Oil price pass-through to consumer prices in Latvia
According to our research*, a 10% increase in global oil prices raises the level of consumer prices in Latvia by 0.6% in the medium term. The increase in oil prices directly pushes up energy prices, i.e. the prices of car fuel, natural gas, heat energy, and – indirectly – the prices of food and services.
This article continues the analysis of the features of Latvijas Banka's short-term inflation projections (STIP) model, this time focussing on the impact of oil prices on consumer prices. The first part assesses the impact of global food commodity prices on consumer prices (see here), while the second part considers the impact of domestic labour costs on consumer prices (see here).
Over the past few months, the oil price forecasts regularly have been revised downwards. Investors have been voicing concerns about both a slower pace of the global economic growth (which also means lower demand for oil products) and an increase in oil production in the US. It seemed that the situation changed significantly on 14 September after attacks on several Saudi Arabian oil plants, including the world's largest oil refinery in Abqaiq. Oil prices soared by more than 10% in the first hours after the opening of the commodity exchange markets.
However, two weeks after the attack, oil prices returned close to their previous levels (Figure 1) as Saudi Arabia increased its oil production volumes sooner than investors had expected. Nevertheless, this case illustrates how volatile oil prices can be. To what extent would consumer prices in Latvia be affected in case of a permanent rise in oil prices? Which prices of goods and services are most responsive to oil price fluctuations? Through which channels and how fast are the oil price dynamics reflected in the Latvian consumer prices? This article will shed light on these issues.
Figure 1. Oil price (Brent; US dollars per barrel)
Petrol and diesel prices at gas stations are first to respond to oil price changes, with most of the impact occurring within a month. This is consistent with our previous published estimates. The car fuel price elasticity to the oil price is positively correlated with the oil price. The higher the price of oil, the larger its share in the price of fuel (at the same time, the share of taxes decreases). Thus, the higher the price of oil, the greater the elasticity (Figure 2). For example, at the beginning of September the price of Brent crude oil was 52 euro per barrel – a 10% increase in oil prices would raise the retail price of fuel in Latvia by 3.5% in the medium term. If oil prices were twice as high, a similar rise in oil prices would increase the fuel prices by 5%.
Figure 2. Car fuel price elasticity at different oil price levels
Notes: Calculations are based on the average distribution and retail margins and tax rates in 2018. The distribution and retail margins reflects the costs related to the delivery of car fuel to gas stations, the costs of gas station maintenance as well as the profits.
For a reader who frequently refuels his/her car it may seem that car fuel prices are more responsive to oil price increases than their decreases, e.g. since 2005–2006, retail car fuel prices in Latvia have risen by half, while oil prices have remained broadly unchanged at approximately 50–60 USD per barrel. This fact may be attributed to three factors. First, the euro has depreciated against the USD dollar by one-seventh over the last 15 years (it means higher crude oil price in the euro currency, other things held constant). Second, the excise tax rates on car fuel have almost doubled since 2005. Third, rising labour costs are affecting the fuel retail margins. We take into account all these factors when projecting inflation. While the car fuel price elasticity to domestic labour costs is not high – indeed, it is much lower than its elasticity to oil prices – even this factor alone can contribute to a rise in fuel prices without any oil price changes (Figure 3).
Figure 3. The structure of car fuel prices (euro per litre)
Notes: The distribution and retail margin reflects costs related to the delivery of car fuel to gas stations, the costs of gas station maintenance as well as the profits. The car fuel price is defined as an average of petrol and diesel prices.
Oil prices also significantly affect the consumer prices of natural gas and heat energy. Main supplier of the natural gas JSC "Latvijas Gaze" adjusts a tariff for households twice a year, and it is linked to the nine-month average prices of fuel oil and diesel. Therefore, the speed of a pass-through is fairly slow: while natural gas prices are still responding to the changes in the prices of oil products observed over the previous nine months, the current crude oil prices might already move in the opposite direction. In addition, several Latvian cities (including Riga) mainly use natural gas to produce their heat energy, thus amplifying the impact of oil prices on the heat energy prices. With the price of oil rising by 10%, the consumer prices of natural gas and heat energy in Latvia are expected to increase by 5–6% in the medium term (Figure 4). As the natural gas and heat energy tariffs are subject to administrative regulation (changes in tariffs must be approved by the Public Utilities Commission before they take effect), the speed of the pass-through may vary.
Figure 4. Consumer prices of natural gas and heat energy in Latvia (index; 2015 = 100) and crude oil prices
Notes: The numbers near the dots represent years over the period 2005–2018.
Fluctuations in oil prices affect fuel prices and, thus, also the transportation costs, one of the factors behind the food price developments. Most food prices respond statistically significantly to the changes in car fuel prices. Thus, the prices of food products depend not only on the global food commodity prices and domestic labour costs, but also on the crude oil prices. For example, a 10% increase in crude oil prices raise the prices of fish, non-alcoholic beverages and processed fruits by approximately 1% and those of dairy products and confectionary by 0.6% (Figure 5).
Figure 5. Pass-through of 10% increases in oil price, average wage and the global prices of food commodities on consumer prices of selected food products in Latvia (%)
Notes: Estimates are based on monthly data for the period 2005–2018; the simulation assumes permanent 10% increases in the oil price, the average wage and food commodity global prices as from January 2019. Food commodities are cereals, meat, fish, dairy products, sugar and coffee.
Consumer prices of air transport services are significantly affected by fuel and labour costs. According to the International Air Transport Association's report on the global airline industry, fuel prices and labour costs represent 25% and 23% of operating costs respectively (IATA, 2019).
Similar figures could be attributed to Latvia, given the intense competition in this market as well as the high level of integration in the European aviation market. In Latvia, however, the price of fuel affects the airplane ticket prices much more than the domestic labour costs. This could be related to the fact that airline companies tend to recruit their staff internationally as well as the fact that the dynamics of airline ticket prices depend on competition. As a result, airline ticket prices may have little to do with the ever-increasing domestic labour costs in Latvia. Indeed, it could have been the intensifying competition that lead to the downward trend in Latvian air transport prices in recent years: between 2014 and 2018, they fell by 32% representing one of the sharpest declines among EU countries.
The prices of air transport services, in turn, affect the prices of package holidays (in which costs of travel and accommodation are bundled and sold in one transaction; Figure 6). The total indirect impact of the 10% increase in the oil price affected headline consumer prices (reflecting the impact on food and services prices) approximately by 0.1%.
Figure 6. Pass-through of 10% increases in the oil price and average wage on consumer prices of selected services in Latvia (%)
Notes: Estimates are based on monthly data for the period 2005–2018; the simulation assumes permanent 10% increases in the oil price and the average wage as from January 2019.
Crude oil prices fluctuate substantially and can rise by 10% even within a single day. With a permanent 10% increase in oil prices, the level of consumer prices in Latvia would rise by 0.6% in the medium term. This is far more significant than the effect caused by a similar increase in the global prices of wheat, milk, gold or any other product. Moreover, crude oil prices affect several consumer price components simultaneously. The direct impact on car fuel prices (0.25 pp) can be observed already within a month after the oil price changes. A rise in car fuel prices translates to higher transportation costs, thereby indirectly increasing the consumer prices of food and some services (0.1 pp). With some lag, changes in crude oil prices also pass through to the consumer prices of natural gas and heat energy (0.25 pp). Taking into account the direct and indirect effects of the crude oil price pass-through to consumer prices, one can improve the accuracy of inflation forecasts, in times of rapid oil price changes in particular.
* This article is based on the research developed by Latvijas Banka's experts, the full version will be published later.
 As a result, oil production in Saudi Arabia, the world's largest oil exporter, has shrunk by 5.7 million barrels a day or by more than a half. Historically, this is the sharpest one-off drop in oil production (more pronounced than that witnessed during the Iraq-Kuwait war in 1990 or during the Iranian Islamic Revolution in 1979), accounting for approximately 5% of the global oil production.
 In our estimates we use a price of car fuel as a proxy for price of jet fuel. This is justified due to the fact that the prices of car and jet fuel are highly correlated.
 By comparison, the prices of air transport services in the euro area increased by 7%, including a 12% rise in Estonia and a 4% fall in Lithuania.
 It should be noted that the price of oil is also likely to affect the prices of other services, even if this impact cannot be quantified (e.g. the impact of oil prices on the prices of bus and taxi services or the driving school prices).