Oil rally complicates China fuel pricing

China's latest fuel price rise may be its last easy fuel pricing decision for a while.

Under a pricing regime that links retail fuel prices to the the global cost of crude, the government upped pump prices for gasoline and diesel by about 7 % from Tuesday, taking them to the highest ever.

But the system's clarity, the main reason for its introduction at the start of the year, only operates when crude is below USD 80 a barrel, a level the global benchmark is bumping up against.

Above this, and fuel price decisions increasingly become mired in politics, as the government tries to steer between "too low" -- when refineries decide producing gasoline and diesel is not worth it, and "too high" -- when economic growth starts to gag on the price of a fill-up at the pump.

The problem is that the pricing guidelines, set out a year ago by the National Development and Reform Commission (NDRC), don't spell out how refinery margins will change above USD 80 a barrel, only that "normal" margins won't be guaranteed.

How much pressure should the government put on prices? How much pain should refiners be expected to take? How much help is needed for the economy, which is expected to grow by more than 8 % this year and is churning out record numbers of cars?

The stakes are high for top Asian oil refiner Sinopec and Asia's top oil and gas producer PetroChina, which still made refining losses last year even with combined a government subsidy of 66 billion yuan (USD 9.67 billion).

At the State Information Center, a key think-tank attached to the NDRC, senior researcher Niu Li is in no doubt as to what should be done.

"Weighing up current inflation and economic performance against a possible fuel price rise, I think policy makers should choose the latter without the slightest doubt," said Niu.

"If raising prices can help solve various problems, why not do it? This is good for energy saving and is in line with our overall energy strategy. But it will require more sophisticated calculations to set the size of the price rise each time."

From "Normal" to marginal

The uncertainty seems like a return to the old pricing regime which, in its last throes in December, produced a 15 % gasoline price cut and an 18 % diesel cut, far less than merited by a 70 % collapse in crude prices.

"This was because the two oil majors were still producing fuel from the expensive crude stocks they built up before the Olympics," said Yan Kefeng, a senior analyst at Cambridge Energy Research Associates.

The two Chinese refining majors, whose reluctance to produce fuel at a loss led to intermittent shortages last year, have naturally been advocates of the new system as prices have risen. Sinopec has been especially vocal, most recently complaining of a refining loss in October because of rising crude prices.

After the latest rise, the belt-tightening begins.

Under the year-old oil pricing regime, refiners can count on normal margins while crude is below USD 80. Above USD 80, rising crude won't necessarily translate into higher prices at the pump.

A senior industry analyst with knowledge of the pricing regime said that the normal margin is set at 5 % of the corresponding crude cost. As crude moves from USD 80 to USD 105, the margin will be lowered proportionately from 5 % to 0%.

While crude is between USD 105 and USD 130 a barrel, refining margins will remain at zero, but retail fuel prices should still reflect crude costs, said the analyst, who declined to be named due to the sensitivity of the issue.

When crude rises above USD 130, fuel prices will be decoupled from global crude costs and the government will use tax incentives or subsidies to encourage oil firms to keep producing fuel, he added.

A predictable future

The NDRC's pricing formula is just one element in the government's fuel price policy. The price setters -- and the forecasters who try to call the next move up or down -- have to factor in other pressures such as overall economic performance, inflation and domestic demand.

"Right now the crude price seems to be the only thing the government needs to worry about as a sound economic recovery is assured. But from spring next year, it will have more considerations, especially early signs of inflationary pressure," said Qiu Xiaofeng, an analyst at Merchant Securities in Shanghai.

If crude prices rebound towards last year's peak of USD 147, all the problems that occurred last year, such as state controls, subsidies and short supply, would reappear again, said Lin Boqiang, director of Energy Economics and Research Centre at Xiamen University.

"To root out these problems, China needs to completely give up government control over oil prices, which is not something that will happen any time in the near future," Lin added.

Under the old system, price moves came out of the blue, sometimes lurching by more than 10 % after months of pressure. The reformed pricing system was part of a quest for more transparency.

SIC's Niu said there should be no sudden return to the old unpredictability as crude moves through the USD 80-USD 130 range.

"As the government can control the size of each price move, I think it will still track the rhythm of global crude changes and follow the price regime it has set up," he said.