Why China Gas Subsidies Don't Matter

In an interview with the German television early this moth, German Chancellor Angela Merkel said she hoped the Group of Eight could exert more pressure on big developing countries like China and India to reduce oil consumption and ease the tension on the international oil supply.

She added that the key to stabilization is to reduce China's demand and blamed its oil subsidies, saying it keeps domestic oil prices far below international standards. The result: more consumption, in turn, sending prices even higher.

The International Energy Agency echoed similar remarks in a June 30 report, calling for China to eliminate its subsidies.

Since the beginning of this year, oil prices have gained nearly 50 percent, hitting a record high at more than $147 a barrel, and continues its upward trend. But could the internal policies of one nation really be affecting prices for the rest of the globe?

The Subsidy Effect

The Chinese government has been sheltering its citizens from the high prices of oil by capping gasoline prices. Oil refineries also get direct or indirect subsidies to ease their losses as they sell the low priced gas.

While this works well for Chinese companies and fuels tremendous national growth, some observers say these subsidies are distorting demand and sending prices artificially high.

"[I]f prices are subsidized in one country, then the brunt of the burden falls on citizens of others," explains Robert Levitt, the Chief Investment Officer of Levitt Capital Management "The OECD (Organization for Economic Co-operation and Development) countries can't really solve the problem by increasing prices or interest rates because the inflation is driven by the third world."

Many experts believe that where markets are completely free, or at least places where subsidies are lower than China's, then market forces will naturally slow demand for oil.