Case Study 5
Who caused the fuel crisis? Does it need solving?

In September 2000 the UK was almost brought to a standstill by a blockade of wholesale oil supplies. Not in the Persian Gulf, nor organised by trade unions. Rather it was the result of a spontaneous protest - largely by road hauliers and farmers, traditional heavy users of fuel - within the UK. They enjoyed huge public support. People minded that petrol and diesel prices had gone through the roof, and wanted government to ‘fix’ the problem.

Some people said it had all been caused by a resurgence of OPEC, the world cartel of oil producers. Others said that it was the result of a deliberate attempt by government to raise taxes on fuel, either actively or as a result of their automatic connection to oil prices. People argued that fuel was unfairly taxed, and the results were inefficient too.

Let’s take a closer look at some of the issues.

OPEC and the world oil market

The Organisation of Oil Exporting Countries was founded in 1960 and currently has 11 members. The table shows their share of world oil output. OPEC produces just under 40 per cent of world oil, perhaps less than you thought?

Why then is OPEC so significant? Because these countries are part of a cartel that tries to cooperate to set a common price and make common decisions on output levels.

In 1973, OPEC first managed to agree a significant reduction in oil output. Since rich nations needed a lot of oil, whatever the price, in economic speak, their demand was very price inelastic -OPEC calculated correctly that by cutting their output they could make oil scarce and force the price up a lot. When the price tripled in 1973-74, OPEC got rich despite the fact that they were producing less.

In response to high oil prices, gradually rich countries figured out how to supply a bit more oil themselves and demand a bit less. In 1979-80, OPEC responded to weakening oil prices by a further round of output cuts, doubling the price again. By the early 1980s, oil prices were around $30-35 a barrel. But don’t confuse this with a price of $30 in autumn 2000. The scarcity of oil is measured by its real, or inflation adjusted price. To be the equivalent today in real terms of the $30 in 1980, some people have calculated oil prices would have to be about $80 a barrel. Because there was a lot of inflation during 1980-2000, prices had to rise a lot merely to preserve their real, inflation-adjusted value.

Against this background, the fact that after 1982 oil prices fell steadily in nominal terms, and spent much of 1986-99 in the range of $10 to 20 a barrel shows just how much the real price had fallen after the early 1980s. Like most cartels, OPEC was unable to sustain joint cutbacks in output over a long period. Once the price was high, each individual member wanted to expand not maintain the cutback.

By 1999, the nominal price of oil had fallen to around $8 a barrel, perhaps only a tenth of its real price two decades earlier. Since 1999, it has risen sharply, partly because the booming world economy has raised the demand for oil, and partly because after years of less effective action, OPEC has been regalvanised as a cohesive organisation capable (for how long?) of agreeing cuts in output in order to force up the price. Thus, oil prices have risen from around $8 to over $30 a barrel since 1999. The rich countries have been trying to convince OPEC that any price higher than $25 is likely to do so much damage in rich countries that demand for oil, and hence the price OPEC can charge for an extended period, is likely to fall sharply.

It is too soon to say whether this is correct, whether the rich countries are bluffing, and whether any of this will affect OPEC supply decisions. The main reason for the uncertainty is that both supply and demand take a long time to respond to price changes. In the short run, consumers have few alternatives but in the long run they can design and switch to more fuel-efficient cars and different sources of power for electricity generation. Similarly, attempts by the rich countries to increase their own supply take time - they have to engage in slow and costly exploration and new extraction. Increasing concern about preserving the environment also casts uncertainty over whether major new drilling programmes will be allowed in previously uncontaminated environments.

There are many good websites addressing these issues. You make care to look at OPEC’s own site (www.opec.org). Even more useful is the extensive online material at BBC. (www.bbc.co.uk/news/world/opec)

So higher petrol prices simply reflected a supply restriction by OPEC?

They reflected this, especially in the short run, but that was far from the whole story. First, given a booming world economy, oil companies have taken the opportunity to increase their profit margins, and oil companies are generally reporting large profits at present. Some of the rise in domestic oil prices was not the result of OPEC supply but higher global demand, and the fact that oil companies, like many others, tend to have highest profit margins during booms and lower margins in slumps.

The other key issue is taxes. Some taxes (such as VAT) are a constant percentage of the untaxed price. Hence when raw material prices rise, the absolute value of the tax increases (although it remains a constant share of the final tax-inclusive price). This effect on its own has meant that European governments have got significant extra tax revenue as oil prices have risen without having to change tax rates at all.

In addition, there has been a conscious policy in crowded, congested Europe of trying to discourage car use by deliberately taxing fuel so that users pay the full social cost (including congestion and pollution) of using fuel to drive their cars. In contrast, in the land of the free and the home of the brave, uncongested Americans pay much lower taxes on petrol. Many Americans assume that if cars had been around when the US constitution was first framed, that Americans would have had a right to drive cars as well as a right to bear arms. To give some idea of the transatlantic discrepancy, fuel tax accounts for 22 percent of the cost of petrol in the US but 72 percent of the cost in the UK.

If both countries suffered equal congestion and pollution, it would be hard to make sense of such a large differential. However the USA is land abundant, and much of Western Europe is very densely populated, where the true burden of congestion and pollution is therefore much larger. Some (significant) transatlantic difference in fuel prices can therefore be justified. Whether the proper differential is as large (or larger) than the current amount is quite hard to calculate, even on pure efficiency grounds (making people pay for all the induced effects of what they do; what economists call internalising ‘externalities’ that spill over from one individual’s actions on to another).

The accompanying two charts are taken from www.bbc.co.uk/news/world/costoffuel. The top chart shows the very different taxation of unleaded petrol on the two sides of the Atlantic. The lower chart shows that low taxes in North America do indeed induce users to respond by demanding more fuel. Economists believe that (appropriately) high taxes on fuel are part of a strategy for the proper pricing of environmental resources, and the only safe route to preserving our planet in the long run.

But poor people can’t afford to pay!

Who do you think has three-litre cars that drink petrol? Rich people or poor people? Even flat rate tax on petrol is quite progressive - not only do poor people pay less tax in absolute amounts, they pay a smaller percentage of their income in fuel tax.

However, many of us would want to go further. The combined tax-and-social-security system recognises not merely that it is sometimes appropriate to take disproportionately from the rich but also that sometimes the poor need not just zero taxes but subsidies. Many environmentalists who want to use the price mechanism argue in favour of a ‘poll subsidy’.

Give everyone a flat rate handout and then claw back the revenue from those previously paying too little for energy use by levying fuel duties that take account of the true social cost of using fuel. This way the poor as well as the environment can be protected. Economists regard this as distinguishing two different motives for taxation - to improve efficiency of resource use and to redistribute some spending power from richer to poorer people.

Politicians know only too well that issues about redistribution are usually much harder to solve than issues about efficiency. Redistribution - the favouring of one group at the expense of another - automatically creates vocal losers who can make political trouble. Efficiency gains from better policies offer a pure surplus, which can be shared out among many people to assemble a majority for the policy. Of course, in the real world, most changes have consequences for both efficiency and distribution, and we discussed earlier how policies explicitly targeted to help the poor could stop efficiency improvements from having adverse distribution consequences.

Summing up

The Treasury has benefited from additional taxation induced only by the rise in oil prices caused by the world boom and a reinvigorated OPEC. Should this now be used to help those most acutely affected by higher fuel duties, especially road hauliers? A responsible government must recognise the likely volatility of oil prices in the future. Would it be prepared to raise taxes every time oil prices fell? Sounds like a political nightmare.

It was well meaning attempts to stabilise agricultural prices that gave Europe the Common Agricultural Policy forty years ago. Policies of undue interest to one particular group quickly become the focus of their intense lobbying. They have a strong interest in manipulating the policy to their advantage. The rest of us - who may have to finance it - have much less individual interest in it, since its burden is spread across so many of us. In the subsequent lobbying war, it is an unequal contest between the motivated and the apathetic. This explains the government’s reluctance to acknowledge any regular linkage between world oil prices and levels of UK fuel taxation. If politically essential, it is more likely to provide a one off rescue package for hauliers that it hopes will be the end of the matter. But history is littered with ‘final and never to be repeated’ packages which it proved politically difficult not to repeat later. There is no easy answer.

Politicians of all parties claim that the environment will be safe in their hands. Historically, pleading with the public has not proved a bid success in limiting pollution and environmental damage. Taxing the activities that do the damage often seems like a tax without a benefit. It will not be popular, and hence politically attractive, until voters clearly understand how behaviour will change. High taxes have gradually reduced cigarette smoking, though better information has had a major effect. We need to tackle the environment as well, and we need to target measures as accurately as possible on the real problems. A rural doctor driving along a deserted road to visit a remote patient is doing less damage than a commuter by car who blocks London streets and makes other drivers go at slow speeds where petrol combustion is less efficient. The latter should pay more. Uniform taxes on petrol are a pretty blunt instrument.