Why, In China, Gas Is $2.49 A Gallon

China's strong economy and huge appetite for energy have been key drivers in the current $130-per-barrel price of oil. China imports over half of its oil, regards the industry as "strategically vital," controls retail prices and is facing inflation in excess of 8%. The price may seem daunting in the U.S., but it is much more so in China.

Here are China's current oil sector particulars: Domestic production is about 4 million barrels a day, and that figure is rising very slowly. I have found no credible energy expert who expects Chinese production to rise meaningfully above the current range anytime in the foreseeable future.

Current consumption is now about 8 million barrels a day and rising at a rapid 7% annual rate, the highest growth rate in the world. Remember that China is becoming more energy efficient with each passing year--10% real gross domestic product growth, compared with 7% energy use--in line with its historical economic development pattern.

But China has been the primary contributor to the increasing oil demand over the last decade; its demand grows 65% faster than the U.S. and four times faster than India. Over the next decade, I don't foresee much change in oil's share of total energy use in China, compared with coal, natural gas and other forms of energy. Energy source substitution is difficult, expensive and takes time.

So, China is now required to import around 4 million barrels of oil a day just to keep its economy going. China has been a net importer of oil since 1993 and exports essentially no oil. Oil imports are likely to rise about 0.5 million barrels a day each year with a healthy Chinese economy. Using a round number of $100 a barrel, China's annual current oil import bill alone is about $144 billion, up about $72 billion this year alone. It's a big number.

Beijing is left wondering, first, how to handle the short-term price shock and, second, what the best long-term strategy would be.

Controlling oil prices in China is a disaster. In the short term, China's inflation rate is over 8%, a figure that's both high and worrisome. So Beijing is holding down many prices--including oil--with a cumbersome price-control scheme.

Consider the following: Since January 2007, global crude oil prices have risen by 109%; gasoline prices in the U.S. have risen by 77% (roughly apace); gasoline prices in China have risen only 9%.

Gasoline in the U.S. now sells for around $4 per gallon, but it sells for $2.49 per gallon in China. Beijing last raised domestic gasoline prices in November 2007, by 9%, and that was the first and only hike since January 2007, when crude was $87 per barrel. A recent rumor that China was about to lift its gasoline-price controls was quickly dismissed by Beijing.

China's energy sector, regarded as "strategically vital," is dominated by three giant state-owned enterprises. If Beijing wants anything in energy, it is control. But as China becomes more integrated into the global economy, global rules--not China's rules--are increasingly intervening.

So here is where it gets really crazy. China National Offshore Oil Corporation (nyse: CEO - news - people ), largely an exploration and development driller, sells its output at roughly the globally-set crude oil price to the state-owned refiners, primarily PetroChina (nyse: PTR - news - people ) and Sinopec (nyse: SHI - news - people ). CNOOC's earnings were up 56% in the first quarter of this year, in a global bull market for oil. No surprise.

Sinopec, conversely, with little drilling capability, buys crude at the global price and sells at the state-controlled retail price, taking a giant bath on every gallon of product they sell. During the first quarter of 2008, their earnings were down 81%. Ouch.

Then there is PetroChina, which has considerable domestic production but also must buy some oil at world prices and sell at the below-market state-set price. PetroChina's earnings were down 56% in the first quarter.

Beijing will subsidize the domestic gasoline retailers, mostly Sinopec and PetroChina, about $40 billion this year for the price-cost squeeze just described. The oil bureaucrats in Beijing mean well, but what a tangle! How can global investors make any sense of this?

At some point, the domestic oil price in China must rise to the world price, but, at present, that would unacceptably lift inflation. So Beijing watches and waits with a price system that is not functioning. Beijing can afford this massive subsidy to China's oil consumers with its current favorable budget situation.

But make no mistake: This hold-down of retail prices is a subsidy to energy consumers that is hidden in the government's budget. The taxpayers are paying for these lower oil prices. They just don't see it at the pump with the current inflation statistics.

For the longer term, Beijing is actively seeking secure sources of fuel for their economy, hoping to make multi-year deals for reliable energy reserves in the Middle East, Africa, Canada, Russia and elsewhere. Should those deals materialize, Beijing will ensure it has oil available. But oil prices are set in the global market, and Beijing would still be saddled with subsidizing their gasoline retailers if they want domestic prices to remain below market levels.

While I don't approve of how China is behaving in the energy sector at present, it is arguably just as defensible as actions taken by officials in Washington, D.C. It has been almost 35 years since the first oil shock in October 1973. At that time, OPEC raised oil prices from $2.71 per barrel to roughly $8 per barrel--and we still don't have an energy policy. What's the hurry?

Donald H. Straszheim is vice chairman of Roth Capital Partners in Los Angeles, former global chief economist at Merrill Lynch (nyse: MER - news - people ), a visiting scholar at the University of California-Los Angeles Anderson School of Management and a longtime China specialist. He previously served as president of the Milken Institute and joined Roth in 2006 to spearhead the company's China initiatives.

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