The way the government treats its upstream oil companies (involved in exploration and production) and downstream ones (focussed on refining, marketing and distribution) can be very similar to what happens in a family when one child gets coddled while the other is largely ignored.

In this case, it is clear that within the oil and gas industry, upstream companies are considered the industrys milch cows, generating large amounts of cash for the government via the levies that they are forced to pay. Meanwhile, downstream companies in the petroleum marketing and refining arena are protected through tax exemptions primarily due to their direct interface with retail consumers.

Can this be sustainable for a country which needs to optimise its energy resources, which inturn requires appropriately incentivising those companies involved in unearthing them?

This impulse, by the government, to mete out differential treatment to players on either side of the oil and gas spectrum has its roots in 2008, when crude oil prices had peaked at $147 a barrel. Then, the government started considering a windfall tax on domestic oil producing companies. High international prices meant higher gains for them and it was felt that super profits should be singled out for special taxation. While this proposal, put forth by the BK Chaturvedi committee, did not eventually materialise, ever since then there has been a consistent move to either tax upstream companies in newer ways or increase the existing levy on them

In fact, the increase in cess levy for upstream companies from Rs 2,500 a tonne to Rs 4,500 in the Budget can be seen clearly in the context of a series of similar moves, such as the service tax on upstream activities, removal of tax holiday for gas production and other such levies that have emerged in the past few years. "There have been quite a few instances which illustrate the absence of stability in the fiscal policy for exploration and development activities," says Gokul Chaudhri, partner, BMR Advisors.

Take the case of the government's own company, Oil and Natural Gas Corporation. Besides being made to share the subsidy burden of oil marketing companies to the extent that its outgo on this account alone was Rs 1,51,900 crore in the first three months of 2011-12, the company will be taking a hit of about Rs 5,000 crore from an increase in cess and service tax this year.

Upstream companies in the private sector have similarly suffered. Cairn India, which was made to fork up royalty and cess payments on its Barmer production, thereby reducing its profit share, is now facing an additional burden of about Rs 13,282.1 crore due to this increase. While Reliance Industries will not be impacted, since its various production-sharing contracts for fields given out before the New Exploration and Licensing Policy cap the cess, it too has been hit by the denial of tax holiday on gas production. "Both RIL's KG-D6 and Cairn's Barmer discoveries have been surrounded by policy and regulatory complications. Exploration is a high-risk activity, and the government and the industry have significant gains from a successful project. Changing the rules of the game post the discovery is a material dilution of the rule of law which is most important to attract investment," says Chaudhri.

On the other end of the spectrum are the favoured childrendownstream companies such as Indian Oil Corporation, Hindustan Petroleum Corporation and Bharat Petroleum Corporation. Not only have these three companies benefited from tax holidays provided to their refineries, they have also been saved from officially being in losses through subsidies doled out to them. Besides providing Rs 68,481 crore in petroleum subsidy to them last year, the government also took a hit of Rs 24,000 crore in excise duty cut on petroleum products and customs duty exemption on crude oil. Consequently, the government can no longer rely on the petroleum sector as the major contributor to its exchequer.

The state of affairs as it exists on Tuesday wasn't always intended to be so. Chaudhri points out that the policy objective under NELP was designed to ring-fence the upstream projects from the subsidy problems of the downstream sector and hasn't happened due to the inability to align the supply chain with the market pricessuch as supplying to subsidised sectors (like the power industry).

Meanwhile, unchecked consumption of the petroleum sector is encouraged because of the shield provided to the government-owned downstream players against the increase in international prices. "In hindsight, if the government had walked the path of de-control as suggested in the road map by the task force chaired by Dr Vijay Kelkar, and not abandoned the reforms mid-way, the current distortions could have been avoided. The fiscal and energy policies need to be alignedmaybe the time has come for the country to have a National Energy Security Advisor in the PMO, akin to NSA for defence matters," suggests Chaudhri.

There may be, however, another problem that the government cannot get around. SV Narasimhan, former director (finance), Indian Oil, says that it is difficult for any government to pass on the full price increase to consumers. "You have to see consumer interest as well and that is the reason that the government cut taxes." Besides, he points out that even after subsidy-sharing upstream companies like ONGC have been able to make good profit due to the increase in international crude oil prices, they still make a post-tax profit of around Rs 20,000 crore and are able to fund their acquisitions themselves.

However, Rahul Garg, executive director and direct tax leader, PricewaterhouseCoopers doesn't see any harm in the upstream sector bearing a greater burden. "We have to see whether with the kind of oil prices which are prevalent, tax increase reduces profitability to an extent that upstream operations become unviable, like what happens in the case of downstream companies."

One important question is, do onerous taxes hurt the exploration and discovery industry as a whole? Garg doesn't think so. "It is recognized that tax laws are tools to collect revenue rather than determine people's investment behavior," says Garg. "A sector may not necessarily flourish if tax concessions are available. The power sector is an apt example of this," he adds

Most mature economies have a royalty-based tax regime for the upstream sector. For downstream companies, policies are market-driven, with a regulatory regime that ensures there is no monopolistic or restrictive trade practice. "Our upstream regime is a production-sharing system, and hence the government benefits from the higher profit sharing as production or prices increase from the project. Also the royalty rates are ad-valorem. Therefore, the fiscal system self corrects in favour of the government when there is a rise in the oil and gas prices," says Chaudhri. In other words, there is no reason for a tax above and beyond what already exists.

Energy security requires the promotion of the upstream sector in order to facilitate as many oil and gas discoveries as possible. Onerous tax regimes simply disincentivise these companies from using better technology and send a wrong message to the investment community about an ever-changing and fickle fiscal policy. This is bad news for a country hoping to ease its dependence on foreign oil.