In his article in The Hindu (editorial page, “Of Reliance, by Reliance, for Reliance,” July 1, 2013), Surya Sethi has criticised the recent government decision to hike the gas price from the existing $4.2/MMBtu [Million Metric British Thermal Units] to a reported level of $8.4/MMBtu, supposedly based on the formula of gas pricing given in the Rangarajan Committee Report on the Production Sharing Contract (PSC) mechanism. He has averred that there is absence of any evidence-based research backing key economic decisions. Since I was a member of the committee, my academic conscience told me that I should submit to the readers of The Hindu the rationale for the formula and also clarify precisely what the committee recommended and what it did not.

First, the committee only outlined the principles and model for gas pricing, and did not recommend or calculate any particular price. It came up with a transparent formula that made use of various benchmark market prices to estimate the arm’s length price for gas, which the government is contractually committed to adopt under the PSC. The formula would yield the price with a three-month lag, using the benchmark market prices over the preceding 12 months. Since the government has decided to apply the formula with effect from April 1, 2014, the initial price on that date would depend on the relevant benchmark market prices obtaining over January to December 2013. Any calculation regarding what the price would be in April 2014 would necessarily have to make a number of assumptions and projections regarding the benchmark prices and volumes traded or sold in different markets and under various purchase agreements over the next six months.

Unmet demand

So far as gas pricing is concerned, on the one hand there is a clear case for incentivising domestic gas exploration and production on the supply side. Gas is the cleanest fossil fuel. India’s dependence on unclean fossil fuels like coal and oil is not only causing serious environmental problems but has also contributed to macroeconomic imbalances, with the import bill for such energy in 2010-11 equivalent to 38 per cent of export earnings.

On the other hand, there is a huge unmet demand for gas. The Indian market is segmented, regional, and characterised by inadequate infrastructure and domestic monopolies. (National Oil Companies and Reliance Industries Limited are the only domestic producers, with imports being channelised mostly through Gas Authority of India Limited and Petronet LNG Limited). Therefore, it is important to protect consumers of gas from monopolistic exploitation.

It is difficult to meet these multiple objectives with the single instrument of price. This is, in fact, the rationale for prioritising the allocation of gas to the power and fertilizer sectors, which are also themselves heavily subsidised by the government despite the administered gas price.

While gas-on-gas competition, characterised by a large number of competing buyers of gas, is the soundest pricing mechanism when free trade prevails in a competitive gas market, the reality is that the Indian market is nascent and far from competitive. Finding it impossible to derive the competitive arm’s length price from domestic gas market transactions, the committee tried to discover the competitive price from various trade transactions carried out at arm’s length in the global market. As the global market is neither integrated nor very liquid, there is a practice of linking gas price with import parity oil price, which presumes oil to be a very close substitute for gas. This practice is adopted by an increasingly limited number of countries. The committee considered such a presumption of substitutability as unreal in major user sectors like fertilizer and power in the Indian context. In fertilizer, it is only naphtha which is a possible substitute, and in power, coal is a more meaningful substitute. Besides, the transport sector drives the global oil demand, and there is no point in exposing power and fertilizer to externalities generated by the growth of the transport sector through oil price linkage.

In view of the above, the committee felt that it was desirable to discover the competitive arm’s length price for the Indian market from transactions in the global market until such time as the Indian gas market matured enough to enable gas-on-gas competition. The discovered price should ideally represent the price that a global producer on average receives at the well head, which is estimated as the average netback price at the well head after appropriate deductions, such as transportation and liquefaction costs from the landed price.

The committee considered two ways of discovering such a competitive price from global transactions:

(a) Estimating the netback price of Indian Liquefied natural gas (LNG) imports at the well head of exporting countries. Since there were several import sources, the average of such netback of import prices at the well head of export producers was assumed to represent the average global price for Indian imports. The netting back involved subtraction of costs of transportation and liquefaction of gas within the exporting country from the Free-on-board (FOB) LNG export price for Indian imports.

(b) Estimating the average of prices prevailing at the trading point of transactions at major global hubs or balancing points of major markets of gas of different continents. The balancing points recommended for consideration are Henry Hub in North America, and the National Balancing Point (NBP) in the United Kingdom for Europe and FSU (Former Soviet Union). As there is no such hub for East Asia, the netback price of Japanese gas imports was considered as a hypothetical balancing point for East Asia. This simulates the competitive well head price that Indian producers can expect from the world market.

For review

In both estimations, the average transaction price has been taken in view of the non-integrated and somewhat illiquid character of the global gas market and trade. The weights used for averaging are the respective volumes of gas traded. Finally, the committee recommended that the mean of the two price estimates be taken as the basis for gas pricing. Since such an estimated price would change over time, the committee recommended that the prices and volumes for the trailing 12 months period be used for monthly price revision. It further recommended that the model can be reviewed and the feasibility of introduction of gas-on-gas competition as the pricing mechanism be examined after five years.

While the committee did not recommend any particular price, and left price determination to the government, the estimated price as per the formula (a) and (b) for April 1, 2013, on the basis of data for the preceding 12 months, works out to $6.99/MMBtu and $6.68/MMBtu respectively, yielding a mean price of $6.835/MMBtu. This is the only reliable number for assessing the extent of price revision on account of the proposed formula at the present juncture, since the formula price for April 2014 would be a function of many factors and it would not be possible to predict this price with any degree of reliability at this point in time.

Finally, doubts have been raised as to whether a large rise in gas prices would at all attract additional investment from home or abroad and relax the supply side constraint. The increase in investment and supply of gas would however depend not only on the price of gas, but also on the terms of the PSC. While the latter has drawn investments under the New Exploration Licensing Policy, serious problems have arisen due to the tendency of contractors to manipulate the investment multiple parameter by gold plating investment and controlling production, which adversely affect supply. In order to address this, the committee also recommended a new PSC model which, coupled with the recommendations on gas pricing, would do away with the perverse incentives that deprive the government of its share in the production or profit by controlling production and gold plating investments.

(Ramprasad Sengupta was a member of the Rangarajan Committee on Hydrocarbons and is Honorary Visiting Professor of the National Institute of Public Finance and Policy.)

Surya P. Sethi responds:

In an honest academic endeavour to explain the well understood Rangarajan formula, Prof. Sengupta exposes most, though not all, of its shortcomings in establishing a defensible well head price for Indian gas. These shortcomings were detailed in my articles in The Hindu – editorial page, “Making a mockery of domestic gas pricing,” January 18, 2013, and Op-Ed, “Debate@The Hindu,” “A committee to ‘administer’ a ‘market price’ for gas,” February 7, 2013. Prof. Sengupta also upholds my July 1, 2013 opinion in The Hindu by questioning the $8.40 price — now repudiated by the government — and the government’s decision to reward existing producers without addressing their blatant abuse of PSCs.

His argument is that since global gas markets are fragmented and illiquid and the Rangarajan Committee could not assess how well head prices are determined elsewhere in the world, they chose to theoretically impute a well head price based on indices and prices that do not by themselves represent well head prices anywhere. Sadly, this approach fails to deliver a competitive arm’s length well head price for Indian producers of dry conventional natural gas. The hub prices used as surrogates for the American and the European markets are mere indices and very little, if any, gas gets traded at these hubs at the quoted prices. In any event, the hub price index includes transportation to the hub and in the case of the U.K.’s National Balancing Point, the price index covers piped natural gas and LNG linked to crude — a concept that Prof. Sengupta himself questions for the LNG-dominated Asian market. Averaging incorrect and unrelated numbers cannot deliver the right answer. As for macroeconomic imbalances, a higher subsidy burden for fertilizer and power is as consequential as rising imports. And Prof. Sengupta admits that the right incentive structure for raising domestic output must go beyond the price for gas.

The core questions raised in my July 1 opinion remain unanswered. Can Prof. Sengupta identify any gasfield in the world that receives even his lower estimated price of $6.835/Mmbtu at the well head for dry conventional natural gas?

(Surya P. Sethi is formerly Principal Adviser, Power & Energy, Government of India, and Adjunct Professor, Lee Kuan Yew School of Public Policy, National University of Singapore.)

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