The Decline of Fuel Subsidies – Rise of Demand Destruction

India is raising fuel prices by 10% for the second time this year as oil prices stay at record levels. The petroleum minister, Murli Deora put it ever so eloquently.

Due to the relentless increase in international oil prices, it has now become necessary for the consumer… to shoulder a small part of the increased burden, through a marginal hike in prices.

Could this be the beginning a significant amount of demand destruction in the developing world?

Demand destruction is the reduction in demand for oil and oil derivatives as a result of higher prices. This market reaction is expected especially for peak oil due to the lack of scalable alternatives. With the recent rise in prices, demand destruction in the developing world has been limited due to fuel subsidies that protect the poor from the highly regressive impact of higher costs of energy. Two-thirds of new oil demand is coming from countries that have subsidized oil markets1. This is to be expected whenever a market is distorted. Just ask JP Morgan head of energy strategy Katherine Spector.

“A subsidy tells consumers they don’t need to adjust their behavior,” she said.

In the face of rising prices, countries like India have two choices. One is to continue to subsidize fuel and incur large losses, or phase back subsidies and risk inflation and hurting the consumer. For the moment, this is primarily an issue for importing nations like India, which imports 75% of its fuel. Exporting nations will only incur an opportunity cost, at least until the cost of extracting oil increases.

Nevertheless, higher prices around the world will force more people to use less oil and cause the burden of higher fuel prices to be shared. Despite primarily hurting those in the developing world who are poor by western standards, it is likely that higher prices will encourage more sustainable development. Political pressures may interfere with this process, but it is only a matter of when, not if, subsidies will be eliminated and demand will decrease in the developing world.

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3 Responses

  1. This is one of a growing number of signs that behavior may actually start to change. As the consumers that make decisions become less insulated from the prices they will begin to respond. It’s a slow process though.

  2. Good stuff Brian, I’m impressed with your blog, it’s become my primary news source …. this article especially is understandable to non-experts such as myself

  3. […] to raise price of fuel Posted on June 20, 2008 by Brian Cesarotti A few weeks ago we discussed the possibility of more demand destruction as a result of India raising fuel prices by […]

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