No gasoline is worse than $4 a gallon gasoline
05/20/2011 8:30 am EST
Turns out there are worse things than $4 a gallon gasoline.
For instance, there’s driving up to the pump and discovering that there is no gas for sale. Energy shortages are happening across a big swath of the developing world. And it’s occurring not just with gasoline but also with diesel fuel and even electricity.
The reason is very simple: Governments from Russia or China to India to Indonesia to Brazil have pressured or required oil refineries (and other energy companies) to keep consumer prices low even though the costs that they’re paying for oil (and coal) are rising. That’s turned these companies from oil refineries into red ink machines. Not surprisingly they’re reacting to these economics by cutting production-- if you lose money on every sale, you’re going to cut volume. Or by exporting gasoline to countries that pay market prices for their petroleum products. And that has resulted in massive shortages of everything from gasoline to diesel fuel to electricity.
The shortages have become large enough to potentially cut economic growth in the economies that the world increasingly counts on for growth—just as central banks are raising interest rates in these economies to slow growth in an effort to fight inflation.
I’d argue that despite all the worry on Wall Street about how higher U.S. energy prices will hurt the U.S. economic recovery, the biggest danger to economic growth from higher oil prices is in those developing economies that are now caught trying to control prices without squashing supply.
Russia, the world’s biggest oil producer, is a good example of how a developing economy can get caught between a rock and a hard place by rising energy prices
At the end of April gasoline sold for $3.03 a gallon in Moscow. When there is any. Beginning in February gas stations across Russia started to experience shortages. That’s a direct result of investigations launched by Prime Minister Vladimir Putin into steep price increases in gasoline. With the government cracking down on gas prices, effectively capping gasoline prices at a time when world oil prices had soared, Russia oil producers and refiners had started to ship more gasoline overseas. Prices for gasoline and diesel in Russia in March were $70 to $150 lower per metric ton, according to the Jonathan Muir, CFO of the TNK-BP joint venture, than on world export markets. The company, Muir said, would have earned $54 million more in the first quarter if it had exported the gasoline it sold in Russia.
So guess what? Russia refiners started to do just that—and fuel shortages began to emerge first in country’s more remote areas such as Siberia or the southern Altai region, and then in urban areas such as St. Petersburg. In the Altai more than 700 gas stations have closed. In the Siberia city of Tomsk gas stations limited customers, even city buses, to 25 liters a day. Since city buses need 80 to 100 liters a day to operate, you won’t be surprised if I tell you that 20% of buses didn’t run on April 28.
The Russian government has responded to this crisis—Russia will hold elections for the national legislature this year and for President in 2012--by slapping a punitive 44% tariff on gasoline exports, effectively prohibiting exports and diverting all gasoline to domestic markets.
It’s not clear yet whether that’s putting more gas into Russia’s gas stations or if Russia oil companies are changing their refinery mix to produce products with higher profit margins than gasoline.
In India the scenario is much the same—with the difference that India’s oil-marketing companies are government owned and that India, rather than being the world’s largest oil producer, imports 70% of its fuel. Gasoline in India sells for 40% more than it did in February 2010 but the price increase would be even higher if the Indian government and the state-owned marketing companies didn’t subsidize the price of fuel. The government’s budget for fuel subsidies for the fiscal year that ends in March 2012 is about $5.5 billion. At recent prices, the actual bill for government fuel subsidies could hit $20 billion.
The oil marketing companies are pitching in too. Despite the 40% price increase, the state-owned oil companies estimate that they lose almost 40 cents on every gallon sold at current prices. (The loss on a gallon of diesel fuel is about twice that.)
On the one hand, fuel subsidies don’t seem sustainable at these levels. The drain on the government budget is huge and the burden on state-owned oil marketing companies immense. Subsidies keep fuel demand higher than it would be at market prices and India already runs a trade deficit that came to $22 billion in the third quarter of the 2011 fiscal year. The government certainly remembers that in 1991 a technically bankrupt India had to pledge its gold reserves to secure a loan from the International Monetary Fund.
On the other hand, even with these subsidies inflation in India was running at an annual rate of 8.7% in April. That’s down from 9% in March but that’s still nearly twice the Reserve Bank of India’s 4.5% target. And that’s after nine increases in benchmark interest rates from the central bank since March 2010. The benchmark rate is now 7.25%.
End subsidies and risk driving inflation higher ever faster? Keep subsidies and make sure that the Indian economy doesn’t improve its energy efficiency as quickly as it would if prices were higher, and risk busting the nation’s budget?
It’s a truly nasty choice.
The problem isn’t limited to gasoline and oil either. The same dynamic is at work in other energy commodities as well.
Take coal, the fuel for 70% of China’s power plants. The cost of thermal coal is up 30% since August 2010. Government controlled electricity prices are up just 2% over that time period.
I think you can guess what’s happening now, right?
With utilities facing huge losses ($2.8 billion in the first quarter, according to the China Electricity Council) as a result of this mismatch between soaring costs and stagnant prices, some have reduced their production of electricity. The government frowns on this practice but utility company officials seem to be perfectly willing to tell government officials that they will generate electricity at full capacity while in practice cutting back on power production.
China almost always has power shortages in the summer months as a lack of rain cuts into production of hydroelectric power. But this year—thanks in part of the unhappy coincidence of a dry winter in Southern China—shortages have started earlier and look especially deep. Officials say that China could experience its worst shortages of electricity since 2004. Heavy industry—producers of aluminum and steel, chemicals and construction materials—are likely to take the biggest hit from the shortage, which the China Electricity Council estimates could reach 30 gigawatts this summer. Power rationing could reduce second quarter GDP by half a percentage point.
The shortage of electricity from the grid has sent Chinese companies scrambling to get their backup diesel generators ready.
I bet you can see where this is headed. More demand for diesel fuel to make up for electricity shortfalls will drive up the price of diesel fuel—especially because some Japanese refineries, a source of a major part of China’s diesel imports were severely damaged in the earthquake and tsunami.
So the government has slapped a complete ban on exports of diesel fuel so fuel will stay in China’s domestic market and no company will be tempted to export or re-export diesel fuel to global markets where prices are higher than in China’s price-controlled domestic market. (See Russia above for how this works.)
The ban, ordered to “maintain social stability and promote economic development,” according to the National Development and Reform Commission, isn’t likely to solve the problem if oil prices climb back above $110 a barrel. At that level China’s oil companies will be losing money on the price-controlled sales of diesel fuel and will start to cut back on production in order to reduce losses.
Like India and Russia, China is in the midst of a bruising fight against rising inflation. It’s unlikely—nothing is ever dead certain but I’d say the odds here approach 100%--that the government would remove price controls or allow a rapid increase in the price of either electricity or diesel fuel to reduce shortages at the risk of accelerating inflation.
These energy shortages don’t play out in the same way everywhere in the developing world or on the same timetable. It’s quite one thing to artificially depress gasoline prices in India, which imports 70% of its fuel, and in Brazil, which in most years exports fuel.
Not that Brazil is immune from the impulse to intervene in the energy market to lower prices. On May 12 the state-controlled oil company Petrobras (PBR) announced that its distribution arm BR Distribuidora would cut gasoline prices by 6% in order, the company said, to help the government fight inflation. (The move will do more damage to Petrobras competitors such as Ultrapar Participacoes, where fuel distribution accounts for 75% of sales, than it will to Petrobras where distribution accounts for less than 4% of EBITDA (earnings before interest, taxes, depreciation, and amortization.)) But the impact on the national budget of Brazil is likely to be minimal and the economic distortion relatively short-lived. A healthy sugar harvest would cut the price of ethanol—a key ingredient in the blended fuels used by so many Brazilian cars.
China, Russia, and probably India can’t look for similarly quick solutions to their energy rock and hard place problem. China and Russia are looking at political transitions in 2012 and Moscow and Beijing will be extremely reluctant to risk popular unrest by removing subsidies or price controls before new leaders (in Russia quite probably an old-new leader in Vladimir Putin) take power. In India the Congress Party government is fighting for its survival. Fuel subsidies are the least of the goodies the government is likely to hand out.
Looking at the danger to economic growth and the effort to control inflation posed by rising energy prices I don’t get a radical reshuffling of my May 10 pecking order for investing in emerging markets http://jubakpicks.com/2011/05/10/plotting-the-bottom-for-emerging-market-stocks/ . Brazil still comes before China and India still lags the pack. (Russia isn’t in the pack in my opinion. The country’s markets are even more subject to arbitrary political intervention than those of its emerging market peers.) The energy rock-and-hard-place does give me one more danger to watch.
The biggest advantage of this analysis, though, is that understanding this problem gives me some useful context so that I don’t over react to any seasonal drop in China’s GDP due to a worse than usual summer energy shortage. If second quarter GDP does drop unexpectedly in China, I’ll know that is isn’t the end of China’s economic boom—or of growth in the global economy.
Full disclosure: I don’t own shares of any of the companies mentioned in this post in my personal portfolio. The mutual fund I manage, Jubak Global Equity Fund, may or may not now own positions in any stock mentioned in this post. For a full list of the stocks in the fund as of the end of March see the fund’s portfolio at http://jubakfund.com/about-the-fund/holdings/