Mohan Guruswamy, Ronald Joseph Abraham and Abhinav Gupta
August 26, 2005

A price hike on petroleum products is imminent. Both, the Petroleum Minister and the Finance Minister have spoken about this in the last few days. Now it's only a question of when and how much? But whatever be the quantum of that price, it will only be an ad hoc and stopgap measure. Clearly there is no policy or formula. The only formula that seems to be at work is to take the matter to the brink and blink. The Petroleum Ministry needs to come up with a more permanent solution to deal with rising international prices. A pricing mechanism needs to be devised that keeps the government's revenue earnings from the petroleum sector constant and not give it a vested interest in climbing crude oil prices. At the same time, retail prices should not be left to the profit making proclivities of the domestic oil companies. Above all, we need a system that is equitable to all the stakeholders, i.e. the government, local oil companies and the consumer.

In August, 2003 India's imported basket of crude oil cost $28.58 per barrel . Now, it is double that at around $59 and going up. In 2003 the average prices of hydrocarbon fuels in Indian metros were Rs. 35.91 for petrol, Rs. 24.54 for diesel Rs. 258.58 for domestic gas and Rs. 9.00 for kerosene. As of 15th March, this year, these were Rs. 40.80, Rs. 29.28, Rs. 292.81, Rs. 9.00 respectively. Quite clearly the steep rise in the cost of crude oil is not reflected in the domestic fuel prices.

Given the intensely competitive domestic politics, where public-opinion considerations dominate policy creation, the government is unable to make informed decisions to tackle this price rise. However, as in every political game there are losers, Indian oil companies more directly in this case. The Oil Marketing Companies will suffer an under-realisation of Rs. 40000 crores if current prices and taxes remain unchanged. Given that all the State Electricity Boards made a loss of Rs. 21698 crores in 2003-04, the loss now suffered by the other half of the energy sector bodes ill for the national economy.

Losses of the oil sector apart, oil policy is also crucial to the economy in general. Last year over Rs. 120,000 accrued to the Central and State Governments combined. This translates into over 22% of the Government's total revenue. While rising oil prices may not be good news to the general consumer, they do bring cheer to the Finance Ministry. In the latest budget, several changes were made in the tax structure on petroleum. Customs duty on LPG and kerosene was reduced from 5% to nil; and on crude petroleum from 10% to 5%. Excise duty of Rs. 5 and Rs. 1.25 per litre on petrol and diesel respectively were also added. The ad valorem tax on both was brought down to 8%. A special road cess of Rs. 6 per litre was additional.

The Finance Minister additionally claimed that these changes were revenue neutral, a claim not borne out by facts. The excise duty collection in the first quarter of this fiscal year was down to Rs. 6568.9 crores, Rs. 725.8 crores less compared to the first quarter of 2004-05. However, rising international prices, and thus increased customs revenue, bailed out the Finance Ministry this time. Customs duty revenue was projected by pegging crude oil prices at $38 per barrel. Current prices are $20 over that level. Naturally, estimated custom duty revenues also increased proportionally. This was a much needed windfall gain. Clearly something other than luck needs to guide both the revenue collections and the pricing of petroleum in India. Leaving it to the vagaries of the international oil market is to take economic liberalism to its most ridiculous limit.

There are four essential components that determine petroleum product prices to the consumers. First and foremost is the prevalent international price. This is a variable over which the government has little influence, given that in the last fiscal year we imported nearly 99 million metric tonnes of crude oil or 74% of our total consumption. Furthermore, certain experts like, Matthew Simmons, author of Twilight in the Desert: The Coming Saudi Oil Shock and the World Economy, predict that prices will breach the $100 a barrel level by the end of this year! Oil prices are also dependent on the domestic situation in Saudi Arabia. Robert Baer, a former CIA official specialized in the region, suggests that "the Saudi system… seems frighteningly vulnerable to attack". If this happens, the drastic consequences to countries like India, which gets 26 % of its oil imports from that country, can well be imagined.

The next component of petroleum product retail prices is the customs and excise duties on petroleum products. Instead of allowing the total revenues realised from this source to vary with the vagaries of the markets, the revenue rates must be allowed to float, and total revenue be fixed. To facilitate this, the revenue rates should be adjusted on a fortnightly or monthly basis keeping the target in focus. This mechanism is easy to put in place as the number of entry points is few and the number of importers and producers are just a handful. Revenue collections of the government are a function of international prices, total consumption and tax rates. The former two variables, prices and consumption, cannot be influenced. Thus to keep revenues fixed the government needs to keep the tax rate floating. If international prices rise, customs duty will decrease and vice versa. Similarly, if consumption rises, the excise component can be brought down.

The third critical component in determining petroleum product prices is the cost of refining and marketing. If this becomes uneconomic, it is a major disincentive to investment. Suppression of domestic prices and the increasing burden of subsidies are costing the oil sector dearly. Last year the upstream oil companies shouldered over Rs. 7000 crores in LPG and kerosene subsides. What's more, Indian Oil Marketing Companies made losses of Rs. 1500 crores last July alone due to the suppressed oil prices. It has also been reported that the Indian Oil Corporation has put on hold its plan to invest Rs. 15000 crores in a new refinery in Paradip because of its Q1 losses. Populist considerations are the only factor here and no sense of common good is allowed to permeate into the thinking or more appropriately the lack of thinking that goes into the making of policy.

As we keep revenues fixed, expenditure on subsidies should also similarly be kept constant. The designated subsidy can then be disbursed on the basis of the production of each product. For example, let's say the present subsidy on LPG is pegged at Rs. 95 per cylinder. However, if the rate of consumption is more than what was initially expected, this would lead to an increased subsidy bill. Instead, the opposite needs to happen. The total subsidy bill should be kept constant and the rate of subsidy should vary according to consumption. If LPG consumption rises, the rate of subsidy can be brought down to, say, Rs. 90 per cylinder and vice versa.

The fourth and last component of retail prices is state-level sales tax. Last year, Rs. 43254 crores accrued as petroleum revenue to all the states. This was over 18% of their total revenue. Presently each state chooses its own level of taxation. Naturally, the variation between states will not differ much; otherwise consumers will start buying their fuel from neighbouring states. Thus state taxes should be left for the states to decide as it will also have a bearing on their overall economic attractiveness.

There are many features of the oil marketing business that are undesirable. Even as we write this, IBP, an IOC subsidiary, has put out a large advertisement calling for applications. The fine print in the terms and conditions clearly suggest that the selection of retail outlets will be dispensed as per patronage and other considerations. In many countries, the situation is different. There are independent retailers; they own their outlets and are free to choose their suppliers. A large number of independent operators will prevent oil companies from price fixing as prices will be driven by supply and demand. The monitoring mechanism available with the Central and State Governments is sufficient to exercise a degree of price control and to ensure price move within a certain price-band. What is clear in this discussion is the need to evolve a policy that does not blight the oil sector as we have done to the power sector. The only way to ensure this is to keep it profitable and capable of generating future investments in this capital-intensive sector.

To conclude, we summarise the four-point policy framework that should be put in place in the oil sector. Firstly, fix revenue targets so that customs and excise duties will float depending on prices. Secondly, total quantum of subsidies should be fixed and the rate of subsidy should be kept floating. The important point here is that once revenue and subsidy limits are fixed, price movements will become automatic and not an issue for the political market place. Thirdly, allow the marketing and refining companies to fix their own prices as long as it conforms to a formula based on the cost of the imported basket of crude oil. Lastly, free the marketing networks from bureaucratic constraints and allow it to expand. Individual retailers should be allowed to choose their suppliers thus ensuring that oil prices remain competitive. When sky-rocketing global oil prices are not in our control, we need to wise up and not pander to the needs of some citizen-consumers at the cost of the vast but silent majority that consists of the "real" common people.