M'SIAN OIL SUBSIDY: THE FACTS WE CANT SIMPLY IGNORE. THE REALITY WE CANT SIMPLY ESCAPE

UNIT PERANCANG EKONOMI (EPU) DAN MAJLIS TINDAKAN EKONOMI NEGARA (MTEN) (Terbitan Julai 31, 2005)

OIL PRICES AND SUBSIDIES – THE EXPLANATION

(Note: click on the table chart to view in larger size)

1. Why has the price of fuel on the international market increased recently?

• Since mid-2004, the price of crude oil has increased substantially on the world market. For example, the West Texas Intermediate (a reference price used in the United States and globally) increased from US$19 per barrel in 1993 to US$31 in 2003. In October 2004, it reached US$51 and in 2005 it went up to US$67 per barrel.

• The main causes for these increases are:

- The existence of a tight market due to the small margin between production (83.0 million barrels per day (bpd)) and demand (82.5 million bpd);

- High demand for oil by China, India and the United States;

- Uncertainty of supply in some OPEC (Organization of Petroleum Exporting Countries) countries.

- Adverse weather conditions such as Hurricane Emily in Mexico, affecting oil production and

- Speculation on oil prices.

2. Our country produces oil. So why should we increase fuel prices?

• The price of oil and petroleum products are determined by the international market based on supply and demand. These are factors beyond our control. OPEC also plays an important role in setting oil production levels which in turn, affect the market price. Although Malaysia produces and exports oil, we are not a member of OPEC, nor are we a major oil producing country. As such we have no influence on how the price of oil is determined in the international market.

• If there is a large increase in oil prices on the world market, it affects the price of petroleum products such as diesel, petrol and cooking gas (LPG) in our country.

3. How do Malaysian fuel prices compare to neighbouring countries?

• By comparison, fuel in Malaysia is much cheaper than most ASEAN countries. In fact, our prices are among the lowest in the world.

• Due to the much lower prices of diesel in Malaysia compared to Thailand and Singapore, there is a big incentive for Thais and Singaporeans to buy petrol and diesel in our country.

4. How does the Government ensure fuel prices are cheaper compared to neighbouring countries?

• The Government ensures a low price of petrol, diesel and cooking gas in Malaysia by exempting sales tax on diesel and petrol and providing subsidies for all products.

• With the combination of subsidies and taxes forgone, the public can enjoy more affordable public transport. Subsidies also lower operating costs for fishermen and operators of river transportation in Sabah and Sarawak.

5. How are the retail prices of petroleum products in Malaysia determined?

• The mechanism for setting retail prices of petroleum products has been in effect since 1983.

• In brief, the retail prices of petrol, diesel and LPG are set as follows:

Petroleum Products Cost
+ Operational Costs
+ Margin for Distributors of Petroleum Products
+ Commission for Owners of Petrol Stations
+ Sales Tax
- Subsidies
= Retail Price

• The price mechanism is linked to international market prices. The actual product price is determined after taking into consideration prevailing international prices, operating costs such as distribution and marketing costs and finally, sales taxes. In Malaysia, fuel is sold much cheaper than other countries because the Government provides subsidies and sales tax exemptions.

• For example, the retail price of RON97 petrol on 31 July 2005 is as follows:

6. What are subsidies?

• Subsidies are money paid to producers or retailers of a given product by the Government, in order to lower the retail price. It is a form of assistance for a given industry or segment of society.

7. How long will subsidies be maintained? Should they be abolished?

• The Government will continue to provide fuel subsidies but the amount would be determined by the state of Government finances.

• The Government is devising a more effective method to ensure that fuels like diesel and LPG are enjoyed by those truly requiring it such as fishermen, public transport operators and operators of river transportation in Sabah and Sarawak.

8. What are ‘taxes forgone’?

• Diesel and petrol are subject to sales taxes of 19.64 sen per litre and 58.62 sen per litre respectively. These taxes are revenue for the Government in addition to being a means of maintaining stable petroleum product prices. But the Government has decided to forgo this tax so that the retail price of petroleum products remains reasonable. This actually results in a loss of revenue for the Government.

• Recently, the amount of taxes forgone has increased. For example, in 1993, RM190.8 million was forgone, while in 1999 it amounted to RM2.6 billion. This year, it has rocketed to RM7.9 billion. Sales tax exemptions for diesel began in October 1999 following increasing prices, while for petrol it began in June 2004.

9. What are the negative effects of subsidies?

• One of the adverse effects of subsidies is market distortion, meaning the price of the commodity does not reflect its actual cost. This jeopardizes the national economy as it would lead to excessive fuel consumption and wastage in addition to unhealthy practices such as illicit trade, cheating and smuggling. The Government cannot permit the gap between market and subsidized prices to increase as this could encourage profiteering. Today, irresponsible parties make illegal profits by purchasing diesel at subsidized prices and selling it at higher prices to the non-subsidised sector.

• Another outcome from heavy subsidies is the smuggling of fuel, particularly diesel, to neighbouring countries. This is akin to giving foreigners the subsidies intended for Malaysians. Our country suffers a great loss. Based on projected subsidies of RM6.6 billion for 2005, smuggling 10 percent of fuel out of Malaysia would be equivalent to an outflow of RM660 million.

• The Government also has to spend more for enforcement personnel and equipment in order to arrest smuggling activities.

• Also, huge subsidies are ‘opportunity costs’ which prevent us from allocating more to national development to benefit a larger segment of our population. Savings from subsidies could be used to build more schools, hospitals and public facilities which would provide long lasting benefits for our future generations.

• Today, both the rich and the poor benefit from subsidies which are actually meant for the latter.

• Subsidies also jeopardize the ability of the Government to reduce the budget deficit.

10. How much would fuel and petroleum products cost without subsidies?

• Without subsidies, premium petrol (RON97) would cost RM2.45 per litre, and not RM1.62 that we are paying now. In fact when a consumer buys a litre of premium petrol in Peninsular Malaysia, the Government bears 82.82 sen that is 58.62 sen in the form of taxes forgone and 24.20 sen in subsidies.

• The actual cost of diesel in Peninsular Malaysia is RM2.07 per litre. Consumers pay RM1.28 per litre because of the 59.13 sen subsidy and 19.64 sen tax forgone, per litre.

• The unsubsidized retail price of cooking gas (LPG) in Peninsular Malaysia is RM2.39 per kg. However, consumers buy LPG at RM1.45 per kg. This means that there is a subsidy of 93.92 sen per kg. For example, a 12 kg cylinder of cooking gas costs RM17.40 when in fact, the actual cost is RM28.67. In other words, for each cylinder of cooking gas purchased, the Government subsidizes the consumer RM11.27.

11. How much does the Government spend on fuel subsidies?

• The more fuel consumers use, the higher the amount borne by the Government for subsidies.

• As illustrated in Table 5, subsidies in 2001 were RM2.4 billion based on an average WTI crude oil price of US$25.24 per barrel. In 2004, the subsidies increased to RM4.8 billion based on the average international oil price of US$41.60 per barrel.

• This does not factor the loss of revenue from taxes which has also been increasing. Losses in 2002 of RM3.3 billion rose to RM4.8 billion in 2003 and reached RM7.2 billion in 2004.

• By increasing the retail prices of diesel and petrol on July 31 2005, the Government will save RM1 billion on subsidies. For 2005 subsidies are now expected to be RM6.6 billion compared to RM7.6 billion before the price increase (2004 subsidies totalled RM4.8 billion), as illustrated in Table 5.

• Large subsidies are ‘opportunity costs’ as the substantial amount of money could be better used to benefit the rakyat, for example, by building schools or public amenities.

12. The Country benefits from increased oil prices. Why can’t the Government increase its subsidies?

• When oil prices rise, the Government’s revenue increases accordingly. However, subsidies borne by the Government also increase from RM4.8 billion in 2004 to a projected RM6.6 billion in 2005.

• It is true that as oil prices on the global market increase, the country’s export earnings from oil goes up. However, the Government chooses to spend this additional income responsibly. It would be unwise of the Government to utilize the additional income earned to fully subsidize fuel prices.

• We must remember that gains from the increase in oil prices will only benefit us in the short term. In the medium term, subsequent increases in oil prices will adversely impact the world economy and being an open economy Malaysian exports would reduce and consequently national income contracts. As such, in the medium term an increase in oil prices does not benefit us.

• Furthermore, we still have to import to meet some of our domestic oil needs. While it is true that we gain from exports of oil at higher prices, we still have to pay more for the oil that we import.

13. What is the impact of subsidies on Government finances?

• Subsidies and tax exemptions impact Government finances in five ways:

- First, it results in an increase of the operating expenditure. Subsidies of RM6.6 billion in 2005 represent 7.4 percent of operating expenditure. Without subsidies, the fiscal deficit could be reduced.

- Second, if the savings are not used to reduce the deficit, it could instead be utilized for development. RM6.6 billion spent on subsidies represents 23.3 percent of the 2005 development budget, which is equivalent to building 600 secondary schools assuming it costs RM11 million to build one school.

- Third, tax revenue forgone represents a loss in revenue for Government. Sales tax revenue forgone of RM7.9 billion in 2005 represents 8 percent of revenue. If collected, this money could be used to build 316,000 low cost houses.

- Fourth, subsidies and sales tax forgone amounting to RM14.5 billion is sufficient to reduce the fiscal deficit from 3.8% of GDP to 0.7% of GDP for 2005. This would in turn strengthen the Government’s financial position.

- Fifth, a small deficit means that the Government can reduce its borrowings.

14. Should the Government use up contributions by PETRONAS to pay for subsidies?

• In fact, contributions by PETRONAS are sufficient to fully cover fuel subsidies.

• However, spending on subsidies are one-off expenditures which do not generate further income for the nation and its people. Although the Government could fund increased subsidies, it would not be the most prudent course of action as it would adversely affect funding for other productive projects.

• If the rakyat and Government can share the cost of rising fuel prices, thus reducing the need for subsidies, a part of the contributions from PETRONAS can instead be directed to generate new sources of income.

15. PETRONAS profits have increased due to rising oil prices. Shouldn’t PETRONAS contribute more to absorb the cost of rising fuel prices?

• Since its establishment in 1974 PETRONAS has made significant contributions to the nation’s development. During the financial year 2004/2005 it contributed RM31 billion in the form of taxes, dividends and royalties. This was an increase of 47% over the previous year’s contribution. This amount represents 53% of PETRONAS’ gross profits of RM59 billion for the year 2004/2005.

• PETRONAS only controls 30% of the Malaysia retail petroleum market while the remainder is held by competitors like Shell, Esso, Caltex, BP, Mobil and Projet. This means that if PETRONAS were to subsidise fuel prices in full, it would effectively be paying these foreign companies too.

• In Malaysia, PETRONAS owns 3 refineries with a combined capacity of 256,000 barrels per day (bpd), or 47% of the total national output. The remaining 53% is provided by refineries owned by Shell (155,000 bpd), Exxon-Mobil (88,000 bpd) and ConocoPhillips (48,000 bpd). As Malaysia consumes 520,000 barrels of oil per day, it is obvious that in order to meet this demand we need to rely on refineries belonging to international oil companies too.

• PETRONAS also subsidizes natural gas in this country. This subsidy amounted to RM25 billion since May 1997. For the power sector, the price of gas is fixed at RM6.40 per Million British Thermal Unit (mmbtu) compared to the commercial price of RM25.70 per mmbtu. This low price has enabled Malaysia to maintain electricity tariffs at reasonable levels.

16. What would happen if PETRONAS were to use all its profits to provide subsidies?

• PETRONAS is a business entity with domestic and international operations. If a substantial portion of its profits were used to provide subsidies it might be perceived as an irresponsible company, thus affecting its credibility. This could result in it being downgraded by international rating agencies.

• PETRONAS’ primary role is to manage and preserve our country’s oil and gas resources. In order to achieve this, profits must be reinvested into exploration activities both domestically and internationally. In addition, profits should also be spent on research and development.

• In the financial year 2004/2005 PETRONAS spent 61% of its total investments, or RM10.7 billion in exploration activities. If there are no new oil discoveries, Malaysia will become a net importer of oil by 2009.

• Such investments in exploration have resulted in annual increases of oil reserves by 2 – 3% annually. Clearly, this would not be possible if PETRONAS uses all its profits for subsidies.

17. What options are open to the Government in addressing the increase in oil prices?

• The Government has three options:

- To maintain the retail price of petroleum despite rising international market prices.

This would require the Government to increase subsidies and taxes forgone to match the rise in product cost, resulting in an even larger gap between subsidised and market prices of fuel. This would result in less money available for development and would impose severe strains on the Government’s financial position; or

- To completely remove subsidies and reimpose sales taxes; thus allowing fuel prices to be determined solely by market forces. If this is done, there will be no disparity between retail prices in Malaysia and world market prices. This option would allow the Government to use savings from subsidies to fund development. However, consumers would have to bear the full brunt of price increases and the Government might be perceived as being insensitive to their needs; or finally

- To gradually reduce subsidies; as has been done in recent months. This middle path involves the sharing of burden between the Government and consumer. In this option consumers pay slightly more for fuel while the
Government continues to provide subsidies. By increasing prices gradually, consumers will be able to adjust their expenditure accordingly.

• The Government is of the view that the gap between domestic retail and world prices should be reduced gradually. From the three options listed above, the third is the best. The Government will continue to provide subsidies while the consumer contributes by sharing some of the burden.

18. What steps are the Government taking to encourage the use of alternative energy sources?

• The Government is encouraging the use of natural gas vehicles (NGV). Incentives include:

o A discount of 50% for road tax of monogas vehicles and 25% for bi-fuel (diesel) and dual-fuel (petrol) vehicles; and

o Fixing the price of NGV at about half that of petrol pump prices.

• The Government is also encouraging the use of renewable energy under the Small Renewable Energy Programme (SREP), for the generation of electricity under 10 MW using biomass, landfill gas and mini-hydro.

• Hydroelectric power is being developed in Bakun which has a capacity of 2,400 MW. This project is due for completion in 2010.

• The Government intends to introduce the use of green fuels such as biodiesel, using palm oil.

19. As consumers, what role can the rakyat play?

• Following oil price increases certain traders may take the opportunity to profiteer. As such, the rakyat must be prudent and smart in their spending.

• It is also good practice for shoppers and customers to compare prices and the quality of goods between shops prior to making purchases. Such buying habits will contribute directly to improved family finances.

• Through prudent planning and spending, consumers will also prevent wastage.

• The transportation sector constitutes 41% of energy consumption. With prior planning of trips, car pooling and the use of public transport, the expenditure on fuel could be reduced.

20. What measures need to be taken by the rakyat?

• The rakyat should realize that Malaysia could be completely without oil in 19 years. Therefore, we must be prudent in our use of oil resources. We must find ways to reduce our dependency on oil and should be prudent in its use and avoid wastage. We should consider using alternative energy sources such as biofuel.

• Some countries have already implemented radical energy conservation measures. Malaysians have to be prudent in their consumption of energy and should support the Government’s actions in energy efficiency and saving measures.

• The Government will go down hard on irresponsible traders who profiteer from the current situation. Consumers can play a crucial role by reporting unethical practices by traders to the relevant authorities. Traders and businessmen on their part must be responsible and not exploit the public by raising the price of goods and services indiscriminately.