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Petrol, Diesel price cut: Our view

Feb 19, 2007

Rising inflation has been a key concern for the government over the past few weeks. Hence, in an effort to curb the same, the government recently reduced the prices of major transportation fuels like Petrol and Diesel. Petrol, the fuel used predominantly for private transportation, has been made cheaper by Rs 2 per litre (reduction of 4.5%), while diesel, the public transport fuel has been made cheaper by Rs 1 per litre (reduction of 3.2%). In this write up, we analyse the various scenarios of absorbing this reduction by the government and possible impacts of the same. What lead to this?
Primary articles (consisting of food articles and non-food articles) have a weightage of around 22% in the wholesale price index. Petrol and diesel are part of the 'Fuel, Power, Light and Lubricants' category that has a weightage of 14.2%. During the last few months, inflation has risen mainly due to rise in prices of primary products, particularly wheat and pulses. As transport fuels have greater sensitivity to inflation, a case for the reduction in their prices had been gaining strength in recent times. Also, as the date for the forthcoming assembly elections in UP and Uttaranchal is drawing closer, the government is wary of coming into the bad books of the common man.

Some background…
Sales of Sensitive products viz. petrol (MS), diesel (HSD), LPG and SKO account for more than 60% (in terms of volumes) of the total petroleum products sold in the country. An increase in the international crude oil prices and an even higher rise in the prices of these products, once again brought the subsidy issue to the fore. Time and again, we have been left confused by the issue owing to the large number of products and the different taxes and duties imposed on them? Let us try and demystify the energy value chain, the different pricing points and hence simplify the subsidy sharing mechanism on the sale of petroleum products.

Energy value chain and subsidies…
The E&P segment (upstream segment) produces crude oil, which is a basic and raw form of hydrocarbons. Refineries buy crude oil and convert it into refined petroleum products. Marketing companies/divisions purchase these products at the refinery gate prices (selling price for refineries) and inturn sell them to the ultimate consumers after accounting for the relevant taxes.

Having understood this, we come to the conclusion that there are three pricing points in the above mentioned value chain. First is where the refining companies/ refining divisions purchase crude from the upstream players. At this point in the chain, we see ONGC selling its crude to refiners at the prices lower than the international prices. This reduces the prices for the players down the value chain. Discounts on crude oil along with sharing of under-recoveries on the sales of SKO and LPG are therefore a means of sharing subsidy for the upstream majors like ONGC.

At the second point, refineries/refining divisions sell the petroleum products to the marketing companies/divisions; refineries upto recently were made to sell sensitive petroleum products (SKO and LPG) at discount to the international prices.

Finally, the OMCs (oil marketing companies), before selling to retail or industrial consumers, do the final pricing exercise. While the prices at the industrial level are fixed rationally, taking into account the economics of the industry, retail products like domestic LPG and SKO are sold significantly below their actual conversion costs. As far as petrol and diesel are concerned, currently, the OMCs are selling HSD at a loss of one rupee per liter and petrol at gains of Rs 2 per liter.

We can thus conclude that the net- under recoveries for the oil marketing companies are calculated as follows:

Net under-recoveries = Gross under recoveries (desired prices less actual prices) - subsidy sharing from the upstream players – discounts from the refining division (if any) – subsidy sharing as per fiscal budget – subsidy sharing in the form of oil bonds by the government.

Below mentioned table shows the level of subsidy given to consumers on kerosene and LPG.

Subsidy on PDS Kerosene to Consumers…
Particulars ( subsidies per litre) FY03 FY04 FY05 FY06 1HFY07
Subsidy from the fiscal budget 2.5 1.7 0.8 0.8 0.8
Under recoveries to Oil companies 1.7 3.1 8.0 12.1 16.7
Total subsidy to the oil companies 4.1 4.8 8.8 12.9 17.5

Just to highlight, the current price of PDS kerosene is Rs 7.97 per litre, translating into a subsidy of more than 2 times the selling price.

Subsidy on Domestic LPG to Consumers…
Particulars (subsidies per cylinder) FY03 FY04 FY05 FY06 1HFY07
Subsidy from the fiscal budget 67.8 45.2 22.6 22.6 22.6
Under recoveries to Oil companies 62.7 89.5 124.9 152.5 153.2
Total subsidy to the oil companies 130.5 134.7 147.5 175.0 175.8

What does the current move means?
It is quite clear from the above explanation that the current reduction in fuel prices is likely to squeeze the margins for oil marketing companies. The same could be offset by asking the upstream players to contribute more towards subsidies or by further reducing custom duties (a big negative for standalone refiners). However, we believe that the government has already stretched the resources of these companies too far and any further burden on them is likely to deteriorate their economics further. Thus, the government is left with the sole option of bearing the bulk of the burden itself. The two most probable options seem to be the issue of oil bonds and the reduction in excise duties. The case for the latter becomes stronger in view of the recommendations laid down by the Rangarajan committee on the pricing of petroleum products.

Also, as we in our previous articles, Petrol: What are we paying for? and Fuel prices: India vis-à-vis the others, have explained that there has been an increase in excise duty as a % of selling prices over the years, a small reduction at the current juncture would not do much harm. Thus, we believe that in the upcoming budget, we will most likely see a reduction in the excise duty on these products.

Scenario analyzing the effect of the recent price cut on profitability
Possible scenarios Scenario 1 Scenario 2 Scenario 3
Proportionate reduction in excise duty Yes No No
Proportionate Increase in oil bonds No Yes No
Overall impact over current profitability None None Negative

However, the reduction in the excise duty may also not be proportionate. In such a scenario, the profitability of the oil marketing companies will then have to be restored through the subsidy as per the fiscal budget or by the issue of oil bonds by the government or a combination of both. To conclude, the entire exercise reflects the unwillingness of the government to move towards a deregulated environment and until that happens, uncertainties will continue to cloud the sector.

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