“Oil Sector Decontrol - Challenges and Opportunities”
Subash Talatam

Introduction

Prices of crude and petroleum products determine the economic growth of a nation. Petroleum products energize the various modes of transportation - automobiles engines, ships, aircrafts, and also cater to host of industrial applications, power generation, etc. They are also used for safeguarding the country in missiles, in our kitchen, commercial and industrial establishment. Asphalt, a by product of the refining process is used for covering roofs and roads. Some other by-products are also used in manufacture of man-made cloth, tyres, fertilizers, food-processing, pesticides, medicines, paints, jute and plastics.

The oil sector has undergone a major change with the dismantle of the Administered Price Mechanism (APM) w.e.f. April 1, 2002. Oil companies are now allowed to price their products competitively based on demand supply conditions. Restrictions on the production of products have been removed making companies decide on the production levels of individual products. Also the crude procurement by M/s. IOC Ltd was de-canalized, meaning individual companies can directly procure crude from suppliers abroad. The major considerations for pricing include crude oil price; refined product price premium; and location of the refinery and the final consumer.

The history of this sector shows that there were no controls whatsoever on pricing prior to 1939. However, during the 1940s the oil companies themselves maintained pool accounts for major products without any government intervention. In 1948, an attempt was made to regulate prices through Valued Stock account procedure. Under this procedure, realization of oil companies was restricted to the import parity price of finished goods, plus excise duties, local taxes, dealer margins and agreed marketing margins of each of the refineries. Any excess realization was surrendered to the government. The Shantilal Shah committee which submitted a report in 1969 did not favor the import parity price being set as a benchmark for domestic pricing as domestic refining capacity had significantly increased by then. Later on the Oil pricing committee which was setup in 1976 gave a finale to the APM.

The APM Era

The Oil Pricing Committee (OPC) recommended the discontinuance of the import parity principle on the following grounds. Prices of finished products and crude oil did not necessarily move in tandem, and import parity did not take into account inter-refinery differences in terms of product pattern, crude used, location and scale differences. This issue was addressed through Retention Pricing Mechanism (RPM), by which refiners were allowed to "retain" out of the sale proceeds - crude, refining, installation, distribution & administration costs and a reasonable ROI. The OPC therefore suggested that the domestic cost of production should be the determining factor for pricing of petroleum products. The same was extended to marketing companies as well. The GoI also fixed the prices of finished products and the returns of oil companies were de-linked from the final selling price. With the administration of pricing, the retention mechanism also came to be known as the APM.

However, with the advent of globalization and liberalization, the government recognized the challenges ahead for the petroleum sector and set up the Strategic Planning Group for Restructuring of the Oil Industry and to outline a reforms strategy for the hydrocarbons sector as well, in 1995. Based on the recommendations the sector was de-controlled in two phases and it aimed primarily on reducing the deficit in the oil pool account and encouraging the infusion of fresh capital into the sector. However, private investors still had some major concerns. These included the effective rate of protection offered to refineries, marketing rights, and the need for a level playing field. The GoI, in an effort to address the concerns of the private parties, has attempted to distance itself from operational issues. Therefore it has decided to set up a regulatory authority to promote all desirable activities that, among others, as defined hereunder –

• Creation of a market-based production, supply, distribution, and pricing system to promote economic efficiency and competitiveness.

• Provide products to consumers at least cost and lead to optimal utilization of resources.

• Ensure energy security for the country and its citizens.

• Ensure that the industry operates under principles that emphasize on environmental protection, and mitigate any kind of damage that might arise due to resource extraction, transportation, and utilization.

Market Determined Price Mechanism – Challenges and Opportunities.

The APM was dismantled w.e.f. April 1, 2002. The petroleum product pricing would now be based on demand and supply conditions. The Oil Pool Account was dismantled on 1st March, 2002 and the outstanding balance worth Rs.13,000 Cr. was liquidated by issue of oil bonds to the concerned oil companies. The setup of a Petroleum Regulatory Board to oversee the sector is on the anvil.

The subsidy on LPG and Kerosene oil is written of to 30% and 32% respectively by April 1, 2002 and is expected to be written off completely from the subsidy list over the next 3-5 years. Furthermore the government’s decision to put a barrier of $50 Million entry fee for setting up a refinery is an incentive for the expansion of existing outlets. For sustaining economic growth we need additional capacity of at least 5 MMT per annum. The post APM era ensures opportunities for the MNCs to invest in capacities as growth in consumption of petroleum products in inevitable. We are unfortunate to relate petroleum to auto fuels alone, because we use petroleum products in manufacture of switches, to sofas, to bangles, to textiles and even cables which are all part of our day-to-day life.

Though there has been a loud talk by many about a drastic change in the petroleum product prices in the post APM era, it is felt that there would be no such impact on prices. The major component of petroleum-product pricing that would determine the prices of final products would be the freight charges, because the refiners will not be able to sell at the same price throughout the country. Distance of a selling point from the refinery and the freight charges thereunder would determine the price. Cost of crude and overheads will not have a major impact on the price because the companies will try their best to reduce their overheads and also adopt hedging techniques to reduce landed cost of crude. Prices may not see a downward trend because refiners may invest the surplus margins in technology up-gradation rather than selling the final products at lower prices.

Government policies and impact on market structure

Arbitrary administrative restrictions on consumption and imports of petroleum products are not the solution and would affect the economic growth of the country. The correct approach would be to allow scarcity to be reflected in prices. This will create an incentive for conservation and efficient use. However, the complete dismantling is not in place as it requires complete price deregulation (still exists in the case of Kerosene and LPG), operation of efficient market in petroleum sector (entry of private players into marketing arena). This necessitates establishment of prudential rules and regulations by a statutory regulatory authority.

At the same time, we need to provide for oil security through strategic storage of crude oil and petroleum products, diversification of oil imports and holding of equity oil abroad. In view of the strategic importance of oil sector in the economy, there is a need to restructure the public undertakings in the oil sector to have the required strength to compete with MNCs. Restructuring, divestment/ privatization of the PSU's is being undertaken to lead them in the same direction.

The Government has been examining the various options available in this scenario, including raising the domestic prices to import parity levels, and reduction in customs / excise duties as and when required. The approach towards this, however, has to be cautious since any increase in oil prices is known to have a cascading effect in other key sectors like transport, power and even agriculture.

The increase in crude oil prices, and the need to exercise caution in product pricing has resulted in pressure in the refining as well as marketing margins for the oil companies. In turn, this has made it essential for all the oil companies to examine various other areas for revenue generation so as to maintain growth and profitability.

Impact on other sectors and the final consumers

The oil sector decontrol would not have much of an impact, but for the exception of the transport sector. All the sectors have already felt the impact due to dismantling of APM for most of the products earlier. However, sectors other than transport, in general (by way of reduction in freight charges) and the transport sector in particular would be benefited to the extent of price reduction of Motor Spirit and High Speed Diesel. The automobile sector may get a fillip in the light of reduced fuel prices.

While the current scenario shows that the price of crude have risen globally it is good sign that they have stabilized. While this is history we need to examine what would be the plight of these sectors if crude prices rise again. It would be a sad state of affairs for these sectors. Leaving the transport sector aside (which would anyway be affected) the other sectors like Textiles, Automobiles, Fertilizers, etc. would be effected negatively due to rise in cost of raw materials. To add fuel to fire, the final consumers associate petroleum products to auto fuels alone. So, the rise in transport prices is welcomed by them with lesser pain then that of textiles and other products.

The removal of subsidy over the next few years on LPG and Kerosene would increase their cost of living. The government can also not be blamed for removal of subsidies, as it also cannot continue to bear the costs in the light of liberalization. Moreover the average price of LPG comes to Rs.16 per Kg and the consumption of an average family of four will be around 12 Kg coming to an average monthly cost of Rs.192/-. So it should not invite such hue and cry from the consumers. The companies also need to take up this issue of the mind set of the consumers who are well groomed by the subsidy mentality.

Strategies to be adopted in the MDPM Era

By the Government –

• Reduce subsidy on Kerosene and LPG – allow the oil companies to cross subsidise.

• Appoint a regulatory authority to oversee the sector and frame and implement policies and procedures, to ensure that there is no cartelization, fix the floor price and roof price for each product.

• Amend The Consumer Protection Act in line with the recommendations of TERI, to protect consumers from over pricing, poor quality and quantity, service, etc.

• Continue intensive exploration efforts in the producing basins for establishing extension and reevaluation of existing reservoirs and discovery of new resources in subtle traps with appropriate technology.

• Plan strategically for setting up refining capacity that meets 80% of the middle distillate demand considering national oil security and stability of supply and development of the economy.

• The pipeline sector needs to be given infrastructure status

• Make available the exploration blocks under the NELP to the oil companies for ensuring energy security

• Reduce excise duty to ensure favourable margins to the refiners.

By Oil Companies –

• Enter into option contracts on long-term basis (over a year) for global sourcing of crude and refined petroleum products from suppliers abroad;

• Enter into the exploration so as to ensure lesser price fluctuations, oil / energy security, etc.

• Enter into strategic arrangements with industrial customers for maintaining strong customer base.

• Implement ERP system to plan for crude procurement, demand–supply matching, stock movements, pricing, etc;

• Come out with more value added services to gain higher market share;

• Explore markets abroad for slow moving products to reduce handling costs;

• Enter into strategic agreements with transport corporations for Oil movement and shipping.

Subash Talatam
Research Associate
Aurora's P G College, Chikadapally, HYDERABAD - 500 020
subashtalatam@rediffmail.comJai-Kisan Jai-Hind