If you've been keeping track of the recent explosion in the price of oil, you'll notice two points that keep popping up when people try to explain oil's unprecedented rise: The price might not be supported by supply and demand, and, if it is, the surge is caused by exploding demand from China and India stacked against stagnating supplies. Both points might be probably spot-on, but by no means does that give us any hint of what's to come.
In any normal market, if the price isn't justified by supply and demand, it's only a matter of time before things return to sensible levels. In the same way housing annihilated the "glass is 1.5 times full" investors, it'll only be a matter of time before oil returns to the good ol' days, the theory goes. And, if China and India really are contributing to the huge increase in demand, higher prices will eventually sap demand, bringing oil back in check. Right?
Welcome to the beautiful world of subsidies
Kind of. But if you're going to call the oil market in China a real market, you might as well call Milli Vanilli real singers. Fuel prices in many countries are, in part, subsidized by the government. The subsidies -- while helping to keep inflation under control and the people happy -- can distort the forces that usually keep global demand in check -- and that could be costing you some serious money. The same Chinese guy who's paying your mortgage? He's also spiking your gas bills.
Particularly in developing nations like Asia and South America, the prospect of rapid growth can quickly be zapped by inflation. To combat this, governments do the logical thing: place price caps on goods such as gasoline, and subsidize the difference. While a barrel of oil is a barrel of oil, its cost by the time it gets to consumers is anything but universal. Worldwide gas prices range from $0.12 a gallon in Venezuela to well over $6 a gallon in parts of Europe. Part of the reason for the huge discrepancy is that governments can impose taxes or subsidies that create an uneven playing field.
Take China, for example. Until Thursday's surprise announcement, Chinese citizens had undergone just one increase in the price of gas since the middle of 2006, a 10% hike last November. Meanwhile, the Chevron (NYSE:CVX) and Royal Dutch Shell (NYSE:RDS-A) (NYSE:RDS-B) stations down the street from me raised prices 10% in the past five weeks.
Can they keep it up?
You would assume, then, that as world oil prices balloon, the subsidies will have to scale back as the burden proves too costly for the government's funds. For many countries, this is already happening. Taiwan, Malaysia, and Indonesia recently announced plans to reduce oil subsidies and pass along higher prices to its citizens. India -- where oil consumption is growing at more than 20% per year -- took a more dramatic step, announcing it would cease diesel subsidies to all commercial establishments.
China, on the other hand, might be a different story. Unlike smaller countries, China's energy subsidy accounts for only about 1% of GDP. Adding fuel to the fire, its government has more U.S. dollars than it knows what to do with, and runs a budget surplus. China did recently announce a price increase on gas and diesel by 17% and 18%, respectively, which sent shares of PetroChina (NYSE:PTR) and Sinopec (NYSE:SHI) higher and could alleviate global demand, but the underlying issue of energy subsidies for several countries still remains.
Good for them. But what's it mean for me?
Oil's one of the most universal commodities in the world, and its influence on a country's economic potential is taking center stage like never before. While domestic retailers like Wal-Mart (NYSE:WMT), Tiffany's (NYSE:TIF), and Best Buy (NYSE:BBY) face the prospect of weakened consumers saddled with soaring energy bills, those in some of the world's fastest growing economies might not recognize oil's burden if it sat in their lap and called them mama. The reason you should embrace $4 gasoline is that higher prices force necessary changes. But if parts of the world are exempt from the pains of rising prices, the need for change slows -- at someone else's expense.
As millions of Americans who had the benefit of artificially low interest rates on mortgage products learned, if it's too good to be true, it probably is. Whether or not subsidized oil markets will face a similar wrath isn't clear. What is clear, however, is when the price of oil pushes away from what seems ordinary, you've got to remember there's a host of unordinary forces pushing it around.
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