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!

Oil slump: No room for complacency

V Shunmugam

The Economic Times, Jan 10, 2009
(http://economictimes.indiatimes.com/Opinion/Comments__Analysis/Oil_slump_No_room_for_complacency/articleshow/3958830.cms)

With its predominant hold over transportation which has pervaded most economic activities in human life in one form or another, the bull run of crude oil during early 2008 affected all the importing nations. Some of the nations passed the burden of rising crude oil prices onto the stakeholders and most others passed it partially, bearing the brunt of it in their budgets with the hope that the situation would reverse soon. Market analysts too were divided on their take on the direction of crude prices, and those who were of the belief that it would reverse, feared the domino effects it could create given the extensive participation of the economic stakeholders from developing nations in crude markets.
Looking at the pace of bull-run, analysts predicting the reversal even feared that it could cause a major damage to institutions in developed economies with its ripple effects seemingly passed on through the globally integrated network of commerce and trade to other nations. Thanks to the initial spark to the current financial crisis in the form of the subprime crisis which started earlier to the crude market reversal, the crude effect had become a subset of the whole crisis that the global financial institutions are currently facing.
Interestingly, as the crude prices came down and in economies where the effects were immediately passed on, much of the purchasing power had already been washed off due to the credit crisis that had already crippled them and hence could not help build up demand sentiments. This resulted in building up of bearish sentiments in both the physical and derivative markets leading to the reversal of the increasing trend in crude prices with a fall that is steeper than its earlier rise. As the credit and other related bubbles bust, it took the other asset classes on a downward path due to weakening demand sentiments. Crude being one among the commodity asset class, its fall would have definitely provided relief to the policy makers of the largely import dependent emerging economies such as that of China and India. Though the effect of it, particularly in India had not been passed on fully for it to get reflected in other sectors, the prices of other commodities have fallen either due to increased supplies or the weak demand affected by the current financial crisis. Besides, after the elections were over, the government had announced a cautious cut on crude derivative prices by 5%-10%.
Since the issue of cross-border terrorism has hogged all attention, the price cut did not attract much comment. However, there have been public remarks as to the quantum of cut in the media. Setting aside the refining economics that many would feign ignorance about, one should appreciate the recent quantum of reduction if one were to agree with the below analysis. The moot point is that oil prices at the current level can harm the overall oil economy more than it could benefit the importing countries.
As everyone would know, the increase in crude oil production to a large extent is dependent on increased investments in exploration incentivised by higher oil prices. Contrarily, the current low prices had already taken a toll on the Federal Government of Nigeria, the world's seventh largest exporter of crude oil which had presented a deficit budget of Nigerian Niara 800 billion for its 2009 budget with a benchmark of $45 per barrel. A country that had already been riddled with high incidence of socioeconomic problems, lower government spending would further worsen the socio-economic situation in Nigeria. Even if exploration were to be made with external funding, with worsening socio-economic situation it would not incentivise any interest abroad to bid for new fields that may be thrown open. Another nation that is increasingly trying to reduce the dependence of its budget on oil revenues is Iran, with the current fall in oil prices, as part of its good governance. According to President Ahmadinejad, his government has cut dependence of the budget plan on oil revenues by 10%, i.e., from about 62% of the previous budget plan, the current budget plan has only envisaged 52% of the total revenues attributed to oil-related income. While it is good that a nation is reducing its dependence on a single source of revenue, it would be interesting to watch its implications on government spending and efforts to develop other sources of revenue without pumping more oil from the existing reservoir at current prices. Obviously, for a not so open economy in terms of foreign investments such as Iran, it would only mean that there will not be supply augmentation beyond a point.
Amongst the top producers, Russia too is facing the perils of its gloomy oil and gas industry. To sustain production, Russia needs to overcome the 'Greenfield challenge', i.e., the need to develop remote and capital-intensive new oil and gas fields in an environment where newly created "national oil and gas champions" are too heavily leveraged with debts. According to estimates (2008-10), Gazprom, the Russian oil and gas major, faces a high probability of its cash flow moving in loss territory by 2009. As a result, now when many of Russia's brownfield oil and gas potential are on the verge of expiring, the development of the greenfield potential to compensate their losses is proving to be difficult as it requires increased capital investment.
Having been convinced of the implications of current low oil prices to the entire oil economy and taking into account the opposition that the Indian government faces while revising petroleum product prices upward, despite the huge fiscal burden to the exchequer and accumulated losses to the oil companies, it would be unwise to call for further reduction in the administered prices unless the economic situation and the oil prices warrant the same. However, it would be wise if the government strategically tackles the effects of oil price movements through increased participation in overseas exploration, participation in derivative markets, augmentation of domestic production and last but not the least focus on research in alternative energy sources keeping in mind its long payback period.