Blowing Up The Energy Bubble

That said, the global inflation epidemic is making it hard to sell anyone—rich or poor—on price hikes. According to one Morgan Stanley analysis, if India were to raise oil prices to global levels instantly, it would add nearly 4 percentage points to the inflation rate of 11 percent. Yet only the largest countries, namely India and China, have the bulk to really affect the global market. And China, with its $1.5 trillion in foreign-currency reserves, is the best situated to continue subsidizing fuel indefinitely. "China has a bottomless pit of money it can hand out," says Andrews-Speed.

Then there's the question of just how much subsidies can really counteract a fundamental shift in global energy demand. In some cases, raising fuel prices might even have the short-term perverse effect of increasing consumption, as profit-hungry producers race to catch up with pent-up demand. In China, for example, when authorities raise prices, local producers and refiners (which can finally earn a fair price) quickly put more oil on the market. That in turn was snapped up by those lines of thirsty mopeds, boosting consumption. "This is a standard rationing situation," says Peter Buchanan, a senior economist at CIBC World Markets. "People say, 'If you raise prices, that's going to reduce demand.' In fact, in China it appears to be working the other way." Indeed, investors and traders already know this. Although international crude prices fell on the news that China was cutting its subsidies on June 19, they were back up the next day as investors realized that Chinese demand might indeed grow faster after the price hike.

While this dynamic will eventually stop once supply and demand are rebalanced, in the long run what really matters is that big emerging markets are still growing—and fast. In China and India, economies are reaching "the point at which people adopt a more energy-intensive lifestyle," says Buchanan. China alone is expected to increase the number of cars on its roads twentyfold by 2030, according to a study released last year by New York University. And those numbers were crunched before the Indian company Tata introduced its groundbreaking $2,500 car. As a Morgan Stanley research note argues, the "demand destruction impact" of further fuel price increases in China, if made gradually, is likely to be "rather small." The same could be said for India and the rest.

In the end, fingers should perhaps be pointed at the biggest rich-country consumers—namely, Americans. A number of economists put the recent fall in the price of oil, which is now hovering at about $120 a barrel, down to the fact that $4-a-gallon gas finally has Americans driving less. "I think a lot of this is about the U.S. economy and U.S. consumption," says Zhou Dadi, deputy director of the China Energy Research Council in Beijing, arguing that data showing weaker oil consumption in the United States has been motivating the sell-off. "[U.S. demand] is a bigger factor than the Chinese impact." President Bush might not like the economic significance of Shanghai's moped queues, but if he really wants to see lower fuel prices, he'd do better to look at Los Angeles's freeways.

With Duncan Hewitt in Shanghai

© 2008