The right time to push oil sector reforms

Brent crude prices averaged $55 per barrel in the first nine months of calendar 2015, after averaging just under $100 for all of 2014. The oil price environment should stay benign over at least the next 18-24 months, because global economic growth remains muted and supply levels are resilient.

Brent crude will therefore average $57 per barrel for 2016 and move up to $65 per barrel for 2017. This prolonged low price environment offers opportunities for countries such as India — which rely heavily on crude imports and provide large fuel subsidies — to institute reforms that will help the country cope when oil prices rise.

Subsidy sharing While low crude oil prices and the deregulation of diesel prices halved India’s fuel subsidies to ₹762 billion in fiscal 2014-15 from ₹1.4 trillion in fiscal 2013-14, more can be done to ensure that fuel subsidies remain low and subsidy sharing between the upstream companies and the government becomes more transparent and predictable.

For example, a long-term subsidy sharing formula linked to a benchmark crude oil price can be implemented.

In a revenue sharing model, the upstream companies pay a percentage of their production revenues from the nomination blocks to the government directly, and the government shoulders the entire burden of providing fuel subsidies. Such a model will eliminate the uncertainty over subsidy sharing, and will allow the government to reap the full benefit of its efforts on the deregulation of fuel prices. And, if fuel subsidies are eliminated altogether, the government will continue to receive a share of production revenue from the nomination blocks. As for cess — a tax on production — the government could change the way that such an indirect tax is charged. Cess is fixed at ₹4,500 per tonne which currently equates to $9.3 per barrel.

Cess effect Value-based cess can provide the government with the partial hedge against increases in crude oil prices. Such a hedge can compensate for the increase in the government’s fuel subsidy burden. It can also provide protection to the oil companies when oil prices fall, as their cess costs will be lower. In addition, value-based cess can correct the currency mismatch for upstream companies whose revenues, received in rupees, are linked to dollars, while their cess cost is fixed in rupees.

Such reforms will increase the transparency and credibility of the sector, and lead to further investments that are needed to reduce India’s dependence on crude oil imports.

Production policy

For every barrel of crude oil produced in India in fiscal 2014-15, five barrels were imported. In fact, the country’s trade deficit in the fiscal year ended March 2015 was nearly equal to the value of crude oil and petroleum products imported. India also imports nearly 40 per cent of its natural gas consumption.

Dependence on imports can only be addressed by accelerating exploration and production in the country or partly by overseas acquisition. At present, most of the production is undertaken by state-owned companies. Private-sector participation is through the New Exploration Licensing Policy (NELP). However, production from the blocks awarded under NELP has been small.

More than two-thirds of total crude oil production in India in fiscal 2014-15 was from the nomination blocks that were awarded to the state-owned, Oil and National Gas Corporation and Oil India Limited.

These blocks have matured and production rates are starting to decline. Consequently, if production rates in other domestic fields do not rise, India’s dependency on oil imports will increase further.

A large portion of future production growth may come from deep water fields, the cost of exploration and production for which is high. Such projects tend to involve huge upfront investments.

Moreover, given India’s current domestic natural gas pricing policy, any exploration of deep water fields — which may be heavy on gas — will not be economically attractive. A framework that includes incentivised pricing, along with a long-term take-or-pay agreement for production can revive interest in the blocks.

Dependence on imports can be partly addressed by acquiring assets overseas, for which the valuations are more reasonable now. The competition for assets from other oil majors and state-owned oil companies is lower, given the firms’ plans to cut investments.

The writer is the vice-president of Corporate Finance Group, Moody’s Investors Service

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