Brent crude has surged toward $120 a barrel since the US-Israeli strikes on Iran began, with analysts warning of the price reaching $150 or more if the conflict persists. Natural gas prices in Asia and Europe have risen 54 per cent and 63 per cent, respectively, in the week following the opening strikes. Jet fuel has surged $200 per barrel, diesel almost $180 per barrel.
When supply falls sharply and demand does not, a rise in prices is the obvious response in a market economy. This was Europe’s experience in 2022 — it let prices rise, taxed firms that profited, and undertook some redistribution. In India, petrol and diesel prices have barely moved.
The government has held the line absorbing the difference through oil marketing companies and implicit fiscal transfers. This begs the question: is shielding consumers from price signals actually protecting them, or is it simply deferring the cost, distorting the market, and ultimately leaving them worse off?
When a supply shock hits
It is worth beginning with first principles. When a supply shock hits, and less of the commodity is available, consumers need to reduce their consumption, producers need to find ways to bring more of the scarce good to market. These millions of individual decisions get coordinated through the price.
Consider a simple example: When onion prices spike, you do not need a government advisory telling you to use fewer onions. You substitute, and reserve onions for the dishes where nothing else will do. A trader somewhere calculates that the higher domestic price now makes importing viable. Supply rises, demand compresses, and the market finds a new equilibrium. This takes time, and there is hardship and chaos in the short run. But this actually leads to coordination of millions of independent decisions, each responding to the price, which produces an outcome that no allocation committee could have implemented.
When oil prices rise, this is exactly the mechanism that would play out. On the demand side, it will lead to adjustments that preserve supply. For example, households may undertake lesser travel, industry may switch fuels, and make efficiency investments. On the supply side, every alternative starts to look more viable, drawing in investments and innovation, which had earlier seemed too costly.
The arguments against price rises
If the case for allowing prices to rise is this straightforward, why does the Indian state reflexively reach for the price cap? Two arguments are typically made. Let us consider each.
The first argument runs as follows: the poor spend a disproportionate share of their income on energy, and allowing prices to rise unchecked is effectively taxing those least able to pay. However, when governments suppress fuel prices, the poor do not benefit disproportionately. Fuel subsidies in practice flow overwhelmingly to the middle class and the wealthy, who own more vehicles, consume more diesel, and run larger businesses. A flat price cap is a subsidy to everyone, but a larger subsidy in absolute terms is to the affluent. Further, since the supply shock remains, scarcity manifests itself in long queues, in rationed allocations, and in the black market price that the poor, with no connections to help jump the queue, ultimately end up paying.
The second argument places the blame for rising prices on speculators. It suggests that prices are not rising because oil is genuinely scarcer, but because speculators are hoarding the oil, or trading on futures markets, and artificially inflating them. However, a speculator who bets on rising prices and is correct is actually providing early information that allows consumers and businesses to adjust sooner. Capping prices to punish speculators destroys this information, leaving the market blind, precisely when it most needs to see. Suppose the argument is physical hoarding.
But hoarding is profitable up to a point. Storage costs money, oil degrades, and the hoarder’s entire bet depends on selling before prices reverse. So if prices were to rise, they would actually discipline the hoarder. Capped prices not only eliminate the profit opportunity that would induce the release of stocks, but also the signal that would have drawn in competing supply.
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Impact on oil firms
If international prices have risen, and retail prices are not reflecting that increase, who is bearing the brunt? The major cost is being borne by India’s state-owned oil marketing companies, with their marketing margins turning negative owing to the rise in international prices. Reports suggest that IOC, BPCL, and HPCL have lost about $2.25 billion (about Rs 20,000 crore) due to the fuel price freeze. These losses will accumulate on balance sheets, raise borrowing costs, and ultimately circle back to the government as contingent liabilities. The government recently slashed the Special Additional Excise Duty (SAED) on petrol and diesel by Rs 10 per litre each, with the intention of keeping the retail price in check. This gives some relief to the oil companies, but takes away the government’s spending kitty, which will probably have to be made up by increasing other taxes.
A supply shock, not of our making, is upon us. When a supply of say 100 units goes down to 60 units, there is always the question of who gets the supply? The choice is whether this allocation happens through prices, which distribute the burden across millions of decisions simultaneously, or through the state, which leads to fiscal stress, balance sheet deterioration, and eventual crisis. The gains to GDP are greater with adjustments through the price system.
Renuka Sane is managing director at TrustBridge, which works on improving the rule of law for better economic outcomes for India. She tweets @resanering. Views are personal.
(Edited by Aamaan Alam Khan)