India's Insurmountable Oil Subsidy Problem

China have raised prices of gasoline, diesel oil, aviation kerosene and electricity by as much as 18%. China's new gasoline price is at about US$3.29 a gallon, and the diesel price is at US$3.08 a gallon. Despite price hike, break even price for refiners still far below market price (based on crude oil price of US$92 below market price pushes demand growth faster than in an undisturbed market.

Chinese fuel subsidy costs are lower than in some of its Asian counterparts on a GDP basis as it produces around one-half of its oil consumption. Subsidies distort demand. A more efficient way to protect people’s purchasing power would be to let prices increase and introduce direct, targeted subsidies for afflicted consumers like Korea has done, and which Malaysia is now trying to do.

China's total amount of implicit subsidies (financial support from the state budget and losses incurred by state companies) in 2007 was about US$27 billion, 0.8% of GDP. 2008 costs might be US$100 billion, or 2.2% GDP. Chinese fiscal position means it can afford to continue status quo, can do so longer than its neighbors or could raise prices gradually.

China's oil subsidy situation is quite manageable. However, the market seems to be ignoring India's potentially more explosive situation with respect to oil subsidy. I can forsee a dramatic demand destruction in India. If you have been to India lately, you will find a lot of petrol stations closed, seriously. Many of the big refiners and petrol pump stations are state controlled in India. Take Indian Oil, it has 17,800 petrol stations and can register revenue of US$59bn. However, Indian Oil loses US$76m (RM247m) A DAY for every day it allows its petrol stations to operate. That's due to the government insisting that these state companies continue to subsidise all gasoline, diesel and cooking oil.

Presently petrol cost only one-third the price in USA despite a nastily handled 13% hike in fuel price on 4 June recently. If oil stays at US$130 for the rest of the year, there should be at least another 13%-15% hike in order to stop the state budgets and government budgets from totally imploding. Even then, the problem would not be solved. Politically and socially, the Indian public are pretty angry with the recent hike. Can you imagine another round before the year is over?

Manmohan Singh, the PM, is seriously betting that the price of oil would drop back to US$100 by year end or else you can basically kiss the whole government machinery goodbye. Due to the diverse political landscape across India, managing a substantial and dramatic reduction in oil subsidy will probably require military intervention and curfews. It is just unmanageable.

Private oil players such as Essar Oil and Reliance Petroleum are still trying to expand but their oil is unsubsidised, which totally puts them out of the competition. Reliance Petroleum has shut down all 1,400 of its new gas stations while Essar has temporarily closed its 1,250 pumps. Even Shell has closed 40 of its 50 stations. Removing oil subsidy is like one of Buffett's stories. You don't know who is swimming naked until the tide recedes.

Oil subsidy is a bloody crutch and a bloody curse. Industries and economies must compete as close to international input prices as possible. Wealth from resources should be used less and less to subsidise the price of fuel to the general public but rather be used to target support for specific affected groups and improve the social safety nets for the poor. Just Indian Oil is already losing US$76m (RM247m) a day. If you add the other state controlled Bharat Petroleum and Hindustan Petroleum, you are looking at a gigantic problem. If you add the 3 together, you might be looking at RM500m losses a day - how long can any government stomach that??!!

p/s photos: Cholada Mekratree