On Wednesday, I posted a story on how Iranians are upset about gasoline rationing. A key point which figures into what follows is this quote from the article:
The new rules limit drivers of private cars to 100 liters, or 26 gallons, every month at the subsidized price per liter of 1,000 rials, or 10 cents. Taxicab drivers are limited to 800 liters a month. (Emphasis mine)
So we are to take away from this article that gasoline is offered for sale to Iranian citizens at the price of 10 cents per liter and that this price is the result of a government subsidy. (NOTE: 10 cents per liter would be 38 cents per gallon. However, another article cites it as 42 cents. It depends on how you round your exchange rate and your gallon to liter conversion. I will use 40 cents from this point on.)
One of my frequent commenters, spencer, raises an objection that essentially boils down to this. Is that 40 cents per gallon price really a subsidy if, as a major oil producer, they are able to produce the gasoline for just pennies per gallon? Don't OPEC countries have lower gasoline prices anyway? Is that a subsidy, or just price discrimination (supplying the domestic market at cost before putting the rest of the supply on the world market as an oligopolist)?
First of all, spencer points out that the domestic refining and distribution network in Iran is nationalized. I should have pointed that out, and I am grateful that he reminded us of that fact. So, the question is would they be within their power to produce their domestic supply of gasoline cheaper because they can extract the oil at a cost that is much below the $70/barrel the oil fetches on the world market? Absolutely.
How much cheaper? For that, I refer to this MSNBC analysis piece by Robert Windrem from January with the provocative headline: Are Saudis waging an oil-price war on Iran? The entire article is worth a read, but here's the part that matters for us:
The trader notes that Iran, OPEC’s second largest producer, is “in trouble” both in the short and long term. Iran’s oil reserves, he notes, are declining more rapidly than Saudi Arabia’s and are more difficult to extract. While a barrel of oil costs the Saudis $2-3 to get out of the ground and to market, that same barrel costs Iran as much as $15-18.
“Iran does have some oil that costs them $8-10 but most of it is in that upper range,” he said.
Moreover, Iran has a large domestic market for oil, particularly fuel oil, which Saudi Arabia, with its smaller population and milder climate, does not.
Perhaps more important, because Iran has limited refining capability, it must import more than 40 percent its gasoline, making it the second largest importer of gasoline in the world after the United States, according to the Department of Energy’s Energy Information Agency.
And since Iran sells gasoline at a rate comparable to the rest of the Gulf states — around 33 cents a gallon — it must subsidize the price on a massive scale. In fact, say traders, Iran is paying about $1.50 per gallon to subsidize domestic gasoline consumption — the world market price of gasoline minus the tiny price per gallon — a practice that is costing Iran billions of dollars annually and eating up most of the state-run oil company’s discretionary funds.
Yes. You see, as I said in a follow up comment to spencer on the previous post, Iran imports around half of its gasoline. The world wholesale price for gasoline is in the neighborhood of $2/gallon. Being as charitable as I could to spencer's argument, I allow for the fact that they may be able to negotiate a better deal than the U.S. can. Even so, the half of the gasoline supply that comes from overseas surely must cost them more than 40 cents per gallon. Maybe they're not losing their shirt, but I don't see them breaking even. Today's research on the subject suggests I might not have had to be so charitable. They might be losing their shirt, if Windrem's sources are correct.
So I think we can safely lay to rest the claim that this really isn't a subsidy. If the oil coming out of the ground costs $15/barrel, then the cost of producing a gallon of gasoline probably exceeds 40 cents per gallon. (It is commonly stated that a barrel of oil yields 19.5 gallons of gasoline among other products. If the other products fetch a high enough price, you might break even overall, but I'm not sure this is the case.)
The fact is that Iran is facing a lack of refinery capacity. Welcome to the club. The question is how will they deal with this. If this was more of a competitive market situation, the answer would be that prices would rise, refinery profits would increase, capacity would be added and price would head back down towards marginal cost.
Yeah, that's textbook theory. It doesn't work literally here in the U.S. because there are a lot of frictions caused by imperfect competition, regulation, externalities, etc. It certainly won't happen in a state controlled monopoly situation as Iran has. But are they immune to the forces of the market. Absolutely not.
So spencer writes, "First, refining is a public sector industry so the economics are secondary."
I'd prefer "non-market".
He continues, "Second, Iran has budgeted a doubling of refining capacity."
So they are responding then? In fact, that seems like a no-brainer. Of course, if domestic demand is building, oil extraction costs are going up, and you're losing your shirt paying for imports because your nationalized firm can't satisfy your domestic consumers, then yeah, I'd say it's time to think about expanding that line in the budget.
But this is not going to be easy for them. If you are a company that builds refineries, is Iran a place where you want to be building them right now? If you are the government of Iran, where is the money going to come from? This is what I meant when, in the first post, I said:
...I would suppose that more comprehensive solutions will be politically difficult.
So in the end, I have to take issue with spencer's final comment,
But what it comes down to is standard economic theory has little to do with the issue and refinery profitability is not really an issue.
That's true only if you think that standard economic theory begins and ends with the perfectly competitive model. In that model, profitability is the main issue. The market fixes imbalances by sending signals to expand or contract and to enter or exit.
However, governments can and do contravene the operation of the market. They do this for good or for evil, but regardless of the reason behind it, the effect is to obscure the signals. Nevertheless, the forces are still there, and they ignore them at their peril. In setting a fixed market price for gasoline, Iran has committed the resources of the state to supply its citizens with the gasoline they demand at that price, even if that means the state's resources will be drained away from other uses. This they can do because profitability is not the main issue. Political economy is. However, there are still no free lunches, even for nationalized firms. Now, both market and non-market forces outside of Iran have combined to increase the drain on its treasury caused by its commitment of resources.
They must now make a choice. They could allow it to continue and supply at a price that is below cost. (A private firm that did so would soon find itself bankrupt.) They could make a long term investment in capital to lower the marginal cost of supplying the product to bring it in line with the price. (Just as a private firm might invest in the ability to perform a task "in-house" rather than pay a high market price.) But as I pointed out, this may be easier said than done.
Of course, they could just raise the price--doing by committee what the markets usually do. If they get it right, bravo. If they get it wrong, well...
Or they could renege on their commitment to their citizens and reveal that the gasoline is too expensive to obtain and supply to them at the established price, so they will not be able to have as much as they want at that price. This has been known to make people violently angry.
I know that spencer and probably some of my other readers think that I've never seen a problem that the market can't fix. That's simply not true. I tend to favor market solutions, but readily admit that government intervention is sometimes necessary. I'm not even suggesting that a move to a free market is desirable or even possible for Iran without a lot of other considerations.
No, my message here is simpler. You can obscure the signals of the price system with the stroke of a pen. But escaping the forces of the market is more difficult by orders of magnitude. The rigidity of Iran's price controls have allowed this problem to "slow-cook" for a long time in a way that doesn't happen in a free market. They must now deal with the consequences of their choices.
William: a masterly analysis of the Iranian retail gasoline problem, which I imagine economics lecturers would be pleased to use in class, up to Econ 101 level and beyond. I was also pleased to note that you explicitly go beyond a crude ‘perfectly competitive price model’, which so many neoclassical ‘pure-markets-solve-everything-ranters’ throw about as if it is scripture.
Here, in the Iranian case the political factors intrude. These include history, long-term and recent, such as events that still affect the nature of the options available to the government long after they occurred in the past, and, of course, those recent events, for which the current government was responsible.
There are the wider social influences also, such as conflicts with other relevant parties (in this case, neighbours, such as Saudi Arabia, perhaps Iraq) and influencers in world markets for oil (shades of the US and Europe), ideological, including (if I may so) religious tensions. Domestic political tensions also count as an influence and we should note that even totalitarian politics are riven with dissent, mostly subdued, but potentially are ‘explosive’, or at least regime-changing factors.
In process industries, like refining, there are restrictions imposed by technology, the laws of physics, chemistry, and biology, and, of course, simple arithmetic, not forgetting the factor of time; expansion is not achieved at infinite velocity.
Having said that, it leads me to how Adam Smith approached the much larger problem of how economies grew and how they stagnated, which his inquiry in Wealth Of Nations discussed in relentless detail. The ‘diversions’, so called, were the essence of Smith’s political economy and his economics were stronger for them. Your straightforward analysis of the economics of the retail gasoline problem in Iran is in that tradition and it is all the stronger for that. If only more economists would write so comprehensively they might have more influence on policy makers.
Very good job. See, if you look into most subjects a little you find that generally the initial broad brush application of theory is almost on target, but off enough to make a significant difference. But because of my pressure you have done a much better job and produced something you can be proud of.
Don't you feel good about it.
P.S. I just good a very good e-mail from John Maudin on this that I would like to send you, but I can not find your email address.
Gavin,
Thank you for the comment and the compliment. Your comments on Adam Smith are always welcome and appreciated.
spencer,
I'm not sure what to make of your comment. First of all, if I tried to anticipate every commenter's reasons for skepticism on some issue (or even just yours), I'd never get anything else done. Part of the whole idea behind the blog is that it is a conversation. Remember, I know that you are often skeptical of "free market" claims, particularly on energy. We've had conversations about price controls before. I'd be lying if I said that I didn't wonder what you'd think about it when I posted the original piece. So of course I'm glad you commented.
You see, my initial thought when I posted on Wednesday was, "Wow. 40 cents per gallon is way below the world wholesale price. Unless an OPEC neighbor is subsidizing them, they're losing their shirt on the imports." and thus pretty much accepted this as an obvious example of a subsidy. So I didn't press this in the original post. I figured most people's reaction would be the same as mine.
I was not expecting anyone to claim that the International Herald Tribune was wrong to call this a subsidy and that we need to investigate if it really is a subsidy. I admit that you took me by surprise on that one. But your objection, once raised, was pretty easy to deal with.
Not only that, but your assertion that economic theory has nothing to say about it when it is a state industry was just too good to pass up.
However, your comments did not bring me to some kind of revelation about the way markets work. It's what I've believed for years. I didn't come up with this yesterday. I didn't discover it. Indeed, as Gavin Kennedy points out, I'm just trying to stay faithful to the real Adam Smith--the Adam Smith most people haven't heard about. I'm glad you like it, but this is just a sample of what I try to do with my students day in and day out. As far as that goes, it is easier to convey these subtleties in a class discussion or individual conversation than in a blog post. I mean just look how long this post is.
I will have more to say later on your remark about the "broad brush application of theory". As a general point, that deserves another marathon post, but not tonight.
As for whether I'm proud of that post or feel good about it. That is an odd question. I guess I felt the same way as I do in my classes when I get a really good question that allows me to make a point that wasn't in the day's lecture notes. I don't sprain my shoulder patting myself on the back for it because it's just part of the job. Nonetheless, it is satisfying when it is noticed and appreciated. I guess that is why I take blog comments seriously and try to answer them in as much detail as is warranted.
The real world is complicated. It's hard to answer real economic questions in 700 word bursts. Therefore, it is expected that the conversational style of the blog can shed some light on these questions once in a while--and in ways that an op-ed or a textbook simply cannot.
Keep the comments coming.