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from Stratfor.com
China on Thursday announced that it will increase gasoline and diesel prices by up to 18 percent. Electricity prices will rise by about 4.7 percent on July 1. China is also considering new taxes on fuels. Jet fuel prices will increase by 25 percent.
The Chinese have kept a cap on fuel prices in China, creating spot shortages, particularly for diesel fuel, and transferring the cost of oil purchased on the global market to Chinese refiners and distributors, which were buying at global prices and selling at controlled prices. State money undoubtedly flowed to the producers, but the caps the Chinese imposed created massive irrationalities in the Chinese markets.
Those irrationalities remain. The Chinese have not allowed prices to move in tandem with the cost of supplies. They have reduced the differential by raising the caps, but have not eliminated it. Energy prices remain capped, and manufacturers will continue to be able to purchase fuel at artificially low prices. Essentially, the Chinese government has reduced the subsidy for the purchase of energy.
The Chinese are walking a tightrope. As fuel prices rise, the cost of Chinese exports will increase. As the cost increases, foreigners – particularly Americans – could lose their incentive to purchase Chinese goods as opposed to goods from, for example, Bangladesh, where the wage differentials are larger than China’s. If Chinese exports fall, some Chinese businesses – already selling at extremely low margins – could be forced into bankruptcy. That would trigger unemployment and potential social unrest. This is in addition to increased domestic inflation in general.
On the other hand, if energy consumers continue to consume high-priced oil at low prices, the difference has to be made up somehow. The national oil companies were forced to make up the difference for a while – with resistance – but the magnitude of the differential has grown beyond what any private entity can manage. The Chinese government has had to reach into its massive reserves to make up the difference. In effect, the Chinese government has been subsidizing Chinese exports, as well as domestic consumption, by facilitating the purchase of oil at high prices while selling it at lower prices.
China’s reserves are massive, but so is China’s appetite for oil. As the price rose and the cap stayed static, the reserve was being tapped heavily.
It was a situation that could not go on forever (though it could go on for quite a while, given the size of Chinese reserves). The problem that the Chinese had was that they, like everyone else, had gone off the map. They had not anticipated $130-a-barrel oil, did not know if it would remain at that level and did not know how high it would go. They had held their position as long as they could, hoping for decline, but clearly felt that they couldn’t wait any longer, even if the Olympics were coming.
China compromised. Unwilling to let fuel soar to world prices – and live with the consequences – the Chinese continued their policy of subsidizing fuel, but reduced the subsidy modestly. They appeared to be looking for a price that would reduce the drain on their reserves without dramatically raising the prices of exports and triggering a wave of business failures, with the resulting impact on their financial system.
The move is rational if oil prices move down as a result, closing the gap between cost and price. Prices did fall on Thursday, partly as a result of the Chinese news, partly because of a report from the U.S. government forecasting decreased worldwide demand and partly because markets fluctuate on a daily basis.
The real question is not what oil prices did today but what they will do in the coming weeks. At $100 or so, the global economy seemed to be managing fairly well. Things got tough as oil passed $120. So, it would seem to us, the real question is whether oil will go down toward $100, closing the gap for the Chinese and reducing pressures on the global economy.
The Saudis will be formally announcing increased production shortly. The U.S. government is forecasting lower demand. And the Chinese have raised prices. If oil prices are going to give, this is as good a time as any. If they don’t, the Chinese in particular will have some very hard decisions to make.
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