India Friday said gasoline prices will be now be driven by the market, a move which will help the government cut its budget deficit by saving on subsidies, although it may stoke inflation.

State-run oil marketing companies, which now sell fuel products at state-set prices, will gain, as investors showed Friday by cheering on their shares.

The deregulation will lead to an about INR3.50 per liter increase in the price of gasoline from midnight Friday, Oil Secretary S. Sundareshan told a news conference.

The price of diesel will be deregulated later, but will rise by INR2 per liter for now.

Shares of the country's state-run oil marketing companies and explorers--Indian Oil Corp. (530965.BY), Bharat Petroleum Corp. (500547.BY), Hindustan Petroleum Corp. (500104.BY) and Oil & Natural Gas Corp. (500312.BY)--surged on the announcement.

Indian Oil closed 10.4% higher at INR377.30 and ONGC gained 6.4% to 1,254 in a market down 1%.

Indian Oil, Bharat Petroleum and Hindustan Petroleum suffer revenue losses as they sell auto and cooking fuels at state-set discounted prices to help the government control inflation.

The companies are compensated partly by the federal government through cash and partly by state-run explorers through discounts on crude oil and products. But they have to bear some of the losses themselves.

"Even after all these changes, underrecoveries for this fiscal year for the [state-run] marketing companies will be INR530 billion," Sundareshan said.

Despite the deregulation, the government is retaining the right to intervene if global crude prices spike, Sundareshan said.

The government's decision will help more private companies open fuel retailing outlets in India and allow existing players such as Reliance Industries Ltd. (500325.BY) and Royal Dutch Shell PLC (RDSA) expand their retail fuel businesses.

This is the second increase in auto fuel prices this year, after the last one on Feb. 27.

Diesel is sold at INR38.10 per liter in Delhi and gasoline at INR47.93.

Cooking gas prices have been increased--for the first time since July 2009--by INR35 per cylinder. The price of kerosene has been raised by INR3 per liter, the first hike since April 2002.

"The price hike is as minimum as possible," said Oil Minister Murli Deora. "How long are we going to subsidize Mercedes-Benz cars?"

The move to deregulate fuel prices will lift some pressure off the government's subsidy burden, but it will add to the already high inflationary pressure, which could spur the central bank to raise policy rates aggressively.

The Reserve Bank of India could increase rates within two weeks, ahead of its policy review meeting, which is due July 27, said Namrata Padhye, an economist at IDBI Gilts.

Analysts were expecting sustainable policy action from the federal government, rather than just a one-time price hike, because inflation--which rose 10.16% from a year earlier in May, significantly higher than April's 9.59%--is forecast to trend down in the second half of the current financial year through March 2011.

Also, oil prices aren't expected to rise much for the time being due to high crude oil inventories, showed a survey conducted by Dow Jones Newswires on June 18.

India 's federal government wants to reduce its fiscal deficit to 5.5% of gross domestic product in the current financial year from a record 6.6% in the previous year.

Reforms in fuel prices would help the government lower its fiscal deficit and raise funds via divestment in the sector.

"It [gasoline prices] can be increased every day, but we are not moving to that situation," Ashok Sinha, chairman of Bharat Petroleum, told reporters.

"It will be revised every 15-30 days, the individual marketing companies will decide on the price and time for hikes."

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