Asymmetric transmission of crude oil prices into fuel prices - Evidence from Pakistan

Abstract

Research on the pass-through of international crude oil prices into domestic fuel prices has mainly focused on countries with market-driven fuel prices, but overlooked countries wherein fuel prices are set by the government. Against this background, we study the dynamics of price transmission between international crude oil markets and petroleum, light diesel and kerosene retail markets in Pakistan, an oil-importing developing country where fuel prices are regulated by the government. Our hand-collected dataset consists of the government's biweekly notifications on petroleum, light diesel and kerosene retail prices in Pakistan, and international crude oil prices from January-2007 to March-2022. We employ threshold-cointegration models and the associated asymmetric vector error-correction model to analyze the long-run and short-run mechanisms of fuel price adjustments in Pakistan. Our empirical estimates reveal that Pakistan's fuel retail markets are cointegrated with international crude oil markets, but the underlying price-adjustment process is relatively slow. We find evidence of the “rockets and feathers” phenomenon in petroleum retail prices, but not in light diesel and kerosene retail prices in Pakistan. The “rockets and feathers” phenomenon in petroleum retail prices is driven by the government's tendency to exploit decreases in international crude oil prices to increase taxes on petroleum, instead of lowering petroleum retail prices in Pakistan. The observed differences in the mechanisms of price transmission from international crude oil markets into the petroleum, light-diesel and kerosene retail markets in Pakistan highlight that government-regulated fuel prices serve as a policy lever for balancing fiscal constraints with political economy considerations in oil-importing developing countries.