China's New Fuel-Price Inflation

What impact will China's 17% hike in gasoline prices have on broader world markets...?

The UNITED STATES is so myopic, writes Julian Murdoch for Hard Assets Investor.

   Despite growing evidence to the contrary, we think the world revolves around us. This extends not just to sports, politics and culture, but to economic factors like crude oil demand, too.

  
So the news that US citizens are conserving fuel and driving less – enough to save 1% of their fuel demand – made headlines around the world. But as it turns out, there's this whole other world out there that doesn't revolve around the American SUV owner.

  
In a move that many consider a turning point for the energy markets, the Beijing authorities recently cut the subsidies they pay to suppress local energy prices, creating a jump in the price of both gasoline (17%) and diesel (18%).

  
In response, with Chinese consumers finally facing a little fuel-price inflation, crude oil prices fell by $4.75 a barrel...only to pick right back up again over the following sessions.

  
The world markets still are used to thinking of the Chinese economy as an independent unit. English-language reporting continues to focus on China as little more than a demand vacuum, sucking in any and every commodity it can, as fast as it can; there's precious little consideration of the complexity of the China economy itself.

  
But Chinese companies and Chinese consumers react to the same forces as you and I do. So as China moves to raise its energy rates, it pays to consider:

  
What affect will rising energy prices have in-country? What's the impact on consumer behavior? How will those effects ripple out into the wider market?

Crude Oil: It's The Economy, Stupid

  
China's increase in fuel prices goes alongside a planned future increase in electricity tariffs on July 1st. These two key prices will feed an increase in inflation as the Chinese people spend more to purchase goods and transportation, but not necessarily gas.

  
Dong Tao, regional chief economist with Credit Suisse, was quoted in Forbes on Friday estimating that the fuel price increases will raise China's CPI between 1% and 2.3%. The big variable is how high public transportation fees will go up with this new increase.

  
"In our estimation, fuel directly counts for only 3% in [the] CPI basket, but public transportation counts for 5.5%," according to Tao. And this makes sense in a country where private car ownership is growing, but still not the norm.

  
In 2006, there were only 30 cars per thousand people. By comparison, in 2006, the world average was 120 cars per thousand.

  
Of course, there's a possibility that the combination of higher fuel prices and higher public transportation costs could push China's inflation higher still, up from its current already-high 8% per year into double digits.

  
And China ain't no Vegas. What happens there definitely does not stay there. The goods we import from China may soon reflect this jump in Chinese living costs, reversing the so-called "Chindia" effect of low-priced imports pulling down Western consumer-price inflation.

Crude Oil: Who Turned Out the Lights?

  
Beyond the Chinese people, several global industries will be hit hard by the increase in energy costs. Already many businesses are suffering because of inadequate power supply.

  
Power plants buy coal at expensive market prices and then have to turn around and sell the electricity they generate at set government prices. Many times the power plants can't meet demand, and power outages are a fact of life in Chinese commerce.

  
It's the aluminum producers that we're guessing are among the hardest hit. A huge portion of the cost of aluminum is energy-related (up to 40%), so any increase leads to shrinking margins or price increases. And on Friday, China's largest aluminum producer, Aluminum Corp. of China Ltd (Chalco), announced production costs would be rising up to $43 per metric ton.

  
In fact, rising costs combined with severe storms in the first part of the year are blamed for the huge drop in Chalco's profits for the first half of the year.

  
The price of aluminum on the London Metal Exchange has been rising in the past week. But as it stands now, there is plenty of aluminum around.

  
Stockpiles have been rising since November of 2005 and are at their highest since mid-2004. And with the market well-supplied, will prices now rise enough to keep the Chinese smelters solvent? Or will they cut production due to their high costs and the risk of power shortages?

  
This combination of factors – fat inventories, rising costs, rising prices, plus the fact aluminum can be substituted with copper in many uses – makes me think we're headed for an unstable and unpredictable market for aluminum for the near future.

  
Take note: If aluminum production falls in China, there are other areas with the natural resources and potential power supplies that will be looking to fill the gap. Many companies are looking to Africa – a place rich in extremely high-quality bauxite deposits and the potential for large hydropower plants – as an up-and-coming aluminum-producing area.

  
While the infrastructure and political stability may not be in place now, many companies are investing in the area with an eye to the future. While there are many plans, there are also a lot of delays...caused by power shortages and higher-than-expected costs.