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Petroleum economics 101

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    http://www.indianexpress.com/news/petroleum-economics-101/1010085/ Petroleum economics 101 Vikram S Mehta : Mon Oct 01 2012, 23:49 hrs A guide to the necessity
    Message 1 of 1 , Sep 30, 2012
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      http://www.indianexpress.com/ news/petroleum-economics-101/ 1010085/

      Petroleum economics 101

      Vikram S Mehta : Mon Oct 01 2012, 23:49 hrs

      A guide to the necessity of a price hike

      I was somewhat taken aback by the lack of knowledge displayed by our politicians about the fundamentals of petroleum economics. This was brought home to me by their televised reactions to the prime minister’s explanation for the diesel price hike. Some opposition spokesmen challenged the assertion that India was dependent on crude oil imports by arguing that it was in fact an exporter of petroleum products. Others claimed that the PM had no reason to raise domestic prices at a time when international prices were softening. Yet others said that the silver bullet for reducing the fiscal strain of fuel subsidies was through tax rationalisation, not price increases. All, of course, slammed the government for hurting the “aam aadmi”. The government spokesman did not come off any better. Instead of extracting political mileage by countering with fact and logic, they mouthed the standard political platitudes.

      This article has been triggered by the realisation that our public representatives do not understand or are confused by the dynamics of petroleum economics, at least as applied in India. It has been written to enhance understanding and clarify confusion.

      Crude oil is the raw product extracted from the sub-surface. In and of itself it has limited use — it is no more than the start of a value chain that ends with the sale of products that include petrol, diesel, LPG and kerosene. Midway through this chain, crude has to go through the process of refining. That is when it is converted into useful petroleum products. The precise configuration of the product slate depends in part on the quality of the crude — there are many different types, light or heavy, depending on density, and sweet or sour, depending on sulphur content — and in part on the complexity of the refinery (the more “complex” it is, the greater is its flexibility to match output to demand). The products are then sold into the market.

      Refining companies purchase the crude at a price set by the “fundamentals” of supply and demand and the “non-fundamentals” of geopolitics, exchange rates and financial speculation. Had the fundamentals been the singular and decisive determinant, the price of crude in FY 2011-12 would have been in double digits. This is because demand was constrained by the recession in the West and the slowdown in China, and supply was robust because Saudi Arabia was producing to near capacity and the US and European governments were ready to draw down their strategic reserves. The price averaged $115 per barrel (bbl). The reasons for this triple-digit figure were the non-fundamentals of geopolitics (the Israel-Iran nuclear imbroglio, the civil strife in Syria, etc), currency depreciation and Wall Street traders.

      India imports in excess of 80 per cent of its crude oil requirements. This crude is purchased by public sector companies IOC, BPCL and HPCL, and private sector companies Reliance and Essar. It is then refined domestically. Unlike crude, there is a surplus of installed refinery capacity — 213 million tonnes against consumption of 148 million tonnes in FY 2011-12. Approximately 60 million tonnes of products were therefore exported last year. So, the opposition’s claim that India is an exporter of petroleum is correct. They are wrong, however, to conclude that this substantially mitigates our financial burden.

      It is perhaps not widely understood that refiners make a relatively nominal margin compared to exploration and production companies. The latter are engaged in a risky and capital intensive business — only a small proportion of wells drilled make a commercial discovery — but in the event of success, the rewards are commensurately high. The low-cost producers in the Middle East receive margins in excess of $100 per bbl. By contrast, Indian refiners made a margin of somewhere between $4-15 last year depending on the size and complexity of the refinery. In other words, they purchased the raw material (crude) at an average of $115 per bbl and then sold the products at a weighted price of between $119-130 per bbl. The point is that our surplus refinery capacity does not shield us from the vicissitudes of the international oil market; nor does it obviate the need for domestic price rationalisation.

      The final stage of the value chain is supply and marketing. The companies purchase the refined products at a formulaic trade parity price {weighted average of import parity (80 per cent) and export parity (20 per cent)}. This price in September for diesel was Rs 48.64 per litre. The products are then brought to the retail outlet. The cost of transport, marketing, distribution etc adds a further Rs 4.40 per litre to the cost equation. (Bangalore is the reference market). There is then finally the tax burden of Rs 11.10 per litre — Rs 3.50 for excise and Rs 7.60 for VAT (the VAT rate in Karnataka is 16.75 per cent). The total cost, including taxes, for bringing diesel from the refinery to the Bangalore retail outlet is therefore Rs 64 per litre. This is what the companies must charge to break even. The government however mandates that they charge Rs 51.23 (post the recent Rs 5 hike). The companies “under-recover” (euphemism for loss) Rs 13 per litre. Were the government to not raise the diesel price further and/ or reduce taxes, were demand to continue to grow at the current rate, were international prices to average current levels and were the rupee-dollar exchange rate to remain stable, the annualised “under-recovery” from diesel sales alone in FY 2012-13 will be approximately Rs 1,15,000 crore.

      The argument that tax rates should be reduced is valid. The inference, however, that the fiscal route offers a silver bullet is wrong. This would hold only if the Central and state governments forfeited all their petroleum tax revenues — a political impossibility. The sustainable solution will require a hike in prices and a reduction in taxes.

      Bill Clinton asked the Democratic National Convention, “What new ideas did we bring to Washington?” He provided the answer himself: “Arithmetic”. Politicians can legitimately question the policy on FDI in retail, for its arithmetic has yet to be tested. But they should be cautious in obstructing the move to rationalise petroleum pricing. Here, the arithmetic has been irrefutably established.

      The writer is former chairman of the Shell Group in India. Views are personal

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