>A Viable and Sustainable System of Pricing of Petroleum Products

BACKGROUND:
■ 1.1 India‟s imports of oil are increasing. Our import dependence has reached 80 per cent and is likely to keep growing. At the same time 2008 saw an unprecedented rise in oil price on the world market. Oil price volatility has also increased. Though future oil prices are difficult to predict, they are generally expected to rise. Given our increasing dependence on imports, domestic prices of petroleum products have to reflect the international prices.

■ 1.2 When the average monthly price of Indian basket of crude oil on the world market increased from US$ 36 / barrel in May 2004 to US$132.5 / barrel in July 2008, the government did not permit Public Sector Oil Marketing Companies (OMCs) to pass the full cost of imports on to domestic consumers of major oil products, i.e., petrol, diesel, domestic LPG (i.e., LPG used by the households) and PDS kerosene (i.e., Kerosene sold through Public Distribution System of the Government). The consumers of these products thus received large subsidies. As a consequence, OMCs had large under-recoveries1, which were financed partly by Government through issuing bonds, and partly by upstream public sector companies ONGC and OIL, and GAIL through price discounts. The OMCs also absorbed a part of the under-recoveries themselves. A detailed analysis on these issues is provided in Note 1, Appendix to the report.

■ 1.3 These policies had a number of consequences. They put stress on government‟s finances. They reduced the cash surplus of upstream public sector oil companies restricting their ability for exploration of domestic fields and acquisitions overseas. As the oil bonds were not issued to OMCs on time, they created cash flow problems for OMCs who had to borrow from the market, which increased interest payments and reduced their surplus. Since only the OMCs were provided financial support, the private sector companies withdrew from oil marketing. This not only made infructuous the large investments they had made in setting up retail outlets, it also reduced competition in oil marketing. Subsidizing domestic consumers also did not incentivize them to economize on use of petroleum products. Rather, as prices remained low, and personal incomes rose, the demand for petroleum products such as petrol and diesel recorded double digit growth – higher than the GDP growth. Continuation of the present policies is not viable, particularly once oil prices rise again.

■ 1.4 Over the years, Government has followed a variety of policies for pricing of petroleum products, all of which have been found to have some deficiency or the other. An overview of these policies is provided in Note 2, Appendix to the report.

■ 1.5 Countries across the world have followed different strategies to deal with oil price volatility in the recent years. These are summarized in Note 3, Appendix to the Report.

■ 1.6 A viable long-term strategy for pricing major petroleum products is required. A viable policy has to be workable over a wide range of international oil prices and has to meet the various objectives of the government. It should limit the fiscal burden on government and keep the domestic oil industry financially healthy and competitive.


OBJECTIVES OF POLICY AND ISSUES
■ 2.1 The very first question is: Should the government intervene at all in the market and set prices?

■ 2.2 The first reason for intervention is to protect poor consumers so that they may afford kerosene for lighting, which is a necessity for those who do not have access to electricity.

■ 2.3 Another objective may be to provide merit goods to consumers such as clean cooking fuels like natural gas, LPG and kerosene to replace use of biomass-based fuels such as firewood and dung. These biomass based fuels create indoor air pollution that causes respiratory diseases, eye infections and result in many premature deaths, particularly of women and children. Also, use of firewood encourages deforestation and dung is better used as a fertilizer. Moreover, the task of gathering these fuels keeps girls away from schools. Thus, use of clean cooking fuels has many social and environmental externalities, and as merit goods the government may promote them through subsidies.

■ 2.4 Another frequently reported reason for Government's intervention is to insulate the domestic economy from the volatility of petroleum prices on the world market. It is feared that complete pass-through of increase in world oil prices may cause inflation which may persist even when oil price comes down. There is no clear evidence that in an increasingly open and competitive economy, price movements triggered by changes in the prices of oil products would persist over the medium-run. In addition, attempts to insulate the domestic economy against volatility requires discriminating between a secular price rise due to demand-supply forces and a price rise due to transient causes such as speculation in the world market. This is difficult to do.

■ 2.5 To the extent the level of self-sufficiency in domestic oil production increases, the impact of international oil prices on domestic economy would be reduced. Thus, keeping domestic oil firms viable and in good financial health and providing an environment in which they can grow are also important policy objectives. It is equally important to keep domestic private sector firms viable as it is to keep public sector firms viable. A level playing field between public and private sector firms as well as among public sector firms is desirable to promote competition.

■ 2.6 A major objective of policy is to have an efficient and competitive oil economy that promotes efficient use by consumers, appropriate choice of fuels among substitutes and a proper choice of technique. This is best ensured by a competitive energy sector.

■ 2.7 Intervention through price control necessitates that someone bears the financial costs. The issue therefore is to assess the costs and incidence of the burden of alternative mechanisms on different groups in the society. On whom the burden falls depends on the policy and the instruments used. If the costs are financed by a general increase in taxes, or by increasing fiscal deficit or by cutting other government expenditure, all these affect certain sections of the people adversely.

■ 2.8 Price control means setting prices. If it is done on a cost-plus basis, it creates incentives for gold plating and creative accounting. Also, price calculations involve rigid specifications of items to be considered and their costs. This discourages innovation. For example, storage of LPG in large underground caverns facilitates imports by larger ships and reduces unloading time compared to storage in over-ground tanks. But, it may involve increase in operating costs. If the cost formula has set item-wise limits on operating costs, the project may be discouraged even if its total cost is much less.

■ 2.9 If prices are to be fixed by the Government, that has to be based on some principle. Prices can be fixed based on pre-determined formula, which is derived from principles like import parity (IPP), trade parity (TPP), or export parity (EPP). This approach is also fraught with major deficiencies. The formula often involves elements of cost-plus. In an industry, which is continuously changing, a prescriptive and biased cost-plus pricing formula requires continuous monitoring and periodic adjustments in certain components of the formula. For instance, there is no single or unique formula for import parity which is applied globally (Note 3, Appendix). The Rangarajan Committee (February 2006) suggested a pragmatic approach of TPP for pricing of petrol and diesel which was accepted by the Government. It has, since then, been applied to petrol and diesel.

■ 2.10 Price control, subsidies and taxes can introduce distortions which may not be desirable. Apart from inefficient use, it also leads to erroneous choice of technique. For example, if diesel is cheap, it may encourage freight movement by trucks rather than by train. When the price difference between petrol and diesel is high, diesel driven vehicles may be preferred. If there is a large difference between the prices of diesel and kerosene, kerosene may be used to adulterate diesel. In 2008, we have even seen diesel being used in place of furnace oil. Intervention in pricing must be carefully thought out for its possible consequences.

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