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Fuel price deregulation - Reading the fine print

May 20, 2011

The long wait could finally be approaching its end as Government decides whether or not to go for diesel deregulation. The stakes are high and diverse. Needless to say, the worst blow will be borne by end user, be it a normal price hike or deregulation. Let us take a look at the possible actions/policies ahead and what they imply for other stakeholders.

Facts

The total under recoveries reported by Oil marketing companies (OMCs) stand at around Rs 780 bn for FY11. The Government has announced a relief of Rs 410 bn. That leaves Rs 380 bn. Assuming upstream (companies involved in Exploration and Production like ONGC) share one third, it will leave around Rs 100 -Rs 110 bn to be borne by state run OMCs. This compares to a total consolidated profit of Rs 134 bn for FY10 (FY11 results are not declared yet) for BPCL, HPCL and IOC. Imagine the impact on state run OMCs and upstream companies next year when such losses are projected at around Rs 1,700- 1,800 bn. Especially in the light of the fact that the government in its budget for FY12 has announced a subsidy of Rs 236 bn for FY12 and there have been no changes in duties on petrol products.

At current level of crude, the state run OMCs like BPCL are incurring a loss of Rs 15 per litre for diesel, Rs 29 for kerosene and Rs 330 for LPG per cylinder. The under recovery balance of Rs 780 bn for FY11 does not include losses incurred on petrol post June because prices were decontrolled on paper. Hence, even after the ninth round of increase, petrol is incurring a loss of Rs 5 a litre.

Diesel deregulation - how likely?

At current levels of inflation, diesel deregulation looks unlikely. The Government has planned a disinvestment in ONGC (FPO scheduled in July). Since ONGC takes care of around 80% of the upstream share of subsidies, any increase in upstream share of subsidy sharing /lack of clarity can make it a lost opportunity. It may be too late if we wait for rate of inflation to cool down to 7%.

Upstream

There is a buzz in the market that the share of the upstream companies to compensate for under recoveries will be raised from 33% to 38.5%. Because of this, the stock prices of upstream companies have taken some beating.There are high chances that rise in crude prices will offset the increased subsidy burden. If prices come down, it will imply less subsidy dole out. This improves net realizations. However, what is negative for the sector is a lack of clarity on subsidy sharing mechanism.

Downstream

The impact on downstream players will depend on whether the prices get fully freed (and not just on paper). It will be naive to assume that diesel deregulation, if opted for, will bring under recovery balance to nil. With Government owning a majority stake in OMCs, chances are high that prices will be governed by political interests. The OMCs will not get anything if deregulation happens and if they don’t increase the fuel prices as per the global rates (as has happened in case of petrol). The share of downstream companies has varied from nil to 23% in last three years. Hence, deregulation could imply a potential loss for them. For BPCL alone, the under recoveries on petrol are to the tune of Rs 630 crore (not included in Rs 78,000 crore).

Government

Diesel deregulation is a hard bullet to bite for the Government. Nonetheless, it is inevitable. Hence, we believe that any deregulation will come along with cuts in duties to keep inflation in control. As per a CAG (Comptroller and Auditor General of India) report, petroleum products contributed about 60% of total excise revenue in FY10. This is double the Government’s share of under recovery compensation in the same year. This means that this sector is a net income generator for the Government. It is interesting to note that until this price hike of Rs 5 per litre for Petrol, half of the amount paid by a consumer used to go as taxes. Since duties are applied as a percentage on the commodity, the higher the commodity prices, the higher the revenues for the Government by way of indirect tax collections. So in case of rising crude prices, there will be pressure on Government to cut duties. It is estimated that such receipts yield 40% of indirect tax collections. Would not the interest of the state run OMCs and customers be best served if levies are brought down? Tough decision again as it will curtail Government’s revenues and will be adverse for fiscal health of the country.

Auto sector

Already dragged down by Rs 5 per litre of hike in petrol prices post state elections, we believe the auto sector will continue to suffer. This is because, deregulation or no deregulation, we expect the Government to go for a round of price hikes for both petrol and diesel. This along with high rates of interest on auto loans will dampen the performance of the sector.

Need of the hour

While deregulation is the best long term option, at inflation rate of 8.7%, it is a tough call for the Government. Another round of price hike will not be enough. What we all need is a very clear subsidy sharing mechanism. Also, if deregulation happens, it needs to come along with cuts on various duties on fuel products. Taking a step further in direction of reforms, the stakes of the Government in OMCs should be brought down. This will ensure that once deregulation happens, we stick to it in letter and in spirit.

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