The illogic of petroleum pricing

India is not entirely dependent on foreign supplies of crude oil

The performance of the oil companies does not suggest that they are on the verge of a collapse

One of the most important arguments of the government in justification of the unprecedented rate of increase in the prices of petroleum products was that the move was urgently needed to save the public sector oil companies. In his televised address to the nation on June 4, Prime Minister Manmohan Singh justified the hike by citing their “under-recoveries,” which he claimed amounted to about Rs. 2,45,000 crores.

Dr. Manmohan Singh was, of course, careful in his choice of words. He termed them “under-recoveries” rather than outright losses. One has heard of profits and losses, but pray, what are “under-recoveries”? The answer to that question would reveal all that is wrong with the petroleum-pricing regime in India, which is not only opaque but also illogical.

Simple arithmetic would suffice to prove that the numbers on the “losses” do not quite add up. Significantly, on the same day the hike was effected, the Prime Minister appointed a “high-powered” committee under the chairmanship of B.K. Chaturvedi, member of the Planning Commission, to examine the financial position of the oil marketing companies (OMCs).

Among the terms of reference of the committee is the task of “revisiting” the notion of “under-recoveries.” It was also asked to “examine the reported deficit and real deficit faced by the OMCs.” In effect, the terms indicate the government’s grudging and belated acceptance of the possibility of the actual deficit of the oil companies being lower than what it had cited in justification of its move to increase prices of petroleum products.

Hypothetical prices

Soon after the announcement of the hike, officials in the Ministry of Petroleum and Natural Gas made an attempt to make the increase appear reasonable and moderate. They pointed out that although the oil companies actually required a hike amounting to Rs. 21.43 a litre in the case of petrol, the government was only increasing the price by Rs. 5 a litre. A price of Rs. 71 a litre would be reasonable, they said, at a time when crude oil prices were about $130 a barrel.

India is heavily dependent on the import of crude oil, but it is not entirely dependent on foreign supplies of crude. About one-fourth of the nation’s requirements comes from fields within the country. Indeed, the Oil and Natural Gas Corporation (ONGC) supplies its crude to Indian refiners at a discounted price of $55 a barrel. Logically, therefore, the weighted price of the Indian crude oil basket should be about $111.25 at a time when the international price is $130 a barrel.

A barrel of crude is equal to 158.987 litres, which means that the weighted price of $111.25 a barrel implies that a litre of crude costs about 69 cents, or Rs. 29.39 a litre (assuming that a dollar is worth Rs. 42). Incidentally, a large part of the confusion in the media about the “losses” of the oil companies is caused by the fact that the quantity is expressed in barrels while ordinary consumers actually feel the pinch in rupees for every litre.

The cost of crude oil refining, which is essentially the process of converting crude to products such as petrol and diesel, varies a lot depending on a host of factors. But it depends critically on the grade of crude used and a refinery’s vintage. One assessment, by Tapan Sen, CPI(M) MP and a member of the Standing Committee of Parliament on petroleum and natural gas, mentioned in a letter he wrote to the Prime Minister recently, is that “the cost of crude comprises 93-94 per cent of the cost of the finished product.” He pointed out that if refined products were to cost Rs. 71 a litre, crude ought to cost $256 a barrel — which would be patently absurd.

A senior official in a public sector oil company told The Hindu that the refining margins would vary but they would range at the most from about 20 paise a litre for Reliance Industries’ refinery at Jamnagar in Gujarat to about Re. 1 for an old refinery run by his company. Thus, even if one uses the latter as the cost of conversion, the price of a litre of diesel and petrol would not be more than Rs. 30.39. Incidentally, both petrol and diesel cost roughly the same at the refinery gate; it is only the rates of duties that results in the differential in prices that consumers pay for the two. Of course, this does not include the cost of marketing, the profit margin for the refiner and several other costs associated with petroleum refining. However, it is enough to prove the point that the “under-recoveries” are totally divorced from real-world costs.

It turns out — and this fact has been in the public domain for a long time now — that the “under-recoveries” result from a hypothetical price which is not only unrealistic but also opaque and arbitrary. Its fundamental anomaly arises from the fact that it negates Indian self-reliance in petroleum refining. In fact, the country is actually a net exporter of petroleum products.

Illogical pricing regime

The determination of a notional price for petroleum products is a result of the dismantling of the Administered Pricing Mechanism (APM) in 2004. It rests on the import parity pricing principle, which has much to do with the mounting “under-recoveries” of the oil companies. The method of pricing rests on a fetish — that of linking domestic prices to international prices, no matter that the country does not actually import petroleum products. Since these products are not actually imported, the method uses the next best option, namely to assume these are imported.

It takes the average fortnightly international price of petroleum products, adds ocean freight rates, customs duties and other charges such as insurance and ocean loss to arrive at the import parity price, which is supposed to reflect the cost that any other petroleum product purchaser anywhere in the world would pay for the fuel. This fantasised price is the base price on which the oil companies compute their “under-recoveries,” irrespective of what the cost of the fuel actually is at their refinery gates.

India has a refining capacity of almost 150 million tonnes, which is substantially more than the demand for petroleum products. The logic of benchmarking domestic fuel prices to international prices makes a mockery of self-reliance. This price unification caused by the linkage threatens to open the national market to international oil cartels and other speculative influences which can have adverse consequences for national energy security. It also undermines the competitive edge that the Indian oil industry has achieved over decades.

Does this mean the problems of the public sector oil companies are entirely fictitious? At present the OMCs do face a problem of accessing crude oil in the international market, especially at competitive rates. However, this appears to be more of a short-term cash-flow problem rather than outright losses. The Reserve Bank of India (RBI) has purchased bonds issued by the government to the oil companies, thereby providing some relief to them.

It is also true that the public sector oil companies sell LPG at lower-than-market rates but are short-changed by the government through the offer of oil bonds, which are in effect a form of deferred payment.

The performance of the oil companies does not suggest that they are on the verge of a collapse. IOCL’s gross refining margins — the difference between the market price for crude oil and the market price for fuel — was $9.1 a barrel in the April-December 2007 quarter, increasing from $ 3.6 in the same quarter of the preceding year.

The other two major refiners, Bharat Petroleum Corporation Limited (BPCL) and Hindustan Petroleum Corporation Limited, made a similar showing during this period. All this does not indicate an industry in distress.

The government, it appears, is more concerned about the profits of the oil companies than setting a fair and transparent price for the scarce resource.