Walking the Tight Rope in Petroleum Products Pricing

V Shunmugam

An investor with an uncanny knack for anticipating policy effects on the markets would have balanced his portfolio with the gravity-defying performance of the so-called ‘public sector blue chips’ into crude refining, including HPCL (35.1 %), BPCL (39.2 %), etc., July 11 till Feb-end. Of course, being an explorer of oil and gas ONGC was an exception to the gravity-defying price trend. Thank god, that they were not fully disinvested, which would have otherwise led to the whole of the profits of this price differential between derivatives and crude accumulating into a few private hands. This would make one wonder if our current policy only serves its main objective of protecting the vulnerable sections of the society from market volatility. Given that our administered prices have become stickier of late, it did protect the vulnerable population when the markets were upwardly volatile but have not when the markets were south-bound since July, 2009.

Why did the stickiness get built into a mechanism which was supposed to be flexible? It was expected to be less glutinous as the then government decided to mark the prices of crude derivatives to markets on a 15-day interval during 2002 in an effort to make way for gradual dismantling of administered price mechanism when the crude markets were calm at their bottom. Unfortunately, the spirit behind this pioneering move was lost in few months as was evident in the slowness with which derivative prices were marked to the market movements. The mark-to-market (MTM) policy ran out of steam as crude began its unstinted northward journey. The volatility also remained high due to heightened geopolitical concerns/rigid supplies and the MTM needed more time for political and financial homework to be done than the policy would desire. This was well reflected in the retarded policy response that often matched the policy comfort level than the commercial comfort levels of the PSU and even the private sector (Reliance) refiner who took up aggressive domestic marketing. The complete reversal of the 2002 policy made the then private sector efforts into expanding retail network to be dispersed into thin air. Fortunately, the escalating real estate prices would have helped them make good of their losses.

With the crude prices at the bottom of the market (though volatile) compared with the all-time high of July 11 at $147/barrel, is it the right time for us to think of deregulating petroleum derivative prices? Deregulating is easier said than done in a plural democracy with large inequality like ours unless the common man who is being taken out of the umbrella of administered pricing mechanism (APM) understands and is enabled to assimilate market volatility. With crude being much pervasive in human life today, a sudden removal of the APM without a plan to take care of the economically vulnerable sections of the industry and individuals would have the potential to widen the inequality that already exists in the economy.

How can policy makers prevent APM from benefiting a few individuals or institutions (public or otherwise) due to the political stickiness of prices? Of course, the government is a major beneficiary of the refining and derivative marketing profits, holding a stake of about 50 percent or more in the public sector refineries. However, what would be worrisome for public policy making is to find ways that would prevent inordinate cash benefits from getting accumulated in to the hands of a few individuals and institutions arising out of its own operation.

Assuming that the current stickiness in prices is likely to exist for the time being, with the elections around the corner it would least incentivize any government in power to react radically by dismantling APM though crude is at its low (yet unstable). Against this backdrop, if the crude and derivative prices were to remain at the same level since the last revision on January 28, 2009, it will continue to contribute towards the widening of economic inequality in a small way. Such an inequality would get multiplied at times of financial boom. Hence, it is necessary that profits arising out of a public policy be tapped for public purposes rather than letting it slip into private pockets.

The tools that are available with our policymakers include making the derivative prices less sticky so that the profits from public policy making do not fall into private hands but yet making these PSU industries attractive to the investors. Having taken a plunge in to liberalization, disinvestment will remain a priority and may set the tone for APM dismantling.

The other avenue would be to increase taxes on crude or derivatives without affecting petroleum product prices. However, estimates in the recent past revealed that petrol and diesel were being taxed to the extent of 56 and 38 percent respectively. Is it worth an option to look at? Those who ask such question should look at countries such as the UK, Germany, and France that have taxes on petroleum products much higher than ours. At times of high fiscal deficit and policy constrained high prices it will be worthwhile considering a flexi tax option.

History reveals that given crude oil as an energy source is widely used for transportation purposes, nations with high dependence on indirect taxes considered taxing crude heavily to capture a part of the advantage that the petroleum products provides it users to help spread it among non-privileged. But our government has a strong dual purpose of increasing the taxes if it at all decides to do so without changing the administered prices. One to continue supporting subsidization of poor man’s fuel — kerosene, and to accumulate funds in ‘oil pool’ to buy back the oil bonds whenever they mature. Secondly, such tax revenue without affecting petroleum prices become all the more prominent at this time of financial crisis is to keep the fiscal kitty healthy. No wonder, a recent media report quoted finance ministry sources as looking at increasing customs on crude when its prices were on an upward spiral!

Between ‘Aam Aadmi’ and WPI

V. Shunmugam
Recent efforts of the print and electronic media to unplug the current zero level inflation as calculated from the recently released WPI from the increasing price trends at the retail level ended up confusing the ‘common man’ rather than clarifying it. Should he be happy about the near-zero level inflation numbers as revealed from the recently released WPI numbers or should he worry about stiff or increasing prices of commodities purchased by him from the next door Kirana shop? The simple fact that the a stubborn CPI and falling WPI had been existing together for the previous long six months leaves one wondering what the recently announced inflation number means to the ‘common man’. Below is an attempt to compare and distinguish underlying currents in the WPI and its relevance to him.

Fundamentally, WPI remains an attempt to index the prices of about 435 commodities collected at the wholesale level and compiled by the OoEA/Ministry of Commerce and Industry and to calculate the extent of price movement on a year over year (YOY) basis. To filter out the seasonal effects that the fundamentals of the different commodities in the WPI basket might have, YOY calculation has been done to measure inflation or the price change. Hence one has to remember that the inflation numbers calculated based on WPI is only a relative number based on the year ago price level and any lower inflation does not mean that prices have reversed but that the rate of price increase had declined. Further, of the 435 commodities represented in computation of WPI Index only about 77 i.e. 18 percent refers to commodities that can be associated with immediate consumption by the common man which has a combined weight of 21.54 percent. Tracking the movement of WPI, it is natural that the price increase which common man sees in many of the commodities of his frequent consumption is likely to remain higher 4.26 percent at the whole sale level. Though appropriateness of the commodities and their weights remains debatable, to preempt the same, authorities should consider conducting expenditure surveys on a frequent basis (as is the case with the United States) or atleast expanding the scope of the NSSO annual surveys to include WPI related commodities as well to make it reflect ground realities more frequently. It would ensure that policies taken to contain inflation yield intended results.

Rest of the commodities undergo industrial processing/value addition before being consumed by consumers directly or indirectly (services/manufactured goods) and can be grouped into three depending on their consumption availability over a short/medium/long period in time. Among them the first group of commodities gets value added and is available for direct or indirect consumption of our common man in a short period in time. This group would have an immediate term impact on the price levels for the common man if not at the same interval as that of the earlier discussed group of commodities. As per the existing WPI basket, it would approximately account for only about 26 percent of total consumption basket of our ‘common man’. With a 1.56 percent increase in WPI and given its weightage of 31.48 percent, the change in the WPI number would take a short period in time to get reflected on prices of the ‘commodities or services’ that our common man would consume. The second class of industrial commodities (7 percent with 6.19 weight in WPI) would take a slightly longer time (6-12 months) to impact the overall price levels or somewhat indirectly reach our ‘common man’. The last group of commodities which represents about xx percent of the kitty had undergone a price change of 49 percent as per the WPI weightage (40.79 percent) but would take more than an year’s time to get reflected in the price of goods and services that our common man witnesses in his neighborhood. Overall, what he sees in WPI will not be what he would get in his kirana shop or would have an impact on the common services that he consumes due to several reasons.

Firstly, WPI is a reflection of prices that exist at the wholesale markets and there exists a long value chain mired in opaque markets which add to its margins often to mark themselves to what our common man sees as inflation at the whole sale level. Reforms in the value chain connecting producers with consumers and increasing market transparency would help in transferring the benefit of lower increase in WPI into CPI in all groups of commodities, more so in the case of first group of commodities which are closer to our common man. Secondly, given the current high volatility in forex rates (11%), equities (46%), interest rates (24%), and commodities (26%), value addition becomes a costlier process due to high cost of risk management which gets passed on to the consumers reflected in increased prices of processed/value-added products. It essentially leads into price-wage loop as it happened in the previous boom, breaking which would need demand shrinkage that has the potential to lead to an unemployment spiral. Existence of derivative markets in the above asset classes with public and private participation bringing in heterogeneity would help not only help corporates to manage their risks effectively but also acts as the conduit for masses and public institutions to express their price expectations for natural or policy enabled smoother adjustment in demand and supply. Thirdly, existence of an effective competition policy and strict monitoring would help avoid collusion among few industries within a given sector thus preventing higher markups in value added commodities. Though the laundry list of inefficiencies in markets, manufacturers, and service providers is infinite, the first three here are obvious. It will be a combination of policy, institutional, and regulatory reforms that would help shrink the spread between the WPI and CPI. Till then for our common man, it will be not what he sees on the media as inflation or somewhere closer to it that he would get in his neighborhood. After all, there is a reason for the Public Lending Rate of the Commercial banks (12.25%) to remain higher than the RBI’s lending rate to the commercial banks (reverse repo rate – 3.5 %)!