A case for market-linked diesel price

At present, oil marketing companies (OMCs) are incurring record high losses of Rs.12.5 per litre on diesel, Rs.30.5 per litre on kerosene, and Rs.396 per LPG cylinder. This is largely on account of non-revision of domestic prices despite sharp increase in international prices. The under-recoveries (the losses incurred by OMCs on selling regulated fuels below their market prices) increased by 77 per cent in 2011-12 to Rs.1.40 lakh crore from Rs.80,000 crore in 2010-11. Diesel contributed close to 60 per cent of the under-recoveries.

Losses arising from under-recoveries are typically shared by the government, upstream oil companies (ONGC, OIL India and GAIL) and OMCs (IOCL, BPCL and HPCL) according to a proportion determined by the government at the end of every year. Until 2010-11, OMCs were able to bear some part of the under-recoveries — typically ranging from 10-20 per cent — as they were earning healthy profits from the refining business. In 2011-12, due to the global demand slowdown, the refining profits of the OMCs were severely impacted. Hence, OMCs didn’t share any burden of under-recoveries and the entire under-recoveries were shared between the government and the upstream companies.

Although, in 2011-12, the OMCs did not directly bear any under-recoveries, due to delay in payment from the government, they had to resort to higher short-term borrowings to meet their working capital requirements. This resulted in doubling of their interest cost to Rs.10,500 crore in 2011-12 from Rs.5,100 crore in 2010-11. Consequently, their profits declined to Rs.6,200 crore from Rs.10,500 crore in the period under reference. The absence of a fixed annual sharing mechanism for under-recoveries and uncertain timing of cash payouts by the government will continue to weigh on the profitability and liquidity of OMCs. Also, the capital expenditure plans of upstream oil companies and OMCs are adversely impacted on account of lower earnings and higher debt.

In 2012-13, crude oil prices are expected to remain strong averaging close to $100 a barrel. Although crude prices have declined by close to 10 per cent since April 2012, product prices have dropped only marginally due to the depreciation of the rupee by more than 8 per cent in the same period. In rupee terms, international diesel prices are only marginally below the all-time high levels seen in 2008 on account of rupee depreciation despite international prices being over 40 per cent lower. Hence, under-recoveries are expected to remain high at close to Rs.1.40 lakh crore in 2012-13, too, if the prices are not increased.

Rising under-recoveries are not only hurting the oil companies, but also adversely impacting the government’s finances. In 2011-12, oil subsidies, at Rs.83,500 crore, constituted nearly 32 per cent of the government’s overall subsidy bill. Going forward, too, the government will have to share at least half the under-recovery burden.

Hence, the 2012-13 budgetary provision of Rs.43,000 crore towards oil subsidies is grossly inadequate. In fact, more than 80 per cent of this provision has already been exhausted towards payment of arrears for 2011-12. As a result, the government will be left with no option but to borrow additional funds to compensate OMCs during the year, thereby leading to an increase in the fiscal deficit, other things remaining constant. The share of oil subsidies in the overall fiscal deficit has already reached alarming levels of 16 per cent in 2011-12 from 6 per cent in 2009-10. The continued high fiscal deficit could exert further upward pressure on interest rates and would also limit government’s ability to fund critical social and infrastructure projects.

As a result, a hike in prices of regulated fuels, especially diesel, which accounts for 40 per cent of the overall petroleum product consumption, is essential. Crisil believes that at least 10-15 per cent immediate hike is warranted. Also, the price of these fuels should be gradually linked to international prices. Alignment of regulated fuel prices with international prices may affect domestic fuel inflation in the short-term as diesel constitutes nearly 4 per cent of the Wholesale Price Index (WPI).

However, if the prices are increased now, the move will help ease the government’s subsidy burden and reduce fiscal deficit, which will result in lower inflation over the longer term. Further, market-linked pricing would reduce any wasteful consumption of regulated fuels such as diesel.

The author is Director, Crisil Research, a division of Crisil.