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The oil price conundrum
June, 03rd 2008

 The government is doing little to stem the losses being racked up by the public sector oil marketing Companies and soon these Companies may start rationing petrol and diesel. The consequent consumer backlash, particularly from the farmers whose sowing season will have been disrupted, heralds the beginning of the end of this administration. Or the government may indeed raise prices to pull the oil Companies back from the brink of financial collapse. The Left parties may then withdraw support, and the Congress party is pushed into elections under unpropitious circumstances.

How have they got themselves into such a spot? India is not, after all, the only country that is reeling under the twin burdens of historically high oil prices and unprecedented volatility. There is no simple answer. One could, of course, place the blame squarely on the nature of our Politics. However, this is too generic a response. There is a more specific explanation. An examination of the pricing structure will shed some light.

Indian Oil Corporation (IOC) calculates, inter alia, the landed import duty paid price of petrol and diesel every fortnight. This calculation is based on a formula that is linked to international prices. IOCs landed price of petrol in Mumbai for the second fortnight of May was, for instance, Rs 38.1/ltr and for diesel Rs 48.8/ltr. The marketing Companies had to, in other words, pay this amount to the refiners to buy the products. Next, the central government imposes an excise and educational cess on the purchase cost. In May, this was Rs 14.4/ltr and Rs 0.4/ltr for petrol and Rs 4.6/ltr and Rs 0.1/ltr for diesel respectively. The total cash required by the marketing Companies to purchase petrol and diesel in May was, therefore, Rs 52.9/ltr for petrol and Rs 53.6/ltr for diesel. The Companies then sell these products at the ministry of petroleum mandated price of Rs 49.7/ltr for petrol and Rs 35.6/ltr for diesel (Mumbai prices). As such, they lose Rs 3.2 and Rs 18 for every litre of petrol and diesel sold respectively. That, however, is not their total loss. They have to also pay sales tax to state governments. In Mumbai, this tax is Rs 10.6/ltr and Rs 7.1/ltr for petrol and diesel respectively. Thus, the total cash loss suffered on account of the sale of 1 litre in Mumbai is  Rs 13.7 and Rs 25.1 for petrol and diesel respectively. This is, in other words, the amount by which prices would have to be increased at the retail outlet for the Companies to simply break even on a cash basis. Such a hike is, of course, out of the question.

So, what then? The logical solution should be a package that combines a price hike with a reduction in the central and state tax rates. After all, central and state taxes account for 32% (diesel) and 50% (petrol) of the price build up. But logic gets tossed aside in the face of turf battles. The finance ministry will not forego its windfall gain; the top leadership will not force a compromise between the petroleum ministry and the finance ministry. And, the central government does not have the clout to compel state governments to countenance a reduction in their revenues.

The consequence of this stalemate is now coming home to roost. The oil Companies are, of course, close to bankruptcy. But more egregious we are now seeing a distortion in energy consumption patterns. The domestic price of diesel is today less than the price of furnace oil. This is encouraging a switch from furnace oil to diesel and in consequence a sharp hike in the consumption of diesel. Its demand growth is now exceeding 20% per annum. The dieselisation of the Economy is also making a mockery of efforts to secure energy independence.

There is no short-term painless fix. Everyone will now have to bear the implications of ad hocism in policy. This must not, however, take away from the urgency of mitigating the longer-term consequences. Even amidst the twists and turns of current policy, the hope is that the government will look to placing the petroleum policy within the bounds of a more sensible economic and pricing framework. What should be the drivers of such a framework?

First, we should accept that high oil prices are here to stay. This does not mean we will not see sharp declines from present levels. What it does mean is that we will not see prices stabilising at levels significantly below a triple digit number. Second, we must create a mechanism that leads to a graduated reduction in subsidies, an orderly alignment of domestic prices to international levels and a more efficient disbursement of inancial support to the poor. Third, we must quickly and sharply reverse dieselisation. And, finally, we must recognise that the sine qua non of energy security is a robust and competitive domestic petroleum and energy sector.

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