Reducing the Staggering Costs of Cheap Energy

• Author: Dominique Guillaume and Roman Zytek
• Position: a Deputy Division Chief and a Senior Economist in the IMF's Middle East and Central Asia Department.

AS oil prices have risen in recent years, governments in oil-producing countries have faced a hard choice: should they allow domestic subsidies to rise to keep fuel affordable for their citizens—or reduce and even eliminate subsidies and allow market forces to play out? Already, some oil-producing countries, such as the Islamic Republic of Iran, have taken steps toward removing domestic subsidies.

By choosing to allow domestic energy prices to rise to their international level, policymakers in oil-producing countries could discourage wasteful consumption and earn additional revenues from profitable oil and gas exports. The government could then redistribute most of the additional revenue collected from the price increase through an oil dividend, which would buy public support for the price increase.

However, to be successful, any such reform must be accompanied by supportive microeconomic and macroeconomic policies. In their absence, abrupt price hikes could easily spark street riots (as has happened in many countries), lead to high inflation, and trigger further economic losses and social pain.

Energy prices and consumption

From 1940 to 1960 and again in the 1980s and 1990s, when international energy prices were low, giving gasoline, diesel, and natural gas away to domestic users seemed like a simple way for oil-exporting countries to distribute some of their national oil and gas wealth. In addition, the allure of plentiful cheap energy brought investment and much-needed jobs. And as long as domestic prices covered the production costs of energy, subsidies were a nonissue.

Things have changed dramatically in the past decade. On the supply side, the low prices and excess capacity of the 1980s and 1990s kept investment in oil and gas exploration and extraction low. On the demand side, low prices stimulated global demand. Rapid economic growth in many populous emerging markets, such as China and India, pushed demand even higher as the global middle class, with its energy-intensive consumption aspirations, grew.

With demand growth outstripping additions to supply, crude oil prices rose from about $17 a barrel in 1998 to $97 on average in 2008. The high oil price made governments of oil-exporting countries aware of the fact that they were losing billions of dollars in possible revenues by underpricing oil products in their domestic markets. Policymakers in those countries had to wonder if they could do better than practically giving away...