China rations diesel as record oil hits supplies | Markets | Reuters

As I headed into the city for dinner with friends on Saturday night, I witnessed an unusual site: as our taxi passed a petrol station, I saw about 25 or 30 blue trucks (the ubiquitous medium of transporting good from Shanghai’s factories to her ports) spilling out of the parking lot into the road, apparently queued, waiting for a spot at the pump. I’d never seen such a line at any of the petrol stations around Shanghai, and briefly wondered whether it was just a busy night or whether something else was amiss.

Well, reading the headlines in today’s news, I stumbled upon a clear economic answer to the petrol pump mystery. It appears that China has begun rationing diesel fuel at petrol stations in the East Coat provinces.

Truck drivers reported long queues at petrol stations along a national highway linking Fujian and Zhejiang provinces, with each truck getting 100 yuan ($13) worth of diesel, or around 20 litres, per visit at a state-run station and 40 litres at a private kiosk…

“What’s wrong with the oil market? Our drivers had to queue the whole night for only a small amount of fill, slowing the traffic by almost one day,” said Gao Meili, who manages a logistics company.

China is a major importer of oil. With an economy growing around 12%, much of the country’s growth depends on the availability of crude oil at reasonable prices, which China’s oil refining firms turn into diesel, needed to get Chinese manufactured products from factory to port and from port to overseas consumers.

The problem with the oil market in China, however, is that as “Chinese refiners cannot pass the souring crude costs on to consumers.” Oil is an input needed to make a finished product, diesel. As the price of oil goes up (it reached a record of $92 per barrel this week), the average variable costs (AVC), the average total cost (ATC), and the marginal cost (MC) of oil refiners shift upwards. In the petrol market, this leads to a leftward shift of the supply curve since, as we learned, the market supply curve represents the horizontal sums of all the individual firms’ MC curves above their AVCs. As AVC, ATC and MC shift up, this causes a leftward shift (a decrease) in the industry supply. Remember, higher resource costs are a determinant of supply. In this instance, oil is the resource needed to manufacture petrol.

In a free market, a decrease in supply leads to an increase in price. Herein lies the problem with the Chinese oil market that the manager above inquires about: the Chinese petroleum market is not a free market. The government plays an active role in controlling prices paid by consumers for the finished product refiners are producing, petrol fuel:

Beijing fears stoking already high inflation and rigidly caps pump fuel rates to shield users from a 50 percent rally in global oil so far this year.

As firms’ cost curves are shifting up, the government is more concerned about “shielding” consumers from the skyrocketing world oil prices by assuring them a constant, low rate at the pump. Essentially this is another example of a price ceiling, which as we have learned is meant to help consumers at the expense of produces, but usually ends up harming both producers and consumers, as shortages result in excess demand. This explains the queue of 30 blue trucks spilling onto Huaxiang road last night.

So why, exactly, does the government’s enforcement of a lower than equilibrium price result in such severe shortages that truck drivers are only allowed to pump 20 litres of petrol per visit and made to wait hours each time they need to refill? Here’s the short answer to this question:

As we learned, as costs rise (AVC, ATC and MC shifting up) in a competitive market and price (MR=AR=P) remains the same, economic profits are eliminated and losses incurred (click graph to the right). If costs remain high (as they have in the case of China’s refiners due to the ever rising price of oil, its main input), firms will begin to exit the industry and shift their resources towards a more profitable market. In the case of Chinese oil refiners, they have begun to shut down certain plants as losses are incurred:

China’s army of small local oil refiners — a growing swing supplier making up more than 10 percent of the market — have cut output more sharply, exacerbating the tightness, officials said.

In a free market, this reduction in supply is just what is needed to restore the market to equilibrium. As firms exit, market supply shifts left, raising the market price, eliminating losses, and perhaps even restoring profits for oil refiners. (click on graph to the right)

The problem with the Chinese market, however, is that this long-run adjustment is kept from happening by a government that refuses to allow the market price to adjust upwards, meaning the Chinese petrol market is stuck in disequilibrium. Price controls mean quantity demanded will exceed quantity supplied: thus, the lines of blue trucks waiting their turn to pump 20 litres of diesel into their tanks.

Clearly the intent is to help petrol consumer by keeping fuel affordable; this fails as is evident by consumer frustration in the petrol market. Not only does government interference harm Chinese consumers and Chinese producers, but ironically it actually may benefit foreign petroleum producers, who have enjoyed greater demand for their output by petrol-thirsty Chinese consumers:

These supply cuts have forced China to boost its imports from international markets, traders said.

Following a rare surge in gasoline imports in September, top refiner Sinopec also extended strong diesel imports into November, buying at least 60,000 tonnes and looking for more to replenish dwindling stocks.

“The market is chaotic now. We are worried that supplies in the coming months could be even tighter,” said the Guangzhou official.

If you were president Hu’s economic adviser, what would you suggest as a solution to the woes in China’s petrol market?

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About the author: Jason Welker is a teacher at Zurich International School in Switzerland, where he teaches Advanced Placement and International Baccalaureate Economics. Jason was an international school student in Malaysia before studying economics at Seattle University then earning his Masters in Education. He calls Seattle and Northern Idaho home. In addition to maintaining an economics wiki and this blog for economics student and educators, Jason also gives presentations on using Web 2.0 tools in education at workshops and conferences around the world. His economics wiki won the 2007 "Best Educational Wiki" award from the "EduBlog Awards".

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