Politics and Economics behind Petroleum Products

The biggest hike in the petrol price in the history of India, in 2012 (although followed by some roll backs) has evoked public outcry and criticism of the UPA II government. Paradoxically, the decision of largest hike has come at the time when the international crude prices have been gradually moderating. This simply reflect the fact that politics (Petropolitics) rather than sheer economics is the primary guiding force behind the pricing of petroleum products.

Since fuel is a “sensitive” commodity in the economy as its pricing has explicit impact on the overall economy in general and inflation in particular, thus administering its prices by political leadership has some merit. However, the fundamental intend of such arrangement must be to safeguard the interests of vulnerable and marginalized sections of the society and to curb the inflationary trends. The recent decision of this biggest hike of the petroleum prices is no way related to the above noble intentions. On the other hand the aim behind such hike was to gain political mileage in the assembly elections.

There are two major causes that are related to the petroleum prices

1. The price of crude oil in the international market
2. Value of rupee vis-à-vis other currencies

Apart from these two factors the taxation of the petroleum products also plays a vital role in determining its cost to the end user. The following taxes are involved in the distribution processes:

1. Excise Duty
2. Import Duty
3. Value Added Tax (VAT)

While the first two taxes belong to the Central Government, the third one goes into the exchequer of the State governments. Since the structure of VAT is different across the states that’s why the price of petroleum products are priced differently in states.

 In order to understand this complex issue of pricing of petroleum products, it is essential to have a clear understanding of the value and supply chain of the petroleum products.

The oil and gas industry is usually divided into three major components: Upstream, midstream and downstream, though midstream operations are usually included in the downstream category.

The upstream oil sector is also known as the exploration and production (E&P) sector. The upstream sector includes the searching for potential underground or underwater oil and gas fields, drilling of exploratory wells, and subsequently drilling and operating the wells that recover and bring the crude oil and/or raw natural gas to the surface.

The midstream companies make money by fractionating, transporting and marketing these natural gas liquids.

The downstream oil sector is a term commonly used to refer to the selling and distribution of natural gas and products derived from crude oil. Such products include liquefied petroleum gas (LPG), gasoline or petrol, jet fuel, diesel oil, other fuel oils, asphalt and petroleum coke.

The profits of upstream and midstream companies are almost insulated from the international price of crude oil as well as value of rupee. It is the bottom line and under recoveries of downstream oil sector companies or Oil Marketing Companies (OMCs) which are critically linked to these two factors. To understand the issues more clearly it is pertinent to understand two terms i.e. Import parity pricing and under- recoveries of OMCs.

Import parity pricing and under- recoveries of OMCs

Import parity pricing is a pricing policy adopted by OMCs for their sales to domestic customers; according to which price of the petroleum product in the international market is taken as a benchmark for the accounting purposes. It is set at the cost of the imported substitute good. Such price is set equal to the world price converted into rupee, plus any transport, tariff and other costs the customer would bear if importing.

This import parity pricing is closely linked to the under recoveries. Under-recoveries are a notional measure representing the difference between the trade-parity cost of refined product paid by OMCs and their realized sale price. It is the gap between the local price of fuel and what would have been the price if the fuel were imported.

Mathematical expression:

Suppose the price of imported oil for retail is Rs X per liter on a particular day

The price incurred by the oil marketing company along with distribution cost for retail is Rs Y per liter

The managed price at which it is sold the end consumer is Rs M per liter, than:

Rs (X- M) = under recovery of OMC per liter

Rs (Y- M) = loss of OMC per liter

Generally X and Y are different prices. Consider a case when X > M> Y in such case the OMC would report the under recoveries but actually it would be making profit.

In case of kerosene, oil companies suffer an under-recovery as well as a loss because the local retail price is much lower than the cost of crude oil. But sale of a product like petrol can still be very profitable at times, even if oil companies are reporting under-recovery of a few rupees a litre. It is argued that the procurement prices paid by OMCs (some of whom are vertically-integrated refiners) are actually less than trade-parity prices, as currently calculated – meaning the actual effect of managed prices is less than that suggested by under-recovery figures.

Sharing of under-recoveries

The under-recovery burden is usually shared among the oil marketing companies, the upstream companies and the government. However, deteriorating financials of the oil marketing companies and the government restrict their ability to foot the rising bill. Equitable Burden Sharing Mechanism (EBSM) is applicable for sharing of under-recoveries.  Under this system, it was agreed that India’s upstream public oil companies (Oil and Natural Gas Corporation (ONGC), Oil India Limited (OIL)) would shoulder one-third of the burden of under-recoveries. However off late the subsidy share of the upstream companies (ONGC and Oil India) and GAIL has rose from one-third to almost 38 per cent.

The alternatives to tackle the under recoveries

There are various possible alternatives before the government to arrest the ballooning under recoveries of the OMCs. These are as:

1.      Raising retail prices;

2.      Reducing duties to keep retail prices unchanged while transferring the benefits of the duty reduction to the OMCs;

3.    Generating revenues by taxing the super profits of the oil companies that are involved in the production and export of crude at the current high prices, so as to compensate the marketing companies;

4.     Generating resources through additional taxes on or lower tax concessions for India's high net worth individuals and the corporate sector, so as to pay for subsidies that protect the ordinary consumer against the effects of the global oil price shock

5.      Borrowing money to compensate the OMCs for their losses.

How could UPA have handled it better?

There was a considerable hike in the international crude oil price which even reached about $ 150 per barrel. This was coupled with the depreciating value of Rupee against the dollar. Therefore the hike or implementation of any of the alternatives was inevitable because of the ballooning under recoveries of the OMCs.

If UPA and its collation partner were so much concerned about the prices of the petroleum products, they must reduce the excise duty and the VAT rates across the country.

Even if the government was of the view that price hike was best alternative to handle the situation, it must have not waited for the assembly elections to get over. Government didn’t allow the OMCs to go for a price hike in the backdrop of assembly elections in the five states, by the time the government gave its assent for the hike, the deficit turned out to be so huge that country witnessed the biggest hike. NDA government too faced the similar situation and it hiked the fuel prices 33 times in six years. However the hikes were so tiny that they didn’t invite the public outrage and media attention.

Suggestions for tackling the issues

The following can be the suggestions to tackle the issues:

1. The efficacy of the notion of under recoveries needs to be questioned. Since India imports crude oil and not petrol or diesel, but this concept takes into account the international price of diesel and petrol for accounting.
2. The long-term target must be to bring the ratio of imported crude to total consumption down to the historical level, last seen in the 1980s and early-1990s, of around 65%.
3. We need to reduce bureaucratic delays in case of the policy related to exploration. Cairn, for example, has to waite for nearly two years to ramp up production in its Mangala oilfield.
4. We must encourage more joint ventures in exploring foreign oil and gas fields. ONGC Videsh's Russian investments in Sakhalin-I and Videocon's fields in Mozambique, Brazil, East Timor and Australia should encourage Reliance Industries (RIL), Essar, Adani and other private sector exploration companies to expand their global footprint
5. We must go for rationalization of duties and taxes on petroleum products.
6. Sustainable alternatives of petroleum products like bio fuels must be promoted
7. Different types of diesels should be used for trucks and luxury cars. It makes no sense to supply diesel at subsidized rate for the owner of a luxury diesel car.
8. It is high time that the railways also switched over to the use of 100% electricity for running the trains.
9.  For transport vehicles CNG should be used, which is less polluting, on the one hand, and would result in liberating the goods transport sector from the use of diesel, on the other.