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Oil price deregulation: Will it benefit consumers or suppliers?

The second term of the UPA government is burdened from the high expectations of oil marketing companies, since the oil sector reforms are said to be a top agenda for the Dr Manmohan Singh led government. News report suggests that the government would be initiating strong measures to introduce reforms in the pricing of petroleum products. After the successful first term (tenure) in the petroleum ministry, Petroleum Minister, Murli Deora, has set forth 6-8 weeks for possible action on the various issues facing the oil sector.

Industry observer feels that in spite of the various positive feelers, it remains to be seen whether the reforms are a substitute arrangement for the long impending structural problem of oil subsidies in the country or prove to be a change in move for the sector. However, given the current unplanned nature of subsidy-sharing, it would be interesting to ascertain who are likely to be the key beneficiaries of the proposed reforms i.e. whether it will lead to improvement in the earnings of the Oil Marketing Companies (OMCs) or upstream segment or government finances?

De-regulation of Retail prices - How long will it work?

A senior official from Bharat Petroleum Corporation Ltd said that this is not the first attempt by the government to de-regulate petroleum product prices. In April 2002, in an attempt to phase out subsidy on petroleum products, the government dismantled the administered pricing mechanism (APM) paving the way for free pricing mechanism for petrol and diesel, while prices of kerosene and LPG were still kept under the Regulator's purview.”

During 2002, the government gave limited freedom to the OMCs to revise retail prices within a band of +/-10% of the mean of rolling average of the last 12 months and the last 3 months international cost and freight prices. In case of violation of the band, the matter had to be taken up with the Ministry of Finance for modulation in Excise duty rates. “Oil companies were given some freedom to determine the prices based on the international petroleum market. However, the euphoria of dismantling was short-lived,” said an official from state-owned oil corporation.

He said, “When the crude prices began to increase in 2004 and oil companies wanted to pass on the same, but the government interference halted the free pricing of petrol and diesel.” Thus, the past record of implementation of the pricing reforms has not been very impressive.

Pre-requisites for successful implementation of price de-regulation

Successful implementation of de-regulation of subsidized products hinges on following factors:

Stability in crude prices:

Stability in crude prices is a prime requirement for successful implementation of price de-regulation, a technical analyst foresees. However, historical evidence as well as current news reports indicates that price de-regulation will be allowed with certain price bands. So, in the current scenario of volatile crude and product prices, successful continuation of the any possible price deregulation might not be easy.

It may be noted here that post the sharp correction in crude oil prices from US $147 per barrel (bbl) to a low of around US $32 per barrel last year, it has once again bounced back significantly and currently hovering in excess of US $65 per barrel. “Volatility in crude prices is still not behind us, and the government might follow the wait and watch policy before taking a stand over price de-regulation,” he said.

Angel Broking, a domestic broking firm, believe that the crude oil prices are likely to average at US $55/bbl and US $60/bbl in the current and next financial year, which is lower than the estimated cap of US $75/bbl for the free pricing of products. This in turn provides an ideal scenario for de-regulation of the subsidized petroleum product prices.

Stable and lower product cracks of subsidised products:

If recalled, the last fiscal proved to be a nightmare for the OMCs due to substantially higher under-recoveries. Increase in the crude oil price has been the spoil sport. However, it may be recalled that in the past prices of key subsidised products, viz. diesel and kerosene had significantly appreciated higher than their historical levels due to substantially higher product cracks. The increase, which generally tends to be in the range of US $10-12/bbl shot up significantly and added fuel to fire.

However, on account of the ongoing global slowdown, the cracks of diesel and kerosene have declined substantially and are likely to remain under pressure going forward on account of addition of significant refining capacity. “If the cracks remain subdued in line with our expectations, it would result in lower refining profitability for the OMCs. Thus, cracks prove to be a double-whammy as on the one hand while it hurts the marketing operations when they are high and boosts refining, on the other, when they are low it boosts profitability of the marketing operations and dents the refining profitability,” said an official from another state owned oil corporation.

Stable and reform-oriented government:

Industry analysts observe that successful implementation of the pricing reforms requires stable and reform-oriented government. Fortunately, this time around, it seems to be in place. “However, in spite of being a stable government, the UPA is a coalition government with the DMK and TMC as its key allies. With both Tamil Nadu and West Bengal likely to hold Assembly elections in 2011, we believe that the Congress will find it tough to persuade its key allies for the pricing reforms,” said industry analysts.

Moreover, with elections likely to take place in some state or the other every year, complete de-regulation without the price bands is quite unlikely. Moreover, full de-regulation of the subsidized product prices goes against the image of the Congress, as a representative of the “Aam - Aadmi”.

“We do not rule out the possibility of partial price decontrol of transport fuels, but we still continue to believe that partial decontrol within the bands is unlikely to provide solution to the long impending structural problem of under-recoveries for the Indian OMCs as the underlying variables involved in the price determination are volatile in nature,” a source from Ministry of Petroleum and Natural Gas said.

The subsidy burden (without considering the case for de-regulation) for FY2010 and FY2011 is to result in under-recoveries of Rs 15,182 crore and Rs 39,140 crore, respectively. In terms of composition, FY2010 subsidy constitutes only cooking fuel, while in FY2011 almost 3/4th of the subsidy would comprise cooking fuels. Thus, subsidy on auto fuel does not form a major chunk of the overall subsidy burden for companies even if it exists. Thus, possible de-regulation would not lead to material reduction in the overall subsidy burden for the Sector.

Subsidy-sharing structure holds the key

A officer from state owned oil company said, “We believe that possible de-regulation will certainly have some effect on the position of under-recoveries going ahead. However, the possible beneficiary of price de-regulation still needs to be ascertained.” The likely beneficiaries of possible price de-regulation are expected to be determined on the basis of the subsidy-sharing structure between the various stakeholders, viz. the government (via oil bonds), upstream companies (viz. discount on crude and products sold) and the OMCs.

Historically, the trend in sharing of subsidy burden seems to be missing with the subsidy between various parties shared in an ad-hoc manner. For instance, the share of OMCs has fluctuated between 0 - 71%.

The sharing structure of the last fiscal was seen as an exception wherein the government and upstream companies took the burden of the subsidy as the OMCs were unable to share the load on account of huge inventory losses and weak refining fundamentals. Thus, we believe that the OMCs will continue to share the burden on subsidized products. Overall, in spite of the ad-hoc subsidy sharing structure, one can gauge the government's intent to keep the OMCs profitable to maintain their credit rating and normal functioning.

Given the fact that losses on cooking fuel are likely to remain high on account of non-revision in their prices, as mentioned earlier, the resultant under-recovery on the account of this is likely to be high for the OMCs. Thus, earnings of the OMCs will continue to be highly dependent on receipts from the government by way of oil bonds and upstream discounts. Thus, in spite of all the hype over de-regulation of the auto fuel prices, earnings visibility for the OMCs remains low.

We believe that with things unlikely to change in the coming years, oil bonds and upstream discounts would continue to remain critical for the OMCs due to the large losses in the cooking fuel segment and thus, re-rating of these stocks fundamentally appears low. Nonetheless, though it is easier to believe that the Upstream Segment is likely share around 33% of the gross under-recoveries, predicting the extent of oil bonds is tricky.

The government is likely to be the key beneficiary on the account of de-regulation of the subsidized auto fuel prices. The government could retain the benefits of the pricing reforms by lower issuance of oil bonds to the OMCs in FY2010 and FY2011, especially considering the problems it faces on the fiscal deficit front. “Thus, in spite of the partial pricing reforms, we expect neither the earnings nor the visibility associated with it likely to improve for the OMCs,” said a brokerage firm.

However, the pricing reforms will improve the cash flows of the OMCs, to an extent, as earnings will be substituted with cash profits instead of oil bonds. In a non-deregulated scenario, industry observers 33% subsidy sharing mechanism by upstream, 50% by government and the rest (17%) by OMCs for sharing under-recoveries for FY2010 and FY2011. For FY2010, if the partial de-regulation were to take place and the government reduces the proportion of oil bonds to 50% or less with the upstream companies maintain their share of 33% of gross under- recovery, the OMCs would earn lower profits than in case of non-de-regulation scenario. Similarly, for FY2011, if the oil bonds were to be issued to the tune of around 44% or lower, profits would be lower than in case of non-de-regulated scenario.

Thus, the extent of the oil bonds issued will determine the fate of the OMCs going ahead.

About the Author

Hi i am Vikas.I am associated with EPC World Magazine. I writes on sectors like ,oil and gas Aviation Industry mining and metals, for the last couple of years.

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