• JANUARY 5, 2011

Oil bonds: Defusing the ticking time bombs

The year 2010 has been a crucial year for Indian energy sector. While the first half will be remembered for freeing up of petrol prices and endless talks of diesel prices to follow, the second half will be marked for the strength in crude oil prices post global crisis and talks of disinvestment in oil companies. This article talks about none of these. Infact, what we will focus on is one more reform that got less attention than what it deserved. We are referring to the decision to stop issuing oil bonds and to use cash subsidies instead.

Before going further, let us understand what oil bonds are and how they work. We believe them to be a live testimony to India's savviness when it comes to innovating fancy financial products. The following discussion will make our point clear.

Since fuel prices in India are highly subsidized, domestic oil marketing companies (OMCs) bear huge under recoveries. Just to clarify, the under recoveries are the losses due to the difference between the purchase price of crude oil (determined globally) and the retail price at which refined products are sold (which is fixed by the Government). To keep the OMCs in business, the Government either issues oil bonds or provides cash subsidies. It is a little unfair to name the instruments issued as 'bonds' as the Government doesn't mop up any cash in lieu them. These are just a lame compensation for losses 'forced' on OMCs, encashable at a future date.

Oil bonds serve OMCs in two ways. The first is to earn interest on these bonds and get the face value of the bonds at maturity. The other option is to sell these bonds to a third party and get immediate cash. These oil bonds hardly help OMCs as the interest income is too small (and most of the time indefinitely delayed) to meet their day to day expenses. As far as the redemption of the bonds is concerned, it is dated far away in future. Even if the bonds are allowed to be traded, they sell at huge discounts (which we feel is fair since there is no asset generation from these bonds) and have very low liquidity. Ironically, the oil bonds are shown as an 'investments' in OMCs' balance sheet while in reality these are virtual compensation for real losses.

Hence, OMCs have to meet their expenses by taking high cost debt that leads to general interest rate hikes and crowds out the private investment. Lack of funds in time also cause delay in project execution for OMCs, leading to reduced profits and hence less tax collections for the Government that inflates fiscal deficit. Interest on the bonds is finally borne by public in the form of high tax payments.

The obvious reason to issue bonds instead of paying in cash is that there is no immediate cash outflow for the Government in former case. The not so obvious reason is that the oil bonds, which are a form of debt that Government owes to OMCs (or whosoever has these bonds) are kept off the financials of the Government. In other words, it does not get reflected in the fiscal deficit.

On the other hand, cash subsidies are actual outflows that and get accounted for in government's books. They are more transparent and serve the OMCs' cash needs better. Also, since they have an impact on fiscal accounts, the government is likely to be more careful is disbursing them. The practice will also force it to rationalize time and amount of subsidies on fuels apart from petrol.

However, the story doesn't end here. The switch is a huge concern for upstream sector. With crude oil prices at two year high, we will not be surprised if the Government passes more of subsidy burden to upstream sector. This will have an adverse effect on its profit margins. There are high chances that the decision will claw back as the Government intends to come up with an FPO for ONGC soon. With so many dilemmas and pending decisions, we are sure that year 2011 will be no less interesting for this sector.

Copyright © Equitymaster Agora Research Private Limited. All rights reserved.
Any act of copying, reproducing or distributing this newsletter whether wholly or in part, for any purpose without the permission of Equitymaster is strictly prohibited and shall be deemed to be copyright infringement.

LEGAL DISCLAIMER: Equitymaster Agora Research Private Limited (Research Analyst) bearing Registration No. INH000000537 (hereinafter referred as 'Equitymaster') is an independent equity research Company. Equitymaster is not an Investment Adviser. Information herein should be regarded as a resource only and should be used at one's own risk. This is not an offer to sell or solicitation to buy any securities and Equitymaster will not be liable for any losses incurred or investment(s) made or decisions taken/or not taken based on the information provided herein. Information contained herein does not constitute investment advice or a personal recommendation or take into account the particular investment objectives, financial situations, or needs of individual subscribers. Before acting on any recommendation, subscribers should consider whether it is suitable for their particular circumstances and, if necessary, seek an independent professional advice. This is not directed for access or use by anyone in a country, especially, USA, Canada or the European Union countries, where such use or access is unlawful or which may subject Equitymaster or its affiliates to any registration or licensing requirement. All content and information is provided on an 'As Is' basis by Equitymaster. Information herein is believed to be reliable but Equitymaster does not warrant its completeness or accuracy and expressly disclaims all warranties and conditions of any kind, whether express or implied. Equitymaster may hold shares in the company/ies discussed herein. As a condition to accessing Equitymaster content and website, you agree to our Terms and Conditions of Use, available here. The performance data quoted represents past performance and does not guarantee future results.

SEBI (Research Analysts) Regulations 2014, Registration No. INH000000537.

Equitymaster Agora Research Private Limited (Research Analyst)
103, Regent Chambers, Above Status Restaurant, Nariman Point, Mumbai - 400 021. India.
Telephone: +91-22-61434055. Fax: +91-22-22028550. Email: info@equitymaster.com. Website: www.equitymaster.com. CIN:U74999MH2007PTC175407