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The case for windfall taxes
August, 02nd 2008

The rising fortunes of Samajwadi Partys Amar Singh, bolstered by the recent trust vote in Parliament, has added a new dimension to the linkage between the business and political class of the country.

Amar Singh casts a long shadow on the bitterly feuding Ambani brothers, by virtue of his proximity to the younger sibling. As a result, his eagerness to levy a windfall tax on oil companies is viewed with suspicion. After all, Mukesh Ambanis milch cow is a behemoth 33 million tonne petroleum refinery.

Such legacy issues have stymied a fair debate on the question. Here is an attempt to wedge open the issue.

Exploration business: Over the past two years, vaulting crude oil prices have led to rising incidences of oil contractors parting with profits, present and future, to the countries they operate in. In 2005, North Sea operators in UK, all in the private sector, coughed up 2.3 billion.

The Labour government yielded to the affordability woes of consumers who saw their gas bills rise 20%. Industry protested in vain: the North Sea fields were well past their prime, with production on the decline. They needed stiff doses of investments to sustain production. The government relented only two years later, when it offered tax rebates that would aid in improved pumping from the fields.

Several countries, however, went beyond the policy play in UK, one of balancing investments with consumer interests. In Russia and Venezuela, it was as much or more about controlling the fields. The response of investors has varied. In Russia, Shell and BP, who were at the receiving end of the states heavy hand, took the body blow silently. It was worse for Shell. The state forced the Anglo Dutch company to sell its stake in a Sakhalin venture at a discount.

In Venezuela, however, as many as four of the six foreign investors in the Orinoco belt conceded control. Exxon Mobil, the worlds largest oil company, took on the state. It got a court order in London, freezing the states assets to the extent of losses, amounting to $12 billion.

Both the countries represent the dilemma that oil investors face. In doing business in such countries, does commercial sense outweigh political risk? After all, these two countries are estimated to bear the largest reserves of hydrocarbons in the western hemisphere.

In India, the high crude oil prices have made little difference to the average quality of bidders for exploration blocks. It is precisely for this reason that the petroleum ministry has argued against levy of a windfall tax a levy would blunt the much needed investments in the sector.

A closer scrutiny of the states role in the sector points to several other deficiencies that blunt investments. For one, big oil companies like Exxon, Chevron find commercial sense in participating only in large blocks. The size of blocks offered in India doesnt measure up.

As regards raising revenues, the states regulatory oversight on the quantum of costs allowed to be recovered by contractors has been deficient. This hurts since the state gets a share of revenues from sale of oil or gas only after the contractor recovers costs incurred in developing the field, which nets from initial sales.

It is only recently that this end has been reinforced, by raising the level of due diligence in approving costs. Interestingly, in 1997, under-regulation proved to be a key reason behind a 5.2 billion windfall tax levy by the UK government on electricity, water and sewage utilities.

Refining business: Historically in the throngs of a boom and bust cycle, creaming off profits in this conversion business would affect investments. This would hold provided it is primarily the supply-demand profile for products that drives refinery economics and investment cycle. However, that is not the case. The profit contagion in the crude oil travels to the refinery business as well.

In a rising crude oil market, the refiners profits are significantly boosted since there is a month or twos lag between the time the refiner buys crude and sells the products. For the first quarter this year, public sector refiners CPCL and MRPL doubled their margins over the same period previous year largely on this count. It is another matter that RIL chose not to book the inventory gain this quarter in the process, its refinery margins were lower than that of the two PSU refiners.

One might argue that when crude oil prices drop, the margins will pare. True, but the question is: to what extent will crude prices drop? Estimates are aplenty. BP projects it to soften to $100 by the year end. For the producer, the profits pare. However, for the refiner, inventory losses invade the books, since he will sell products that are cheaper than the crude oil purchased two months earlier.

That said, there is a fair volume of inventory related profits that are not eroded since crude oil is not expected to plunge to the $50-$60 mark. One-time gains are witnessed by both oil producers as well as refiners; the latter, though, to a lesser extent. Hence, a case for super profit tax on crude oil producers must be raised in conjunction with one for refiners as well.

The case for windfall taxes, however, goes beyond a situation of unreasonable profits, or the absence of a complete cyclical behaviour of industry. A key ingredient is political expediency. In India, state interventions have thus far been on revenues rather than on profits export duty on iron ore, ban on sugar exports.

For the state, its a question of when political expediency cuts future investments. In 2005, although RIL paid out Rs 750 crore towards sharing the oil subsidy bill, it did not go back on the decision to set up another giant refinery. In regard to oil producers, if the government nicks PSU units ONGC and OIL to meet the oil subsidy bill, it must not spare BG or RIL either. Over to the state.

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