price, because of taxes, also declines less than proportionally.

4. A maximum price of KZT 109 per liter of AI-92 gasoline is now in force. Oil traders may set prices lower, and nobody forbids it, but here gasoline has to be viewed as a commodity governed by supply and demand. Gasoline is an inelastic good, meaning that demand for it is practically independent of price. If oil traders cut prices, their sales volumes will not grow proportionally, so it is in their interest to sell at the maximum prices. Besides, in Kazakhstan the quality of gasoline matters a great deal, and many of us trust only the large filling station chains, while small ones are no competition for them even if they cut prices. We have large national chains, of which there are not many (KMG, Sinooil, Helios, RP and Gazprom Neft), and large regional chains such as Nomad, Bakhyt and the like. Since competition is limited, the market is an oligopoly: once three chains agree on prices, everyone else will keep to them.

5. Because export prices for oil have fallen sharply, our subsoil users are bearing heavy losses, which they are trying to offset on the domestic market. That is why oil prices here are now higher than world prices. Many large subsoil users have long-term contracts under which they supply this oil for export, while the domestic market remains under the influence of those 30%. Demand for oil therefore remains, which allows subsoil users to hold prices.

6. Wholesale oil traders are also an intermediary layer between subsoil users and retail chains. The wholesale market is also an oligopoly. Wholesalers differ from subsoil users and retail chains in that they hold refining contracts with the refineries. And since by law only the retail price of oil is regulated, wholesalers can dictate prices to both subsoil users and retail chains. The oligopolization of wholesalers stems from a number of shortcomings in the law on the regulation of petroleum product circulation, as well as from the limited refining capacity of the refineries. Consequently, wholesalers can be influenced only by lowering the maximum prices for gasoline.

7. The domestic price of oil also does not change in proportion to the market price on world markets, because it is calculated as the world price minus taxes and transportation costs. Besides the rent tax, there is the export customs duty, which does not depend on the oil price. Transportation costs also do not depend on the oil price. A barrel is now trading below $50. We can calculate what the gasoline price could be at such an oil price. First, let us calculate the domestic oil price after deducting all costs and taxes. Fixed costs per ton of oil that do not depend on the oil price (export customs duty, transportation and the trader's discount) come to 80+43+29 = $152 per ton. The reduction of the mineral extraction tax (MET) by 4.5% of the price comes to $49 per barrel x 4.5% x 7.2 = $16 per ton. Less the export rent tax: 49 x 7% x 7.2 = $25 per ton. Total: the domestic price will be 49 x 7.2 - 152 - 16 - 25 = $160 per ton. Refining costs $80 per barrel, losses are 5%, or $8 per ton, plus delivery costs of $100 per ton. Suppose we sell fuel oil at $100 per ton; then $60 is shifted to the cost of gasoline: 60 x 0.4 (fuel oil yield) = $24 per ton. The result is 160+80+100+24 = $364 per ton. Add to this an excise tax of $30 per ton and additives for AI-80 gasoline of $100 x 0.7 (AI-80 yield) = $70. That gives $440 per ton. Traders will earn, say, $100 per ton (wholesaler plus retail chain), which brings us to $564 per ton. Add 12% VAT and we get $632. So a liter of gasoline should fairly cost 632 x 0.73 x 185 / 1000 = KZT 85 per liter. The catch is that the Ministry of Energy has not lowered the maximum fuel prices, in order to support our subsoil users, since this is now the only source for covering their losses. We must also take into account the time lag, because oil does not automatically turn into fuel: it has to be delivered, refined and brought to consumers. That takes about a month.

Incidentally, this is a very good time to establish a formula for the maximum fuel price depending on the oil price. The formulas can be spelled out clearly using regression equations, so that in the future we would no longer land in awkward situations where the oil price rises but it is difficult to raise fuel prices within the country. In Europe, for example, there is a clear correlation between the oil price and the price of gasoline. Building such an equation is not difficult, since all the parameters are known except the oil price. It will be an equation with one unknown. Prices could then be revised on the first day of each month depending on the average price of the previous month.