The gorilla in the room can only be managed with transparent and fair regulation

Nothing that happens in the oil and gas industry is free of controversy. Certainly not when you have an 800-pound gorilla sitting in the room and whose long shadow extends over every policy move and executive decision of the government. It is no surprise, therefore, that the decision to revise gas prices upwards, or, to be more precise, allow gas producers to double prices from April 1, 2014, has raised eyebrows.

There are questions about the need for international prices, and the formula that has been adopted to arrive at the price. But the facts first.

India’s is a gas-starved economy. We have a little over 20,000 MW of gas-based power plants that are starving for the fuel. These are now either idling or using more expensive liquid fuel wherever the technology allows them to do so. We also have fertilizer plants that are using naphtha, a more expensive liquid fuel, to produce urea. But these fertilizer companies are not worried because the costs are passed through straight to the government in the form of subsidy.

Reliance and KG Basin

Reliance Industries, which discovered the Krishna-Godavari deep-water gas field, is sitting on massive natural gas reserves which it is unable to monetise due to what it claims are “technical problems”. However, these have not been validated by the government or the regulator, Director General of Hydrocarbons. Gas output from the KG Basin hit a peak of 69 mmscmd in 2010 but has since dropped sharply to less than 15 mmscmd now.

There are those who believe that the company has deliberately closed the tap as the present price of $4.2 per million British thermal unit is “low”. Those who subscribe to this theory point out that savvy multinational BP (formerly British Petroleum) invested $7.2 billion in some gas blocks of the company, including those in the KG-Basin. Would BP have sunk in so much money in a field beset with technical problems? It is a valid question.

If we were to believe this theory then what Reliance has done is create an artificial scarcity for natural gas and thus generate a scarcity value that could be embedded in future price discovery for the fuel. If that is indeed the case, then the company has succeeded with the increase in price now.

But the problem is that there is no way of proving this theory as right or wrong without access to technical data. The only entity that can call the bluff, if it is indeed that, is the government. But then, the government has either been unwilling or incapable (or probably both?) of doing so. The one person who dared to even take a step in that direction, former Petroleum Minister, Jaipal Reddy, was packed off from his job earlier this year.

Reliance though will not be the only beneficiary of higher prices. ONGC and OIL from the public sector and Cairn India, to a smaller extent, will also benefit. As per a research note of ratings agency, CRISIL, ONGC’s operating profit is likely to increase by Rs.15,000 crore, and that of OIL by Rs.1,500 crore.

The government will also gain in terms of higher royalty earnings though that will be offset by the rise in subsidy payable to urea producers.

Problem for gas generators

On the user side, power tariffs will rise as gas-based power plants will now pay double of what they were doing until now. The problem that these companies will face is that under the merit-order dispatch system, which is used by state distribution utilities to purchase power, the cheapest sources of power will be picked up first. After the increase now, gas-based power might fall in the priority list and in some states such as Gujarat and Maharashtra where there is no power shortage and abundant coal-based generation, gas-based power will come a cropper as it will be the least in priority.

This is something for gas-based power plants to mull about. Generally, gas-based stations are used only for meeting peaking power deficit and not as base-load plants though in this country we have been running them as base-load stations. So, we might well see gas stations turning peak-load generators as a consequence of the higher gas prices now.

As for fertilizer producers, the increase hardly affects them since the feedstock costs are part of the pass-through subsidy mechanism and will be borne by the government.

Why international prices?

Now to the basic question: why should we pay international prices for a resource that lies in our territory? There are two reasons. First, the investments made by the gas producer in exploring and developing the field such as in hiring drilling rigs, equipment, personnel and so on are all related to prevailing international oil prices. If prices rise, rig hiring costs rise too and vice versa. Given this, and the risks involved in oil exploration where the chances of drilling a dry well are higher than that one with oil or gas at the bottom, international prices are a fair expectation. Second, if a user were to go for a substitute such as LNG, he has to pay international prices anyway.

The point is that if you invite a private player to develop a field, then you have to pay the price for it, literally. The alternative would have been for the government or its companies to develop gas fields and supply at prices that are related to the domestic market conditions and not international prices. But then, neither the government nor its companies have proved equal to the task until now. Neither do they have the financial and technical resources nor the will to execute such high risk projects. ONGC, for example, was allotted a field in the same KG-Basin block at the same time as Reliance but it has simply not been able to develop it.

That said, to protect user industries, the government should think in terms of a cap on the price based on a reasonable return on investment for the gas producer. It is not fair that the producer will enjoy all the upside in international prices well after he has recovered his costs or run through the investment phase. The government should also try to mitigate the currency risk for user industries as the price is denominated in dollars. A mechanism to adjust for rupee depreciation (or appreciation) needs to be put in place, one that can be reviewed at periodic intervals along with the price itself.

First step

At the end, we should remember that this is the first step towards the creation of gas-to-gas competition in the market. Hopefully, the imperfections will be ironed out as the market for natural gas takes off in the country. Meanwhile, the Rangarajan formula, imperfect as it is now taking into account numerous variables, should be reviewed based on experience and altered if necessary. Remember, the $8.4 per mmbtu price is only the initial one; it could well rise as global prices increase. The government should also regulate the sector better with a tighter scrutiny of the gas producers and their financial and technical data, which does not seem to be the case at the moment.

The other important recommendation of the Rangarajan Committee to move to a revenue-sharing arrangement rather than the ‘profit oil’ basis now which can be manipulated by loading fictional costs onto the field, needs to be given serious thought to. Ultimately, the gorilla in the room cannot be wished away; it can only be managed with transparent and fair regulation, something we have not seen till now.

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