Fuel Pricing in India - Sumit Poddar

Background

The retail price of petroleum products has of late been a topic of extensive discussion in global as well as Indian context. This is primarily due to the international price of crude having shot up to unprecedent levels, and a part of such increase being reflected in the price of petrol and diesel at retail outlets (petrol pumps) in India, impacting the common man.

The pricing mechanism of petroleum products is a complex issue. There are various reasons for this. First of all, we all know that international prices of crude oil significantly fluctuate due to various geopolitical issues, demand supply mismatch, weather, political unrest, terrorist attacks and speculative activities. Today, with more than 70% of India’s petroleum consumption being imported, the pricing of these products for retail customers has become even more complex.

There is a serious lack of transparency in the pricing mechanism and common consumers do not have a clear understanding of how exactly the mechanism works. For example, how is the price per litre of petrol, or diesel, arrived at? What is the landed cost in India when the fuel is imported? How big is the tax component that is added on to this by the Government? We also hear that the government subsidizes the cost of petrol and diesel: is this true? Then, which statement is correct: does the government tax petroleum products, or do they subsidize the products? We also hear that oil marketing companies like Hindustan Petroleum, Indian Oil and Bharat Petroleum are absorbing the losses that arise from subsidization of retail prices. How does this fit into the overall pricing policy for the country’s petroleum products? In this article we will attempt to analyze answers to many of the questions raised above. We will also attempt to provide solutions to some of the perceived problems and discuss the practicality of implementing the same.

History

During the mid-1900s a large number of international oil companies like Shell, Esso and Caltex were operational in the Indian petroleum retail sector. These oil companies had independence in pricing oil products. However, during independence, an attempt was made by the government to regulate prices by imposing a ‘cap’ on prices that could be charged to consumers. The government subjected petroleum product prices to a ‘cap’ based on a formula that would be calculated on the imported price of the petroleum product, plus taxes (including excise duties and other local taxes) and an acceptable margin for refineries. This was made applicable for all oil producing and marketing companies irrespective of the cost of production and marketing. The lack of linkage between the cost of production and the eventual price of petroleum products was the major drawback of this pricing mechanism. However, during 1975, when around 90% of the country’s consumption demand was met by domestic production and refining of crude, an ‘Oil Pricing Committee’ set up by the government recommended the discontinuation of the above pricing methodology; it introduced a pricing mechanism that used the domestic cost of production as the base for pricing, rather than the imported price of petroleum products. This turned out to be what till recently was known as the Administered Price Mechanism (APM) which was managed by the Oil Coordination Committee (OCC). This methodology of pricing allowed the domestic refining and marketing companies to retain a surplus over and above their cost of production and thus remain profitable. The APM and OCC supplemented the role of the market through intervention and control. It compensated the producers, refiners and marketers and provided them with an acceptable return on investment.

Post independence the government of India gradually gained control of the oil industry. Domestic oil discoveries in Cambay and Bombay High made India’s supply side position comfortable. Subsequent to the industry policy resolution of 1956, Indian Oil Corporation (IOC) was formed. Indo Burma Petroleum (IBP), a private sector player, was later acquired by IOC during 1970. Two other new oil marketing companies Hindustan Petroleum Corporation Limited (HPCL) and Bharat Petroleum Corporation Limited (BPCL) were also incorporated in 1974 and 1976 respectively. By early 1980s the government of India was controlling the entire oil industry.

The APM was administered through creation of an ‘oil pool’ account, to which the surplus, or deficits, arising out of retail sale of petroleum products were charged. Until the early 1990s, when international crude prices were soft and the fluctuations in prices were at a minimum, the oil pool account was running at a surplus and the pricing mechanism was running effectively. The final price for petroleum products being charged to the retail consumers more or less balanced costs, resulting in no major subsidies at the aggregate petroleum products level. However, there were cross subsidizations involved. What this means is, diesel and kerosene were deliberately priced lower and deficits out of these were subsidized by deliberately holding the price of petrol above its cost. (Diesel in India is priced around 25% below petrol, whereas, globally diesel is around 20% more expensive than petrol; this results in petrol prices in India being one of the most expensive in the world). Subsequently however, the demand for petroleum products started to grow exponentially and global prices started to move sharply upwards primarily fuelled by volatilities in West Asia and the 1991 Gulf War. At this point in time, due to political sensitivity, respective governments were unable to pass on the increased burden to consumers, and this started pushing the oil pool deficit to alarming levels. Meanwhile, the government, on the recommendations of Sundarajan Committee, had decided to dismantle the APM in a phased manner which was intended to be fully effective by 2002. During 2002, the government also allowed 100% Foreign Direct Investment (FDI) and private players to operate in retail marketing of petroleum products. This saw the emergence of large local and international players in the retail oil marketing business. Today, there are around 37,000 petrol pumps, private and public sector owned, in the country.

Current Situation

The so called dismantling of the APM was to facilitate a market-based mechanism where the retail prices of petroleum products would be determined by the market forces; thus, the retail customer would pay the market price and at the same time, the oil refining and marketing companies would not lose money by having to sell products at a price below the cost of production. If this had worked effectively, the oil marketing companies should have been able to charge retail consumers a price that was in line with the cost of production, or the cost of imports, as applicable. But in spite of dismantling the APM, this did not happen and subsidies continued, though in a different form. The APM now operates such that the oil marketing companies can increase the price of petroleum products only when the government approves the same. Of late, again due to political sensitivity and vulnerability of the coalition UPA government, only a small portion of global crude oil price increases have eventually been allowed to be passed on to the retail consumers. The oil marketing companies have thus been asked to absorb the deficit. This deficit is being made good through issuance of oil bonds to the oil marketing companies that could be cashed by the latter only over a long term; in effect, therefore, the government is borrowing from the oil marketing companies to finance the deficit resulting from the increased petroleum product prices, which the government has been unable to pass on to the retail consumers for fear of political backlash. This has resulted in oil marketing companies losing significant cash, which amounts to around Rs.14 for every litre of petrol sold, Rs.25 for every litre of diesel sold, Rs. 38 for every litre of kerosene sold and Rs.340 for every 14Kg LPG cylinder sold. This roughly translates to a daily loss of around Rs.400 crore for IOC alone, and would further translate to a projected loss of Rs.212,000 crore in 2008-09 for all the three oil marketing companies put together. The government however seems to have issued oil bonds only to the extent of Rs.60,000 crore, until now. So for all practical purposes, the oil marketing companies are taking on the burden of cash losses resulting from the government’s inability to raise prices of petroleum products to market-determined levels in a timely manner.

Let us now discuss the composition of the various components of the eventual petroleum product price. IOC has been calculating the landed cost of petrol and diesel periodically, which is linked to the international price of crude. The landed price in Mumbai during May’ 08 was, for example, Rs.38 per litre of petrol and Rs.49 per litre of diesel. The oil marketing companies were required to pay this price to procure the same from refiners. On these amounts, the government imposes an excise duty and educational cess, which amounts to Rs.14.5 per litre of petrol and Rs.5.1 per litre of diesel. In addition, sales tax has to be paid to the state government amounting to Rs.11 per litre of petrol and Rs.7 per litre of diesel. This results in a total cost of Rs.63.5 for a litre of petrol and Rs.61.1 for a litre of diesel, which is what the oil marketing companies eventually spend to make available petrol and diesel at the petrol pumps. Unfortunately, the companies are not free to sell the products to the retail consumers at this cost plus a margin. The companies sell the same at the prices which the government prescribes them to sell, which is Rs.49.7 per litre for petrol and Rs.35.6 per litre for diesel (prices that prevailed in Mumbai, in June’ 08). This results in a loss of Rs.13.8 per litre of petrol and Rs.25.5 per litre of diesel.

Coming back to the pricing mechanism of petrol and diesel, it appears that the government is still securing revenue from tax amounting to Rs.25.5 (Rs.14.5 plus Rs.11) per litre of petrol and Rs.12.1 (Rs.5.1 plus Rs.7) per litre of diesel, while it is the oil marketing companies that are absorbing the losses of Rs.13.8 per litre of petrol and Rs.25.5 per litre of diesel, though oil bonds are issued. Taxes thus constitute around 40% of the cost of petrol and around 20% of the cost of diesel, which is significantly high compared to international benchmarks; United States, for example charges around 10% taxes.

Pricing mechanisms in developed and developing nations

Oil subsidies have been part of every country, only the extent of subsidy varies. United States (US), for example, is the largest consumer of petroleum products in the world with close to 50% of total consumption being in the form of gasoline. The pricing mechanism in the US (as in April 2008) results in around 75% of the final gasoline price being attributable to the cost of crude oil, 10% to refining, another 10% to taxes, and the remaining 5% to distribution and marketing. The US reasonably subsidizes gasoline prices; price per litre of gasoline as of June 2008 was around US$1.07 a litre. The pricing structure in the European countries however results in a higher tax component; a litre of petrol costs more than twice the US price, at around $2.33 in the United Kingdom. The oil rich countries such as Venezuela sell petrol at around US$ 0.05 to its retail customers. Many other countries steeply subsidize their petrol prices including Iran (US$0.11), Saudi Arabia (US$0.12), Egypt (US$0.32), Malaysia (US$0.84) and Nigeria (US$0.10). India sells the same at around US$1.30 per litre. In China too, (US$0.81 per litre) the story is similar where the state oil companies are restricted from passing on new crude costs to their consumers in order to maintain the 10% plus economic growth that the country has been achieving.

Way Forward

Analysts argue that high ‘triple digit’ oil prices are here to stay, though they may settle down at marginally lower prices over the short to medium term. Various solutions are also being contemplated by analysts, which includes taxing ‘what the traffic can bear’; for example, charge petrol users having larger capacity cars by a bigger amount, possibly through higher registration taxes. But critics are quick to respond that these are nothing but extension of subsidies in a different form. One development that seems more or less inevitable in the Indian context is the creation of a mechanism that will, over a period of time, reduce the subsidy for retail consumers. This will result in actual costs of petroleum products being charged to end users and hence could possibly incentivize the end users to achieve reduced consumption levels. At present, this seems to be the only way to streamline a system ridden with complicated cross subsidies. However, this is bound to have serious political ramifications, but mature leaders need to bite the bullet, albeit in a phased manner.

You have viewed the article and may have liked the content, as you know the Advanc`edge MBA has many more such invaluable articles that will help you to understand the issues and give you pertinent information to clear you entrance tests and get an entry in top B-schools, to read all the articles and to have an access of this website you need to subscribe to this unique journal

CONTACT INFORMATION
Title :
*Name :		Surname :
Address :
*E-Mail :	@
OTHER INFORMATION
How did you like the article ? Very Good Good Fair Poor Bad