We all knew, or at least most of us thought that oil prices were indeed getting bubbly. The current situation of supply and demand didn't seem to warrant such an extended run. The question really was when would the pain for consumers, or pleasure for oil investors, stop?

What I thought was particularly of note, what really made me feel like we were approaching a top, was when oil shot right through $140, right after China announced that it would increase oil prices.

"The price of gasoline was raised by 17% to 6,980 yuan per ton, from 5,980 yuan; diesel prices were raised by 18% to 6,520 yuan per ton, from 5,520 yuan; and jet-fuel prices were raised by 25% to 7,450 yuan per ton, from 5,950 yuan."

- MarketWatch

The hidden secret was that China needed to increase prices so that its two main oil refiners, PetroChina (NYSE: PTR) and Sinopec (NYSE: SNP), would stop losing so much money.

And that was the primary motivation for the Chinese government when it made its decision to raise prices, said Sun Mingchun, economist with Lehman Brothers.

"The main reason was to make sure China has enough fuel supplies during the Olympic Games," he said, "because the price controls have distorted profit margins."

In a note published shortly after the price rise was announced, Goldman Sachs also said that "the price hike could lead to normalization of supply versus the recent rationing of sales at the pump."

- qaumnet.com

Since topping out at a market cap of $1 trillion dollars in October, PetroChina has been in a freefall. Its share price of $126.79 gives PetroChina a market capitalization of $232 billion -- just short of a 75% drop in value.

Other than the bubble being imploded in China, the reason PetroChina has seen such a steep drop is that in recent quarters it has only been losing money for each barrel of foreign oil it refines and sells to domestic (Chinese) consumers. The cap on the oil prices that the government has now put into place means PetroChina and Sinopec will continue to buy oil at the current exorbitantly high prices and won't be able to pass along the price increase to consumers.

"Sinopec said earlier its refineries would break even if oil prices fall back to $76 a barrel or below."

- MarketWatch

As we all know, crude oil prices are not even close to $76. But state-owned means state motivated (kinda sorta) and China needs oil to fuel its growth. Therefore Sinopec and PetroChina have both been refining oil at a loss. (Note that Sinopec imports 80% of its oil, while PetroChina imports 20-30%.)

So when Goldman Sachs says that the price hike could result in a "normalization" of supply, this is meant relatively. The reasoning is that if PetroChina and Sinopec can charge more for their refined oil, they will be more motivated to refine it.

What personally strikes me as odd, however, is that if these operations are state-owned in the first place, then why would they need these seemingly "superfluous" motivating factors to refine oil? If they were already refining it at a loss, what would a 25% (just for generous estimates) cushion really do?

Sinopec has stated that they need oil to trade at $76 a barrel to break even. A 25% increase in their selling price would then require them to have $95 a barrel oil to break even. Currently we sit at $140 oil.

Further inhibiting the effects of increased pricing cooling down demand in China is that the Chinese government is now offering oil subsidies to industrial consumers so that they continue to purchase oil:

Shortly after the NDRC announced the price rises, China's Ministry of Finance said that it would provide 7.8 bln yuan in fuel subsidies to farmers, and a further 12 bln yuan to the urban transport, fishing and forestry sectors.

I don't fully understand the whole picture because I don't fully believe the picture being presented to me. Either way for me, curiously odd price action tends to mean bubble popping soon. But, I'm second guessing myself because,

For the first time in several months, the International Energy Agency Thursday slightly raised its 2008 world oil-demand growth forecast but cautioned that global crude consumption will remain well-below trend into 2009 amid declining economic conditions.

- WSJ

For oil to come down in price, either demand has to shrink, or supply has to expand. And then, investors need to realize that it's happening. Because it's the investors that set the prices, and it's the investors that decide how long the bubble will last.

Right now, even with the price increase in China, investors don't really see either happening.

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Brian Pham

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