Do Energy Subsidies Inflate Oil Prices?

A Disneyland theme park and a Shanghai gas station don't normally have much in common, but lately they've shared one important trait: endless lines. During evening rush hour in the Chinese metropolis, long queues of mopeds back up outside the city's main downtown stations, where riders wait up to half an hour to top off. They have no choice: at least 35 stations closed down earlier this year, the victims of government- imposed price controls, which force the stations to sell gas below cost.

National subsidies for petroleum consumption, which keep prices for motorists and other oil users at artificially low levels, are one of a long list of factors—including speculators and terrorist acts—accused of sending oil prices skyward. But recently, energy subsidizers, including many of Asia's largest nations, have come under the most fire. In July, President George W. Bush sounded off against subsidizers, blaming them for keeping demand high, which "may not be causing the market to adjust as rapidly as we'd like."

While it's convenient for the leader of the world's largest oil-consuming nation to direct attention elsewhere, there's some truth to the rhetoric. Before June 19, Chinese consumers were paying half the global market price for oil. When the government made a surprise announcement that day to raise prices by nearly 20 percent, the price per barrel of Texas light sweet crude fell by nearly $5. Now politicians around the world are calling for more of the same, hoping for a quick cure to the plague of costly oil. What's unclear is exactly how much an end to global energy subsidies would reduce the price of oil, and how quickly.

Consumers in dozens of countries, from Egypt to Indonesia to India, now pay well below cost to fill up or switch on the lights. In China, even after the June increase, motorists pay about $2.80 per gallon, versus $3.75 in the United States and $8 in France. In oil-exporting nations, the situation is downright ludicrous: Saudi drivers pay an incredible 45 cents a gallon. But autocracies aren't the only offenders. Even democratic India holds the price of oil to about $80 a barrel.

Pressure from economists and politicians has resulted in some cuts. China's June price hike made it the fifth country to make such a move in recent months. Indonesia, Taiwan, India and Malaysia have also raised retail prices between 10 and 50 percent since late May. And analysts expect more such hikes, in part because the fiscal burden has become too much for most countries to bear. Subsidies are now costing many governments, including India, China and Malaysia, 2 percent or more of GDP. The burden is worse in smaller countries, like Turkmenistan, which pays a whopping 15 percent of GDP to subsidize fuel, according to the IMF.

If oil subsidies were to disappear overnight, that could shave $10 to $40 off the price of oil, says Jim Burkhard of Cambridge Energy Research Associates, who warns that such figures are essentially educated guesses. But no one is expecting that dramatic a shift any time soon. Most subsidizing nations are still poor countries, and many are dictatorships; capping the price of gas is seen as a way to help the poor and preserve social stability, even though many of those who benefit are among the middle and upper classes. "People living in nice apartments with air conditioning in Beijing absolutely should pay more for their energy," says Philip Andrews-Speed, a professor and energy expert at the University of Dundee. The IMF and others agree that the poor would be better off if the billions spent on fuel subsidies went toward other schemes, such as direct cash transfers to the least well-off.

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.