The sky-rocketing price of crude oil sparking increases in fuel prices back home is a complex economic issue. Some blame rising demand in India and China; many blame speculators. As the Al Jazeera video (above) shows the media has been caught on the wrong foot in explaining what is happening.

Bhamy V. Shenoy (below), who has worked in the Indian and international oil industry for 40 years, advised several governments in the former Soviet Union, and is now a senior advisor at the Center for Energy Economics at the University of Texas, Austin, says the situation is worse in India where the issue of fuel prices has become the pet poodle of populist politicians.

“While the international media blames India and China, we blame the government and our public and private sector companies. Truth is, the Indian government is transferring massive amounts of wealth through the vehicles of public sector oil companies to the rich and middle-classes by artificially keeping petrol, diesel and cooking gas prices below the cost price, and the intelligentisa is perfectly happy with this.

“This is what the British did during the Raj, allowing landlords to take over the land belongings of the poor. We are critical of the Raj. But we seem to support the strategy of new rulers who are doing the same but in a different way.“

***

By BHAMY V. SHENOY

The UPA government was finally forced to implement an increase in prices of petroleum products on June 5 as crude oil prices were setting a daily record. But it was too little, too late, and not well received. Worse, even after the price increases and adjustment to tax rates both by the central and state governments, oil marketing companies (OMCs) continue to bleed.

There is also enormous confusion in the minds of the public.

On the one hand, the view has gained ground that the oil companies are earning huge returns, as also the government. And, on the other hand, it has been suggested that the oil companies are not actually losing money; what they are suffering from is “under recoveries”.

Both views are far from the truth if we employ simple economics.

It is true that the state governments are indeed continuing to collect a higher amount despite the cosmetic adjustments. Just like the central government, it would be better for the state governments if they adopted fixed tax rates rather than continuing with ad valorem tax rates.

***

Since 2004 crude oil prices have had a gravity-defying rise. Experts had predicted prices would stay in a narrow range of $25 to $30 per barrel.

At the current high crude oil price of around $130 per barrel, US, Japan, Europe, China, India will transfer unprecedented amount of more than $1.5 trillion to Russia, Saudi Arabia, Iran, Venezuela and other OPEC countries in 2008.

This must be one of the largest transfers of wealth from richer to developing  countries during the peace time.

India’s share in this transfer is not insignificant.

Thanks to coalition politics, and mostly influenced by the communist parties, the oil sector is likely to transfer more than Rs 1,80,000 crore from the poor to rich and the middle-class this year.

In this game of distribution of wealth, oil marketing companies are being used by our political system to the benefit of a tiny sector consisting of petrol and LPG dealers, and their political masters.

Let me try to unravel the mystery behind petroleum product prices using the example of diesel.

At crude oil price of $120 per barrel, the raw material cost to make one litre of diesel is Rs 31.70. When crude oil is distilled in a refinery, along with diesel, subsidiary products like petrol, LPG, kerosene, fuel oil, etc are produced. Products like fuel oil are discounted. This results in most products like diesel, petrol and kerosene commanding a premium over crude oil.

At present, diesel is able to get a premium of Rs 6.63 per litre which reflects the refinery fuel cost, operating costs, and refinery margin. In addition, there is also the cost of transportation to move the diesel from the refinery to petrol stations and the dealer margin. This adds up to Rs 2.30 per litre.

Thus the total cost of supplying diesel is Rs 40.63 per litre without any taxes.

At the current diesel price of about Rs 37 per litre, oil marketing companies lose Rs 3.03 per litre straightaway. In addition they have to pay central excise and cess of Rs 3.57 and state sales tax of Rs 8.38 per litre. Thus, the total losses amounts to Rs 15.58 per litre.

Based on this level of product prices, the profitability of the refinery is Rs 0.37 per litre only and can hardly compensate for the huge loss incurred by the public sector oil companies. (In more sophisticated refineries like Reliance, the loss could be as high as Rs 4 per litre.)

Similar losses are incurred while selling petrol (Rs 5.5 per litre), kerosene (Rs 30 per litre), and LPG (more than Rs 330 per cylinder).

The government claim of the oil marketing companies losing as much as Rs 15 per litre is, therefore, not true.

***

Some political parties have argued that the government should impose windfall profit taxes on oil and gas production. This is a sound argument. But this will not have any impact on product prices.

Most of the oil production in India is by public sector companies and they are already forced to share their profit with oil marketing companies. Thus we already have indirect “windfall taxes” on Oil and Natural Gas Corporation (ONGC) and Oil India Limited (OIL).

Oil production by private oil companies is only about 14%.

***

It is a misconceived policy to siphon off the cashflow from ONGC and OIL to oil marketing companies or to the government treasury to support lower product prices. These upstream companies are tasked with the mission of exploring and finding crude oil and gas all over the world.

How can they meet those goals if their profits are taken away by the political masters?

They could have used the additional profits to look for oil and gas reserves to contribute to India’s energy security. As a result the oil companies are starved of much-needed investment.

In the case of private oil companies, if the Production Sharing Agreement terms had been properly structured using the right kind of expertise, windfall profits would indeed flow to the government. PSAs are a better vehicle to divert greater cash flow to host-countries as oil prices go up. It is not correct on the part of any government to break the contract though many oil exporting countries do it all the time.

The government has eliminated customs duty on crude oil import. This will not have any impact on product prices since the oil marketing companies are expected to pay refinery gate prices based on international equivalent prices. This will increase refinery profitability only.

Reducing customs duty on petrol and diesel will also have marginal impact since India is in surplus with both these products. India is a net exporter of petrol and diesel.

***

During the protests against petro price hike, there has hardly been any informed discussion on the real winners and losers of not responding to higher oil prices. All of us should realize that in one way or the other India has to pay for higher oil prices since more than 75% of crude oil is imported.

There is no free lunch; the Indian economy has to pay for the additional cost of importing crude oil.

There are three types of stakeholders who have to pay for the increase directly or indirectly. These three are: the rich and middle-class who own cars and two wheelers and who have an above-average energy consumption propensity; very poor and lower middle-class who consume very little energy; and petroleum product dealers and PDS shop owners.

The first category of stakeholders can easily pay for any increase; they are the ones who consumer petroleum products directly and indirectly.

The last category is an even surere bet since they will be able to continue to adulterate the product they sell with subsidized products like kerosene and by diverting residential LPG to commercial sector.

The fact of PDS kerosene being diverted to the free market or being used to adulterate petrol and diesel is well documented. The same is true with residential LPG. When the same product is sold at two vastly different prices, it is just impossible to eliminate black marketing of products.

It is the poor who are supposed to be the beneficiaries of the subsidy largesse; unfortunately, they are the real losers in several ways.

The poor not only do not get their quota of subsidised kerosene, they end up being the victims of greater inflation caused by a higher oil deficit. The poor also do not use petro products directly for sure. Even indirect use of petrol products by them is insignificant.

***

All over the world, in all developed and most developing countries petrol products are heavily taxed to meet the budgetary needs of the government. In India also this has been the policy so far. However since the oil crude oil price increase, the government has come under great pressure not only to reduce those taxes, but even to transfer funds from other sources. This will reduce the amount of money available to meet the welfare needs of the poor.

If the government had not taken over the responsibility of fixing oil prices when the administered price mechanism (APM) was dismantled, we would not have been in today’s difficult situation. Yes the country would have faced the problem of managing the problem of high crude oil prices as most countries are facing today in the rest of the world. But it would have been in a different way.

Oil marketing companies would have implemented the price changes as crude oil prices changed in the world and would not have waited as the government was forced to. They thought that they could avoid the problem should oil prices fall as they have done it in the past. Unfortunately it did not happen. Making quantum changes to a strategically important commodity like oil is extremely difficult.

It is high time that the government decides to hand over the responsibility of fixing product prices to oil companies as intended when APM was dismantled in 2002. This will help the government to concentrate on tax policy. It can then continue to assist the poor by distributing subsidised products through smart cards as recommended by the Planning Commission.

Also read: CHURUMURI POLL: Is the Dream Team exposed?