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Oil price hike: Our view - Views on News from Equitymaster
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Oil price hike: Our view
Jun 6, 2006

Finally against opposition from various fronts, the ruling UPA government has increased prices of diesel and petrol. The other two subsidized products – kerosene and LPG – have been spared the hike. While the rate of increase may vary city to city, broadly, petrol and diesel are dearer by 8% and 6% respectively. Also, though the rate of increase may still not be commensurate to the increase in input costs, this is certainly a welcome move for oil marketing companies (OMCs). Apart from the price hikes, lowering of customs duty (on petrol and diesel) and issuance of oil bonds to the tune of Rs 280 bn has also been decided. As far as the oil bonds are concerned, these will be issued in 4 equal installments and would be treated as a part of SLR requirement for banks, thus lending them liquidity. In this write up, we explain the Rangarajan Committee recommendations, and the implications of the price hike on profitability and under-recoveries.

Rangarajan Committee recommendations
The Rangarajan Committee was set up by the government to provide recommendation on pricing and taxation of petroleum products. The Committee gave its report in February 2006 and following were the noticeable features of the same:

  • Shift towards trade parity from import parity: Post the dismantling of administered price regime (APM) in April 2002, the government decided to price petroleum products based on import parity principle, which has been a commonly used approach for tariff protection. Prices, under the import parity principle, are based on the landed cost of petroleum products (inclusive of ocean freight, duties as applicable and other costs associated with import of products). However, considering the global demand-supply scenario for refining products and India’s surplus domestic refining capacity, the committee recommended that the refinery gate pricing of products be based on trade parity principle in the ratio of 80:20 (a mixture of import parity and export parity).

  • Termination of principle of freight equalization: Currently, prices of petroleum products is stable across the country (leaving aside local taxes). The Committee recommended the termination of the freight equalization scheme, which will result in lower prices in coastal areas and higher prices in inland locations.

  • Rationalization of custom duties: Currently, the custom duty on the crude is 5% while on petrol and diesel, it was 10% (prior to yesterday’s announcement). The committee recommended a reduction in custom duties on petrol and diesel to 7.5%.

  • Restructuring of excise duties: Excise duty on petrol and diesel is a combination of ad-valorem and specific duties. The excise duty on petrol is 8% ad-valorem in addition to specific duty of Rs 13 per litre, while the excise duty for diesel is 8% ad-valorem in addition to specific duty of Rs 3.25 per litre. The committee suggested parting away with the ad-valorem duty.

Implications of the price hikes
As is known to everyone, international crude oil prices have increased significantly over the recent years, while the domestic prices of petroleum products have been out of sync with the same. This has resulted in oil marketing companies incurring significant losses. As per government statistics, the total under-recoveries on account of sale of petroleum products in FY07 are estimated at Rs 735 bn (the same in FY05 and FY06 were Rs 201 bn and Rs 397 bn respectively as per the Ministry of Petroleum and Natural Gas). Here, we would like to inform subscribers that the current price revisions and subsidy sharing is based on crude oil prices at US$ 70 per barrel (of 159 litres).

On oil refining and marketing companies: In FY06, IOC incurred losses to the tune of Rs 3.07 per litre on the sale of petrol as against a loss of Rs. 0.10 per litre in FY05. Prior to the price hike yesterday, the company was losing Rs 7.20 per litre (Source – IOC). After the Rs 4 per litre price increase in petrol, based on the losses in May 2006, there is still a deficit of Rs 4.2 per litre. To narrow the deficit even after the price hike, the government will be issuing oil bonds, which will reduce the losses even further. That said, since kerosene and LPG prices have not been raised, oil companies would continue to have under-recoveries going forward.

Thus, OMCs will be the key beneficiaries from the proposal. However, the shift to trade parity pricing and lowering of the customs duty on the petrol and diesel would result in lower GRMs (gross refining margins) at the refinery gate level (for BPCL, HPCL, IOC and MRPL).

On standalone refining companies: Implementation of Rangarajan Committee recommendation by shifting from import parity pricing to trade parity pricing along with decrease in customs duty from 10% to 7.5% will lower the effective protection available to standalone refineries (from 40% to 20%). Going forward, gross refining margins for standalone refineries will be under pressure. This is not only on account of the aforesaid measures, but also on account of discounts to oil marketing companies (on petroleum products). We believe that standalone refineries will be the most affected post the government proposal.

Despite political compulsions, the price hike is definitely a bold move. But in our view, it does not solve all the issues that energy companies in India are faced with. As we have maintained in the past, India has a potential to emerge a refining hub in the long-term, provided the government’s policies are tuned towards the same. Even after the price hikes, without any visibility as far as return on investment are concerned, companies will be hesitant to commit large capital expenditure. We will be meeting the oil marketing companies post which, we will update our subscribers with respect to our views on the concerned stock.

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