June 9, 2008 | posted by Michael Baxter in Oil |

It is just getting ridiculous.  Oil closed in on $140 over the weekend.    In fact, reports suggested it saw the biggest one-day hike ever recorded.  More reports have been published predicting oil will reach $200, claims we have reached peak oil are growing, and yet…

As we have argued before, at current prices, oil is unaffordable.   In the short-term, demand for oil is what economists call inelastic.  Demand is not affected by price. 

In the longer-term though, oil is just like everything else.  If price is too high, we find different way of doing things.  We buy fewer SUVs, and in the US, fewer pick up trucks, for example.

Furthermore, when something rises as fast as oil did over the weekend, then we are seeing the hallmarks of a bubble.    Bubbles burst.

Last week we told how across Asia, countries have been lowering oil subsidies – meaning consumers in India, Malaysia and other countries are now paying more for their petrol – this will result in falling demand.

But in China, the subsidies are still in place.  

According to Capital Economics: “China’s retail fuel prices are well below international levels. Consumers pay around 50 per cent more for gasoline in the US than they do in China, but the fiscal costs to China of keeping prices so low are still relatively small.”

In fact, Capital Economics calculates as follows: “If international prices remained at their current levels, and the price for all refined products was kept at the same discount to international prices, the implicit subsidy for the year as a whole would be in the region of $110bn, or 2.8 per cent  of GDP. 

However, the cost to the government is in fact less than that as: “The government has in effect been forcing the oil companies to subsidise their downstream refining, distribution and retail operations using revenue from upstream activities.”

As a result, Capital Economics believes the true cost to the Chinese government of subsiding oil is around 0.5 per cent of GDP.

Now normally, 0.5 per cent of GDP would be too much for most governments to bear.  But in a country that is growing by 10 per cent a year, and in a country that sees inflation as a threat to growth, a subsidy costing half a per cent of GDP is a small price to pay.

It is just that this can not carry on for ever.  China’s state-owned oil companies are losing money, sooner or later they will be unable to subsidise the prices they charge.  Furthermore, if oil does reach $200, then the cost to the Chinese government will be much higher.

The general feeling seems to be that China’s subsidies will stay unchanged until after the Olympics.

But if oil stays at current levels, or does indeed rise further, expect the subsidies to go, eventually. 

Then demand for the black stuff will soon plummet.

Calling the end to bubbles is notoriously difficult.  The bubble probably won’t burst this year, and probably won’t burst next year, but sooner or later it will.