August 23, 2005
Oriental Oil Imbroglio

While it may seem that the great dragon of China is able to shrug off the super-high oil prices that are percieved to be strangling everyone else, the truth is actually quite different:

The chaos created by sudden fuel shortages in Guangdong Province continues ... The official reason for the shortages proffered by the central government, laughably, concerned last week’s typhoon that hit the province. Additional speculation for the shortages blamed market distortions due to price controls, alas this was only partly correct. Finally, the Hong Kong media got it right yesterday, the real reasons for the shortages have been common knowledge in Guangzhou for several weeks...

While the author cites warring oil companies turning off the taps in a conspiracy to corner China's burgeoning petroleum market, the actual reason is right there... price controls. This explains a lot about what's going on in the oil markets right now. When prices go up, what's supposed to happen is that demand goes down. In the market-driven economies of the west, that's exactly what's happening. This then results in a stabilization of prices, eventually leading to a reduction of price as things regain equilibrium.

But China's throwing a wrench into the works. By instituting price controls, China has allowed demand to grow at a rate completely disconnected from the reality of oil supplies. High prices should cause factories, farm equipment, cars, and power plants to become more efficient just to stay in business, causing them to use less oil, stopping and then eventually reversing price hikes. But since the Chinese government is shielding its industries from this effect there is no incentive to improve, no reason to become more efficient. Wasteful tractors, inefficient power plants, and gas-guzzling cars are allowed to continue operating, even faster, because there's no reason for them not to.

However, the "ain't no such thing as a free lunch" principle is finally starting to take hold. Someone's been left holding the bag on this, eating this price difference, and it would appear to be the oil companies. The inevitable result of any attempt to artificially control prices is a shortage, and now that these oil companies have cut off the taps all sorts of hell may start breaking loose. Because you see most people don't understand why market forces, even ones that seem to hurt people, are a long-term good. They instead focus on the short-term evil of shortages, long lines at gas stations, brown-outs at home, and crops left to rot in fields because there's no fuel for the tractor.

These are the times when democracy shines, and therein lies a deep and perhaps insoluble problem for the current Chinese government. When western nations tried to have it both ways by controlling oil prices in the face of real scarcity back in the 1970s, the resulting economic chaos simply caused voters to boot out the engineers of the disaster and bring in others who could fix it. In some places these fixers were then booted out in turn*, but there was no social revolution, no dismantling of an entire country, no civil wars.

China doesn't have this safety valve. Worse still, the communist party leadership has made the common error of assuming it is the country, and therefore its leaders cannot get their heads around China existing without them. If they can't get ahead of this oil crisis, and quickly, Very Bad Things will start to happen. If they can't get the oil companies to play ball, economic collapse is right around the corner. If they can't get the populace to accept higher prices, social revolution is right behind it.

And therein lies the rub... it seems clear the populace won't accept higher prices, and China's Byzantine bureaucracy and endemic corruption mean their oil companies may not have to play ball. And even if they do, oil prices aren't going to drop just because the Chinese government wants them to, so getting the oil companies to come around will merely delay the crisis, not avert it. When irresistible forces start flitting around immovable objects, reality has a way of clubbing those who refuse to see. If the Chinese government doesn't do something to reign in demand, I'm expecting that club to hit them right between the eyes.

I've often said we're sitting on an oil price bubble that merely needs a pinprick to burst. China's economy collapsing into a heap would fit the bill nicely. Unfortunately their governmental structures are so rigid and inflexible, social revolution would almost inevitably follow. Considering China holds an enormous amount of the US's debt, this would definitely cause "interesting times" for just about everyone.

But that's another story...

* Westerners are no better at seeing long-term good versus short-term evil, and I can vividly remember the anger most people felt as jobs were lost, farms were foreclosed, and businesses went under during the early 80s. Reagan lost most of his congressional power base in the 1982 elections because of this, and I'm still amazed Margaret Thatcher stayed in power at roughly the same time.

Posted by scott at August 23, 2005 10:03 AM

eMail this entry!

Thanks for the link Scott. Great write up by the way. I agree totally. Do you mind if I add your post to the comments over at The Peking Duck? I'll link to this site of course.

Martyn - Peking Duck guest blogger

Posted by: Martyn on August 25, 2005 05:18 AM

Please do :)

Posted by: Scott on August 25, 2005 08:10 AM

Done. Thanks.

Posted by: Martyn on August 25, 2005 10:22 AM

Great points.

I would be cautious that democracy alone may not solve the whole problem. e.g. rent control in certain US counties in the past. but it definitely helps to curb irrational policies from drifting too far off. in my view, the decoupling of SOE P&L from state control alone would solve this problem.

Posted by: sunbin on August 25, 2005 03:22 PM
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