Portfolio

Oil and Gas Sector: Energised by reforms

Anand Kalyanaraman | Updated on January 22, 2018 Published on September 13, 2015

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The rout of crude oil and key policy changes over the past year have given a boost to the oil and gas sector

The Modi government has been facing flak from many quarters as being big on talk and small on action. But that does not seem true for the oil and gas sector, at least. Diesel decontrol, direct bank transfer of LPG subsidy, formula for domestic gas price fixing, crystallisation of subsidy sharing mechanism for 2015-16, and a progressive framework for auction of marginal fields — it’s been quite an energy-packed year.

Lower under-recovery

True, much of this has been possible thanks to the fortuitous rout of crude oil since June last year and the groundwork done by the previous government. For instance, diesel decontrol — the most significant reform — would have been far more challenging to implement in a scenario of rising fuel prices and at one go.

The gradual monthly hikes begun by the erstwhile UPA regime, combined with a sharp dip in oil prices, made it that much easier to free up diesel pricing in October last year. Still, that the government seized the opportunity deserves credit. So does the successful roll-out of the direct transfer of LPG subsidy to customers’ bank accounts. The upshot: Similar to petrol whose pricing was decontrolled in 2010, there is now no subsidy on diesel. The latter was the largest contributor (about 60 per cent) to under-recoveries incurred by the oil marketing companies (OMCs) from selling fuels below cost.

Also, the direct bank transfer of LPG subsidy and restricting the subsidy to 12 cylinders a year for a household has addressed, to a good extent, the problem of diversion of subsidised LPG cylinders to the black market. Ergo: under-recoveries have been cut down drastically — from nearly ₹1,40,000 crore in 2013-14 to about ₹72,000 crore in 2014-15. With crude oil trading at multi-year lows, under-recoveries should be much lower in 2015-16.

This is good news for the OMCs — Indian Oil, HPCL and BPCL — which suffer under-recoveries in the first place and then get compensated, fully or partially, by the government through cash payment and by the upstream companies ONGC, Oil India and GAIL that provide them product discounts. The government compensation is often delayed, resulting in high borrowings and interest cost for the OMCs. Now, with under-recoveries shrinking, the scale of the problem is much lower.

Subsidy sharing crystallised

Besides, unlike in the past, when the subsidy sharing mechanism was ad-hoc and the OMCs were also often left with a portion of the under-recoveries, the sharing mechanism for 2015-16 has been announced in advance. The government will shoulder ₹12 a litre on kerosene and ₹18 a kg on LPG cylinders; the rest will have to be borne by ONGC and Oil India (GAIL has been exempted). So, the OMCs will get fully compensated though there may still be delays on the government’s part.   

 The crystallisation of the subsidy sharing mechanism has other benefits too. The government has kept a cap on its burden, while ONGC and Oil India now at least know what to expect. In the past, even when crude oil traded above $100 a barrel, the net realisations of these upstream companies could be below $50 a barrel due to heavy, unpredictable subsidy burden finalised usually at the year end.

For instance, in 2013-2014, the gross realisation of these companies was $106-107 a barrel, but their net realisation was just $41-47 a barrel. Paradoxically, for companies engaged in production of hydrocarbons, ONGC and Oil India were expected to benefit from a decline in crude oil price — that’s because their subsidy burden was also expected to fall sharply, and net realisations to improve. This seems to have played out in 2014-2015 - gross realisation of about $85 a barrel was lower than in the previous year, but net realisation at $45-47 was at par or better.

But the rout of crude oil has been so sharp that at $47 a barrel, it now trades close to the net realisations of last year. So, even with no subsidy burden — since the under-recovery is currently just ₹11.76 a litre on kerosene and ₹10 a kg on LPG cylinders — the upstream companies find themselves in an unenviable position. Their fortunes could improve if Brent recovers to $65-70 a barrel. But that seems unlikely in the near term (see related story: “ Oil remains on a slippery slope”).  Private sector explorer Cairn India, whose fortunes move in sync with crude oil prices, has taken a severe knock. The risk of an unfavourable merger with parent Vedanta is also an overhang on the company.

Fuel security steps

For the country, though, crude oil on the mat has been a godsend. It has helped lower inflation and reduce government subsidies. But at about 80 per cent, India’s import dependence remains very high and keeps the country vulnerable. A sharp rebound in crude oil prices, though it seems unlikely for now, cannot be ruled out — this will again exert a lot of strain on the economy.

Meanwhile, low oil price has dampened investment sentiment , with companies unwilling to take on high risk for uncertain and low returns. For instance, Cairn India has cut down on its planned capital expenditure.

It is imperative however to keep going with steps that reduce the country’s energy dependence. The filling up of the 1.33 million tonnes (mt) strategic oil reserve facility in Visakhapatnam earlier this year was timely, making good use of attractive prices. Work is also on to soon put into operation the 2.5 mt Padur facility and 1.5 mt Mangalore facility. Also, initiatives such as ONGC’s recent move to acquire 15 per cent stake in Vankorneft, Russia’s second largest oil project, seem well-timed, given the turmoil in the oil market which has depressed asset prices.

Improved auction norms

 Besides, the government’s recent decision to auction 69 marginal oil and gas fields surrendered by ONGC and Oil India on terms significantly different from previous auctions is welcome.

Key changes include a more transparent and easy-to-implement revenue sharing mechanism instead of the earlier cumbersome cost-recovery model, freedom to sell output at market rates to any customer, and a unified licence that allows production of all hydrocarbons. These should hopefully encourage private and foreign players to participate in the auctions.

If extended to previous contracts and the next round of NELP auctions too, these changes have the potential to alter the country’s hydrocarbon landscape, which remains largely unexplored. Under prevalent production sharing contracts (PSC), contractors are allowed to recover costs before sharing profits with the government. In contrast, the proposed revenue sharing mechanism does away with cost recovery and entails sharing of revenue with the government from the time production commences. Since contractors will bear higher risk, it remains to be seen whether they would be game for the revenue sharing mechanism, especially for deep water blocks where costs and risks are very high.

Gas pricing formula

 While there has been quite some action on oil products, the zeal seems to be less when it comes to natural gas. Unlike crude oil, the price of natural gas in India is not market-determined.

The domestic gas price formula announcement last year was long overdue. But the formula was a far cry from expectations of a market-linked price. It also fell short of the formula recommended by the Rangarajan Committee. A weighted average price of four global gas benchmarks — the US-based Henry Hub, Canada-based Alberta gas, the UK-based NBP, and Russian gas — the new formula does not take into account the price of gas imported into India or into other Asian markets, where it is typically costlier. India’s gas imports come mostly from Qatar.

The formula has resulted in domestic gas price (currently $5.18 a unit) being lower than the price of imported gas. With the international benchmarks under pressure, the domestic gas price which is reset every six months is set to decline further on the next revision in October. Market-linked price, a long-pending demand of the major producers ONGC, Oil India and Reliance Industries, can help boost output of domestic gas. Nearly a quarter of the country’s needs are now being imported. For many quarters, low gas availability has adversely impacted the operations of transmitter GAIL whose pipelines remain under-utilised.

Also, gas importer Petronet’s terminal at Kochi is severely under-utilised due to lack of pipeline connectivity. City gas distributors such as Delhi-based Indraprastha Gas have been moved to the top of the pecking order in domestic gas allocation; this reduces their cost of procurement. But the government is yet to come up with concrete steps to implement the proposed national gas grid. For that, it has to first ensure adequate gas availability.

Stock performance

 The varying fortunes of the oil and gas companies are reflected in their stock price movements.

Lower under-recoveries and healthy gross refining margin (GRM) — the difference between product price and crude oil cost — have seen the stocks of Indian Oil, HPCL and BPCL double to quadruple since August 2013 when the bull run began. They have also held out well in the volatile market since January this year. ONGC, Oil India and GAIL which sprinted in the run-up to the elections last year have given up the gains made since August 2013 and now sport flat to negative returns. Cairn India has done worse losing half its value over the last two years.

Reliance Industries is flat over the past two years — its exploration business has dragged and the market seems unsure about benefits from expansion plans in other segments. Indraprastha Gas has doubled since August 2013 thanks to more domestic gas allocation and a favourable court verdict in its dispute with the downstream regulator. Petronet LNG, while up over the last two years, has lost ground since January due to volume and margin concerns.  

Published on September 13, 2015

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