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October 13, 1999


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Devangshu Datta

Caught In The Oil Slick

For fifty years any resemblance between the domestic Indian prices of petro-products and the prevailing international prices has been merely coincidental. This has now led to a classic set of problems for the new National Democratic Alliance government, which inherits this absurdity.

The day the polls ended, the price of diesel was hiked by 40 percent. Since April, when the price was last reviewed, international diesel prices have risen 70 per cent. So the Indian economy ought to have been braced for a hike and, as hikes go, this is moderate. True, it's a vital commodity. Ok, a rise in diesel prices will add perhaps one per cent onto the wholesale price index (quick estimates are 0.8 per cent of WPI).

But what's the alternative? We've been lucky for the past five years while global prices stayed depressed. And inflation right now is low enough for the economy to sustain the shock. That logic hasn't stopped NDA ally Om Prakash Chautala of the Haryana-based Indian National Lok Dal demanding a rollback even before the government was sworn in. His party expects the government to spend an extra Rs 6,600 crore on the diesel account by holding the price at the current level.

Just how did the government get into this absurd situation anyhow? Well, the fifty-year tradition of controlling oil prices is kind of strange given that India isn't a primary producer with a surplus like Saudi Arabia. After all, when you import over 60 per cent of your requirements, you have to pay what the producers demand.

Of course, inherent absurdity hasn't stopped India from trying to control prices. Diesel, kerosene, LPG and several other petro-products are all controlled by means of something called the Administered Pricing Mechanism (APM). The APM is supposed to be dismantled by April 2002, after which these prices will align automatically to global levels (plus taxes).

There is more absurdity piled on the first basic absurdity. Petrol and aviation turbine fuel (ATF) is heavily over-priced in the APM. This is supposedly to enable diesel and kerosene to be heavily subsidised. The theory is that well-heeled car-owners and airline-passengers will pay for the poor. The reality is that eight litres of diesel are consumed for every litre of petrol; cheap kerosene is used to adulterate expensive petrol; there is a perennial kerosene shortage and a thriving blackmarket; and diesel vehicles are sold at premiums because of fuel cost differentials.

Because of the diesel-petrol consumption ratio, there is a perennial outflow on the Oil-Pool Account. So there are two problems related to the energy sector. The first is that India is a net oil importer, which means pressure on forex reserves. The second is that the government loses money on every litre of diesel and kerosene consumed.

Given the state of sarkari finances, these aren't problems that India can live with for much longer. The fiscal deficit could just skyrocket out of control and our Balance of Payments (BOP) could also deteriorate if global prices stay high. The combined effect of a rising fiscal deficit and a worsening BOP is potentially much worse than that of a hike in the price of just one economic input.

Let us indulge in a thought experiment. What would happen if the government immediately decontrolled all petro-prices? Diesel and kerosene prices would rise, while the price of petrol and ATF would both decline. The obvious beneficiaries would be the refiners. A rupee hike in diesel prices versus a rupee decline in petrol prices equals seven extra rupees. The consumption ratio would probably start to align closer to worldwide norms, which are closer to 4:1. This would take care of the internal oil-pool deficit and pressure on the fiscal, from this sector at least, would cease.

To understand the forex situation, we must factor another interesting detail into this thought experiment. By the end of the year, India will be a net exporter of diesel, motor spirits, petrol and other refined products. This year, according to the Oil Coordination Committee reckoning, exports will hit 2.5 million tonnes. Already, between Indian Oil, Hindustan Petroleum, Bharat Petroleum, Reliance Petroleum and several smaller players, India has excess refining capacity. The surplus should grow. Domestic demand is rising at around 7-8 million tonnes per annum but 45 mtpa of additional refinery capacity comes on-stream in the next two years.

By 2002, Essar Oil (assuming help from bailouts) will have another 24.5 mtpa on-stream; IOC will have 20 mtpa more. By 2002, the entire oil-pool balance will change because of this surplus capacity. By 2002, India will be an importer of 113-118 mtpa of crude and a net exporter of 15-20 mtpa of value-added products. Even with low refining margins, forex outflows will not be a serious problem.

Going further, with surpluses and competition, price decontrols would not lead to profiteering. Kerosene would become freely available and actual retail prices would decline. The quality of fuels would improve with less adulteration. On the other hand, if prices are not decontrolled, you will see the further absurdity of Indian companies pushing exports where they get higher prices, while ignoring domestic demand. So let's hope that the government accelerates the dismantling of the APM. It stands to gain on every count.

Even if APM is not dismantled ahead of schedule, there are obvious plays now available in the energy sector. IOC, BPCL, HPCL and Reliance Petroleum are all absurdly under-priced at current levels. They have ridiculously low earnings and cash earning discounts of 2-3 on average. If you assume a conservative 300-500 per cent growth in earnings starting 2002 when APM goes, then the values are positively mouth-watering. There are also interesting plays available in oil-exploration though these are more complex and require a gambler's judgment. And what about Essar Oil? The company is steeped in debt but there is bound to be a bailout.

In the interests of political expediency, the new government may be forced to review the diesel hike. I hope not, but it could happen. In that case, the investor will have to patiently hold onto energy and refinery stocks for another year. But that is the outside timeframe for easing controls on this vital sector. The build-up of refinery capacity has to a large extent been dictated by anticipation of APM dismantling. It has been financed substantially by Indian Financial Institutions. Indian PSUs stand to gain just as much as Reliance Petroleum and Essar Oil. Let's hope they can collectively lobby some sense into the government.

Devangshu Datta

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