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.

When China, which is responsible for about 9 to 10 percent of global consumption, is not curtailing demand however, "the western markets have to bear the priceas they reflect in higher global demand and higher prices of crude," Niket Patankar, CEO of research firm Adventity told IBTimes.

But the country hasn't stood still. Under the pressure of rising oil prices and criticism, China has been slowly easing its subsidies since June 20, with both petrol and diesel prices adding 1000 Yuan per ton, and Kerosene price gaining 1500 Yuan per ton. Markets became elated, or at least temporarily.

International crude prices dropped almost immediately. In Nymex trading, crude oil futures tumbled nearly $5 a barrel to close at $131.93. Analysts praised the curbing of subsidies in Asian countries and primarily in China, saying it would help slow demand for oil

But what happened next had analyst second guessing themselves.

In spite of the drop in subsidies, the price of oil not only rebounded on the second day, it kept rising for the next 3 weeks finally peaking on July 11.

"The criticism of the international community regarding the 'fairness' of Chinese oil price controls is at best hollow and self-serving," explained Dr. Antonin Rusek, economics professor at Susquehanna University.

Even if price liberalization would result in a 10 percent reduction in Chinese domestic demand an unrealistically large number Dr. Rusek predicts that world demand would only fall by about 0.9 percent (using 2007 numbers).

"It should be obvious that the impact of an increased Chinese demand for oil during the last five years (2003-2007) is rather small its share increased by 1.9 percent over 5 years," he explained.

China's Real Impact

The spike in last month's oil prices amid softening Asian subsidies has cast a new perspective on the impact of China's internal policies and the global oil market. While China's current impact on the oil markets remains small, its appetite is predicted to drive up prices soon if new supplies aren't found.

"Chinese subsidization of oil prices is not what drives world oil prices 90 percent increase in the last 9 month with no substantial changes in quantities traded [is what did it]," Rusek said.

In the past few years global oil demand increase by about 9 million barrels per day while at the same time production of oil has only increased 4 to 5 million barrels per day, according to The Energy Intelligence Group.

The IEA also changed its stance in its July report, saying China's oil demand is mainly a product of its own economic growth and not favorably low prices. In fact, China's demand is already suppressed by global supplies..

The agency predicts China's annual demand for oil will account for one third of the whole world within the next years. Unless global oil producing countries can increase output, China may once again become the scapegoat for supply and demand economics.