MacroScan (Printable Version) - The Oil Conundrum

With international oil prices rising rapidly, crossing the $135-a-barrel mark and heading, according to some predictions, towards even $200-a-barrel, the oil economy has become a prime cause of concern for the government. The weighted average price of the basket of crudes imported by India has risen to $125.28 a barrel as compared with $30 plus-a-barrel four years back and $60 plus-a-barrel just two years ago. Such large and quick increases have resulted in a sharp divergence between the domestic prices of oil products set by the government and the international prices at which imports are being made.

This divergence many would argue is unavoidable. The sheer magnitude of the increase in international prices makes it foolish to argue that domestic prices should be adjusted upwards to cover much or all of the increase. Oil is a universal intermediate and a price increase of that magnitude would have direct and second-order effects that would transform the current inflation into a veritable inflationary crisis.

On the other hand, if prices are not increased and little else is done the burden of adjustment is transferred onto the oil companies that receive much less per litre on sales of petroleum products than the costs they incur in importing the crude and refining them to obtain those products. While estimates vary, projections of losses that would be incurred on this account by the three oil marketing companies (Indian Oil Corporation, Hindustan Petroleum Corporation Limited and Bharat Petroleum Corporation Limited) during the current fiscal year go up to as much as Rs, 2,00,000 crore, as compared with Rs.77,000 crore last year. If they are not compensated in some way, their viability is clearly at stake.

It needs to be noted that not all oil companies are faced with this difficulty. Those that have access to reserves and are in a position to extract oil for export before or after refining, would be making substantial profits as the selling price of oil products soars relative to their cost of production. Even in India there are companies that benefit thus in the current situation, though the fact that India imports much of the oil products it consumes, makes the divergence between international and domestic prices more of an issue here. Maintaining a differential between domestic and international prices is easy only in countries that are self-sufficient in oil. On the other hand, in countries that are dependent on imports of oil the real issue is the way in which the gap between domestic and international prices can be financed.

This conundrum indicates that in import-dependent contexts policies relating to the oil economy must be innovative. In fact, recent trends in global oil prices make clear that given the array of factors, economic and geopolitical, that influence these prices, no country can adopt the simplistic view that domestic oil prices must be aligned with international prices. Put differently, the domestic price of oil cannot be set at levels that recover the costs of import, since those costs are too volatile and rising. Rather the domestic price should be set on the premise that it is one element in a tax-cum-subsidy framework, with the price serving as part tax when international oil prices are unduly low, and part subsidy when international oil prices are as high as they are today.

It is the refusal of the government to adopt this position that partly accounts for the current crisis. That attitude stems from two sources, with contradictory motivations. The first is the ideologically-driven and ill-advised decision to move away from a regime of administered prices to one in which prices are aligned to those signalled by international markets. The decision to opt out of the administered price mechanism for oil was adopted as part of the reform, but the government has been hard put to implement that decision in practice. All it has managed to do is to transfer the burden or benefit of differentials between the international and domestic price of oil from a specialised facility to the oil marketing companies themselves.

The second reason why the government has been unwilling to treat the oil price as an instrument of its tax-cum-subsidy regime, is that the Finance Ministry has gained much from treating the prices of oil products as values on which indirect taxes of various kinds can be levied. This has made the petroleum sector a cash cow that yields large revenues in the form of customs duties and excise duties. What is more since these duties were specified as ad valorem rates proportional to the value of the commodity being taxed, revenues garnered from taxation rose along with the increase in the international and domestic prices of the commodity. (It is only in the the last budget that the Finance Ministry partly replaced the ad valorem duty with specific rates of duty on “unbranded” petrol and diesel whose share in total consumption is on the decline.)

The use of oil, especially autofuels, as a source of tax revenues has meant that the retail price of petrol and diesel includes a substantial duty component. Petrol and diesel imports are subject to a customs duty of 7.5 per cent and the tax component in the retail selling price of these two commodities is placed at 53 and 34 per cent respectively. As a result in 2006-07, out of the proceeds from sales of petroleum products at the retail level, as much as Rs.10,043 crore accrued to the government as revenues from customs duty and another Rs.58,821 crore as revenue from excise duty. If the government had chosen to forego this revenue, but the retail price had been kept at its earlier tax-inclusive level, the “underecoveries” of the oil marketing companies would have been much less. Small upward adjustments of price would have been adequate to fully compensate the oil marketing companies. Further, in the long run, since there would be periods when the oil marketing companies would earn large surpluses because international prices rule low but domestic prices are held stable, part of the adjustment could come from inter-temporal transfers of past surpluses to finance current deficits.

Finally, even if increases in global oil prices are persistent as they have been in recent times, the government, if it treats oil prices as one instrument in its tax-cum-subsidy regime, could choose to mobilise revenues from taxes imposed elsewhere in the system and compensate the oil marketing companies, so as to ensure their viability even when retail prices are held constant. One source of such revenues could be the superprofits garnered by the upstream oil companies (including private ones) involved in production and refining of oil. But if the Finance Ministry chooses to treat the petroleum sector as a cash cow and exploit increases in prices to garner additional revenues which it then presents as evidence of successful resource mobilisation, such a strategy cannot be pursued.

These conflicts between the interests of the Finance Ministry, the Oil Marketing Companies, the consumer and the ideologues of reform was indeed recognised by the Rangarajan Committee which was set up to examine the oil pricing conundrum in an environment of liberalised pricing. Based on its analysis of different stages of the oil pricing chain, the committee concluded that the burden resulting from any persistent increase in international oil prices should be shared by the upstream oil companies and refineries, which receive prices that more than compensate for costs; the central government which garners revenues in the form of customs duties and excise duties (besides dividends from the oil majors); the state governments which benefit from sales taxes; and the consumer, shielded partially from the full impact of international prices.

The committee had much to say on the principles that should govern how the burden should be shared. Given its period of analysis the committee found that the upstream oil companies (or oil companies other than the oil marketing companies, such as ONGC, OIL and GAIL) had recorded profits to the tune of Rs. 15,600 core in 2004-05 and Rs. 14,600 crore in the first nine months of 2005-06. That the oil industry’s contribution to the central exchequer in terms of duties, taxes, royalty, dividends etc. rose from Rs. 64,595 crore in 2002-03 to Rs. 77,692 crore in 2004-05. That the petroleum sector alone contributed around two-fifths of the total net excise revenues of the Centre. That taking Delhi as an example, central and state taxes amounted to 38 and 17 per cent respectively of the retail price of petrol and 23 and 11 per cent respectively of diesel. And that the incidence of taxes as a proportion of the retail price in India was, higher than in the US, Canada, Pakistan, Nepal, Bangladesh and Sri Lanka, though they were lower than in many countries in Europe known for their higher average level of prices.

This analysis suggested that there was an adequate buffer to shield domestic consumers from the effects of the increase in international prices, so long as segments that can afford to take a cut in petroleum-related revenues because they have alternative sources of resource mobilisation are willing to accept such a reduction. Even though the recent increase in oil prices is too large for the burden to be shouldered by any one segment involved, it is clear that if the Centre is willing to forego a large part of the revenues it has been milking out of the petroleum sector, prices need only be marginally increased if the oil companies are to be adequately compensated.

Further, if the government is willing to compensate the oil companies with resources mobilised through taxes that fall on those who can afford to pay rather than through an increase in the prices of oil that burden rich and poor alike, prices can be still held constant at least till such time as the current inflationary situation is brought under control. But to do this the government needs to give up the view that petroleum product prices should be determined by “market forces”, on which the Finance Ministry can conveniently impose taxes for revenue generation purposes. Rather petroleum prices should be seen as a tax, the use of which should be gauged relative to other options that are available. But that may require taxing precisely those well-to-do sections that the Finance Ministry has protected for long in the name of incentivising private savings and investment.

There is, however, some hope. The fact that this is an election year at both state and central levels, that inflation is already a major problem confronting the government, and that both the government’s allies and the opposition have hardened their stand, is forcing a rethink. Some right decisions may be made, even if not out of conviction.



Themes > Current Issues	17.07.2008


The Oil Conundrum

C.P. Chandrasekhar

With international oil prices rising rapidly, crossing the $135-a-barrel mark and heading, according to some predictions, towards even $200-a-barrel, the oil economy has become a prime cause of concern for the government. The weighted average price of the basket of crudes imported by India has risen to $125.28 a barrel as compared with $30 plus-a-barrel four years back and $60 plus-a-barrel just two years ago. Such large and quick increases have resulted in a sharp divergence between the domestic prices of oil products set by the government and the international prices at which imports are being made. This divergence many would argue is unavoidable. The sheer magnitude of the increase in international prices makes it foolish to argue that domestic prices should be adjusted upwards to cover much or all of the increase. Oil is a universal intermediate and a price increase of that magnitude would have direct and second-order effects that would transform the current inflation into a veritable inflationary crisis. On the other hand, if prices are not increased and little else is done the burden of adjustment is transferred onto the oil companies that receive much less per litre on sales of petroleum products than the costs they incur in importing the crude and refining them to obtain those products. While estimates vary, projections of losses that would be incurred on this account by the three oil marketing companies (Indian Oil Corporation, Hindustan Petroleum Corporation Limited and Bharat Petroleum Corporation Limited) during the current fiscal year go up to as much as Rs, 2,00,000 crore, as compared with Rs.77,000 crore last year. If they are not compensated in some way, their viability is clearly at stake. It needs to be noted that not all oil companies are faced with this difficulty. Those that have access to reserves and are in a position to extract oil for export before or after refining, would be making substantial profits as the selling price of oil products soars relative to their cost of production. Even in India there are companies that benefit thus in the current situation, though the fact that India imports much of the oil products it consumes, makes the divergence between international and domestic prices more of an issue here. Maintaining a differential between domestic and international prices is easy only in countries that are self-sufficient in oil. On the other hand, in countries that are dependent on imports of oil the real issue is the way in which the gap between domestic and international prices can be financed. This conundrum indicates that in import-dependent contexts policies relating to the oil economy must be innovative. In fact, recent trends in global oil prices make clear that given the array of factors, economic and geopolitical, that influence these prices, no country can adopt the simplistic view that domestic oil prices must be aligned with international prices. Put differently, the domestic price of oil cannot be set at levels that recover the costs of import, since those costs are too volatile and rising. Rather the domestic price should be set on the premise that it is one element in a tax-cum-subsidy framework, with the price serving as part tax when international oil prices are unduly low, and part subsidy when international oil prices are as high as they are today. It is the refusal of the government to adopt this position that partly accounts for the current crisis. That attitude stems from two sources, with contradictory motivations. The first is the ideologically-driven and ill-advised decision to move away from a regime of administered prices to one in which prices are aligned to those signalled by international markets. The decision to opt out of the administered price mechanism for oil was adopted as part of the reform, but the government has been hard put to implement that decision in practice. All it has managed to do is to transfer the burden or benefit of differentials between the international and domestic price of oil from a specialised facility to the oil marketing companies themselves. The second reason why the government has been unwilling to treat the oil price as an instrument of its tax-cum-subsidy regime, is that the Finance Ministry has gained much from treating the prices of oil products as values on which indirect taxes of various kinds can be levied. This has made the petroleum sector a cash cow that yields large revenues in the form of customs duties and excise duties. What is more since these duties were specified as ad valorem rates proportional to the value of the commodity being taxed, revenues garnered from taxation rose along with the increase in the international and domestic prices of the commodity. (It is only in the the last budget that the Finance Ministry partly replaced the ad valorem duty with specific rates of duty on “unbranded” petrol and diesel whose share in total consumption is on the decline.) The use of oil, especially autofuels, as a source of tax revenues has meant that the retail price of petrol and diesel includes a substantial duty component. Petrol and diesel imports are subject to a customs duty of 7.5 per cent and the tax component in the retail selling price of these two commodities is placed at 53 and 34 per cent respectively. As a result in 2006-07, out of the proceeds from sales of petroleum products at the retail level, as much as Rs.10,043 crore accrued to the government as revenues from customs duty and another Rs.58,821 crore as revenue from excise duty. If the government had chosen to forego this revenue, but the retail price had been kept at its earlier tax-inclusive level, the “underecoveries” of the oil marketing companies would have been much less. Small upward adjustments of price would have been adequate to fully compensate the oil marketing companies. Further, in the long run, since there would be periods when the oil marketing companies would earn large surpluses because international prices rule low but domestic prices are held stable, part of the adjustment could come from inter-temporal transfers of past surpluses to finance current deficits. Finally, even if increases in global oil prices are persistent as they have been in recent times, the government, if it treats oil prices as one instrument in its tax-cum-subsidy regime, could choose to mobilise revenues from taxes imposed elsewhere in the system and compensate the oil marketing companies, so as to ensure their viability even when retail prices are held constant. One source of such revenues could be the superprofits garnered by the upstream oil companies (including private ones) involved in production and refining of oil. But if the Finance Ministry chooses to treat the petroleum sector as a cash cow and exploit increases in prices to garner additional revenues which it then presents as evidence of successful resource mobilisation, such a strategy cannot be pursued. These conflicts between the interests of the Finance Ministry, the Oil Marketing Companies, the consumer and the ideologues of reform was indeed recognised by the Rangarajan Committee which was set up to examine the oil pricing conundrum in an environment of liberalised pricing. Based on its analysis of different stages of the oil pricing chain, the committee concluded that the burden resulting from any persistent increase in international oil prices should be shared by the upstream oil companies and refineries, which receive prices that more than compensate for costs; the central government which garners revenues in the form of customs duties and excise duties (besides dividends from the oil majors); the state governments which benefit from sales taxes; and the consumer, shielded partially from the full impact of international prices. The committee had much to say on the principles that should govern how the burden should be shared. Given its period of analysis the committee found that the upstream oil companies (or oil companies other than the oil marketing companies, such as ONGC, OIL and GAIL) had recorded profits to the tune of Rs. 15,600 core in 2004-05 and Rs. 14,600 crore in the first nine months of 2005-06. That the oil industry’s contribution to the central exchequer in terms of duties, taxes, royalty, dividends etc. rose from Rs. 64,595 crore in 2002-03 to Rs. 77,692 crore in 2004-05. That the petroleum sector alone contributed around two-fifths of the total net excise revenues of the Centre. That taking Delhi as an example, central and state taxes amounted to 38 and 17 per cent respectively of the retail price of petrol and 23 and 11 per cent respectively of diesel. And that the incidence of taxes as a proportion of the retail price in India was, higher than in the US, Canada, Pakistan, Nepal, Bangladesh and Sri Lanka, though they were lower than in many countries in Europe known for their higher average level of prices. This analysis suggested that there was an adequate buffer to shield domestic consumers from the effects of the increase in international prices, so long as segments that can afford to take a cut in petroleum-related revenues because they have alternative sources of resource mobilisation are willing to accept such a reduction. Even though the recent increase in oil prices is too large for the burden to be shouldered by any one segment involved, it is clear that if the Centre is willing to forego a large part of the revenues it has been milking out of the petroleum sector, prices need only be marginally increased if the oil companies are to be adequately compensated. Further, if the government is willing to compensate the oil companies with resources mobilised through taxes that fall on those who can afford to pay rather than through an increase in the prices of oil that burden rich and poor alike, prices can be still held constant at least till such time as the current inflationary situation is brought under control. But to do this the government needs to give up the view that petroleum product prices should be determined by “market forces”, on which the Finance Ministry can conveniently impose taxes for revenue generation purposes. Rather petroleum prices should be seen as a tax, the use of which should be gauged relative to other options that are available. But that may require taxing precisely those well-to-do sections that the Finance Ministry has protected for long in the name of incentivising private savings and investment. There is, however, some hope. The fact that this is an election year at both state and central levels, that inflation is already a major problem confronting the government, and that both the government’s allies and the opposition have hardened their stand, is forcing a rethink. Some right decisions may be made, even if not out of conviction.



© MACROSCAN 2008