China's Cheap Fuel Underpins Global Oil Price Spike

To find out why global crude prices are at historic highs, look no further than Christina Lu and her silver Honda Odyssey.

A beneficiary of China's artificially cheap gasoline, she drives as though the world's energy resources are limitless.

China and other emerging economies have recently accounted for the entire growth in global oil demand as more mature economies have cut consumption.

This is partly expected, since China is in the middle of what looks set to be its sixth year of double-digit economic growth.

But price caps on gasoline and other oil products also play a huge part, insulating China's consumers from the real price of energy.

The nation's oil majors, Sinopec and Petrochina, suffer under price caps as they cannot pass the costs on to their customers.

In turn, they get subsidies from the government to cover most of their losses.

Observers see it as a classic example of how government interference covers up the actual state of the market, leaving people with little direct sense of the value of the goods they consume.

This is not just China's business. Since it is a power with growing global clout, economic developments such as this have repercussions far beyond its borders.

CICC cited a detailed simulation which showed what would happen if China raises its oil product prices by 50 percent around mid-2008 to put the domestic refining gross profit margin in line with international levels.

Under this scenario, international oil prices would decline to $116 per barrel by the end of 2008, and $95 one year later.

By contrast, if China continues to control domestic oil product prices, international crude oil price will hit 200 dollars per barrel, the CICC's simulation shows.

According to Lin Yixiang, general manager of TX Investment Consulting, the Chinese system has brought about a litany of social ills.

However, the government may be reluctant to change, as a rise in the cap on fuel prices could boost inflation, potentially a source of immense public dissatisfaction.

China's consumer price index rose by 7.7 percent last month, easing only slightly from April's 8.5 percent and still hovering near 12-year highs.

The question is how much longer the government can afford to subsidise energy use.

As late as 2007, the value of China's direct and indirect subsidies was a manageable 0.9 percent of gross domestic product, lower than the three percent seen in many other economies.