Managed float: A detailed explanation

 

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World crude oil prices are hovering around the $50/barrel mark, half of what it was just a year ago. In Malaysia, this has translated to a lower cost of retail fuels at the pump.

However, many questions have been posed about the ‘managed float’ mechanism currently in use, against the greater contexts of the free market, deregulation and subsidies. With that in mind, Business Circle interviews Datuk Shahrol Azral Ibrahim Halmi, President of the Malaysia Petroleum Resources Corporation (MPRC), for some insights into the details of the current pricing schemes for retail fuels. Read on to find out why you pay the prices you do for retail fuel.

Q:           Why has the government moved towards the current “managed float” system?

A:           Technically speaking, the “managed float” system has existed since – and even before – the early 90s prior to the Asian economic crisis; however, the average rakyat was not exposed to it because the government had additionally subsidised and absorbed the differences between the actual costs and the prices paid at the pump, allowing the price of petrol to remain the same throughout Peninsular Malaysia; Sabah; and Sarawak. What has changed since December 2014 is that to improve market efficiencies, as well as to encourage greater fiscal discipline, the subsidies have been taken away, exposing the rakyat to the underlying ‘managed float’ system.

The previous subsidy system was put in place for various historic reasons that had to do with Malaysia’s economic and development conditions then prevailing. At that time, Malaysia’s development was still uneven, with both urban and rural environments, and it was a decision of the government at that time that firstly, all communities are served equally well, and secondly, the transportation and industrial sectors would function best with predictable fuel prices.

Q:           Where does Malaysia procure retail fuels?

A:           Malaysia is a net importer of retail fuels, which are purchased from whoever – whether from Saudi Arabia, India or even the United States – will sell it to us at the cheapest rates (subject to Malaysia’s fuel quality standards), and even the feedstock that is refined domestically (at refineries in Port Dickson or Melaka, for instance) is usually also obtained from international sources; hence, we are exposed to world market prices. We are increasingly using our own oil in local refineries, but our demand for refined fuels cannot be matched by our local supply.

Q:           How does the “managed float” system currently work? Are there any issues or challenges with the mechanism as it exists?

A:           Using the “managed float” system, the government sets pump prices based on the average cost of MOPS fuels of the preceding month. Pump prices (per litre) also include an ‘alpha’ (fixed payment to cover cost differences between published MOPS prices and prices actually paid by oil companies for the fuels), a fixed payment for operational (including marketing, freight and distribution) costs, a fixed margin to cover the oil companies’ capital and other operational expenditures, and a fixed commission to the dealers to cover their capital and operational expenditures.

As with any fixed price mechanism, even one that is based on market prices, there are going to be inefficiencies. When you try to fix prices across the entire country with its diverse urban and rural areas, in various areas, the pump prices will not reflect the true costs of the fuel sold (in terms of transport, storage and overheads), whether higher or lower.

Additionally, a party must set the profit margin, as it is no longer the market that is doing so – in this case, it is the government rather than a consortium or oligopoly of oil companies. This means that the margin fixed could possibly be in excess of what a free market would bear.

Furthermore, for reasons of enforcement and regulation, the number of oil companies and dealers has to be limited – it would be almost impossible to police noncompliance if everybody and his brother could open a fuel station. This reduces the level of competition between the various players in the industry.

Also, because of the one-month lag, customers do not buy necessarily fuels at the same price that the dealers or oil companies paid; hence, payments are made either from the oil companies (if the pump price is higher) to the government or vice versa. The terminology used is that of ‘tax’ and ‘subsidy’, but it is in reality simply balancing payments. This is not quite so much of an issue because in the long run, the cash flow between the government and oil companies/dealers tends towards zero.

Q:           Questions are being asked about oil companies’ guaranteed profits, based on pump prices including a margin and commission for both producer and retailer/dealer. Are such questions reasonable, and why or why not?

A:           The questions are understandable, of course; nobody likes the idea of any party being guaranteed a profit. Indeed, in a fully-deregulated fuel retail market, pump price margins are often close to (if not actually) zero, and all the money is made via other means (attached car repair/wash facilities, petromarts etc.) – this is not the case in Malaysia. But again, the system was put in place decades ago, when the intention was to jump-start the nation’s industrialisation and development. Even now, the road transportation network in East Malaysia is nowhere near as sophisticated as that of Peninsular Malaysia, and hence getting someone to consider opening a fuel station on the road to Kapit or Serikin in Sarawak – or even more remote areas – requires some incentivisation.

Q:           Is this “managed float” system an indication that Malaysia will move towards a fully deregulated fuel retail market, allowing all fuel stations to set their own prices in a completely competitive environment? If so, is there a timeline towards full deregulation, and if not, what are the challenges that have to be resolved prior to such a move?

A:           At the moment, there is no timeline set for full deregulation of the fuel retail market. Personally, I would like to see us moving in that direction at some point to improve market efficiency. However, nothing concrete has been put in place yet.

It should be said that in a fully deregulated environment, Malaysians must get used to pump prices that can change at a moment’s notice – from hour to hour, even. Currently, whatever happens to world oil prices, consumers are insulated from it until the end of the month; in a free market for retail fuels, the changes could be reflected in pump prices within the day.

Q:           What else should the rakyat understand about the “managed float” system?

A:           It is important to look at the current system within its historical context. In the 80’s when the Automated Pricing Mechanism (“APM”) was first implemented, there was an intense push for Malaysia to move from an agriculture-based economy to one that is based on manufacturing industries. One of the key pillars was the development of an indigenous automobile industry. A deliberate decision was then made to increase Malaysia’s car-owning population, via automobile-friendly policies such as a world-class highway system and predictable fuel prices.

It is against this background that one must weigh the current system. Of course, it is by no means perfect, but it was the best compromise at the time, given all of the various (and sometimes conflicting) requirements the government faced. Moving forward, now that circumstances have changed to some degree, the challenge that remains is to ensure that the rakyat continues to get the best deal no matter which part of the country they live in.

I encourage those who are questioning the need for the current system to remember their fellow Malaysians who do not have the good fortune of living in an urban environment like KL or PJ. The challenge moving forward is to think through and implement a system for the pricing of fuels that is efficient, yet meets the needs for those who are living in rural areas as well.

 

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