By Diyat Rungta
Edited by, Anandita Malhotra, Senior Editor, The Indian Economist
Given diesel’s pre-eminence as the blood of the Indian economy, and the recent measures by the central government to deregulate diesel prices, this article aims to shed light on the system of under recoveries that existed till now, and the expected benefits from the diesel deregulation.
To begin with, let us first understand the relation between the state run Oil Marketing Companies (HPCL, BPCL and IOC) and the government. The OMCs import crude oil as the raw material (around 80% of total requirement is imported), and process it in domestic refiners into 3 main products, namely diesel, LPG and kerosene. Up until now, the government would regulate the prices of sale of the three main petroleum products, which more often than not stood at lower than break-even. The under recoveries calculated on the sale for each year, would then be shared by the government, oil PSUs and upstream companies (which are responsible for extraction of crude oil in India). The government’s share in paying off under recovery on sale diesel is what we call diesel subsidy. This amount would be paid every 3-6 months to the OMCs, often leading to cash flow issues for the OMCs.
Factors leading to deregulation
The BJP has been lucky in some sense and has seized the opportunity to deregulate prices, with the current fall in crude prices having perfectly complimented the UPA’s move to gradually increase diesel prices in January 2013.
Global crude prices, which in 2008 stood at 150$, have fallen to 85$, primarily due to a rapid increase in non-OPEC countries, as well as resurgence in production in middle-east countries after prolonged unfavorable geopolitical conditions. USA has seen a shale oil boom owing to techniques like fracking and horizontal drilling, and is supplying oil at the fastest rate in three decades. Russia, Brazil and Gulf of Mexico are also expected to produce at all time highs soon. Along with these factors, demand in previously heavy users like China and Germany have also seen a dip.
In January 2013, the then UPA government had placed a regime to increment prices of diesel by 50 paise/litre for the next 20 months. A little more than 20 months down the line, the retail price of diesel are now at international rates. Last quarter, state own OMCs posted profits for the first time in their history. The under recoveries on diesel, which were as high as Rs. 10.48 / litre in December 2013, ran into over recoveries of over Rs. 3/litre a few weeks back until the recent cut back.
The curious system of under recoveries
Under recoveries, are often loosely regarded as the losses obtained on diesel sales in India. The primary difference is that under recovery is a notional loss, or a kind of opportunity cost of supplying diesel at regulated rates. The government would set a desired price, known as trade parity rate. This would be the higher end price required to sell diesel to make profits. However the catch is that there is a significant percentage of diesel sales which utilize domestically produced crude oil, and do not cost as much as the desired price to producers of oil products.
The system of under recovery has been controversial to say the least, with some serious loopholes. Now that deregulations are in place, they system of under recovery will naturally be done away with.
The CAG, in its audit report submitted in July this year on ‘Pricing Mechanism of Major Petroleum Products in Central Public Sector Oil Marketing Companies’, stated that prices of petrol, diesel, domestic LPG and kerosene were calculated by adding elements such as customs duty, freight, insurance, ocean loss charge to prevailing international price of these products. The fact remains that the OMCs do not incur bulk of these expenses as majority of the products are processed in OMC refineries, rather being imported. The current trade parity pricing method of calculating under-recoveries, also assigns an 80 per cent weight to refined product imports as compared to 20 per cent weight to exports, which clearly is not the case.
Furthermore, the distribution of under recoveries between the government, OMCs and the upstream companies is not explicitly stated in advance. Thus, by paying significantly more than required, the government was simply adding on the inefficiencies to final consumers either directly though higher pricing, or through increased subsidies.
Expected Benefits from the deregulation
Now that diesel has been deregulated, it has become like just another product in the open market, say a T-shirt. The OMCs that have been functioning as a cartel for long will see private players like Reliance and Esaar as serious competitors in the frame. The private players were forced to shut operations around 2008 when crude prices soared to 150$/barrel, making sale at regulated prices economically infeasible. Efficiency in production, and effective marketing by OMCs will have to be incorporated. Under the controversial under recoveries system, the state run OMCs had been indirectly covering the inefficiencies. With the government out of the frame, and competition from more players, PSU companies will have to ramp up their refining processes to lower costs.
The working capital required by these OMCs will also reduced. In status quo, the government would compensate them with a lag of around 6 months, and often it would be through oil bonds that the companies sold to public to a discount. The time lag would also force OMCs to take loans to maintain liquidity, leading to high interest costs. During the periods 2007-08 and 2011-12, OMCs borrowed working capital and suffered an interest loss of Rs.5180 crore and sold bonds at a discount suffering a loss of Rs.3994 crore.
There is also going to be a massive fall in the fiscal deficit by virtue of reduction in government subsidy. While the government spent almost Rs. 62 billion in the previous fiscal as diesel subsidies according to credit rating agency ICRA, the expected amount for this year is Rs 15 billion. At the current rates, there will be no diesel subsidy for the following fiscal. Price inflation will further be in control with the government on track to achieve a 4.1% fiscal deficit coupled with falling diesel prices.
To sum up, the government has made the most of the opportune situation by bringing in a much-needed reform. However, it still remains to see whether the fall in crude prices is temporary or here to stay for a long time. A sudden shoot in prices of crude oil may well test the government’s willingness to intervene as a populist measure. After all it is the NDA government that had introduced deregulation of diesel in 2002, only to allow administered pricing back in early 2004 with crude prices rising and the general elections a few months ahead.
Divyat Rungta is currently a second year student pursuing B.A Economic (Hons) in Shri Ram College of Commerce. He is a die-hard sports lover and enjoys listening to Indie music. He has been deeply influenced by his parents, teachers, and the Indian Army! As a member of Enactus SRCC, he spends a lot of time working on social entrepreneurship projects undertaken by the team. Having the opportunity to interact with various communities and give them a sustainable livelihood has made a huge impact in his personal life. He strongly believes the student community has the responsibility of shaping a new India, and wants to make a significant contribution to it.