China slashes fuel price subsidies, crude unchanged. Will anything bring down the price of oil? – 24 June 2008

 

China’s sudden fuel and electricity price hike on the evening of Thursday 19 June came as a surprise to most. From 1 July 2008, the average price of retail fuel in China will be increased by 16.7%, diesel by 18.1%, and the electricity price by 4.7% (although earthquake areas appear to be exempt). The Chinese will still have to pay less than USD100 a barrel, but the effect of these fuel price hikes will probably be to increase headline CPI by around 0.3% this year. Given the Chinese government’s fear of inflation, most pundits guessed that by raising fuel prices, the government was signaling that other inflation (particularly food price inflation) is firmly under control.

 

But I am sceptical – the sudden slashing of subsidies seems to be linked to the rather tense relationship between the Chinese government and the Chinese refiners. As the price of crude has rocketed, the refining companies have had their margins squeezed as they have been forced to buy increasingly expensive crude oil on the international markets and sell at domestic prices fixed at low levels by the PRC government. Subsidies for the refiners have been financed out of China’s large current account surplus, but with the oil price at USD130+, these subsidies do not dull the pain as much as they did six months ago.

 

Reports of shortages of refined products and electricity began to emerge several weeks ago. It seems as if the refiners were refusing to run crude through their plants because of the losses incurred by the Chinese “buy-high, sell-low, receive fixed-subsidies” system. This is reflected in China’s imports of refined products (red line on the chart), which have shot up since January in volume terms, even as the price of crude oil has moved skywards (white line). The refiners were getting stroppy and refusing to refine! The Chinese government could have chosen to boost subsidies or to raise domestic fuel prices; they chose the latter path.

 

 

After the Chinese fuel and electricity price hikes, the price of crude oil on COMEX immediately dropped by around 5%. The assumption was that higher oil prices will send a ‘price signal’ to Chinese consumers, who will consume less oil. US consumers have not had their oil subsidised, and so it has simply become too expensive for Americans to drive as much as they used to. They have also started to buy relatively fuel-efficient Japanese vehicles rather than Detroit monster-trucks, and so demand for gasoline has dropped. Now that subsidies have been eased in China, there appears to be an assumption that high oil prices will also lead to demand destruction there (and elsewhere in Asia where fuel subsidies have been cut over the last three weeks). However, I am very doubtful that this will occur as quickly or on the sort of scale that some commentators seem to be expecting…

 

Nearly 50% of crude demand in the US is estimated to come from discretionary consumer demand for gasoline, in other words from the US national driving addiction. That is an awful lot of demand which is waiting to be destroyed. The equivalent figure in China is around 8% of consumption (reflecting the fact that auto penetration is lower); most of the rest of Chinese fuel consumption is from industry demand which powers GDP growth. I would bet that in the short-term, Chinese industry will go on buying oil and contributing to GDP in the same energy-inefficient way that it always has. Although Chinese GDP growth will probably slow slightly in 2008 on a yoy basis, the CCP knows that it is imperative that GDP growth should not fall below +8%, say. If it did, this would violate their great unspoken ‘pact’ with the Chinese people, i.e. given that there is now no overriding ideological basis for CCP governance in China (save a vaguely-defined patriotism), the Party must continue to enrich the Chinese people in order to stay in power.

 

Analysts are estimating that recent price hikes across Asia could shave 100,000-200,000bpd off global demand assumptions. Last weekend, Saudi Arabia announced that it would boost production by 200,000bpd. Rare positive news from both the demand- and supply-side, but even this does not seem to have been enough to bring down the price of oil.

 

Maybe it is just as well to remember that Middle Eastern consumption has been responsible for just as much of the growth in oil demand that China has. The higher the price of oil goes, then the more cash flows into Middle Eastern coffers, which is in turn spent by Middle Eastern consumers and governments, which then contributes to world oil demand and higher oil prices. An interesting virtuous (or vicious) circle, depending on your viewpoint…

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