Domestic Demand for Petroleum in OPEC Countries

Transcription

1 Tufts University From the SelectedWorks of Ujjayant Chakravorty 2000 Domestic Demand for Petroleum in OPEC Countries Ujjayant N Chakravorty, Tufts University Fereidun Fesharaki Shuoying Zhou Available at:

2 Domestic demand for petroleum in OPEC countries Ujjayant Chakravorty, Fereidun Fesharaki and Shuoying Zhou Abstract The literature on OPEC energy policy has focused primarily on its production and export potential. The rapidly increasing domestic demand for petroleum products in OPEC countries has often been ignored. This study estimates domestic demand for petroleum products by the major OPEC economies and forecasts consumption trends under alternative assumptions regarding economic growth and price deregulation. It concludes that product demand is generally price and income inelastic and thus domestic consumption in OPEC will continue to grow rapidly, even if domestic prices are raised closer to world levels in the near future. March Organization of the Petroleum Exporting Countries 23

3 Ujjayant Chakravorty is Associate Professor of Economics at Emory University, Atlanta, and Adjunct Research Fellow at the East-West Centre, Honolulu, USA. Fereidun Fesharaki and Shuoying Zhou are respectively Senior Fellow and Research Intern at the East-West Centre Organization of the Petroleum Exporting Countries OPEC Review

4 T HE ORGANIZATION OF the Petroleum Exporting Countries (OPEC) has traditionally been considered as an Organization primarily involved in exporting petroleum products. This impression, however, has changed somewhat in the past few decades, due to the increasing domestic consumption of petroleum products by OPEC nations. With the continued economic development of the OPEC nations, this trend is expected to intensify in the near future. Rapid increases in domestic consumption in OPEC economies will have a significant effect on the availability of oil exports from the Organization, because, with rapid increases in the domestic demand for oil, the volume of exportable petroleum products may be restricted. The problem of how many barrels per day (b/d) of OPEC oil demand must be subtracted from future supplies has become an important issue for oil importers, especially in the Asia-Pacific region, which is expected to become increasingly dependent on OPEC exports in the new millenium. The rapid increase in commercial energy consumption by these countries, especially in petroleum products, is the result of robust economic growth, coupled with extremely low domestic prices. For example, in 1993, the prices of gasoline, kerosene, fuel oil and other petroleum products in the Islamic Republic of Iran were all around one per cent of the average European retail prices and, in the case of gas oil, only 0.34 per cent. In 1995, the domestic prices of petroleum products in Venezuela were, on average, only a quarter of their export prices. In many OPEC countries, the liberalization of energy markets has yet to take effect and nominal prices of petroleum products usually remain constant for many years before a new price is implemented. For example, in Iran, domestic product prices changed very little after 1960, until they were doubled in 1995 (Salehi-Isfahani, 1996). Iran still has some of the world s lowest oil prices. If inflation is factored in, real prices have actually declined over this period, when nominal prices were constant. At the same time, natural increases in population and the use of automobiles have pushed up the consumption of oil and energy products. The future impact of continued growth in domestic demand has caused concern among oil industry analysts. One comprehensive study of refinery balances and product flows in the Middle East region concludes that the shrinking export base and growing demand in the region suggests that the major issue for the next ten years in the Middle East is not export capabilities, but simply meeting domestic demands (FACTS/ SRTC, 1995). A surge in domestic demand for middle distillates, such as gasoline, is forcing many traditional importers of OPEC output, especially in the Asia-Pacific region, to seek supplies from alternative sources. The OPEC economies are also highly vulnerable to fluctuations in the world petroleum product market. As international oil prices declined and stabilized after the second oil crisis in , OPEC countries suffered a decrease in real national income, due to a decrease in petroleum product prices. Political factors have also played an important role in the evolution of the Middle East energy economy. The Iran-Iraq War and the Gulf War, as well as the United Nations embargo on Iraq, have all had significant negative effects on the OPEC countries involved, and a sharp downturn in March Organization of the Petroleum Exporting Countries 25

5 these countries GDP has been observed. Although oil prices rose sharply during the second half of 1999, a sudden downturn in the near future could again lead to serious current account deficits in the OPEC economies. Several authors have studied trends in OPEC domestic consumption, given its critical importance for the world oil market. However, most of these studies have estimated aggregate energy consumption for OPEC as a whole, as opposed to a country-by-country analysis. The former approach is somewhat limited, because it does not take into account major differences within the OPEC national economies. The diversity in economic development and consumption trends among OPEC countries and major variations in energy policy and the regulatory environment suggest the need to examine OPEC energy consumption at a disaggregated level and not as a homogeneous unit. Totto and Johnson (1982) attempted to correct for this problem by analyzing the consumption of four petroleum products for Ecuador, Indonesia, Iran, Saudi Arabia and Venezuela, countries for which reliable data were available at the time. They used three sets of dummy variables in a pooled sample for the period and found that a log-linear model was superior to semi-log and linear models. Their study, however, included only limited data and only a few countries the estimated demand equations were adapted to the remaining OPEC countries, using standard statistical techniques. Too many dummy variables unnecessarily complicated their model. Al-Faris (1992) examined price and income elasticities although only for gasoline demand in OPEC countries with time series data for the period Major changes have taken place in these countries, since the study was completed in the early 1990s. Ecuador withdrew from OPEC at the end of 1992; the Iran- Iraq War came to an end after eight years and the Gulf War created turmoil in the region, including the destruction of most of Kuwait s refining capacity and the stillcontinuing oil embargo on Iraq. Since then, most OPEC governments have raised domestic prices of oil products significantly. Although not explicitly included in our study period, supply curtailment by the OPEC countries, as well as rising demand from the recent turnaround in the Asian economies, has resulted in higher product prices through The changing international and regional environment has affected economic growth and energy consumption in the region, creating the need for a more in-depth analysis of OPEC demand in petroleum products. The purpose of this study, therefore, is to do an econometric estimation of product-specific demand relationships by country and use these estimates to forecast individual countries consumption behaviour under different scenarios for economic growth and price deregulation. The following major products are included in the study: liquefied petroleum gas (LPG), gasoline, kerosene, gas/diesel oil and fuel oil. Our conclusions suggest that product demand in OPEC countries is characterized by a low price elasticity of demand. In most cases, we also found low income elasticities of demand, contrary to the findings of Dahl (1994), who indicated that demand elasticities in developing countries tend to be income elastic. Part of the reason for this result could be the fall in real incomes observed in many Middle Eastern Organization of the Petroleum Exporting Countries OPEC Review

6 countries in recent years and the use of price data that were adjusted rarely and often by the same magnitude, as suggested by Pindyck (1979). We use a simple econometric model to forecast domestic product demand for the year 2000, under alternative assumptions of: (i) (ii) no change in current domestic retail price levels; and a doubling of retail prices, as countries move domestic prices closer to world prices. The forecast analysis suggests that our predictions compare reasonably well with those provided by informed industry analysts. It also suggests that, because of low price elasticities, demand growth in OPEC countries will continue to be robust in the near future, even if the proposed retail price changes are implemented. In terms of broader energy policy, continued increases in domestic demand may seriously affect OPEC supply shares of petroleum products in the years to come. The remainder of this study is organized as follows. Section 1 provides a description of the methodology and sources of data used. Section 2 presents the results of the econometric analysis and Section 3 provides forecasts. Section 4 presents the policy implications of the analysis and concludes the paper. 1. Methodology and data Since limited domestic product price data are available, the analysis in this paper is restricted to Algeria, Indonesia, Iran, Iraq, Kuwait, the Socialist People s Libyan Arab Jamahiriya, Qatar, Saudi Arabia, the United Arab Emirates and Venezuela for the period Gabon (which terminated its Membership of OPEC with effect from 1 January 1995) and Nigeria are excluded, due to insufficient data sources. We feel that the ten countries included in the study provide a balanced representation of OPEC, in terms of energy and petroleum product consumption patterns, social and economic development and geographic location. Of them, Iran, Iraq, Kuwait, Saudi Arabia and United Arab Emirates are considered by the International Energy Agency (IEA) as the five major oil suppliers in the Middle East. For the period , figure 1 shows the total energy consumption for the OPEC countries discussed in this study. For the remainder of this paper, the acronym OPEC will mean the ten countries examined here. Notice that energy consumption started from a very low base and was most rapid in the late-1970s and early-1980s, growing by more than 20 per cent per annum between 1970 and OPEC petroleum product consumption for the same period is shown in figure 2. The average annual growth rate for petroleum product consumption is approximately ten per cent. The similarities between figures 1 and 2 suggest that the time trend in petroleum product consumption is similar to that of total energy consumption during this period, and that the former has been the driving force behind the rapid increase in energy consumption in OPEC. Oil and natural gas consumption grew at more than 20 per cent per annum, while coal and hydropower consumption rose at a relatively low March Organization of the Petroleum Exporting Countries 27

7 Organization of the Petroleum Exporting Countries OPEC Review Figure 1 Aggregate OPEC energy consumption mtoe Algeria Indonesia Iran Iraq Kuwait Libya Qatar Saudi Arabia UAE Venezuela

8 March Organization of the Petroleum Exporting Countries Figure 2 Aggregate OPEC petroleum product consumption mtoe Algeria Indonesia Iran Iraq Kuwait Libya Qatar Saudi Arabia UAE Venezuela

9 Organization of the Petroleum Exporting Countries OPEC Review

10 six and nine per cent, respectively. Countries with the highest growth in energy consumption are Saudi Arabia, Iran, Venezuela and Indonesia. In the 1980s, the Iranian Revolution and the prolonged Iran-Iraq War disrupted demand growth, reducing it to about per cent per annum. Figures 3 and 4 show the relative composition of energy sources in the OPEC countries in the years 1972 and It suggests that, although some countries have shifted somewhat from oil to natural gas and vice versa, there is an overwhelming dependence on petroleum products in almost all OPEC countries, accounting for more than 50 per cent of total energy consumption in most of them. The major OPEC countries, such as Iran, Iraq, Saudi Arabia and the UAE, get per cent of their enduser energy from oil. On the other hand, Kuwait and Qatar are countries that are heavily dependent on natural gas. The overall heavy dependence on petroleum products also suggests the need to accurately estimate domestic consumption trends. The model As mentioned earlier, there is only a handful of studies on OPEC domestic demand, although studies exist for individual OPEC countries, mostly for gasoline. The previous studies have overwhelmingly employed single equation estimation techniques, which assume that the price of gasoline is exogenous (Dahl, 1986). Economic theory asserts that price and quantity are simultaneously decided by the market and that the simultaneity between price and quantity would cause the ordinary least square (OLS) estimate to be biased. This concern, however, does not pose a serious problem in our specific case, due to the fact that, in OPEC countries, domestic prices of petroleum products are not determined by domestic market demand and supply, but are set by the central government and do not reflect the true opportunity cost of the resources. In many countries, nominal prices are held constant arbitrarily for many years and, even when raised, they do not seem to have a major impact on the level of consumption. Based on this observation, price is treated as an exogenous variable in our model. Attempts have been made to model the effects of increased energy consumption on economic growth. However, these efforts require a more extensive data set than is available for OPEC countries to determine the simultaneous relationship between petroleum energy consumption and the growth of income. For the purposes of this study, we assume that the relationship between energy consumption and income will not change significantly in the near future. It is intuitively obvious that consumption is positively related to income and negatively related to price. The functional forms and variables used, however, reflect a host of additional considerations. We have already ruled out using a system of equations for the estimation of demand. In order to easily capture the price and income elasticity, the log-linear functional form is often considered superior to other functional forms, because the regression coefficients directly yield the relevant elasticities. This functional form has also been widely used in previous studies and has been shown to provide better estimates than semi-log and linear forms. The inclusion of a lagged endogenous variable is also considered appropriate, because it facilitates March Organization of the Petroleum Exporting Countries 31

11 the estimation of both the long- and short-run demand elasticities and incorporates the impact of last-period consumption on the current period. Based on the above consideration, the model used in this study takes the following functional form: ln Cijt = αij + βij * ln Pijt + γ ij *ln GDPjt + δij *lncijt 1 (1) where: C ijt = consumption per capita of the i th petroleum product by country j at time t; P ijt = real domestic price for the i th petroleum product in country j at time t; GDP jt C ijt 1 = real GDP per capita in the j th country at time t; and = one time period lagged consumption of the i th petroleum product by country j at time t 1. This model is consistent with general economic theory and is easy to apply. It is also straightforward to get the long- and short-run income elasticities directly from the estimation results. We realize, as correctly pointed out by a referee, that the simple specification of the model employed does not capture the short-term dynamics within the energy demand system, which can be explored by the use of cointegration techniques and error-correction systems. However, in an effort to focus the study on the longer-term impacts rather than short-term fluctuations, we choose this simple specification over other functional forms. The OLS regression technique was employed and the econometric and statistical work was performed by a statistics software package called Execustat version 3.0. The data One of the problems in using econometric techniques is the availability of good time-series and/or cross-section data. This problem is especially serious in the case of OPEC countries, for which only incomplete and/or inconsistent historical data on income, petroleum product consumption and product prices are readily available. Different data sources were examined and compared and subjective judgment was involved in the selection of data sources. Collecting and manipulating data from different sources turned out to be a time-consuming exercise. Historical data on energy consumption were obtained from the Paris-based International Energy Agency (IEA, 1994). The IEA has collected data on OECD and non-oecd countries energy consumption, in units of thousands of tons of oil equivalent. Data on the consumption of LPG, gasoline, kerosene, diesel/gas oil and fuel oil for the OPEC countries were obtained from the IEA. Various issues of the United Nations World Energy Statistics Yearbook and the OPEC Annual Statistical Organization of the Petroleum Exporting Countries OPEC Review

12 Bulletin were also examined for consumption data, and there were substantial differences between these sources, due to different definitions of certain petroleum products. For example, OPEC figures do not separate jet fuel from kerosene and, although these two products are essentially the same, their usage is quite different, which, in turn, leads to a difference in retail prices. Jet fuel consumption is included under kerosene for certain countries, because domestic prices are the same for both. Gas oil and diesel oil are considered alike for consumption purposes and the price of diesel oil is used as the common price for both. IEA statistics detail specific products and are more complete relative to United Nations and OPEC data. Whenever there was a mismatch between the data sources, we attached more weight to IEA data. Although export prices of petroleum products are easily available, domestic prices are generally not published in one place. Even though the IEA has reliable time-series data on international retail prices for various petroleum products, they bear no relationship to domestic oil prices in these countries. Fortunately, the Annual Statistical Report of the Organization of Arab Petroleum Exporting Countries (OAPEC) publishes the domestic prices of petroleum products for the Arab Members of OPEC. These prices are available both in their domestic currency and in US dollars. Even though the data are sometimes incomplete, because it is a compilation of country reports, we found this to be the only source for domestic prices in OPEC. The domestic price in US dollars/litre was used in the analysis. The weighted average of premium and regular gasoline prices is used as the price of gasoline. For Kuwait and Saudi Arabia, the percentage of regular and premium gasoline is estimated to be 60 per cent and 40 per cent, while, for the remaining countries, this ratio is estimated to be 80 per cent and 20 per cent. LPG is mainly for industrial use, but, for certain countries, such as Algeria and Saudi Arabia, it is also used by households. The weight of LPG for industrial use versus household use was estimated at 83 per cent and 17 per cent, respectively. Certain countries provide jet fuel and kerosene prices separately and, since the IEA provides consumption data separately for jet fuel and (other) kerosene, separate consumption data were used when individual prices were available. Consumer price index (CPI) data for Algeria, Saudi Arabia and Kuwait were available from the World Bank s World Tables and, for Indonesia, Iran, Iraq, Libya, Qatar and Venezuela, were obtained from the International Monetary Fund s International Financial Statistics series. CPI data for the UAE were not available and the CPI for Saudi Arabia was used instead. In all cases, domestic prices were converted to real prices using the CPI, with 1987, 1980, 1975 and 1990 as the base years. Data on gross GDP per capita come from the OPEC Annual Statistical Bulletin and World Bank s World Tables. GDP deflators for Algeria, Indonesia, Iran, Kuwait, Saudi Arabia and Venezuela are available from the World Tables. The GDP deflators for Libya, prior to 1980, were obtained from the IMF s International Financial Statistics. GDP deflators for Qatar and Iraq could not be found, and the deflators for Saudi Arabia were used instead. Finally, population statistics were mid-year figures taken from the OPEC Annual Statistical Bulletin. March Organization of the Petroleum Exporting Countries 33

13 2. Results of the econometric analysis Tables A1 A5 in the Appendix summarize the estimation results for LPG, kerosene, gasoline, diesel/gas oil and fuel oil, respectively. Overall, the LPG model exhibits a high explanatory ability, with an R 2 as high as 0.98 for Algeria, 0.96 for Iraq and 0.91 for Saudi Arabia. The coefficient of the log price of LPG gives the own price elasticity of demand and is a measure of consumer responsiveness to changes in price. The majority of the estimated coefficients have the expected negative sign, but are statistically insignificant at the 95 per cent confidence level. This suggests very inelastic demand for LPG in OPEC countries and can be explained by these countries extremely low and controlled prices set by their administrations. More than 80 per cent of LPG is used for residential use, with the remainder in the power sector. It is likely that residential demand is inelastic, since there are often no viable substitutes, at least in the short run. The few cases of wrong price signs are not totally unexpected. Since domestic prices are much lower relative to international retail prices, a modest increase in price is not necessarily strong enough to discourage consumption. At the same time, due to economic development and increases in population, consumption could keep rising, in spite of a small increase in the domestic price. Hence, in some cases, we can observe a positive relationship between consumption and price, which cannot be supported by traditional economic theory. Many OPEC countries domestic consumption of petroleum products is heavily subsidized by the government, since the low prices do not necessarily reflect the true cost of production of the resource. As consumption continued to increase at high rates and the cost of price subsidies increased, many OPEC governments increased domestic prices substantially in the early 1980s. Most retail prices are now above spot prices and are somewhere between wholesale and retail prices in free markets. However, there are exceptions: residential kerosene is heavily subsidized in some countries; and, in Saudi Arabia and Iran the two biggest OPEC nations retail prices are far below international spot prices for most petroleum products. Generally, within OPEC, domestic prices are still far from being high enough to play a significant role in affecting domestic consumption. This is true not only for LPG, but also for all the major petroleum products in most of the countries. Hence we have very price-inelastic domestic demands for OPEC countries. The regression coefficient of the natural log of real domestic product per capita is similarly interpreted as the income elasticity of demand. The individual income elasticity for LPG ranges from for Libya to for Iraq and is generally insignificant at the 95 per cent confidence level. Several countries show a negative income elasticity. As international oil prices declined and became stable later in the 1980s, many OPEC countries suffered a decrease in real national income, which depended critically on oil exports. However, at the same time, domestic consumption of oil products kept rising, due to infrastructure construction, transportation development, increases in population, urbanization and other factors. Hence, GDP and domestic consumption of oil products in some countries exhibit a negative relationship, leading to a negative effect of income on consumption Organization of the Petroleum Exporting Countries OPEC Review

14 The kerosene model is more problematic compared with others and has low explanatory power. Besides the reasons discussed above, the inconsistency in data may also have contributed to the fact that the signs of the regression coefficients are somewhat counter-intuitive. For example, some countries include jet fuel in kerosene when computing statistics on consumption and price, while others do not. Jet fuel and kerosene are virtually the same product, but are used for different purposes. Kerosene is mainly used for cooking, while jet fuel is used in air transportation. The latter is generally more expensive than kerosene. For our analysis, since the IEA separates jet fuel from kerosene, the consumption figures are quite accurate. But the OAPEC data on domestic prices lists jet fuel prices distinctly from kerosene for some countries, while, for others, only one kerosene price is given. It is not clear if this kerosene price is the weighted average price of jet fuel and other kerosene products or if it is the price for kerosene products other than jet fuel. We take the price of kerosene to be separate from jet fuel and this may be one explanation for the unexpected price elasticity. The income elasticities for kerosene are well below unity for most of the countries, except Algeria (0.901) and the UAE (0.869), indicating generally incomeinelastic domestic demand. The observed variability in income elasticity can be largely explained by the availability of kerosene substitutes (natural gas, electricity, LPG, etc) in each country, the degree of urbanization and population growth. For example, a one per cent increase in income in a country where there are more kerosene substitutes may cause a smaller increase in kerosene consumption than in a country where there are fewer substitutes available. Also, in a more urbanized economy, an income increase might cause a small or no rise in kerosene consumption, relative to a developing economy, in which kerosene is widely used for heating, cooking and other basic household uses. The more urbanized a country, the less kerosene it uses for household consumption. In some countries, kerosene might even be an inferior good, as people switch to natural gas, electricity and other more efficient and cleaner fuels, as their income increases and their energy requirements get more sophisticated. The gasoline model explains the variation in the data quite well. Price elasticity is low for all the countries, as well as insignificant. The income elasticity indicates that gasoline is a normal good in all the countries, except Iran, Qatar and Kuwait. In the case of Iran, since gasoline prices are one of the lowest in the region, the income effects are probably minimal. Gasoline income elasticities are significant at the 95 per cent level for Algeria, Indonesia, Libya and Venezuela, countries in which gasoline prices are comparable with world prices. The diesel/gas oil model has good explanatory power, with R 2 values in the range of for major OPEC countries, such as Indonesia, Iran and Saudi Arabia. Diesel is used extensively in OPEC countries, mainly in road transport. Our estimates suggest a low price elasticity for diesel, which indicates that efforts in the mid-1990s in Saudi Arabia and Iran to raise the price of diesel and reduce consumption may have limited short-term impacts, in terms of substitution to alternative fuels, such as gas and fuel oil. We could not obtain domestic fuel oil prices for Kuwait and Qatar. For other countries, except Iraq, fuel oil demand also has low and insignificant price and income elasticities. The explanatory power of the model is generally low, except for Saudi March Organization of the Petroleum Exporting Countries 35

15 Arabia, Libya and the UAE. For Iraq and the UAE, fuel oil seems to be an inferior good, with negative income elasticities. OPEC fuel oil is mostly used in bunkers and in the industry and power sectors. The above estimated coefficients provide short-run price and income elasticities. The corresponding long-run elasticities can be calculated as the short-run elasticity divided by unity minus the elasticity or coefficient of the lagged dependent variable. The long-run elasticities are summarized in tables A6 A10 in the Appendix. The elasticity figures support Dahl s general conclusion from her survey (Dahl, 1994) that oil product demand is price-inelastic. Counter to Dahl s generalization, however, demand in OPEC countries does not seem to be income-elastic. The fact that income elasticity is lower in our analysis, compared with figures available in the literature, might be partially due to different data sources, the methodology employed and also the extended time-series data used in our analysis, which may have captured developments in these economies that were not covered in previous data work. The estimation results also justify our choice of a country-specific and productspecific model. It is easily observed that there are vast differences among countries and among products, even within the same country, and hence, when treated as a homogeneous unit, certain differences may even out, resulting in biased estimates. This is especially problematic, when the model is used to forecast future demand patterns. In view of the diverse domestic regulatory policies in OPEC countries, it is hard to imagine that they would all follow the same pace of development and similar consumption patterns. 3. Forecasts Forecasting future consumption levels in OPEC countries is complicated, because it involves the projection of future income levels and domestic prices. These countries GDP is heavily dependent on crude and product exports and can rise or drop dramatically within a relatively short span of time, because of the volatile nature of the international oil market, as well as output curtailment policies. Domestic prices are even harder to predict. With a few exceptions, current domestic retail prices in most OPEC nations are below those paid by consumers elsewhere, although, contrary to popular impression, they are no longer small fractions of those in the international market. In two of the main OPEC countries Saudi Arabia and Iran product prices are generally lower than even international spot prices. Prices in Iraq are also quite low, if the unofficial rather than the official exchange rate is used in the calculations (FACTS/SRTC, 1995). Moreover, it is difficult to accurately predict future domestic price movements, given the frequently turbulent political climate in at least some OPEC countries. We use our model to forecast consumption for the year 2000 and then compare our estimates with the latest available analyst estimates for these countries (FACTS/ SRTC, 1999). Income projections In forecasting future GDP levels, subjective judgment was used, based on shortterm projections from several sources. The Economist Intelligence Unit s (EIU) World Organization of the Petroleum Exporting Countries OPEC Review

16 Outlook publishes short-term (one year) forecasts for more than 180 countries in the world. The International Monetary Fund (IMF) produces the World Economic Outlook, that has similar short-term predictions. Neither of these sources, however, gives longer-term forecasts. In doing the long-run forecast, the economic and political situation of each country was studied, in order to decipher possible long-term trends. Since the period of our study is from 1972 to 1992, we would like to make projections beyond this period, and have chosen the year 2000 for this purpose. Qatar was excluded from the forecast, because of the difficulty of obtaining its consumer price index for a reasonably long period. Forecasting product consumption in the year 2000 implies assuming annual average growth rates for the period The estimates were obtained from data and projections available from the East-West Centre Energy Programme. Algeria has maintained stable growth during this period, due to economic reforms being on course and the steady inflow of external funds into the Algerian economy. For the period , Algeria is expected to maintain an average annual growth rateof 3.5 per cent. In spite of the major political and economic upheaval in , the Indonesian economy is turning around and is expected to maintain an impressive rate of GDP growth during the entire period. Iran, however, has been under great economic pressure and is expected to show only a moderate growth rate during this period. Iraq is currently the subject of an international oil embargo and, although the embargo has been partially lifted and limited sales of Iraqi oil are being allowed, Iraq s GDP is expected to average a low 1.5 per cent annually since The recent upward movement of international oil prices should make it possible for Kuwait to continue to maintain its moderate economic growth through the year In the case of Libya, oil production is the backbone of the economy and it has benefited from firmer prices and increased demand. However, the government s economic policies lack a clear direction towards deregulation and modernization of the economy. Libya has also been the subject of a United States-led ban on large-scale private investment in its energy sector. It is expected that the Libyan economy will recover from the negative growth rates of the early 1990s and exhibit slow, but positive growth in the near future. Saudi Arabia is the largest economy among all OPEC countries, but its real GDP growth rate fluctuates drastically from year to year from 10.8 per cent for 1990 to 3.0 per cent for The economy has registered marginal positive growth after the mid-1990s, as a result of firmer oil prices and decreased infrastructure investment, due to rising short-term interest rates. The UAE has registered a negative growth rate for the first half of the 1990s, and its economic growth rate has been curtailed to some extent, because its production capacity is already near the OPEC quota. Venezuela s oil sector has shown positive growth, due to the flow of foreign investment, especially in the refining and petrochemicals sector. A summary of the average annual growth rates of real GDP and population for the above countries for the period is provided in table 1. The population projections for each country are based on historical rates of growth obtained from the IEA s World Energy Outlook. March Organization of the Petroleum Exporting Countries 37

17 Table 1 Average annual growth rate of real GDP and population, % per year GDP Population Algeria Indonesia Iran Iraq Kuwait Libya Saudi Arabia UAE Venezuela Domestic retail price projections Given the estimates of population and gross domestic product, the forecast for countryspecific consumption of petroleum products was obtained under two price scenarios. The low-price scenario assumes that current price levels will be maintained until the year Country-specific inflation rates are compiled from the EIU, IEA and IMF. Even though this low-price scenario may not seem reasonable, it is not rare to find nominal prices being held constant for almost ten years in the countries studied. However, the likelihood of administered prices holding constant for such long periods has to some extent diminished in the era of market liberalization. The domestic consumption of petroleum products in most OPEC countries is heavily subsidized and it is widely believed that this may continue to be the case at least in the near future. Despite recent efforts to increase domestic retail prices and a growing realization among policymakers of the economic arguments for getting prices right, political and social pressures could serve to keep nominal prices untouched for a certain period. With the rising tide of religious fundamentalism in many OPEC nations, governments are also loath to deregulate, for fear of antagonizing the mainly poorer sections of the population. If inflation is taken into account, constant nominal prices actually mean declining real prices a common phenomenon among OPEC countries in the past few decades. The high-price scenario assumes that the current nominal prices will increase by a margin of 100 per cent by the year This scenario may be unrealistic, given that we are already in the year 2000, but the purpose of this exercise is to show the effect of market liberalization on consumption patterns in these economies. In reality, one should assume different price hikes for each country that more accurately reflect recent trends in domestic product prices, as well as towards market reforms. However, in this paper, we keep things simple by treating every country in a homogeneous fashion. It is possible that most OPEC countries have realized that the subsidies they provide for the domestic consumption of petroleum products have drained and Organization of the Petroleum Exporting Countries OPEC Review

18 distorted their economies. The recent trend of increasing domestic prices in the major OPEC economies, such as Iran and Saudi Arabia, may continue in the near future. A 100 per cent across-the-board price increase, however, may still be far from sufficient, in terms of making domestic retail prices comparable with international market prices, at least for certain petroleum products. This may be a conservative prediction in countries where there is a strong potential for upward price adjustments. In a more detailed empirical study of price liberalization, other factors, such as the rates for economic growth, energy consumption, production capacity, political stability, population growth, the current price level relative to the international market, etc, need to be taken into consideration for each individual country. Domestic demand in the major Middle East economies Special emphasis was placed on the five Middle East countries considered as major suppliers by the IEA, i.e. Iran, Iraq, Kuwait, Saudi Arabia and the UAE. Iran has the largest demand (and population) of any country in the Middle East. It also has the lowest prices in the world, averaging around one US cent per gallon (although gasoline costs about 3 8/gal). Iranian product demand has grown rapidly for nearly a decade and a half, with the result that Iran has turned into a major product importer, importing almost 190,000 b/d in Currently, there are plans to raise domestic prices, and a modest price increase is expected to slow down demand. Unlike many Middle East countries, Iraq has not been concentrating on exportoriented refining projects, but has been preoccupied with meeting domestic demand. Iraqi demand growth has suffered because of the two wars, but is now rebounding rapidly. Due to the continued international sanctions and a constrained production capacity due to war-damaged refineries, Iraq will probably not have a major effect on the product market for a few more years. Kuwait has been the leader in downstream expansion in the Middle East, with one of the most sophisticated refining systems in the world. But the Gulf War caused serious damage to its oilfields, refineries and infrastructure. A major rebuilding effort has been in place and the country is facing serious financial problems as a consequence of the war, which is likely to restrict its production capacity. Saudi Arabia is the largest refiner in the Middle East and the second largest oil consumer after Iran. Its demand has grown rapidly, although there have been recent price increases that may not only slow demand growth in the near future, but also may cause a major reduction in demand for diesel, which has been priced below the costs of all other fuels, including fuel oil. As Saudi Arabia increases its crude production, there will also be increased output of natural gas, which may in turn reduce the demand for oil. Demand per capita in the UAE is the highest in the Middle East, but, since the population is low, aggregate demand is relatively small. Oil product retail prices are comparable with world prices; thus major price changes are not expected in the near future. Planned refining expansions will enable the UAE to increase its product exports for the foreseeable future. March Organization of the Petroleum Exporting Countries 39

19 Organization of the Petroleum Exporting Countries OPEC Review Table 2 Petroleum product consumption in the year 2000 under two scenarios 1,000 b/d* LPG Kerosene Diesel/gas oil Gasoline Fuel oil High Low FACTS High Low FACTS High Low FACTS High Low FACTS High Low FACTS Algeria n/a n/a (7.2) (3.6) (17.2) (8.6) (34.8) (17.4) (3.8) (1.9) Indonesia n/a n/a (22.08) (11.04) (30.12) (15.06) (55.22) (27.66) (22.08) (11.04) Iran n/a n/a (0.60) (0.30) (0.4) (0.2) (4.00) (2.00) (0.20) (0.10) Iraq (1.8) (0.9) (1.8) (0.9) (4.2) (2.1) (4.44) (2.22) (0.4) (0.2) Kuwait n/a n/a (7.3) (14.6) (13.4) (26.8) (26.8) (13.4) (29.6) (14.8) Libya (26.8) (13.4) (24.8) (12.4) (46.6) (23.3) (69.6) (34.8) (7.4) (3.7) Saudi Arabia (14.92) (7.46) (10.6) (5.3) (6.4) (3.2) (13.64) (6.82) (8.0) (4.0) UAE (38.0) (19.5) (42.0) (21.0) (39.8) (19.8) (44.52) (22.26) (32.4) (16.2) Venezuela (11.82) (5.91) (27.18) (13.59) (20.6) (10.3) (24.26) (12.13) (16.76) (8.38) * Prices in US cents/litre are shown in parantheses. The low-price scenario assumes current price levels will be maintained until 2000 and the high-price scenario assumes that nominal prices will increase by a margin of 100 per cent by 2000.

20 Comparison of forecasts Forecasts for consumption (in thousands of barrels per day kb/d) for each product category are presented in table 2. The kerosene consumption of Algeria cannot be accurately projected, since the lack of domestic price data for previous years makes it hard to foresee future price trends. The forecasts suggest that, in general, current annual growth rates of nearly ten per cent are not likely to be maintained in OPEC countries. Product demand growth rates are likely to be substantially lower, under both price scenarios. Table 2 compares our results with detailed country-specific forecasts made available by FACTS/EWCI (1999) for the five major Middle East suppliers. Note that FACTS/EWCI (hereafter referred to as FACTS ) statistics include the direct use of crude and gas oil and bunker fuel oil in fuel oil consumption, which, in certain cases, such as for Iraq and the UAE, may have caused some of the significant differences between our forecasts and theirs. For the case of Iran, our forecast for kerosene is 170 kb/d, which is consistent with the FACTS forecast of kb/d. Our diesel forecast of kb/d matches well with the FACTS figure of kb/d. Our gasoline forecast of kb/d is somewhat higher than the FACTS estimate of 225 kb/d, although that could be explained to some extent by the fact that the latter is exclusively for motor gasoline. The doubling of future product prices will result in major consumption effects, especially for fuel oil and diesel. It is generally expected that Iranian domestic consumption figures will be at the lower end of these numbers, because of expected future price increases by the Iranian government. Our estimates for Iraq compare well with those from FACTS, except for LPG and fuel oil. Kerosene consumption is expected to be approximately 30 kb/d, while FACTS predicts 32.7 kb/d. Both sources estimate diesel consumption to be around 126 kb/d. As for gasoline consumption, our forecast is higher, by about 30 kb/d. The effect of price doubling on consumption in Iraq is small relative to Iran. For Kuwait too, both sources predict gasoline consumption of around 42 kb/d. Our LPG forecast of 4.35 kb/d is higher than the FACTS prediction of 3.6 kb/d. The model results for diesel and kerosene are higher than that of FACTS. Kuwait experienced a collapse in demand during the occupation and, as reconstruction takes place, it is expected to exhibit overall growth in oil demand of about five per cent. Except gasoline, the other product estimates are not highly pricesensitive. For Saudi Arabia, the gasoline and fuel oil consumption forecasts are very close to those of FACTS. For example, we predict gasoline use of kb/d in the year 2000, while FACTS predicts 239 kb/d. Relative to them, we grossly underestimate LPG and kerosene use, while, at the same time, overestimate diesel use to some extent. Demand is observed to be highly price sensitive for gasoline and fuel oil and, to a lesser extent, for diesel. For the UAE, both forecasts are on the mark for gasoline, while we underestimate fuel oil and LPG use and overestimate kerosene and diesel use, compared with FACTS. The prices of oil products are much higher in the UAE and the outlook for product demand is likely to continue the recent trends, with less possibility of price March Organization of the Petroleum Exporting Countries 41

21 increases compared with other countries where domestic prices are extremely low. Gasoline will continue to be the major consumption item, with an annual growth rate of less than three per cent, yet accounting for around half the total petroleum product consumption. Demand is price-sensitive for diesel and only to a small extent for other products. The forecasts for Indonesia were compared with those made by the East-West Centre (EWC) Programme on Resources (Fesharaki, et al, 1996). Our econometric model underestimates the consumption of kerosene, diesel and gasoline and overestimates fuel oil demand, although the difference in most cases is not substantial. For example, our diesel forecast is kb/d, while that of EWC is 451 kb/d. Similarly, our kerosene demand is in the range kb/d, compared with 233 kb/d for EWC. Price elasticities are relatively high for diesel and gasoline and moderate-to-low for kerosene and fuel oil. The model s forecasts for Venezuela were compared with preliminary forecasts provided by SRTC (1996). Our high gasoline prediction is 170 kb/d, while the corresponding figure for SRTC is 218 kb/d. Our kerosene estimates are in the range kb/d, while SRTC predicts 15 kb/d. Demand is not very price-elastic, and analysts predict that LPG use is expected to rise sharply in the future, while gasoline and diesel use will continue to grow, albeit at a slow rate. 4. Concluding remarks This study attempts to estimate the domestic consumption pattern for major petroleum products for OPEC countries. A log-linear model was developed and both long-run and short-run income and price elasticities were obtained for the ten major OPEC countries for which data was available and for each major petroleum product. Projections of consumption were made for the year 2000 under two price scenarios: first, current domestic retail product prices were assumed to remain constant; and secondly, it was assumed that OPEC governments would attempt to raise prices to levels closer to international prices, and, therefore, a doubling of current prices was simulated. Plausible estimates of economic growth were assumed in the forecasts. A major finding of the study is that OPEC countries generally exhibit low price elasticities of demand for petroleum products. This is mostly due to the fact that domestic retail product prices in OPEC nations are significantly lower than world prices, although, contrary to the popular impression, except in Saudi Arabia, Iran and Iraq, they are not as low as they have been in the not-too-distant past. The heavy expenditure incurred in subsidizing petroleum products, notably kerosene, diesel and gasoline, has created serious balance of payments deficits in major OPEC economies. Even if prices are raised in the near future, our results suggest that the domestic consumption of petroleum products will continue to grow at significant rates. Thus our forecasts, which, in most cases, are within the range of other informed industry forecasts of OPEC domestic consumption, suggest a healthy growth of demand in OPEC countries. It is important to speculate further on the impact of OPEC domestic demand growth on OPEC exports, especially for major fuels, such as gasoline, kerosene and Organization of the Petroleum Exporting Countries OPEC Review

22 diesel. For example, Asian countries, such as China, India, Korea and even Indonesia, have emerged as major importers of petroleum products from the Middle East since the mid-1990s (Fesharaki, 1995). It is expected that, by the year 2000, about 5.4 mb/d of Middle East crude and products will be demanded by countries in the Asia-Pacific region. Thus, growth in domestic demand in OPEC may result in serious export shortages and a consequent rise in world prices for petroleum products. Of course, much depends on the current proposals for expansion in refinery capacity in the Middle East countries, as well as on the possible continuation of OPEC supply curtailments. Although not a focus of this study, it is important to examine in more detail the effect of OPEC domestic demand growth on the world market for products, including non- OPEC exporters, as well as on domestic pricing systems and budgetary constraints in OPEC economies. After the Gulf War, there was a significant increase in demand for oil products by OPEC nations, as Kuwait began reconstruction. But, as in many other countries, demand growth is likely to slow down markedly from the early-1990s. In several countries, such as Saudi Arabia, recent price increases on all domestic oil products are expected to encourage conservation and fuel-switching. Iran s rulers are also getting around to the idea of raising product prices, although accompanied by cash subsidies to poor households. In view of the large percentage of kerosene used in the residential sector and diesel/gas oil consumed in non-transportation uses, there exist plenty of opportunities for future structural changes in the oil sector, since LPG, gas and electricity are substitutes for kerosene and diesel/gas oil is subject to competition from other fuels. If the massive gas resources of the Middle east are increasingly tapped for domestic use, rather than just for LNG exports, experts predict a continual erosion in the demand barrel in many OPEC countries (FACTS/EWCI, 1999). There are several limitations that need to be considered in future work. The lack and/or inconsistency of historical data created considerable difficulty in econometric estimation. Further improvement in the results would depend on the availability of complete and accurate data. Supply constraints from political and other factors may also have biased the estimation of elasticities. Besides income and price, variables, such as the number of automobiles and their energy efficiency, can be incorporated in the estimation of gasoline consumption and would increase the accuracy of the model significantly. Also, the degree of urbanization and substitution possibilities between diesel and gasoline could also be taken into account. Unfortunately, this would require a more complete and complex data set, the preparation of which would take considerable time and resources. In future work, more modern econometric estimates could be employed to investigate the short-term impacts of price and income changes, relative to the longer-term focus of this paper. Furthermore, special regulatory and political conditions in each country could be used to fine-tune predictions made by a more generic model, as used in this paper. March Organization of the Petroleum Exporting Countries 43