Making a mockery of domestic gas pricing

Dr. Rangarajan was my professor and I worship him as an economist and academician. However, I fail to understand why he lends his enormous reputation to reports on the energy sector that are far removed from his area of experience and expertise, especially when the Committee he recently chaired did not have a single member with any notable knowledge or understanding of the complex global gas markets. A one-hour consultation with an independent industry expert would have informed the Committee that its recommended methodology has no relevance to “determining the basis or formula for the price of domestically produced gas” in India — a task it set out to deliver under its terms of reference.

Price sensitivity

The report recognises the price sensitivity of gas demand in India, yet, like most government documents, it presents indefensible demand and supply numbers completely independent of gas prices. The report confirms that most Indian natural gas producers are currently guaranteed a well head price of at least $4.2 to $5.25/MMBTU. However, it does not clarify if this is the price for dry or wet gas thereby forgetting the economic value of natural gas liquids extracted by producers before selling the dry gas as feed stock and/or an energy source. More importantly, the report suggests that the above price is not sufficiently remunerative to encourage domestic natural gas production but fails to provide any evidence to support such a conclusion. Can the Committee identify any significant independent conventional gas field in the world that receives or has received this high a well head price for dry natural gas year after year on an arms-length basis?

The Committee justifies the formula approved for pricing natural gas from KG Basin’s D-6 field, overlooking the objections that the then Cabinet Secretary and I had raised against the proposed formula. Here too, the Committee fails to point out that India is the only country in the world that adopted a formula by which the gas price rises exponentially with the price of crude between its floor price and its cap. The rest of the world follows formulae by which such linkage is a linear function, with a more gradual slope between the floor price of gas and its cap. Under the approved formula, the floor price of KG Basin gas determined at a crude price of $25/barrel is $2.50/MMBTU but it rises exponentially to $3.50/MMBTU at a crude price of $26/barrel yielding a 40 per cent increase in the price of gas for a 4 per cent increase in the price of crude. In the then relevant range of crude prices between $50/barrel and the cap determined at $60/barrel, the price of gas varies very narrowly between $4.1 and $4.2 per MMBTU. In essence, the approved formula violated international practice to ensure that, under prevailing market conditions, the KG Basin gas receives a price that was well beyond the price at which the same gas was bid out under an international tender or its cost of service. Fortunately, KG basin produces dry gas thereby negating any additional bonanza from natural gas liquids. Suffice it to say that despite the CAG’s report, the full extent of the KG Basin scam is far from being completely exposed. The Rangarajan Committee, nevertheless, finds the KG Basin gas price, that also triggered an increase in the gas prices approved for ONGC, not sufficiently remunerative.

The above shortfalls, I dare say, are minor oversights when compared to the indefensible formula recommended for determining the well head price of conventional natural gas produced in India. The recommended formula estimates the price by averaging some numbers derived from foreign gas markets even though those numbers neither represent well head price of conventional natural gas anywhere in the world nor reflect the cost of service for producing conventional natural gas in India.

In layman terms, the suggested formula establishes the fair price of carrots based on some imputed prices of bananas, apples and oranges. Let me explain this in more detail.

As a first step, the Committee recommends estimating, on a monthly basis, what it calls the “Average Producer Net Back for Indian Imports” for the trailing 12 months by deducting $3 to $4 from the prices paid by India for import of LNG from different sources over the same period. It is recommended that all LNG imports, including spot purchases and term contracts, be included. The $3-$4 number representing current cost estimates of liquefaction, transportation and sweetening natural gas would be updated regularly. Surely, such an exercise would yield a number. What this number represents, though, is anybody’s guess. Certainly, it is not the average well head price of conventional natural gas in the countries exporting LNG to India; nor is it relevant to determining fair well head prices for Indian producers of conventional natural gas.

Next, the Committee recommends that we estimate, on a monthly basis, something that it calls the “Weighted Average Price to Producers in the Global Markets” during the trailing 12 months. To calculate this number it uses the Henry Hub spot index as the price for all U.S. gas sales, the NBP spot index of U.K. for all gas sales in every country comprising Europe and the Former Soviet Union and the “Average Producer Net Back” for all Japanese LNG imports (computed on the same basis as recommended above for India); over the same period. Again, it is recommended that total volume of all gas contracts in the respective jurisdictions be included irrespective of their differences. This exercise too will yield a number but what it represents or its relevance to Indian gas producers is beyond comprehension.

Finally, the Committee recommends that the average of the two numbers calculated above, based on hitherto unknown concepts in the global gas markets, be used to compensate producers of conventional natural gas in India.

I cannot lay bare all the complexities of the regionally fragmented global gas markets here but let me simply state that natural gas varies widely in its characteristics across different sources and the three regions covered have distinctly different pricing mechanisms for gas. The ownership structures in the industry make it difficult to fathom at what point in the value chain is the profit being booked and how much. Gas contracts vary from spot purchases to long term with widely varying basis for pricing. The structure of the regional gas market and the related gas infrastructure in the relevant jurisdiction impact gas prices significantly. Finally, non-price elements that are not transparent, geo political considerations and security of supply concerns play an important role in the pricing of gas. The Henry Hub benchmark index is available for next day delivery and up to 108 months in the future. Similarly, the more recent NBP benchmark index permits trading of gas as a commodity on spot and longer term basis. However, importantly, the physical trade occurring at the typically quoted Henry Hub or NBP price is minuscule compared to the global trade in gas.

Disequilibrium

Unlike oil, natural gas does not have a fungible global market thereby exacerbating the above complexity. The resulting disequilibrium is illustrated by the fact that in 2011 the reported average dry gas price per MMBTU at Henry Hub was $4.01 while at NBP it was $9.03 and the Japanese LNG imports averaged $14.73 cif — which, based on the Rangarajan Committee’s definition, would yield an “Average Producer Net Back” of $10.50 – 11.50/ MMBTU for Japanese imports. IEA projects that such disequilibrium will continue at least for the coming 10-15 years.

Given above market realities and the current state of the gas industry in India, a well regulated cost of service would be the preferred option for determining the well head price of Indian gas. And as the original proponent of price discovery through limited sectoral competition, let me reiterate that, if done properly, it too deserves a far more serious consideration than that given by the Rangarajan Committee. Both these approaches have been successfully implemented in markets at a stage of development similar to India. The diffidence of the Committee in recommending these two approaches perhaps reflects its lack of confidence in India’s governance and regulatory capacity/capability. Recommending a Mickey Mouse formulation as a substitute to improving such governance and regulatory capacity/capability is, however, clearly undesirable.

As long as the PMO keeps appointing “acceptable” babus and academics to such important committees and specialised positions of governance and regulation, it will be the blind leading the blind and we will stumble from one blunder to another under historical myths that pervade India’s energy and other key sectors. This ruling clique’s inability to deal with well informed and well intentioned professionals who raise fundamental questions is evident in more arenas than just energy. The forbidden citadel must open its gates to such professionals if India is to move forward.

(The writer, formerly Principal Adviser, Power & Energy, Government of India, is Adjunct Professor, Lee Kuan Yew School of Public Policy, National University of Singapore)