The Hindu Business Line : Tight oil position ahead?

An increase in domestic oil prices would severely affect economic operations, as higher running costs would translate into higher road freight rates, which will be passed on to the consumer. Even if the Government were to oblige the oil companies by raising prices, the latter would still be financially badly off following the changes made in the 2005-2006 Union Budget.

NOT surprisingly, given the steep increase in world crude prices, the Indian oil majors are clamouring for an increase in the prices of diesel and petrol which would help them cut their losses.

According to reports, the companies stand to lose some Rs 500-600 crore during the current fortnight if prices are not revised upwards, with Indian Oil alone standing to lose between Rs 250 crore and Rs 300 crore.

Specifically, the oil companies would like petrol prices to be increased by Rs 3.50 a litre and diesel by Rs 2.80 if parity is to be maintained with world crude prices. But this is not all.

As reported, in letters to the Union Petroleum Ministry, the companies have sought a further increase in prices by Rs 1.50 a litre for the two fuels (taking the petrol price up by Rs 5 a litre and diesel by Rs 4.30) to account for the substantial investment being made to upgrade the petrol and diesel quality to the Euro-III standard for supply to 11 major cities and to the Euro-II standard for supply to the rest of the country.

The first point that should be made here is that the oil companies should forget the earlier stipulation (laid down during the NDA regime) that there is an automatic link between the world crude price and domestic oil prices, the latter being adjusted every fortnight to maintain parity with international prices.

In fact, the UPA Petroleum Minister, Mr Mani Shankar Aiyar, made it abundantly clear some months back that the "flexible" pricing system (which even the Vajpayee Government had begun to observe more in the breach than otherwise during the last year of its tenure) was a mere figment of the imagination and that, more importantly, the administered pricing system was very much in vogue. The only concession to flexibility that was made was adherence to a "band methodology", changes in the domestic price structure being considered possible only if world prices breached the upper and lower limits of the price band in question.

The second point is that, even if the Government were to agree to raise domestic oil prices, it would be naïve to expect it to go by the suggestion of the oil companies and alter petrol and diesel prices by the proportions indicated by them.

The long and the short of it is that, even at the present juncture when no State elections are around the corner, such a decisive step would be considered politically inexpedient, particularly when the NDA is riding a favourable wave in the aftermath of the Goa and Jharkhand Ministry-making botch-ups, not to speak of the mess which the UPA made in Bihar, where President's Rule is currently in force.

This apart, a price increase of this magnitude would severely affect economic operations, be they in the rural sector where farmers run their water pumps on diesel or the transport sector where higher running costs would be translated into higher road freight rates which would then be passed on to the consumer, affecting adversely the general inflation rate. Even so, as proof of the seriousness of the financial plight of the oil companies, the Government is reported to have taken steps to pave the way for a petrol and diesel price increase.

Specifically, the Petroleum Ministry has reportedly put up a Cabinet note recommending a two-phase increase, the first (to come into effect "in a few days from now") increasing prices of the two fuels by Rs 2 a litre each, and the second increasing prices by the same amount from May 1.

On the face of it, the splitting of the price-increase move is seen as a softening of the blow to consumers, which is a sensible decision.

Another reason could be for the Government to wait and see whether the current world crude price spurt continues into the second half of April when, according to one school of thought, there could be a damper on prices following an expected fall in demand for fuel oil in the western hemisphere consequent on the final withdrawal of the cold weather.

(It will be noticed that even if the Government does finally raise domestic oil prices by Rs 4 a litre for both petrol and diesel, the move will fall short of the demand of the oil companies to raise petrol prices by Rs 5 and diesel by Rs 4.30.)

Indeed, even if the Government were to oblige the oil companies by meeting their demand, the latter would still be worse off following the changes made in the 2005-2006 Union Budget in which, apart from the increase in the road cess, a number of changes were made in Customs duties and excise duties. According to one estimate, the oil companies would be losing around Rs 106 crore on petrol and Rs 158 crore on diesel every fortnight merely on account of these Budget measures.

If just this loss is to be made up, petrol and diesel prices would have to be raised by Rs 2.85 and Re 1 a litre, respectively, over and above the other increases considered necessary to account for the increase in the world crude price.

For the Indian economy, what all this means is that an immediate price increase of around Rs 2 a litre for petrol and diesel is on the cards. This is bad enough, both for the micro consumer as well as for the macro picture covering the national economy. Clearly, the disturbance would be much more severe if prices were to be raised further six weeks from now, the resultant increase in costs across the board perhaps even affecting the economy's fundamentals. The crucial question is: Will this eventuality come to pass?

As is always the case, this is a difficult question to answer. But, on balance, the point can perhaps be made that the world oil market will continue to remain tight in the weeks ahead in spite of the announcement made last week by OPEC that it would step up output by 500,000 barrels per day (bpd) with immediate effect, keeping a further increase in output to the same extent in abeyance (till the end of March). As the OPEC president, Skeikh Ahmad al-Sabah, said last Wednesday: "If prices continue as they are now during the coming seven to 10 days, we will begin our contacts with our colleagues so that we can consult on the additional 500,000 bpd".

The problem is that the oil cartel is already pumping crude at a 25-year-high level and other major producers like Russia and Norway are not in a position to increase output significantly at short notice.

On the other hand, as certified by the IEA, relentless demand pressure is being maintained by China, which could extend to 2007 and even beyond that. The demand-supply position is therefore tight, the inference being that, on this count alone, the pressure on oil prices will continue.

But this is not something new to the world oil scenario and, quite clearly, does not explain fully the present price behaviour.

According to analysts, the factor that is driving crude prices to pierce the ceiling is speculation by investors who are increasingly diversifying into the energy and commodity markets. For this tribe, the tight demand-supply crude scenario is fertile ground for making a quick buck, which is one reason why the oil futures market is scaling heights.

If prices are to cool down on a long-term basis, speculators will have to be weaned away from the world crude market. But the question is how. An increase in crude supplies is one way of doing so, but that is not possible at the present time.

Another route could be to increase US interest rates which would attract hot money, but the decision to do so is a very complex one since higher interest rates would have a crucial bearing on other fundamentals of the US economy. Perhaps this is one reason why a price level of $60 for a barrel of oil has not been ruled out by observers.

For New Delhi at least, this should be a grim warning that unless it is able to increase domestic crude supply sources (whether from internal or external sources is immaterial) and reduce its current dependence on imported oil (currently at 70 per cent), sustaining an 8-10 GDP growth rate in the years to come could become an even more difficult proposition than it already is now.

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