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An absurdity called oil bonds
May, 31st 2008

Why can't oil companies, which are now threatening to ration sales of cooking and motor fuel in a bid to cut losses, settle their tax payments against the bonds the government issues them from time to time? Most policymakers and economists will call it bizarre and rubbish it as absurd. But the bloodbath in India's oil and gas sector is no less bizarre. However, a proposition on these lines may well be the way out for the liquidity crunch the oil companies are facing. Let cash-strapped oil companies opt for the oil bond route to settle their dues to the central exchequer.

The absurdity of the current scenario plays out thus - the government imposes taxes (up to 50% plus on petrol and more than 30% on diesel) on the retail selling price of fuel. The tax increases the selling price of fuels. But the government then steps in to artificially control prices with a subsidy and to protect the consumer. This subsidy takes the form of special bonds called oil bonds, which have so far proved illiquid for the oil companies. If the oilcos were permitted to use the bonds to settle their tax dues, the subsidy would cancel out the tax receipts, bringing out the absurdity underlying the entirety of administered oil pricing.

 The oil sector is the largest tax contributor to the central exchequer, paying close to Rs 70,000 crore on account of customs and excise duties. This is apart from the dividend they shell out to their owner, the government, on their profits. The same oil companies, however, are dependent on the government to remain in the black. Although, pricing of petroleum products was 'decontrolled' in April 2002 with the dismantling of the administered pricing mechanism, the government regulates prices of all major fuel at the retail level.

Result: The consumer prices of motor fuels, petrol and diesel, and cooking fuels, LPG and kerosene, are way cheaper than the true market rates. This leads to huge losses for the oil companies. The government, on its part, issues bonds from time to time to compensate the oil companies for the losses they incur on sales of petroleum products at controlled prices.

So on the one hand, while the oil companies are writing out cheques to meet their tax and dividend obligations, on the other, they have to be bailed out through government bonds to remain profitable. But the bonds issued by the government fail to solve the oilcos' liquidity crunch as they often have to be sold at a discount. Further, oil companies can sell only 25% of the bonds in a given quarter, thus posing huge financial challenges for the companies.

Also, the bonds issued by the government have few takers in the secondary market given the yield rates . Then, the appetite for these bonds was particularly low among institutions as till recently the bonds were not SLR-eligible. Oil companies which have been totting up huge losses have managed to remain in the black thanks to the oil bonds. Losses on fuel sales have reached record levels and are expected to cross Rs 1,80,000 crore by the end of this fiscal.

Absence of enough liquidity has put severe pressure on the creditworthiness of some of the companies. Take, for example, Indian Oil Corporation. Despite being a Fortune 500 company, IOC was downgraded by ICRA for its long-term credit rating to LAA from its earlier position of LAAA in November, even as credit rating agency Moody's changed the future outlook for IOC to negative from stable. A liquidity squeeze poses huge challenges for oil companies like IOC or BPCL as they depend heavily on imported crude to run their refineries. Most international oil traders or even oil companies are unwilling to open letters of credit unless the company is in a comfortable financial position.

 Companies would be left with more money in their hands if they are allowed to set off their tax payments against the bonds with which the government part-compensates them for their losses on retail sales. And something on these lines could well be under discussions in the corporate boardrooms. Refining companies are reported to have mooted a proposal by which they could sell their bonds to upstream oil producers like ONGC to pay off their crude purchase bills. An idea which was nipped in the bud with upstream companies rejecting outright such a proposal.

Paucity of funds has already started taking a toll on the capacity building plans of the companies. Even as private sector refiners like Reliance Industries and Essar are adding huge capacities, public sector refinery companies have either put on hold their new refinery plans or are going slow. The skewed pricing policy in the petroleum sector and non-transparent way of doling out subsidies have already started deterring investors from the oil sector.

At a time when global oil majors are clocking record profits, thanks to the surge in crude and product prices, Indian oil companies are only adding to their losses. Even oil producers like ONGC, who should have been raking in the moolah, are forced to fork out huge discounts, as part of the subsidy sharing formula.

According to latest projections, Indian refiners and oil marketing companies could be headed towards a total subsidy bill of almost Rs 2,30,000 crore in ficsal 2008-09 if the scenario continues. All the downstream oil companies - IOC, HPCL and BPCL - have been borrowing heavily to meet their working capital requirements. While HPCL and BPCL will soon hit the borrowing ceiling, even market leader IOC is not far off.

Issuing oil bonds which have a tenor of three to seven years only defers the financial liability of the government, posing huge problems for future governments. The fiscal deficit figures given out by the government thus fail to reflect the true picture as was recently cited by RBI governor Y V Reddy.

Policymakers would tend to reject such an outrageous proposition. After all, revenues collected from taxes or dividends are the main source of income for the government to meet its expenses or fund social sector programmes. Globally too, revenues from oil companies have gone to fund public good projects in health, infrastructure and education. Choking out these revenue flows and settling them against bonds issued by the government may not be a sustainable economic solution. Issuing bonds with huge fiscal liabilities does not make economic sense as well.

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