CHINA/ENERGY: SIGNIFICANT AND SURPRISING PRICE HIKES

UNCLAS SECTION 01 OF 02 BEIJING 002433

SIPDIS
SENSITIVE

STATE FOR EAP/CM AND EEB/ESC
TREASURY FOR OASIA/DOHNER
USDOC FOR 4420
STATE PLEASE PASS USTR FOR STRATFORD

E.O. 12958: N/A
TAGS: ECON ENRG EINV EPET EFIN PREL PGOV CH
SUBJECT: CHINA/ENERGY: SIGNIFICANT AND SURPRISING PRICE HIKES

REF: BEIJING 2331

SUMMARY
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1. (SBU) In a surprise move that came late on June 19, China's
National Development and Reform Commission (NDRC) announced
significant energy price increases. Effective June 20, gasoline
rose 16.7 percent, diesel 18.1 percent, and jet fuel 25.2 percent;
effective July 1, electricity will rise an average of 4.7 percent,
although household consumers, the agriculture sector, and areas
struck by the Wenchuan Earthquake in Sichuan will be exempted. The
change in energy prices was driven by shortages caused by refiners
finding it unprofitable to place fuel on the market as a result of
rising global oil prices. The move was unexpected given recent
inflationary trends, remarks last week by a senior official that
subsidized fuel prices were important for social stability, and
reports from economists that emphasized China's ability to maintain
subsidies given its strong fiscal position. The price increases
could add a fraction of a point to the consumer price index (CPI),
but if food price inflation continues to slow, the overall CPI may
actually show a decline nonetheless. Higher fuel prices could drive
up demand for imported oil in the short term as refiners supply more
fuel to a market presently facing shortages. In the longer term,
however, the movement away from subsidies should slow demand growth
for finished fuel products, and it is this anticipated effect that
led to global oil prices falling 3.5 percet in response to the
pricing news from China. Customers at a local filling station told
Embassy staff they believe price increases will change car buying
and driving patterns. END SUMMARY

FIRST PRICE HIKE SINCE NOVEMBER
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2. (SBU) The NDRC announced significant energy price increases in a
surprise move late on June 19. Effective June 20, gasoline rose
16.7 percent, diesel 18.1 percent, and jet fuel 25.2 percent;
effective July 1, electricity will rise an average of 4.7 percent,
although household consumers, the agriculture sector, and areas
struck by the Wenchuan Earthquake in Sichuan will be exempted.
Natural gas prices were not raised, while coal prices were capped at
their June 19 rates for the remainder of 2008. China's policy of
moderately subsidizing gasoline and diesel has insulated the public
here from global oil price increases since the last price hike, a 10
percent rise in November 2007 when oil was trading around USD
90/barrel.


3. (SBU) Although domestic shortages have led to mounting pressure
to raise fuel prices, this week's adjustments were greater and came
sooner than many economists expected. Less than two weeks ago, NDRC
Vice Chairman and Head of the National Energy Bureau Zhang Guobao
was quoted by Xinhua stating that China's current finished oil
prices are conducive to the country's social and economic stability
and that raising fuel prices too quickly would have a significant
impact on the domestic economy.

PRICING DECISION DRIVEN BY SHORTAGES
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4. (SBU) The NDRC told media the increase came as a result of rising
international oil prices that had led to refineries shutting down,
creating lines at filling stations and even limits on purchases in
some parts of the country. State-owned refiners Sinopec and
Petrochina have over recent months faced massive losses on sales of
gasoline and diesel at below-market prices. According to local
media reports, in the first quarter of 2008, fiscal subsidies to
Sinopec reached RMB 7.4 billion due to rising international oil
prices. In April alone, Sinopec received fiscal subsidies of RMB
7.1 billion. Meanwhile, Sinopec reported that the subsidies were
covering less than half of its total losses on refining operations.
China, the world's second largest petroleum importer, brings in just
over half of its needs, thus forcing its refiners into an
unprofitable situation where they must pay global prices for a
significant portion of the crude they process but then sell their
output at capped rates (Note: Sinopec relies more on imports than
Petrochina. End Note.) The result has been widespread spot
shortages, particularly for diesel, impacting transport by truck.

MARKET IMPACT
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5. (SBU) Global oil prices fell 3.5 percent following the pricing
announcement, in anticipation that a movement away from subsidies

BEIJING 00002433 002 OF 002


should slow demand growth for finished fuel products. Of note, NDRC
Vice Chairman Zhang Guobao in recent weeks has dismissed the idea
that rising demand in developing countries such as China and India
is to blame for the surge of oil prices, arguing that investments by
hedge funds and other speculators have played a key role in driving
up prices. Independent Beijing-based economist Andy Xie supported
this argument in a recent article in the economic journal, Caijing,
in which he argued that unusual supply and demand dynamics, low U.S.
interest rates, and speculative capital have come together to create
today's oil price bubble.

SHORT-TERM: MORE IMPORTS, GRUMBLING
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6. (SBU) The new pricing should be an incentive for greater refinery
production and may, ironically, lead to greater imports as pent-up
demand is satisfied, according to RBS Economist Ben Simpfendorfer.
But it is unclear whether the price hikes are sufficient to bring
independent refiners, which account for as much as 15 percent of
domestic production capacity, back into the market. Whatever the
case, Chinese consumers and even state-controlled media have over
time demonstrated significant irritation with high fuel prices, and
the grumbling is likely to continue.


7. (SBU) An LES employee queried customers at a Beijing Sinopec
station near the Embassy on June 20. Asked about the government's
decision, younger drivers reluctantly accepted the price increase,
stating that they understood that the decision is a result of higher
international oil prices. Older drivers said they were surprised by
and unhappy about the price hikes, adding that the price increased
too rapidly. Most drivers said that this week's price increases
will make them more inclined to use public transit and will
encourage consumers to purchase smaller, more fuel efficient
vehicles. (Note: The persons queried were probably among Beijing's
more affluent population. Emboffs have not yet been able to gauge
reaction among the city's poorer residents. End note.)

LONGER-TERM: MORE RATIONAL ENERGY USE, MORE INFLATION
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8. (SBU) One of China's top economic and environmental priorities in
the 11th Five Year Plan is reducing energy intensity by 20 percent.
With car ownership exploding here, there have been widespread calls
for subsidy reform to bring proper price signals to the market.
Higher gas prices should have an impact. By contrast, the top
short-term economic priority of the government is combating elevated
inflation, running around 8 percent over recent months. Raising
fuel prices could add to this figure but this may not be noticed if
food prices -- the overwhelming cause of recent inflationary trends
-- continue to stabilize. Gasoline makes up a small part of the
basket of goods used to measure inflation so the impact of fuel
price increases on CPI is expected to be relatively small. Goldman
Sachs economist Hong Liang expects the direct impact on CPI to be
around 0.13 percent, while UBS economist Wang Tao estimates the
impact on CPI to be about .5 percent. Hong Liang notes that a more
pronounced impact is likely to be seen in declined profitability of
downstream industries. Nonetheless, the price increases and
resultant increase in fuel and power supply to the market could
improve prospects for industries that were previously threatened by
the possibilities of oil product shortages and power outages.

MORE TO COME?
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9. (SBU) RBS economist Ben Simpfendorfer estimates the new spread
between locally capped priced and international market prices for
refined fuels to be 37 percent. UBS economist Wang Tao estimates
that China's new oil product prices would be at an import parity of
about USD 90/bbl. This suggests that further hikes are likely,
especially if international prices continue to rise. Of note,
however, the Chinese Government's fiscal position remains strong, so
it is capable of choosing the time and pace of any further price
hikes. Morgan Stanley economist Qing Wang claims that China is
well-positioned to maintain subsidies compared to its peers in the
region due to its low government debt levels. With concerns about
inflation and social stability still running strong, the Chinese
Government will be inclined to carefully monitor public response to
this week's price increases before making further adjustments.

PICCUTA