Account for under-recoveries

Last week, the government administered the sharpest increase yet of Rs 5 a litre in retail petrol prices. A group of ministers will soon sit down to decide if prices of other products such as diesel and cooking gas (LPG) also need to be increased.

Crude oil prices, though they have softened in the last one week, have been ruling high in the last one month and more. The oil companies have been crying hoarse about their “under-recoveries” and demanding an increase, and stiff ones at that, in retail prices of all petroleum products.

What are under-recoveries? Are they losses suffered by oil companies while selling products below cost price as is being made out? Should the government accept at face value the figures dished out by the oil companies as under-recoveries? Who certifies these figures?

These are some of the questions that need to be answered in a fair manner. Let us get this straight first: Retail prices of petroleum products need to be revised at frequent intervals to reflect the prevailing international price trends. There can be no two opinions on that. The quarrel is only with the manner in which such price revisions are arrived at, without following due regulatory process.

No Regulator

Unlike the telecom industry or the power sector, the regulator for the petroleum industry — Petroleum and Natural Gas Regulatory Board — does not validate price revisions though it is well qualified to do so. The Government has chosen to keep this function alone out of the purview of the regulator for reasons political and economic.

Given the politically-sensitive nature of petroleum products, the Government obviously would like to retain control.

Yet, such control seems to have now taken on proportions that threaten the prospects of a crucial infrastructure industry. Everyday, we are confronted with gloomy news of rising “under-recoveries” with dire predictions that they threaten the very financial fabric of the oil companies. The impression that the consumer gets is that if prices are not revised, the oil companies would go under.

Understanding under-recovery

It is true indeed that oil company financials are in trouble because of their inability to pass on price increases to consumers. Yet, that does not mean that what they call as “under-recoveries” should be the basis for pricing decisions. Under-recoveries are nothing but the difference between the retail price of a petroleum product and its trade-parity price, which is a combination of landed price of imports and the value that exporters from India get for the product.

By its nature, trade-parity prices are notional in nature with several elements of cost loaded on to them, but not actually incurred, such as duties, insurance, freight and other levies. They are not incurred because the oil companies do not import petrol or diesel. What they sell in the domestic market are fuels produced in their own refineries.

So, where is the logic for including un-incurred costs, so to say, and claim them as under-recoveries. Note that oil companies never call this difference as loss.

The Chaturvedi Committee that went into the financials of oil companies in 2008 frowned upon the concept of under-recovery saying that “under-recoveries could not be linked either to the change in the crude oil price or to the published annual accounts of the company”. The Rangarajan Committee in 2006 was also critical of the concept.

Importantly, under-recovery figures that oil companies cry hoarse about are not audited by their statutory auditors. It is also not clear if the Government assesses the numbers before taking decisions on price revision.

The question is: Why should price decisions not be linked to the intrinsic cost structure of the oil refining and marketing companies? The refinery-gate price, which is the basic price of fuels, should reflect the cost of production and margins and not consider landed cost of the products.

In fact, ideally, it should be a situation where competitive forces determine retail price as in any other product. For long, the government has shied away from unleashing competition under the excuse that these are sensitive products. The best way to handle this would be to allow free pricing with subsidy targeted at deserving sections alone. The affluent urban middle-class certainly does not deserve cooking gas subsidy just as the high-end diesel car owners don't too.

Why the difference?

A study comparing retail fuel prices now with mid-2008 when global crude oil prices were at similar levels leads to interesting conclusions.

The comparison in the Table shows that petrol prices (in Mumbai) are now 35 per cent higher than what they were in April 2008 when Brent crude was trading at similar levels. Diesel prices are now 16 per cent higher. How can product prices be so much higher when crude oil price is about the same? What explains this?

First, import duties on petrol and diesel then were 2.5 per cent; they are 7.5 per cent now. Remember, these are included in the computation of retail price though the products are not imported.

As much as Rs 2.70 per litre of petrol and Rs 2.30 per litre of diesel now is because of including import duties in the pricing structure. Second, the Government may have shared more in the under-recovery in 2008 compared to now.

But the most important reason could be that there is an element of cross-subsidisation between the prices of petrol, on the one hand, and cooking gas and/or kerosene, on the other. Could that indeed be the case?

In the absence of a certification mechanism for under-recoveries it is impossible to tell one way or the other.

The point though is that we need to either move away from the under-recovery-based pricing decisions or if that is not possible, have a method of certifying or auditing the under-recovery figures before revising prices.

The government is fond of saying that petroleum product prices are sensitive and affect the common man.

That is precisely why they should not be left to the whims of the oil companies and subject to greater regulatory purview.

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