Miss Afia Mushtaq

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University of Management and Technology

 Trends in Oil Prices

Abstract

Oil price shocks have raised serious concerns among the policy makers around the world,

because of its adverse impacts for the net oil importing economies. This paper has analyzed

the impact of rising oil prices along with the changing macro conditions on output using the

IS, monetary policy and augmented Phillips curve for Pakistan. Oil prices and output are

found to be strongly related, and to a great extent this relationship is non-linear, that is, after

a certain level it becomes negative. In addition, lower debt-GDP ratio, lower deficit

spending, lower real effective exchange rate, and the existence of foreign exchange reserves

and capital investment would cause output to rise.

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Table of Contents
1.Introduction 5
2.Problem Statement 7
A. Inflation and Oil Price
3. International & Domestic Oil Prices

i. International Oil Price 9

ii. Domestic Oil Price 10

4.Causes of fuel trends

A. Fuel and US pricing11
B. Factors affecting the cost for the customer 12
i. Cost of production and delivery of diesel fuel to consumers 
ii. Operating Cost of Retail Station
iii. Federal, State and Local Taxes

C. Global market factor affecting retail price of fuel 14

i. Supply and Cost of Crude Oil

ii. Worldwide Production Capacity & International Demand of Diesel Fuel
iii. Imbalances in Supply & Demand
iv. Seasonal Variations in Demand
v. Geographic Variations

D. Worldwide increase in fuel price 16

i. Fuel Production
ii. Increased Demand for Diesel
iii. Stringent Environmental standard
iv. Fuel Taxes

E. A closer look at the Rise & Fall in 2008 17

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5. Impacts of High Oil Prices

i. Oil Dependency 21
ii. Macroeconomic effect 24
iii. GDP growth and oil prices 25
iv. Balance of payment effect 27
v. Fiscal Impact 29
vi. Impacts on exports and imports 31

6. Forecast for the Year Ahead

i. Projected Price Trends 31

ii. Projected Consumption Trends 31
iii. Projected Supply Trends 32

7. Recommendations 33

Conclusion 35

References 36

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1. Introduction
The high degree of dependence on oil producing countries and any irregularities in prices and

supplies has a pervasive effect for an economy that imports crude oil to cater to its often fragile

industry. Following the sharp surge in oil prices since 2003, developing countries that rely

heavily on oil imports, are now faced with an increased threat to macroeconomic instabilities,

with Pakistan as no exception.

This brief note provides an overview of international oil price trends witnessed since 2002.

Observations are also made on how domestic furnace and high speed diesel oil price trends move

in consonance with the international oil prices. The need to focus on furnace oil and high speed

diesel oil prices trends arises from the fact that of the total production by oil refineries of major

components of crude oil, diesel constitutes the highest share of 31% with furnace oil comprising

the second largest share of 29.4% in Pakistan (2006‐07 estimates).

Chart plots the annual change in the real prices of crude oil for the period 1961 to 2008. The

figure shows that the price of oil jumped sharply twice in the 1970s. In 1973-74, oil prices

increased by an incredible 222% in real terms and 257 % in nominal terms. In this sense, the

present price level is not unique. The increase in oil prices during 2003-08 occurred relatively

gradually, allowing countries more time to adjust. For example, the oil prices in real terms rose

by 13 % in 2003, 27 % in 2004 and 37% in 2005. Then it was decelerated to 16 and 8 % in 2007,

before rising by a dramatic 69% in 2008.

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2. Problem Statement
This study will specifically focus on how this increasing trend in international and subsequently

domestic furnace and high speed diesel oil prices; translate into creating imbalances in the

economy by soaring inflation. It will also focus on how high oil prices exacerbated the balance

of payment crises, impacted the rates of other commodities and input prices and the effected the

exports and imports of the country. Consequently, the dire need of exploring alternate and

indigenous energy potential perhaps has never been more pressing.

A. Oil Prices and Inflation

Higher oil prices directly lead to increase in food prices. As a result there was a substantial

increase in head line inflation. The recent need to import food items like wheat, sugar etc, and

depreciation of Pakistani rupee further led to an increase in food prices. Due to increase in global

oil prices and import bill of food group, headline inflation is constantly going upwards. The

impact of inflation would have been even worse, had the government not offered subsidies on oil

products and food commodities.

Figure shows the inflation experienced in food prices since 2002‐03 in major groups.

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Similar to other developing countries (Ethiopia, Sri Lanka and Ukraine), Pakistan too faced

inflationary impact of rising food and oil prices which is likely to be amplified by continuing

demand pressures. Other than increase in oil prices, the surges in food prices is due to

withdrawal or reduction of subsidy on food as existing subsidy became too costly for the

government.

Soaring oil prices with increased food prices are evidently have a negative impact on growth and

drive up the cost of inputs. Both these factors are posing a great challenge to the macroeconomic

situation of Pakistan. Faced with such a situation, the low‐income households find it very

difficult to protect themselves against inflation, especially those living in urban areas.

Another channel via which high oil prices may affect macroeconomic performance is through the

high costs of production thus reducing output. This supply side channel exerts an inflationary

pressure on the economy. In addition, higher oil prices directly raise consumer prices via higher

prices of imported goods and petroleum products in the consumption basket. Another implicit

effect is felt as producers pass some part of higher input (oil) costs to the price of final goods.

Moreover, consumers who experience a loss in real income may consider seeking wage

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increases, which feed back into higher production costs, and then into prices. However, when oil

prices fall, nominal wage and other price rigidities can limit the pass through to lower final

goods prices.

When the rate of inflation is high, governments may be concerned with adding it further and

hence less willing to see a full passing on of oil price increase. High oil prices has also become

an important factor (along with rising house rents and shortage of food items) contributing to

high inflation in Pakistan in the past few years. General Price level (for virtually all goods and

assets) has been increasing (9.3 percent in 2004-05 considerably very high compared to the

previous years). Even in the last two years average inflation was near 8 percent (Table 1).

Despite efforts from SBP through tight monetary policy19 (high interest rates) average inflation

was 7.1 percent in the first quarter of 2007/0820 (IMF 2008).

Table 1: Consumer Price Index Trend

2000-01 2001-02 2002-03 2003-04 2004-05 2005-06 2006-07

Average CPI 4.4% 3.4% 3.3% 3.9% 9.3% 8.0% 7.9%
Source: Board of Investment 2008
Increase

3. International & Domestic Oil Prices

International Oil Prices

The global economy has found itself in the midst of an all time oil price peak which has also

surpassed the peaks experienced during the Iranian Revolution in 1970s. This surge is having a

compounding effect on the existing macroeconomic challenges for countries whose domestic

economy is consequentially linked with the international oil market and other product prices.

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World oil average prices during 2003‐04 were over 11% higher than the average prices during

2002‐03.

End of the 2004‐05 experienced a sharp upward swing in prices, with an increase of over 41%

compared to the average price/barrel in the preceding year. Newer peaks were reported in

price/barrel during 2007‐08 when a 53.4% increase in prices was witnessed, compared to 2006‐

07. Overall, there has been a 360% increase in price/barrel of oil since the first quarter of 2002‐

03 to the end of 2007‐08, with the first quarter of 2008‐09 opening into even higher average

prices and etching newer records with prices over $140/barrel on a given day. Graph shows the

recent trends in world oil prices.

Domestic Prices

Being an importer of oil, the domestic furnace oil prices in Pakistan follow the rising trend

witnessed in international prices.

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Figure shows that domestic prices of furnace oil rose by 25% during 2004‐05 and over 50% by

year end 2005‐06. With a slight deceleration in prices during 2006‐07 (‐1.98%) prices during

2007‐08 posted a record increase of 57.36%. Holistically, it can be observed that domestic

furnace oil prices have been following very closely the general price trend observed in the

international oil market.

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4. Causes of Fuel Price Trend

A) Crude oil price and US dollar:

Crude oil is considered an investment to fall back on when the US dollar value is devaluated.

The current monetary policy could affect the US dollar to decline in value compare to major

commodities and thus it could cause a rise in demand for crude oil as an alternative investment,

along with upward pressures in crude oil price.

There is also the demand for oil: if the monetary policy will work out as expected by the Fed, it

will improve the condition of the U.S. economy which will stimulate more businesses and

consequentially the demand for energy will likely to rise; as a result, there will be pressure

for crude oil price to increase.

Therefore, it seems that in both cases the Fed’s monetary policy could further cause to crude oil

price to rise. Since, however, there are many other factors that affect crude oil price, it’s

premature to speculate that energy prices will increase in 2011 based on the Fed’s policy.

(B) Few factors affecting the cost for the customer

Let us first take a look at how the retail price of diesel fuel is computed. Several factors are

considered while computing the retail price of diesel fuel. These include the following – 

1. Cost of production and delivery of diesel fuel to consumers 

Diesel fuel is obtained as a distillate in the process of fractional distillation of petroleum

or crude oil.

The refining, processing, procurement and distribution costs of diesel fuel include –

(a) Cost of crude oil

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(b) Refinery processing costs

(c) Marketing and distribution costs

2. Operating Cost of Retail Station

Retail outlets can be owned and operated by refiners themselves or by independent

organizations that purchase diesel fuel from refiners or distributors and resell the fuel to

consumers. Operating costs of retail stations depend on various factors such as –

(a) Local market conditions

(b) Location of the outlet

(c) Marketing strategy of the retail station owner

3. Federal, State and Local Taxes

In 2008, Federal excise taxes levied on diesel fuel amounted to US 24.2 cents per gallon

while State excise taxes were US 22.0 cents per gallon on an average.

The final retail price of diesel fuel reflects the costs incurred by each unit of the supply

chain comprising refiners, marketers, distributors, and owners of retail stations. The

relative share of the various components in the final retail pump price of diesel fuel

changes with time based on market conditions and also varies across different

geographical locations. The figures below illustrate the share of each cost element in the

national average retail price of diesel fuel at $4.43 per gallon as of May 2008 and at

$2.45 per gallon as of December 2008. It can be seen that the dip in price of crude oil

from May to December is reflected in the lower proportion of crude oil price in the

overall retail price of diesel fuel for December 2008.

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(C) Global Market Factors Affecting Retail Price of Diesel Fuel

Computing the retail price of diesel fuel is not as straightforward as it may appear to be. There

are several worldwide factors, political and economic, that influence supply and demand of crude

oil and diesel fuel leading to variations in retails prices

(1) Supply and Cost of Crude Oil

Global supply and demand of crude oil affects the price of crude oil, one of the most

important components in the retail price of diesel fuel. Member nations of the

Organization of Petroleum Exporting Countries (OPEC) own about two-thirds of the

estimated reserves of crude oil in the world and account for 40% of the global crude oil

production. The last few years witnessed unprecedented increase in crude oil prices

worldwide due to disruptions in crude oil supply during the Arab Oil Embargo of 1973,

the Iran/Iraq war in 1980, invasion of Iraq in 2003, unrest in Nigeria, and hurricanes in

the Gulf of Mexico in 2005. The trend of surging crude oil prices reversed with the recent

onset of the worldwide economic crisis.

(2) Worldwide Production Capacity & International Demand of Diesel Fuel

Refineries in the US have been operating at 90% of their production capacity for more

than a decade. Tight worldwide refining capacity and competing international demand for

refined distillates affect the price of diesel fuel in the US.

(3) Imbalances in Supply & Demand

Diesel fuel is primarily a transportation fuel. Problems at refineries or inadequate and

delayed imports lead to unexpected disruptions in the supply of diesel fuel. As

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inventories fall, there is competition amongst wholesalers and marketers who are willing

to bid higher for available stocks of fuel. This pushes the retail price of diesel fuel

upwards. Price spike due to insufficient supplies is a scenario commonly observed in all

commodity markets.

(4) Seasonal Variations in Demand

Prices of diesel fuel increase during the fall, dip in late winter, surge during early spring,

and again drop a bit during the summer. Demand for diesel dips in spring and summer as

gasoline consumption increases during these peak-driving seasons. In autumn, diesel

consumption increases due to increased agricultural and transportation activities before

the onset of the holiday season. Stores are known to increase inventories during the

holiday season in winter.

(5) Geographic Variations

Retail outlets that are farthest from refineries and distribution terminals have higher

diesel fuel prices to account for the costs incurred in transportation of the fuel. Local

market conditions such as number of retail outlets, traffic patterns, State and local fees

also influence the final retail price of the diesel fuel.

The figure below illustrates the change in the nationwide average monthly retail price of

diesel fuel in the US from May 2002 to January 2009. The rise and fall in fuel prices in

2008 is clearly the most drastic change observed in recent years.

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(D) Worldwide increase in fuel price: 

In the US, the average price of diesel fuel has historically been lower than that of gasoline. In

October 1998, the national average price of diesel fuel was $1.039 per gallon and that of gasoline

was $1.038 per gallon. As of October 6, 2008, diesel fuel was priced at $3.875 per gallon

whereas gasoline was priced at $3.484 per gallon. The price differential comes about due to

several factors including domestic and global supply and demand forces, economic development,

and political and regulatory influences. A few of these are explained below –

(1) Fuel Production

As per the current refinery structure, each barrel of oil produces more gasoline than

diesel. 19% of each barrel of oil is used for the production of diesel fuel as against 47%

of each barrel that is used for production of gasoline. This implies lower production costs

for gasoline than for diesel.

(2) Increased Demand for Diesel

Demand for diesel, especially in Asia, Europe and the Middle East grew more rapidly

than US demand for diesel. Developing countries saw an increased requirement for diesel

to support rapid industrialization. Financial incentives in Europe favored the use of diesel

over gasoline to such an extent that more than 53% of all new cars sold in the European

Union in 2007 were diesel cars.

(3) Stringent Environmental Standards

Effective June 1, 2006, ultra--low sulfur diesel fuel (ULSD) began to account for at least

80% of the production of refineries in the US. Sulfur is naturally present in crude oil and

the refineries were required to adopt additional measures and processes to produce

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ULSD. This led to an increase in the cost of production of diesel fuel. This in turn

affected the retail price of the product.

(4) Fuel Taxes

Effective October 1, 1997, the federal government has imposed a tax of 24.4 cents per

gallon on diesel fuel as compared to a tax of 18.4 cents per gallon on gasoline. In

addition, each state levies a diesel tax. This ranges from 8 cents per gallon in Alaska to

32.9 cents per gallon in Wisconsin. The nationwide average is about US 22 cents per

gallon. Currently, 15 states levy a greater tax on diesel than on gasoline whereas only 6

states impose a higher tax on gasoline than on diesel.

(E) A Closer Look at the Rise & Fall in Prices in 2008

Till the beginning of 2008, booming economies worldwide led to increased consumption of

products such as diesel, gasoline and jet fuel, derived from crude oil. At the same time, world

supplies of crude oil and derived products were threatened due to political tensions in oil-rich

countries like Iran, Nigeria and Venezuela and also due to reduction in output from the aging

oilfields of Mexico, the US and other nations.

In the face of a weakening dollar in early 2008, the financial world began betting heavily in favor

of oil and other commodities. The Energy Department of the US government began to purchase

40,000 barrels per day (bpd) of sweet crude oil, which has low sulfur content and is low in

viscosity, for its Strategic Petroleum Reserve, thereby inflating demand for the product.

Consequently, we saw crude oil prices peaking at an astronomical amount of $147.50 per barrel

on July 11. The US Energy Department stopped filling the Strategic Petroleum Reserve on July

1st.

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However, there was a drastic reversal of trend as the threat of a worldwide economic recession

began to loom large and consumption of oil-derived products began to decrease. Demand for

crude oil and derived products fell by more than 800,000 bpd in 2008, the steepest drop since

1982.

A similar trend in Europe led to a rapid rise and plunge in demand for crude oil in the European

Union (EU). In 2007, the US and the EU compelled refiners to produce ultra-low-sulfur diesel

fuel. Addition of several countries to the EU created a surge in demand for diesel and crude oil

refiners began to bid against each other to secure supplies of low-sulfur crude oil. However, the

euro began to fall against the dollar and European motorists began to feel the pinch of increasing

crude oil prices. To add to the mayhem, refiners worldwide have now begun to introduce

efficient processes and are now able to produce ultra-low-sulfur diesel from less premium grades

of crude oil. All these factors led to a great turbulence in the world market for crude oil and

consequently affected the consumption of oil-based products such as diesel fuel.

5. Impact of High Oil Prices

Since 2003, oil prices are constantly on the rising side. End of 2007 has seen the maximum of

$100 per barrel. This rising trend in oil price in the international market has hurt the economies

of many countries in the world including that of Pakistan. The extent to which economies hurt as

a result of price shock depends on the country’s dependency on oil. Before analyzing the impact

of high oil prices at the macro level the paper will look at some of the indicators showing the

vulnerability of the Pakistan’s economy.

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1. Oil Dependency

Oil dependency or how much vulnerable a country is to price shock can be observed from the

following indicators:

Oil Self-sufficiency index:

It is the percentage change in oil production minus consumption to oil consumption. This ratio

will be negative for oil importers. If its value is -1, country has no oil production and is totally

dependent on oil imports; and a positive number means that a country is a net exporter. For

Pakistan the index has remained negative from 1990-91 to 2005-06 (Table 7). It was -0.69 in

1990-91 and became -0.85 in 1999-2000 but later on started declining given the negative growth

in oil consumption in the last five years, but still the index is at -0.79. Despite the slight decline

country is highly susceptible to high oil prices.

Oil Intensity in Energy Consumption:

Vulnerability to rising oil prices also depends on the intensity with which oil is used. The

intensity of oil use in energy consumption index measures the share of oil in an economy's

primary energy consumption. If a country relies only on oil to produce energy, the value of the

index is one; if no oil is used in producing its energy, the value is 0. Oil intensity in Pakistan has

declined over the years (see Table 7) because of switching to alternatives, more specifically gas

and to some extent coal. It can also be observed in Figure 3. This will be discussed in detail in

Section 4.

Energy Intensity:

This variable measure the energy intensity for an entire economy (measured as percentage

change in energy consumption divided by percentage change in GDP). Decrease in energy

intensity is considered as the most promising route for reducing vulnerability to oil shocks

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(Bacon and Kojima 2006). There are number of factors affecting energy intensity including

country's climate, size, level of development, as well as whether it produces and refines oil.

Countries that have colder climate consumes more energy, other things being equal, while

countries with a large oil contribution to GDP are likely to be more energy intensive. It also

varies with income levels. Its decline can be achieved moving away from energy intensive

industries; changing household consumption patterns away from activities which require large

amounts of energy (e.g., using less transportation); and involvement in those production

activities that are more energy efficient, in response to the rising input costs. For Pakistan energy

intensity is almost constant since 1990-91 to 2005-06 (Table 2). It indicates the efficiency with

which the energy is used. And the trend for Pakistan indicates no improvement in efficiency. All

the indicators discussed above are likely to be closely correlated with a country's susceptibility to

oil price shocks. One way to bring this information together is to measure the potential impact of

higher oil price on oil import costs.

Table 2: Oil Dependency in Pakistan

Oil self- Intensity of Energy intensity Net Oil Imports

sufficiency oil of Real GDP in terms of GDP

1990-91 -0.69 0.46 0.91 -3.13

1995-96 -0.82 0.48 1.01 -2.60
1999-00 -0.85 0.47 0.99 -3.76
2000-01 -0.84 0.46 1.05 -4.60
2001-02 -0.82 0.43 1.02 -3.73
2002-03 -0.81 0.41 0.91 -3.71
2003-04 -0.78 0.38 0.93 -3.18
2004-05 -0.79 0.36 0.99 -4.20
2005-06 -0.79 0.32 0.90 -5.24

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Net oil Imports in GDP: The magnitude of the direct effect of a price increase depends on the

share of net oil imports in GDP. In other words, it is an index of the relative importance of the oil

price rise to the economy in terms of the potential adjustments needed to offset it. For net

importers this ratio will be negative. Higher value of this ratio create more concerns for the

government, may be to reduce oil imports and more willingness to pass through the price to

consumer so as to stimulate a reduction in demand12. For Pakistan over the last few years, this

ratio has risen to -5.24 in 2005-06 (Table 2).

An immediate reaction to an oil shock is consumers and producers reduce their demand for oil

either by fuel switching or by switching to other goods or products. As a result import bill will

go down. This is a short term adjustment. In the long run, oil consumption can be reduced

through efficiency and changes in industrial structure and household consumption patterns. A

dynamic policy response will reduce the vulnerability of the economy (Bacon and Kojima 2006).

For Pakistan energy intensity (an indicator of efficiency) as discussed above has remained almost

constant. However, consumption of oil products has declined (may be as a reaction) in the last

few years, an outcome of fuel switching.

2. Macroeconomic Effects

As discussed above, the magnitude of the direct effect of a given price increase depends on the

share of the cost of oil in national income, the degree of dependence on imported oil and the

ability of end-users to reduce their consumption and switch away from oil (IEA 2004).

Unless country is running in surplus, or has extremely large foreign exchange reserves, high oil

price is dealt by a reduction in total demand for all imported goods, so as to restore balance of

payments equilibrium. Higher oil prices leads to inflation, increased input costs, reduced non-oil

demand and lower investment in net oil importing countries. Tax revenue falls and the budget

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deficit increases. It is the reduction in domestic demand (both consumption and investment)

which leads to reduced imports and reduced domestic production. If real wages are sticky

downwards this also results in increased unemployment.

The rate of growth declines in the short term transferring income from oil importing to oil

exporting countries. The fall in final expenditure indicates that the shocks to households and

firms in terms of welfare may be large since the price they pay for imports is much higher and

has to be balanced by lower quantities (Bacon and Kojima 2006, IEA 2004).

This section will examine how the macro economy of Pakistan has behaved (output i.e., GDP,

inflation level, balance of payment and fiscal status) and the capacity of the economy to

withstand the price rise. The simplest estimate available in the literature to calculate the direct

impact of higher oil prices on GDP is based on the ratio of the net imports of oil and oil products

to GDP. If there is a zero price elasticity of demand for oil and oil products then following a rise

in the oil price, GDP will have to change by as much as the change in the value of net imports.

For Pakistan household and industrial demand for energy products such as kerosene and gasoline

is highly inelastic (Burney and Akhtar 1990). To calculate this ratio average values of GDP and

net imports for the period 2001 to 2006, correspond to a base oil price of US$ 28.21 per barrel in

2001, which increase to US$ 65.14 per barrel in 2006, that is, increase of US$ 36.93 per barrel,

equivalent to 130.9 percent increase of the base price. The ratio calculated for Pakistan comes

out to be (-5.47), it indicates the proportional loss in GDP as a result of price increase of US$

36.93 is equivalent to a shock lowering GDP by 5.5 percent.

3. GDP Growth and Oil prices:

At the time oil prices have been rising, Pakistan’s economy has shown a high growth trend (for

the last five years) (Table 3) resulting in a substantial increase in the demand for energy.

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Theoretically, increasing oil prices squeeze income and demand. At a given exchange rate, more

domestic output is needed to pay for the same volume of oil imports. If the domestic currency

depreciates in response to induced payments deficits, this further cuts the purchasing power of

domestic income over imported goods. Since important trading partners are also likely to suffer

income losses, slower growth of external demand aggravates these direct impacts. Higher oil

prices also squeeze aggregate supply, since rising intermediate input costs erode producers’

profits and may cause them to cut back on output. Lower profits may then result in the decline in

investment spending and cause potential output to fall over an expanded period. It is somehow

difficult to identify the factors been responsible for the high growth in Pakistan in the presence of

high oil prices. One reason might be consumers have been shielded by limiting the direct pass

through to final oil prices. The extensive use of fuel subsidies in the form of PDC was helped by

strong foreign reserves position; it may have contained output losses in the past few years.

Table 3: GDP growth in percent

1990-91 1995-96 2000-01 2001-02 2002-03 2003-04 2004-05 2005-06 2006-07

GDP 5.5 4.8 2.6 3.6 5.1 6.4 8.4 6.6 7.0
Source: Estimated using GDP data from IMF database.

In addition, the continued strong performance of the services sector had made contribution to the

GDP outcome. On the demand side it is the consumption expenditure that has proved to be the

main source of growth in GDP for the last couple of years, here credit flow to private sector in

the form of consumer financing played a significant role15. But since 2006-07 situation has

somewhat started changing. Private credit is showing a downward trend16 (Table 4), which may

effect GDP growth. Private sector consumed Rs. 23.533 billion from July 1st to Oct 20th,

2007against Rs. 69.870 billion in the corresponding period last year. Credit to small and medium

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enterprises is also on the decline given high interest rates and undocumented trade (Khan 2008).

With this scenario it would be difficult to maintain the high growth pattern.

High price of oil in the international market, and declining volumes of exports along with private

transfers in 2006-07 resulted in the current account deficit equal to 4.9 percent of GDP (US$ 7

billion), one percentage point higher than in 2005-06 (Table 11).

Table 4: Private Credit (annual percentage change)

2000-01 2001-02 2002-03 2003-04 2004-05 2005-06 2006-07

Private Credit 4.8 18.9 29.8 33.2 23.2 17.2
Source: IMF 2006, 2008

Large scale manufacturing has missed the growth targets in the last two years. In this year, high

oil prices, gas and electricity crisis, high cost of production, declining trend in private credit and

high interest rates because of monetary tightening, would not favour industrial growth at all.

The government has consumed its budgetary target of bank borrowing (Rs. 130 billion) by

January 2008, further borrowing from banking or non-banking sources may destabilize the

financial health (Khan 2008). It is estimated that utilization of PSDP would remain significantly

lower than allocated Rs. 520 billion.

Rapidly growing economies will generally experience more rapid growth of non-oil taxation, and

hence be better able to withstand the fiscal impacts of a less than fully passing on of oil price

increase. In Pakistan, non-oil taxation is more or less the same for the last few years.

4. Balance of Payment Effect:

Our petroleum imports account for 24 percent of total imports (and represented up to 44 percent

of export earnings) in 2006-07. While, in 1999-2000 the share of petroleum imports was 27

percent of total imports and accounts for 33 percent of total export earnings. Improving terms of

trade would mean that a smaller volume of exports would be needed to pay for a given quantity

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of imports. For Pakistan this ratio however is decreasing, that is more exports are needed to

offset the burden of rising import bill.

Table 5: Performance of External Sector

2000- 2001- 2002- 2003- 2004- 2005- 2006-

01 02 03 04 05 06 07*
Terms of Trade (1990-91=100) 90.96 90.83 82.07 78.68 73.60 65.01 ----
Exports in US$ (growth rate) --- 2.3 20.1 13.5 16.2 14.3 3.2
Imports in US$ (growth rate) --- -7.5 20.1 21.2 38.3 31.7 8.0
Current Account including official --- 3.9 4.9 1.8 -1.4 -3.9 -4.9
Source: IMF 2008 * estimated
current
ADB (2005) has estimated the impact of high oil prices on the net import bill. By assuming 75%

rise in oil prices (approximately the increase in prices between the start of 2005 and end August),

the estimated impact on the net import bill for Pakistan is almost -4.17. Similarly, the percentage

point growth in exports that would be needed to pay for a 75% rise in the cost of imported oil is

potentially very large (i.e., 18 %) 21. This estimate is for the 75 % increase in oil prices but in

actual the prices have risen more than 100%. It means the required rate for exports growth is

much higher than this. The trend in the growth of exports can be observed in Table 5. It was only

in 2002-03, where exports growth has crossed 18 %. However, imports overall have grown quite

significantly. The government has failed to improve the export performance. However,

significant increase in imports has laid a negative impact on trade deficit. Pakistan's trade deficit

has swelled to $7.2 billion, an increase of 32.38 percent in the period July-November (2007-08)

as compared to $5.44 billion in the corresponding period last year. It is the third consecutive year

that the country is missing its export target. Trade deficit is expected to reach $9-10 billion by

the end of this fiscal year.

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Imports of petroleum group in fiscal year 2006-07 registered an increase of 12.0 percent. Within

the petroleum group, imports of petroleum products registered sharp increase of 38.6 percent

(substantial increase in furnace oil import, largely for electricity generation purpose). However,

imports of crude petroleum declined by 6.7 percent (in value terms and 10 percent in quantity

terms) because refineries operate less than their full capacity. Thus, low demand for crude oil

and so was the production of petroleum products. Current account deficit has also gone up quite

significantly (Table 5). In the current fiscal year (2007-08), from July to November, current

account deficit increased by 17 percent (US$ 4.784 billion). In the same period of 2006-07, it

was US$ 4.077 billion (IMF 2008).

In Pakistan, in the last few years, external financial sector (that is, remittances, US aid, and

foreign inflows from FDI) has shown a solid performance23. It has helped the government in the

maintenance of the fiscal situation. However, this is only a short term solution. The government

has extensively utilized this facility but has not made substantial efforts to explore other options

to reduce trade deficit or explore areas that would have decreased its fiscal burden. Because of

this fiscal deficit has also started increasing.

5. Fiscal Impact

Fuel taxes have important revenue implications for Pakistan. Oil and gas sector together accounts

for a significant share of government revenues. Taxes on Petroleum products are the largest

source of indirect revenues in Pakistan. Petroleum product prices are higher than the import

parity price because of these taxes. Petroleum products contributed Rs.120 billion to government

revenues in the form of indirect taxes (custom duty, excise taxes and sales tax) in 2006-07. It is

23.2 percent of total indirect taxes (net) 24 collected in 2006-07, while this share was only 12

percent in 2000-01. Petroleum development levy (PDL) is not included in this total. Petroleum

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development levies collected in 2005-06 were Rs 24500 million25. Adding this will make total

indirect tax revenue from petroleum products to Rs. 129.6 billion for the year 2005-06 (that is

26.6 % of total indirect taxes). The share of PDL in petroleum taxes is almost 18.9 for 2005-06.

For the fiscal year 2006-07 exact figure is not available. However, the estimated sum of

development surcharge in both gas and petroleum sector is Rs. 74 billion as compared to Rs. 54

billion last year, 2006-07 (IMF Report 2008). The taxing of fuel is one of the easiest and

relatively straight forward way to raise revenue, as consumption of petroleum products is

relatively price inelastic and income elastic, ensuring buoyant revenue as income rises and tax

rates are increased

Table 6: Petroleum Taxes (in Billion Rs.)

1999-00 2000-01 2004-05 2005-06 2006-07

Custom, Excise and Sales Tax 10.7 15.2 67.1 105.1 120
Petroleum Development Surcharge 25.4 17.9 10.6 24.5 ----

As mentioned earlier, the government has used petroleum development levy to keep the end user

price constant, given the fluctuations in the international price of oil. Even when there are price

reductions in the international market, government does not transfer it to the consumer for

domestic budgetary support and increase the PDL. Revenue from the petroleum levy almost

doubled in the first half of FY2006, as the increase in domestic prices of petroleum products put

through in September and October 2005 was not reversed when global oil prices declined in

November and December. But now due to price capping, the trend in

PDL is in the downward direction, it will have a negative effect on the share of petroleum taxes.

As far as the overall fiscal deficit relative to GDP is concerned, theoretically, smaller the deficit

(or in surplus) government might not pass the whole international oil price increase at the retail

level, as government would be in a better position to survive the fiscal implication of doing so.

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Considerable efforts have been made over the last seven years to maintain financial discipline by

pursuing a sound fiscal policy. Pakistan has succeeded in reducing fiscal deficit from an average

of 7 percent of GDP in the decades of 1980s and 1990s to an average of 3.5 percent during the

last seven years. However, the fiscal deficit although declined to only -2 percent in 2003-04 but

since then it is rising and has reached to -4.3 percent in 2005-06 and 2006-07 as well (Table 6). It

is expected to rise even further in 2007-08. There are apprehensions that the government may not

be able to keep the fiscal deficit within the projected limits because of freezing domestic oil and

electricity prices besides slow growth in revenue. The country would be facing huge budget

deficit of over Rs. 535 billion in FY 2008. It is estimated that if the rising oil prices are not

transferred to consumers, the government will have to bear an additional burden of Rs. 136

billion which will shoot the budget deficit to 5.4 percent of GDP (Khan 2008). The high ratio of

tax revenue to GDP is needed to reduce fiscal deficit. For Pakistan, revenue GDP ratio is shown

in Table 7, not very encouraging.

Table 7: Revenue (including grants) and Fiscal Surplus/Deficit as a percent of GDP

2000-01 2001-02 2002-03 2003-04 2004-05 2005-06 2006-07*

Revenue 16.1 17.2 14.6 14.1 14.8 15.2
Surplus -4.34 -4.52 -4.10 -2.1 -4.17 -4.31 -4.3
Source: IMF 2006, 2008 * Estimated

So is the case in Pakistan, in the light of rising fiscal burden government in the current fiscal year

has also decided to slash the PSDP (public sector development programme) for the remaining

five months of FY2007-08 by Rs. 70 billion. According to Ministry of Finance, oil prices have

remained unchanged for the last 13 months, and government was finding it difficult to pay Rs. 14

billion every month in oil subsidy.

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6. Impact on Exports and Imports

Exports have increased by only 72% since 2002‐03, whereas imports have increased by 227%.

This widening gap has caused the current account to persistently report a deficit, which is

growing at alarming levels. By the end of 2007‐08, total imports stood at around $40 billion;

more than twice that of exports. The acceleration seen in imports is largely being driven by the

surge in international oil prices and the fact that Pakistan is heavily dependent on oil imports.

This is further substantiated by the graph, which shows that the oil import bill constitutes over

35% of the total import value during the last quarter of 2007‐8 compared to 25% in the preceding

quarter. This share has increased drastically when compared to the share of 15% in early 2003‐

04. This, along with pressure from increased food prices has constantly come at a cost of

shrinking shares on other items such as Machinery and Agricultural & Other chemicals.

Source: SBP

This certainly has had a negative impact not only on the BOP but also poses as a threat to the

level of industrialization and technological improvements to the manufacturing sector which then
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translates into deteriorating exports. Imports of textile machinery have witnessed a negative

growth rate of 17% and 36 % during 2005‐06 and 2006‐07, respectively. Similarly, large‐scale

manufacturing growth too has experienced a slump with recording only 4.8% growth during

2007‐08 as opposed to 8.6% during 2006‐07.

Fiscal imbalances have also been created by GoP’s continued policy of providing subsidy on oil

products to protect poor households and the domestic industry. The burden of subsidies in face of

ever increasing international prices rise, along with the depreciation of the rupee against the

dollar and the debt service burden is adding to the pressure on government budgets and

increasing political and social tensions.

6. Forecast for the Years Ahead

According to statistics provided by the US Energy Information Administration (EIA), the downward trend

in prices of crude oil and diesel is expected to continue in 2009 and 2010 due to low demand, weak

economy, and failed attempts by the Organization of Petroleum Exporting Countries (OPEC) to trim

production in order to support substantially higher prices. While oil consumption is expected to

continue to decline in 2009, increasing oil production capacity in OPEC and non-OPEC nations will lead to

surplus production. The imbalance caused by excess supply and reduced demand will be detriment to

the desired upward pressure on prices.

Projected Price Trends

Crude oil prices are expected to average $43 per barrel in 2009 and $55 per barrel in 2010. The

price of diesel fuel, which averaged $2.45 per gallon in December 2008, is projected to average

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$2.27 in 2009. Price trends will be largely dictated by the duration and depth of the worldwide

economic downturn, the timing and pace of recovery, and actual production by OPEC refineries. 

Projected Consumption Trends

Global consumption of diesel is expected to drop by 800,000 bpd in 2009 followed by a modest

rebound in 2010 by 880,000 bpd from the previous year’s levels. Oil consumption is expected to

increase in countries that are not members of the Organization for Economic Cooperation and

Development, namely China, the Middle East and Latin America. However, decline in

consumption in OECD countries is likely to offset any increase registered by non-OECD nations.

The US consumed 65 billion gallons of diesel in 2007. In 2008, consumption of petroleum

products in the US fell by about 1.2 million bpd. This trend is expected to continue in 2009 with

consumption levels expected to fall by an additional 400,000 bpd. The expected economic

recovery in 2010 is likely to boost consumption of petroleum products marginally by 150,000

bpd.

Projected Supply Trends

Supply of crude oil and diesel from non-OPEC nations fell by 340,000 bpd in 2008 due to delays

and disruption of projects in the Gulf of Mexico and Central Asia. Non-OPEC supply of crude

oil is expected to increase by 180,000 bpd in 2009 and by an additional 90,000 bpd in 2010.

However, there is a lot of uncertainty pertaining to increase in supply from non-OPEC nations

since these regions face a far greater risk than OPEC nations from unexpected project delays and

the credit crunch prevalent in the market, which could render high-cost projects unviable. The

good news is that supply from nations such as the US, Azerbaijan and Brazil is more than likely

to compensate for decline in production in non-OPEC nations.

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In 2008, the US produced an average of 4.9 million bpd of domestic crude oil, a decline from the

2007 production levels by 140,000 bpd. Domestic production is likely to increase in 2009 by

over 300,000 bpd to an average of 5.25 million bpd, marking the first significant increase in

production in the country since 1991. Output is further expected to increase by 50,000 bpd in

2010 with new refineries slated to go on stream by late 2009.

It is expected that until 2010, refineries will continue to see a drop in margins due to continued

decline in the consumption of diesel and other products in the US and other parts of the world. A

lot is dependent on the rate of recovery of world economies. The faster the recovery of global

economies, the lesser would be the decline in consumption of oil and derived products such as

diesel.   While all of this information should shed some light on how prices are determined, and

possible trends in the future, nobody can truly be certain what the future holds as far as oil or

diesel fuel prices are concerned.  The only thing we can be certain of is that like most economic

cycles, it will surely continue to go up and down, to what extent or extremes, we’ll just have to

wait and see.

7. Recommendations
For long run development oil will remain an important source of energy. What is required is to

make rational choices about the development of energy mix for the future.

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The government should chalk out strategies for ensuring efficiency in use and development,

adequacy and reliability of supply, and measures to alleviate environmental impacts.

For Investor’s confidence in all energy sectors a predictable and transparent framework is

essential. Since better investor climate will in turn increase supply and help stabilize prices.

Within the framework of a national energy policy, a number of specific measures to promote

energy efficiency and diversity will help in reducing vulnerability to high oil prices (Asian

Development Bank 2005).

About 28% of total commercial energy is imported in Pakistan and the dependence on imported

fuels is expected to increase even further in future given the depleting gas resources.

The continuously rising trend in the oil prices in the international market will have a negative

impact on Pakistan’s foreign reserves.

Following are the recommendations to control the prices of fuel from further increasing.

1. Pakistan needs to explore the vast potential of its indigenous energy resources, much of

which has remained unexploited, especially that of coal.

2. The government must diversify the country’s energy supply mix to reduce the risk of oil

price fluctuations in the global energy market.

3. In Pakistan, liquid fluids are primarily used in the transport sector and power sector.

There is a need to improve efficiency in the use of petroleum products in these sectors.

4. There is also a need for increasing the reliance on coal given the domestic availability of

huge amount of coal resources.

5. The easiest form of substitution is in new plants required to meet incremental demand,

where the choice of the economic fuel can be made without allowing for the advantages

of sunk costs of installed plant.

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6. In addition transport policy can play a major role in influencing future oil dependency

and energy efficiency.

7. Decision about investments in road and rail infrastructure, urban transportation systems,

vehicle taxation, and user costs will all exert an important structural influence on demand

for and dependence on oil [Asian Development Bank (2005)].

8. The development of competitive markets in oil and other energy products is important.

Involvement of private sector to participate in the oil and energy sector is likely to be

beneficial but require an independent regulatory mechanism.

9. Energy conservation programs should be applied.

10. There is a need to seriously promote efficiency improvement or demand management. So

far this seems to be a loss opportunity for Pakistan.

11. At the macro level, government policy cannot completely eliminate the adverse impacts

of high oil prices but appropriate policy response can minimize it.

12. "Overly contractionary monetary and fiscal policies to contain inflationary pressures

could exacerbate the recessionary income and unemployment effects. On the other hand,

13. expansionary monetary and fiscal policies may simply delay the fall in real income

necessitated by the increase in oil prices, stoke up inflationary pressures and worsen the

impact of higher prices in the long run" (IEA 2004)

14. There is also a need to rationalize taxation/levies on petroleum products to help reduce

the unbalance in the pattern of consumption. It may result in predictable government

revenues and balanced consumption of petroleum products. And may also help in the

reduction of those products for which we have to rely largely on imports.

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15. In addition, since Pakistan is on the high growth path therefore, there is also a need to

focus more on non-energy taxes.

16. For the improvement of balance of payment, Pakistan should made serious efforts to

boost its exports to counter high oil payments.

17. There is a need for an autonomous regulatory authority to enable and control any possible

monopolistic and collusive behavior in the oil industry, to promote competition in all

segments of the oil industry, and to check any irregularities.

Conclusion
Oil prices and its fluctuations continue to pose as a consequential macroeconomic concern for

both developed and developing countries. For oil importing countries like Pakistan the impact of

irregular and unexpected price hikes quickly seeps into the domestic economy, threatening the

already existing macroeconomic imbalances. Oil price hikes are aggravating the energy shortage

in Pakistan which is now feeding into increased general prices, transportation cost, slowing down

agricultural and industrial productivity and aggravated water shortages for the rural economy.

This is having an enormous financial impact on our competitiveness in the external sector,

creating record trade and BOP gaps and depleting our foreign exchange reserves. In order to

move towards attaining fiscal stability and sustainability, the need for tilting away from heavy

reliance on oil imports towards alternative energy and fuel options now becomes increasingly

important.

References

http://www.pide.org.pk/psde24/pdf/01.pdf

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http://www.pide.org.pk/pdf/PDR/2007/Volume4/551-575.pdf

http://www.pide.org.pk/psde23/pdf/Afia%20Malik.pdf

http://docs.google.com/viewer?a=v&q=cache:-u-

dbMnvx7gJ:www.sbp.org.pk/departments/ihfd/OilPriceAnalysis-30-Aug-

08.pdf+fuel+trends+in+pakistan&hl=en&pid=bl&srcid=ADGEESj_BPo-

Rz9xvbUzg2eiS_xIv2zt1sCryIFaZ_SSahNhSKbOi0SyZZOA2RLOvGGbniqj1Ixka4vwjzcqYcp

FQ4skBrV6qgPgM-

SSnPpJ9GB_3rWfKeCqJp6CEjOG90LvhAxqKszN&sig=AHIEtbRweYW0PMWj6C4uiyyKB1

DDV-t7yA

http://www.dieselserviceandsupply.com/Diesel_Fuel_Prices.aspx

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