Oil over $100 pressures Asia to cut subsidies

SINGAPORE Wed Mar 9, 2011 4:11am EST

SINGAPORE (Reuters) - High oil prices are straining the coffers of Asian governments, forcing them to contemplate rolling back fuel subsidies despite the political cost amid rampant food inflation, and even though the move risks hurting demand.

International benchmark oil prices have rallied to 2-1/2 year highs above $100 a barrel as revolt cut output from OPEC-member Libya and protests across the Middle East and North Africa threaten to disrupt more of the flow from the world's top oil-producing region.

Vietnam and Pakistan have both raised fuel prices recently to narrow the gulf between what consumers pay at the pump and what importers pay on international markets, although Pakistan quickly rolled back half the raise in the face of domestic political opposition.

If more countries follow suit and cut subsidies, higher prices would slow the pace of the region's oil demand growth.

"The question is as the price goes up more, will they stick to their guns?" said Lawrence Eagles, head of global oil research at J.P. Morgan. "The fact is that price always impacts demand to some extent. At the margin it has an impact."

How much demand would slow is debatable, as the relationship between price and consumption is tough to gauge. This is partly because there is little room for substitution in transport, which makes up much of world fuel demand.

The International Energy Agency (EIA) last year estimated that the removal of all subsidies by 2020 would cut primary energy demand by 5 percent from what consumption would be if subsidies were unchanged. Fossil-fuel subsidies cost some $312 billion in 2009, the IEA said.

Removing subsidies might prove more straightforward for countries that have budget deficits because they are under pressure to turn to the debt markets for financing, said economist Vishnu Varathan at Capital Economics in Singapore.

And even for countries with a surplus, keeping subsidies or expanding them would have an adverse effect on inflation control and would contravene tightening monetary policies.

"To advocate additional fiscal spending would go against the broad grain of monetary tightening," Varathan said. "It could ultimately be inflationary and self-defeating for the original purpose for which the subsidies were introduced."

CHINA TO LEAD DEMAND GROWTH

Ominously for oil markets, the 12 percent growth in fuel demand from Asia's top consumer came despite a rise in domestic fuel prices to record highs. China burned 8.65 million barrels per day (bpd) last year, around 10 percent of global demand.

The pace of growth in 2011 may slow to half that of 2010, thanks to Beijing's moves to rein in excessive credit. Even so China should continue to lead global demand growth -- as it has done for a decade -- and the IEA forecasts it will use an additional 570,000 bpd in 2011. That is nearly 40 percent of projected global demand growth.

Even as it fights inflation, Beijing has stuck resolutely to fuel pricing reforms it made after a run up to record prices on international oil markets in 2008.

It now charges around $1 per liter of gasoline -- more than the 85 cents per liter U.S. drivers pay. The government has indicated it has no plans to change tack on fuel prices.

"Excessively fast growth in oil consumption is exceeding the tolerance capacity of our country economically and environmentally," China's National Development & Reform Commission (NRDC) said last month.

"Therefore, there is an urgent need to give play to the role of price levers for adjustment and guidance, constraining the excessively fast growth of oil consumption."

Chinese consumers are already paying over 27 percent more for gasoline and 25 percent more for diesel than they did when oil peaked in 2008. International benchmark Brent oil is still around 22 percent below its mid-2008 record above $147 a barrel, while U.S. crude is around 30 percent below that high.

But rising incomes in expanding economies have been stronger prompts for oil demand than high prices, said Michael Waldron, demand analyst at the IEA.

"Income growth, so far, has been the more important variable in driving non-OECD Asia demand growth," Waldron said. "In the short term, prices above $90/bbl will likely slow demand there only marginally."

China's central government budget, published by the finance ministry last week, appropriated 29.647 billion yuan for fuel subsidies for urban and rural public transport and some other public service industries in 2011, a rise of 58 percent over the figure of 18.711 billion in 2010.

As the government prioritizes its fight against inflation above almost everything else, it is not keen to let fuel prices rise to a level where they threaten to fuel wider inflation.

But it is also wary of forcing its refiners to accept big negative margins that will discourage them from producing fuel and lead to shortages, smuggling and unrest, as experienced before pricing reform.

CONSUMERS HURTING MORE, BUT NOT IN INDIA

Millions more Asian consumers are feeling the impact of high prices now than three years ago, as many governments have reformed fuel price controls. The oil price collapse after the financial crisis opened a window of opportunity for change without too much damage to drivers' wallets. But reform was uneven -- and some governments missed the chance.

India and Indonesia have stalled on their plans to reform subsidy regimes, and high prices are likely to extend delays.

"In countries like India and Indonesia there isn't enough political capital to push forward harsh reforms," said economist Varathan.

"The sentiment of inequity is a lot stronger there. As long as an economy has not progressed to where most of the population has surpassed the poverty line, it is very difficult to move."

India, which the IEA says consumes just under 4 percent of the world's oil, or around 3.34 million bpd in 2010, is the largest regional consumer to have held off on reform for most of its fuel prices, and politics makes rapid change unlikely.

The government of Asia's third-largest economy faces some key state elections later this year and is already battling inflation that is among the highest among major world economies. It has repeatedly delayed plans to reform the price of diesel, its most widely used fuel.

With inflation more than 8 percent -- among the highest of the major Asian economies - the government has sanctioned a $5.2 billion subsidy bill on fuel for 2011/12, 38 percent less than the current year's $8.5 billion, but which could be revised up.

The call for action from state fuel retailers -- Indian Oil Corp (IOC.BO), Bharat Petroleum Corp <BPCL.BO > and Hindustan Petroleum (HPCL.BO) -- has been strong, as worries have spread over political developments across the Middle East and OPEC member Libya that are spurring world oil prices. A lingering two-month-old payments row over Iranian oil imports also feeds Indian supply fears.

As global crude prices rise, upstream firms' subsidy payout -- the discount given to state-run refiners on crude oil sales -- is set to increase.

But reforms may come after the elections, said Vivek Mathur, associate at Boston-based consultancy ESAI.

"India is one to watch," he added. "I certainly see domestic diesel demand moderating if controls are lifted on prices."

($1=6.570 Chinese yuan)

(Additional reporting by Chen Aizhu and Tom Miles in Beijing and Krittivas Mukherjee in New Delhi; Editing by Clarence Fernandez)

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