The Hindu Business Line : An alternative oil pricing strategy

Given the need to set prices in a transparent and simple manner, an alternative way could be to fix a base price and then extrapolate it by the monthly/quarterly crude price (of the Indian basket).

Bhanoji Rao Bhanoji Rao

Effective February 14-15, the long ‘awaited’ increase in the prices of petrol and diesel was brought about — roughly a 4 per cent hike in the case of petrol. There was unanimity among political parties in opposing the hike.

The hike, however, is modest in relation to what the oil companies needed to break even. In the case of Indian Oil, for instance, it was reported in early January that a hike of Rs 8-9 per litre would only partly offset the gap between “the controlled retail prices and the high international prices of crude petroleum.”

Price gap

Given that crude oil accounts for some 90 per cent of the cost of production of refined petroleum produtcs, it is to be expected that crude and retail product prices move in tandem. However, the Indian retail prices are not fully reflective of the changes in crude prices, as the data in Table 1 demonstrate.

If we go by the 2002 and 2008 prices changes, the application of the price relative for crude (106.27/23.22) would imply a present Indian retail price of 4.58 times the price in 2002, or a little less than Rs 140, which is way above the current Rs 50.51.

Despite the Government announcement to dismantle the Administered Price Mechanism (APM) effective April 2002, subsidies on Public Distribution System (PDS) kerosene and domestic LPG continue.

The products are assumed to be largely consumed by the “economically weaker sections of society”, though in reality leakages abound. The subsidies were to be phased out in 3-5 years.

In the meantime, the Oil Marketing Companies (OMCs) were to adjust retail selling prices gradually in line with international prices. But politics seems to have prevailed over economics. The prices of PDS kerosene and domestic LPG were not adjusted commensurately, resulting in losses on account of these two products.

The Government decision of 2003 was that the OMCs would make good about a third of the losses on the two products from the surpluses generated on petrol and diesel, while the balance losses would be shared equally by the upstream companies (ONGC/OIL/GAIL) and the OMCs.

Oil dependency

If the country had sufficient crude oil resources, the Government could have fixed a publicly acceptable price for petroleum products. However, the ground reality is different and the data in Table 2 show clearly our oil dependency. Domestic production has been stagnating more or less and imports have been growing fast. On top of this, there is also the huge increase in import prices of crude oil to contend with.

Hiking petrol prices (and related price changes in other petroleum products such as diesel, kerosene and LPG) is no doubt a sensitive matter. It, for one, makes commuting costlier for the public. How then does one go about pricing petroleum products?

This is an important question and the Government has tried to address the issue in its usual way: By appointing a committee to look into the matter.

Committee on Pricing

The Committee on Pricing and Taxation of Petroleum Products under the Chairmanship of Dr C. Rangarajan, submitted its report to the Government in February 2006.

The following principles were adopted by the Committee:

Pricing and taxation of petroleum products should be rationalised to transmit the right price signals so as to minimise, if not eliminate, distortions and inefficiencies that result in misallocation of resources;

Prices of petroleum products should, as far as possible, be aligned with international prices;

Across-the -board subsidies result in inefficiencies and place an undue burden on an already strained fiscal situation;

Subsidies should be minimal, targeted and restrained by a monetary ceiling;

To the extent the Government decides to extend subsidies, the burden should be borne entirely and transparently in the Budget;

Oil marketing companies should be freed from the burden of subsidy;

Customs tariff on crude and products should be rationalised so as to moderate the effective rate of protection to a level that will offset the disadvantages suffered by the domestic producers without, at the same time, allowing them any undue cushion; and

Excise tariffs should be restructured to protect the consumers from excessive volatility in prices.

The set of recommendations relating to pricing of petrol and diesel are:

Shift to a trade parity pricing formula for determining refinery gate as well as retail prices;

Government to keep an arm’s length distance from price determination and allow flexibility to oil companies to fix the retail price under the proposed formula; and

Reduce the effective protection by lowering the Customs duty on petrol and diesel to 7.5 per cent.

As for petrol and diesel prices, the recommendation was to apply a weighted average of the import parity and export parity prices in the ratio 80:20.

A Possible Alternative

Given the need to set prices in a transparent and simple manner, the alternative should be easy to understand, devise and implement. One way is to fix a base price and then extrapolate it by the monthly/quarterly crude price (of the Indian basket).

Table 3 — based on the data in the Rangarajan Committee report — presents the cost structure of petrol in Mumbai and its constituents in December 2005. Costs, including delivery and dealer commission, represent about 45 per cent of the retail price with the balance 55 per cent being Central and State taxes.

In an alternative disposition, the cost, including delivery cost, could be fixed in the base period appropriately, dealer commission pegged at 2 per cent of the cost, and Central and State taxes at 25 per cent each.

Thus, to the cost in Table 3 (Rs 22 per litre), a factor of 2.5 (ratio of the crude price in March 2008 to that in 2005) is applied to obtain the acceptable cost for March 2008: Rs 55. Dealer commission and government taxes will be Rs 1.1 and Rs 27.5 respectively. The retail price will be Rs 83.6. The bitter pill is hard to swallow.

The way out is to plan for a smooth transition by stating clearly that the price will escalate on a quarterly basis. Announce the changes well in advance and let the rest follow.

If the resultant price increases were to dissuade a few private car purchases, so be it.

(The author, formerly with the National University of Singapore and the World Bank, is Visiting Faculty, Sri Sathya Sai University, Prasanthi Nilayam. He can be reached at bhanoji@gmail.com)

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