Seeking a mechanism to rein in oil prices

A solution has to be found that will keep the public sector oil companies profitable and yet ensure that weaker sections have access to relatively cheap fuels.

Sushma Ramchandran

A SECOND "oil shock" seems to have hit the world economy as prices are rapidly shooting up to unprecedented levels. Prices are now touching $66 a barrel and the $70 barrier looms menacingly. The reasons given for this price surge vary from the impact of terrorist attacks in West Asia, to freak weather such as hurricanes, to growing consumption by the new energy tigers, China and India. Simply put, the demand for oil is outstripping supply and international markets are reflecting the situation.

Developing countries such as India, which need oil to fuel higher economic growth, are hard hit especially as nearly three-fourths of their needs are purchased from abroad. In the market place, no concessions are made for such countries. In fact, Asian buyers even have to pay higher surcharge on crude oil deliveries from West Asia, an issue that has been taken up by India with the Organisation of Petroleum Exporting Countries (OPEC). The effort has yet to yield any dividends. The suppliers' cartel is not inclined to give any discounts to developing countries. Nor are production levels likely to be raised, given that oil resources are finite and there is a need for producers to keep output at levels sustainable in the long run.

The world will thus have to live with the reality of high oil prices. For this country, it means a much larger import bill though this is not a worry in the short term, in view of the burgeoning foreign exchange reserves. Interestingly enough, on the positive side, it means that more companies are likely to join the on-shore and offshore oil exploration effort. Exploring for oil is always risky, but the high prices fuel the enthusiasm. No wonder then that the shares of the companies that have found oil in Rajasthan and Assam are having a bull run on the stock market.

This is probably the only silver lining to the high oil price scenario. Ultimately, it means that costs go up in all sectors of the economy. An inflationary impact is inevitable as raw materials and fuel costs for industry will increase; prices of manufactured goods are bound to go up. As for individual consumers, the Government is curbing prices of key petroleum products such as petrol, diesel, cooking gas, and kerosene meant for the public distribution system. These curbs cannot be kept in place for much longer as the public sector oil companies are reeling under the effort of bearing the subsidy.

As a result, the spectre of the blue chip oil companies slipping into the red looms. The giant Indian Oil Corporation (IOC) has, for the first time since it was set up, shown a net loss in the first three months of the current financial year. Other smaller oil companies seem to be following suit with the results of Hindustan Petroleum Corporation Limited and Bharat Petroleum Corporation Limited echoing IOC's dismal financial performance. The solution apparently lies in a revision of retail prices. The Petroleum Ministry has warned that otherwise "under-recoveries" of the oil companies will mount to Rs.40,000 crore during 2005-06.

The bleak outlook is based on the premise that prices will continue to harden during the rest of the year, which appears likely given past trends. It must be kept in mind, however, that global prices generally quoted are those of the most expensive crude oil in the world, the Western Texas Intermediate (WTI). Indian refineries use a much cheaper basket of crudes. Even so, the cost of these crudes also has shot up for Indian refineries and marketing companies, which are being forced to sell petrol, diesel, LPG, and kerosene at prices far below the cost of production. This has led to what are termed "under-recoveries" going up for the oil companies. These are losses on sales of these products though companies may still make profits on sale of industrial petroleum products on which there are no price controls. Similarly, refineries are able to earn profits on processing of crude oil into the various downstream petroleum products. The "refinery margins" have helped the oil companies keep afloat at a time when under-recoveries have been spiralling for most products.

The situation has now reached a stage that even refinery margins have not helped oil companies avoid going into the red; there are very real prospects of their having to slow down future investment plans.

It has become a case of killing the goose that lays the golden eggs. Nearly every year, the Central Government has shored up revenues by directing the till-now cash-rich oil companies to contribute an "interim dividend" before the end of the financial year. This helps in bridging the fiscal deficit apart from the huge amount of excise and customs duties paid by the oil companies on the sale of petroleum products. With the oil companies now going into the red, this ready source of cash inflow may no longer be available to the Finance Minister.

The way out seems to be to raise prices to bail out the oil companies. But what about the hapless consumers, for whom the battle is being waged by the Left parties. World prices may be soaring but the impact is clearly greater for consumers in developing countries.

One of the possible options before the Government is to evolve a mechanism being used in several developing and developed countries. Malaysia and France are among those that use this kind of system to provide a cushion against price volatility for domestic users of petroleum products. Under it, taxes on oil products are altered when world prices either rise or fall sharply. The taxes are lowered in case prices rise, leaving the retail price at the same level.

Such a mechanism, however, has to be tailored to suit Indian conditions since petroleum products here form a substantial segment of excise and customs duty collections. Any decline in revenues from this sector can have serious consequences for the Union budget. One of the arguments being made for reducing taxes on petroleum products is that revenue collections this year had been projected on the basis of much lower world prices for crude oil. The inflow has thus been much larger than expected and it should be easy to go ahead with further tax cuts. But this scenario will not be repeated every year and ideally the Finance Ministry should be asked to devise a system that can be applied in the long run.

In the past, the complex oil pool account mechanism had been evolved to provide a cushion to consumers against volatility in world oil prices. Ultimately, the funds in the account were drawn upon to bolster the fiscal deficit and did not achieve the aim of protecting the consumer. Doing away with the oil pool account system was aimed at bringing about greater transparency in the petroleum sector. The problem of bringing about stability in the oil pricing system, however, remains intractable. A pricing band system was sought to be introduced last year but remained a non-starter as global crude oil prices rapidly crossed the price band.

Absence of level playing field

In the absence of any such pricing mechanism, the burden on the consumers can rise to unduly high levels. The earlier administered pricing mechanism was meant to provide protection to buyers but restricted the autonomy of public sector companies that now have to compete with the private sector. Incidentally, a level playing field has yet to be created as only the public sector is taking care of its social obligations to provide kerosene and cooking gas at subsidised rates.

Similarly, the current system is taking its toll on the oil industry. Making oil companies support a huge subsidy on sales of petroleum products has already had a negative fallout and is clearly untenable in the long run. Even the move to make upstream oil companies such as the Oil and Natural Gas Corporation (ONGC) and Gail India Limited share the subsidy burden has only meant erosion in the profits of these navaratna companies.

The issue is much larger than merely raising prices of petroleum products to prevent the public sector oil companies from going into the red. The issue is of energy security, which is largely the responsibility of these very companies. In a country where 70 per cent of the crude oil demand is met from abroad, these corporates are the drivers for investment in this sector both to find more oil and create sufficient refining capacity. A solution thus has to be found that will keep them profitable and yet ensure that weaker sections have access to relatively cheap fuels.

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