The Hindu Business Line : A pricing policy for the petroleum sector

The Petroleum Ministry needs to come up with a more permanent solution to deal with rising international prices of crude oil. A pricing mechanism needs to be devised that keeps the government's revenue earnings from the petroleum sector constant. Retail prices should not be left to the profit making proclivities of the domestic oil companies. Above all, needed is a system that is equitable to all stakeholders — the government, the oil companies and the consumer, say Mohan Guruswamy, Ro nald Joseph Abraham and Abhinav Gupta.

Reaching new heights: The expected increase in petrol prices can only be an ad hoc and stop-gap measure. — G.R.N. Somashekar

A PRICE hike on petroleum products is imminent. The Petroleum and the Finance Ministers have spoken about this in the last few days. Now, it is only a question of when and by how much?

Whatever be the quantum of that hike, it can only be an ad hoc and stop-gap measure. There does not seem to be in place a policy or formula to deal with the crisis. The Petroleum Ministry needs to come up with a more permanent solution to deal with rising international prices of crude oil.

A pricing mechanism needs to be devised that keeps the government's revenue earnings from the petroleum sector constant and not give it a vested interest in climbing crude oil prices. At the same time, retail prices should not be left to the profit making proclivities of the domestic oil companies. Above all, needed is a system that is equitable to all stakeholders — the government, the oil companies and the consumer.

In August 2003, India imported crude oil at $28.58 a barrel. Now, it is touching $70.

In 2003, the average prices of hydrocarbon fuels in the metros were Rs 35.91 for petrol, Rs 24.54 for diesel, Rs 258.58 for LPG and Rs 9 for kerosene. As of June 20, prices were Rs 44.49, Rs 28.45, Rs 294.75, and Rs 8.91(in New Delhi) respectively.

Winners and losers in the price game

The steep rise in the cost of crude oil is not reflected in the domestic fuel prices. Given the intensely competitive domestic politics, where public opinion considerations dominate policy-making, the Government has not been unable to make informed decisions to tackle the price rise. The losers in this political game are the oil companies. The oil marketing companies will suffer an under-realisation of Rs 40,000 crore if current prices and taxes remain unchanged.

Given that all the State Electricity Boards made a loss of Rs 21,698 crore in 2003-04, the loss now suffered by the other half of the energy sector bodes ill for the national economy.

Losses of the oil sector apart, the oil policy is also crucial for the economy in general. Last year over Rs 1,20,000 crore accrued to the Central and State Governments combined. This translates to over 22 per cent of the Government's total revenue.

While rising oil prices may not be good news to the general consumer, they do bring cheer to the Finance Ministry. In the latest Budget, several changes were made in the tax structure on petroleum. The Customs duty on LPG and kerosene was reduced from 5 per cent to nil; and on crude petroleum, from 10 per cent to 5 per cent. The excise duty of Rs 5 and Rs 1.25 per litre on petrol and diesel respectively were also added.

The ad valorem tax on both was brought down to 8 per cent. A special road cess of Rs 6 per litre was added. The Finance Minister additionally claimed that these changes were revenue neutral, a claim not borne out by facts. The excise duty collection in the first quarter of this fiscal year was down to Rs 6,568.9 crore, Rs 725.8 crore less compared to the first quarter of 2004-05. However, rising international prices, and thus increased Customs revenue, bailed out the Finance Ministry this time. The Customs duty revenue was projected by pegging crude oil prices at $38 a barrel. Current prices are almost double that. Naturally, estimated custom duty revenues also increased proportionally. This was a much needed windfall gain.

Clearly, something other than luck needs to guide both the revenue collections and the pricing of petroleum. Leaving it to the vagaries of the international oil market is to take economic liberalism to its ridiculous limit.

Factors influencing oil prices

There are four essential components that determine petroleum product prices to the consumers. First, the prevalent international price. This is a variable over which the government has little influence, given that in the last fiscal year the country imported nearly 99 million tonnes of crude oil or 74 per cent of the total consumption. Further, experts like Mr Matthew Simmons, author of Twilight in the Desert: The Coming Saudi Oil Shock and the World Economy, predict that prices will breach the $100 a barrel level by the end of this year!

Oil prices also depend on the situation in Saudi Arabia. Mr Robert Baer, a former CIA specialist of the region, suggests that "the Saudi system... seems frighteningly vulnerable to attack". If this happens, the drastic consequences to countries such as India, which get 26 per cent of their oil from Saudi Arabia, can well be imagined.

The next component of petroleum product retail prices is Customs and excise duties. Instead of allowing the total revenues realised from this source to vary with the vagaries of the market, the revenue rates must be allowed to float, and the total revenue fixed. To facilitate this, the revenue rates should be adjusted on a fortnightly or monthly basis keeping the target in focus. This mechanism is easy to put in place as the number of entry points are few and the number of importers and producers are just a handful. The government's revenue collections are a function of international prices, total consumption and tax rates.

The former two variables, prices and consumption, cannot be influenced. Thus to keep revenues fixed the government needs to keep the tax rate floating. If international prices rise, the Customs duty will decrease and vice versa. Similarly, if consumption rises, the excise component can be brought down.

The third critical component in determining petroleum product prices is the cost of refining and marketing. If this becomes uneconomical, it is a major disincentive for investment. Suppression of domestic prices and the increasing burden of subsidies are costing the oil sector dearly. Last year the upstream oil companies shouldered over Rs 7,000 crore in LPG and kerosene subsides. What is more, the oil marketing companies made losses of Rs 1,500 crore in July alone, due to the suppressed oil prices. It has also been reported that Indian Oil Corporation has put on hold its plan to invest Rs 15,000 crore in a new refinery in Paradip because of its Q1 losses.

Keeping pace with subsidies

If revenues are fixed, expenditure on subsidies too should be kept constant. The designated subsidy can then be disbursed on the basis of the production of each product. For example, if the subsidy on LPG is pegged at Rs 95 per cylinder. However, if the rate of consumption is more than what was initially expected, this would lead to an increased subsidy bill. Instead, the opposite needs to happen.

The total subsidy bill should be kept constant and the rate of subsidy should vary according to consumption. If LPG consumption rises, the rate of subsidy can be brought down to, say, Rs 90 per cylinder and vice versa.

The fourth and last component of retail prices is State-level sales tax. Last year, Rs 43,254 crore accrued as petroleum revenue to all the States. This was over 18 per cent of their total revenue. Now, each State chooses its own level of taxation. Naturally, the variation among States will not differ much; otherwise consumers will start buying their fuel from neighbouring States. Thus, State taxes should be left for the States to decide as it will also have a bearing on their overall economic attractiveness.

There are many features of the oil marketing business that are undesirable. For instance, the fine print of a recent advertisement of retail outlets suggests that the selection will be decided on patronage and other considerations.

In many countries, the situation is different. There are independent retailers; they own their outlets and are free to choose their suppliers. A large number of independent operators will prevent oil companies from price fixing as prices are driven by supply and demand. The monitoring mechanism available with the Central and State governments is sufficient to exercise a degree of price control and to ensure price move within a certain price-band.

A four-point strategy

What is clear in this discussion is the need to evolve a policy that does not blight the oil sector as has happened to the power sector. The only way to ensure this is to keep it profitable and capable of generating future investments in this capital-intensive sector. To conclude, here is a four-point policy framework that should be put in place in the oil sector.

First, fix revenue targets so that customs and excise duties will float depending on prices. Second, the total quantum of subsidies should be fixed and the rate of subsidy kept floating. The important point here is that once revenue and subsidy limits are set, price movements will become automatic and not be an issue for the political market place.

Third, allow the marketing and refining companies to fix their own prices as long as they conform to a formula based on the cost of the imported basket of crude oil. Last, free the marketing networks from bureaucratic constraints and allow them to expand. Individual retailers should be allowed to choose their suppliers thus ensuring that oil prices remain competitive.

When sky-rocketing global oil prices are not in our control, we need to wise up and not pander to the needs of some citizen-consumers at the cost of the vast but silent majority that consists of the "real" common people.

(The authors are with the Centre for Policy Alternatives, New Delhi, an independent think-tank. For a full report on this subject email: cpasind@yahoo.co.in)

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