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How to deal with ever-rising crude prices?
June, 03rd 2008

 By keeping prices of petro-products artificially low, we have prevented any reduction in demand.

If there ever was an example of the terrible cost of dithering, it must be this. There was a time not that long ago when crude oil prices averaged less than $20 per barrel.

It was when Vijay Kelkar, as the secretary of the ministry of petroleum and natural gas, set up a committee for dismantling the administered price regime and usher in market-based pricing. The committee produced an excellent report and set out a timetable for decontrol.

Unfortunately, petroleum minister Ram Naik of the BJP didnt want to give up controls. Like many other reports, this one also met its dusty death in some long forgotten filing cabinet.

Ram Naik and the BJP went. In came the Congress: Mani Shankar Aiyar followed by Murli Deora. Neither showed much interest in decontrolling prices, except in bits under the direst of circumstances. And despite being a good economist and a reformer at heart, Prime Minister Manmohan Singh did not exert enough pressure.

What an opportunity we lost! Up to September 2003, there was a parity between crude and petrol prices with a good refiners margin - making it an ideal time for decontrol.

By December 2004, Brent crude prices had risen to almost $40 per barrel. Decontrol was possible, but didnt happen. A year later, crude was at $57. By December 2006, it was above $62, and the Indian oil majors starting posting losses. Instead of decontrolling then, the government doled out bits and bobs of oil bonds to IOC, HPCL and BPCL.

By the end of 2007, Brent averaged over $90 per barrel. Today, Brent is ruling at above $131 per barrel; and experts speak ominously of crude testing $200 some time this year. It is unlikely that crude will go below $100 per barrel in 2008. By which time, we will have comprehensively bankrupted the oil majors, and done no good for anyone else.

The consequences of not passing on higher crude prices have been disastrous. Nothing rations oil demand better than prices. By keeping prices of petrol, diesel, kerosene and LPG artificially low, we have prevented any reduction in demand. It almost borders on being criminal.

While 300 million people live below poverty line, making do with energy inefficient dung cakes, twigs and branches and occasional bits of coal, the urban middle class and the rural rich are splurging on cheap petrol, cheaper diesel, even cheaper kerosene, and absurdly cheap LPG.

The subsidy is massive - hidden by a disingenuous device called oil bonds. Here are some rock solid facts. IOC, HPCL and BPCL are currently losing $137 million a day (i.e., Rs 582 crore per day at Rs 42.50 = $1). They lose Rs 16.34 for each litre of petrol, and Rs 23.49 for each litre of diesel sold in Delhi.

The subsidy on kerosene at Rs 28.72 per litre is over three times the current retail price; and the subsidy on a cylinder of cooking gas at Rs 306 per cylinder exceeds the retail price. The total under-recovery for the oil marketing companies for 2006-07 was over $19 billion. With oil prices touching $135, under-recoveries can be $50 billion this year, unless retail prices are substantially increased.

Can India be insulated from such high prices? No. And it must not, because that will keep demand high, lead to rationing and bankrupting the exchequer. Will this government have the courage to raise prices by at least Rs 12 per litre for petrol and diesel - although that will still not eliminate under-recovery? No.

Because that requires massive political courage and capital. So, we will see a Rs 5 increase, hardly any reduction in demand, may be rationing, may be a surcharge on income tax, and the oil marketing companies going broke. We just dont learn in time, do we?

Substantial increase in prices is inevitable it is high time we honestly reflected on this reality .

The past few weeks have seen a lot of dithering on the part of the government about the way the prices of petroleum products should be increased to reflect the consistently increasing international crude oil prices. This discussion reflects poorly on the economic reform programmes of successive governments of India.

The R (Restructuring) Group headed by Dr Vijay Kelkar had submitted its report way back in 1996 suggesting a move towards import parity pricing. Any positive fall out of these recommendations was soon partially rolled back LPG, kerosene, diesel and petrol were brought back into the realm of control as these were considered to be more socio-economically sensitive.

In effect, the administered pricing mechanism in India has continued as these four products account for over 60% of total petroleum consumption.

So, how sensitive are these four products? As has been shown time and again, very little of the subsidy on LPG and kerosene actually reaches the poor. Nearly 40% of the LPG subsidy is enjoyed by the top 7% of Indias population while only 5.6 % of rural households use LPG and less than 2% use kerosene for cooking.

In other words, the benefit of subsidies on these cooking fuels is enjoyed largely by the urban middle and higher income classes! The net monthly impact of full pricing for LPG would be no more than Rs 400 only Rs 200 of which is due to the recent crude price increases.

Petrol, of course, is very heavily taxed as this is considered to be more of a luxury item and is a major source of government revenue accounting for only 8% of total petroleum product consumption but for 32% of governments excise earnings from this entire sector. It is interesting that the consumers of this product possibly significantly overlap with the consumers of LPG and kerosene.

It can reasonably be said that the revenues from the sale of petrol offset nearly two-thirds of the under-recovery on LPG and kerosene (2006-07). So, we are collecting taxes with one hand and doling out subsidies with the other! All that the government is achieving in this process is the creation of a false sense of security amongst consumers of these products and a consequent distortion of demand!

Diesel prices in India, contrary to popular belief, were not heavily subsidised but enjoyed a lower rate of duties and taxes as compared to petrol. With the recent international crude price increases, of course, the subsidy amount has gone up to nearly Rs 14 a litre this is when we have moved to a specific duty rate.

Since a large amount of diesel is still used for commodity transportation purposes, it can be argued that any increase in price of diesel would have an inflationary impact on the economy beyond the purely sentimental response. In this case the government could definitely differentiate the price of diesel in the urban/peri-urban areas from that in purely rural areas through branding.

The burden being borne by oil marketing companies has gone up to nearly Rs 20,000 crore a month. The same consumers who are enjoying paltry subsidies today face the threat of non-availability of products and related huge inconveniences tomorrow.

The government, in turn, may find it difficult to support more deserving programmes such as the farm loan waiver scheme or the National Rural Employment Guarantee Scheme (NREGS) if it is to maintain some semblance of fiscal circumspection. And the poor would again be subsidising the rich! Substantial increase in prices is inevitable it is high time we honestly reflected on this reality.

(Co-authored by Ruchika Chawla)

Alternative sources of raising revenue, including higher excise on other items must be considered.

Rising crude prices have placed non-oil producing developing countries like India in an economic dilemma. On the one hand is the imperative of managing the oil deficit. On the other is the imperative of ensuring that inflationary situations do not get exacerbated owing to a greater pass-through of international prices.

In the case of India WPI inflation has been hovering around 8%.

From the governments point of view this is hardly the opportune time to allow prices to rise in the domestic markets. But on a closer scrutiny it becomes obvious that there arent too many options in the hands of the government.

A greater pass-through of international prices would have to be allowed. However, a hike in oil prices would have to be accompanied by somewhat reduced indirect tax rates. The government, the oil marketing companies and the consumer would have to share the burden of this rise in price.

At the same time a comprehensive mix of short-term and long-term policies is required to be put in place to minimise impact on the poor, while at the same time preserving fiscal health and containing losses of oil marketing companies.

It is imperative to align petrol and diesel prices at this stage to international crude prices by a well-considered increment. This is necessary not only to reduce fiscal cost of ballooning subsidies, but also to send out the right signals for fuel usage and efficiency.

While higher pump prices will further exacerbate inflation down the line, the continued use of off-budget oil bonds is a worse option for Indias future economic growth. Slower GDP growth will invariably bear negative repercussions for jobs and incomes.

The case for reducing LPG cylinder subsidies is even stronger, as the subsidy now exceeds the price. For kerosene, better targeting and control of subsidies is the right option, in order that it is not diverted to other uses.
Excise and customs duties contribute significantly to the petrol and diesel prices at the pump.

If the government agrees to lower these duties, some of the excise loss can be borne without having to curtail essential expenditure. With persistent high prices, the government may also need to consider alternative sources of raising revenue, including higher excise on other items, sale of equity, or new taxes.

Equally important is setting in place a pricing system that takes into account global price fluctuations and manages inflationary expectations. A price band, with well-defined upper and lower ceilings, and regular revision of prices should be instituted for calibrating fuel prices in India with global changes.

While such measures may help in the short term, in the long run more efforts are needed in areas such as efficient multi-modal public transport, greater reliance on rail traffic, promoting energy efficiency, etc. We need to incentivise conservation technologies and systems and traffic, transport and town planning needs to form part of this overall strategy.

At the same time, domestic exploration and refining need to be stepped up, and energy security strengthened through proactive initiatives in the global arena. Better technology at refineries and more attention to R&D is needed. Alternative sources of energy, such as wind power and solar energy need to be promoted wherever possible, and rural electrification carried out. Judicious use of bio-fuels such as jatropha can be considered as long as food security is not impacted.

Industry, a significant user group, will help with concerted initiatives such as energy efficient furnaces and boilers, energy labelling, extensive awareness campaigns to promote oil conservation in small and medium industries, cogeneration and other energy conservation measures, etc.

CII, through its Centre of Excellence and other initiatives, is already active in this space and would ensure that Indian industry emerges as an exemplar.

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