The opportunity cost of domestic oil consumption for an oil exporter: Illustration for Saudi Arabia

Highlights: • A partial equilibrium framework provides formulas for the opportunity cost under sectoral constraints and pricing schemes. • The opportunity cost of oil consumption can be significantly less than the world market price. • The envelop theorem produces a practical formula to quantify the welfare gain generated by a domestic price reform. • The most efficient domestic pricing policy is to set the price of oil equal to its opportunity cost. • The value of the opportunity cost may depend on the persistence of the project's (or policy shift's) effects on oil demand. We develop a partial equilibrium framework to assess the opportunity cost of domestic oil consumption for an oil-exporting country. We show that the opportunity cost depends on various factors, including the constraints to which the oil producer is subject and the domestic oil pricing scheme. Moreover, through an application of the envelope theorem, we assess net welfare gains that can be generated from a reform of the domestic oil price. Our results show that the most efficient pricing policy is to set the domestic price equal to the opportunity cost. A numerical illustration for Saudi Arabia is provided to demonstrate the practical value of the proposed framework. Our findings can inform public decision-making for projects and policies that impact oil demand.