Under-recoveries: How far under?

In the wake of rising international crude prices, state-run oil marketing companies (OMCs) like Indian Oil (IOC), Bharat Petroleum (BPCL) and Hindustan Petroleum (HPCL) have been making profits in recent years even as they reported rising under-recoveries from sale of sensitive petroleum products like petrol, diesel, LPG and kerosene in the domestic market. This apparent contradiction has led some quarters to wonder if the claims made by OMCs on revenue under-realisation are real. The lack of transparency about the methodology adopted by OMCs also strengthened the suspicion. Meanwhile, the government's decision to allow oil marketing companies to raise prices of petrol and diesel by Rs 5 and Rs 3 a litre, respectively, on June 4, added fuel to the fire. To put a lid on the controversy, Prime Minister Manmohan Singh constituted a high powered committee under the chairmanship of BK Chaturvedi, member, Planning Commission, to examine the financial position of oil companies. The committee is mandated to revisit the concept of ‘under-recoveries' and examine the reported deficit and the real deficit faced by OMCs as a result of price constraints imposed on them.

Under the envisaged subsidy-burden scheme, the government compensates 42.7 per cent of the under-recoveries by issuing oil bonds while upstream oil companies like ONGC, Oil India and GAIL bear 33 per cent. Upstream companies pay their share by providing discounts to OMCs on crude sales. The rest is borne by the OMCs.

The three state-run oil companies reported combined under-realisation of Rs 77,123 crore for 2007-08. But at the same time, they also made profits, though lower compared with the previous financial year.

For example, IOC reported a net profit of Rs 7,912.4 crore in 2007-08 even as it claimed under-recovery of Rs 9,774 crore. This figure was arrived at by IOC after taking into account compensation of Rs 18,997 crore from the government. In the same period, BPCL and HPCL reported net profits of Rs 1,769.5 crore and Rs 1,364.1 crore, respectively, while they claimed increased under-recoveries.

Refining of crude oil is a process industry where crude oil constitutes around 90 per cent of the total cost. The OMCs are currently sourcing their products from the refineries on trade parity basis, which then becomes their cost price. The difference between the cost price and the realised price represents under-recoveries. So, while refining is a profitable business for integrated OMCs, they are losing money in retailing.

After the dismantling of the APM regime in 2002, oil companies were allowed to charge import parity prices that included customs duties, insurance and freight charges, apart from actual product cost. But later, trade parity was adopted as a pricing principle in 2006, after the government slashed custom duty on these products from 10 per cent to 7.5 per cent. Under the trade parity principle, the weighted average of the import and export parity prices is taken in the ratio of 80:20. Pricing is lower than the import parity to the extent of freight cost and other taxes and duties. The move, aimed at softening the impact of rising crude prices on domestic consumers, was in line with the recommendations of the C Rangarajan Committee constituted by the government in 2005 to suggest pricing reforms in the petroleum sector.

The committee did a comparative analysis of the refinery gate price of diesel under alternative pricing models based on the international prices during April-September 2005. The cost of one litre of diesel at HPCL's Mumbai refinery worked out at Rs 19.27 as per cost-plus calculation prevalent under the APM regime, Rs 20.48 as per import parity pricing (with applicable customs duty at 10 per cent) and Rs 18.77 on export parity basis and Rs 19.77 if trade parity principle was applied at 7.5 per cent customs duty.

Hardnews found that there has been a demand from some energy experts to eliminate the differential between customs duty on crude and sensitive petroleum products. The argument is that the differential helps refiners artificially raise their margins, which translates into higher retail price for domestic consumers of petrol, diesel, LPG and kerosene and finally into inflated under-recoveries of OMCs.

The government has traditionally maintained the differential to protect public sector refiners against import competition because most of the existing public sector refineries are based on obsolete technology and can process only light, sweet crude where margins are low.

It was mainly an appreciating rupee that helped them keep their crude purchase costs low and raise refining in 2007-08. For instance, riding on a 10 per cent appreciation in the value of rupee against dollar, IOC saved as much as Rs 10.43 billion in crude acquisition in 2007-08. In the same period, BPCL saved Rs 2.98 billion on purchase of crude. What also came to the OMCs' help was the widening light-heavy crude price spread as the international markets hardened.

The OMCs processed a higher percentage of cheaper crude in their newly added capacities that helped them raise their refining margins in 2007-08. At the same time, they also raised capacity utilisation at their refineries, which helped them optimise their profits from refining operations. Besides, tightening global refining capacity also pushed up the price difference between crude and petroleum products in the world market.

For example, IOC raised its gross refining margin (GRM) to $9 per barrel in 2007-08 from $3.64 per barrel the previous year. It also achieved capacity utilisation of 98.34 per cent, the highest in the last seven years. In the same period, HPCL increased its GRM for the Vizag refinery to $6.30 per barrel from $3.35 per barrel while the GRM of BPCL Kochi refinery went up from $2.2 per barrel to $6.58 per barrel.

Reliance Industries' (RIL) Jamnagar refinery is much more complex and can process up to as much as 90 per cent of heavy, sour crude variety. Riding on that advantage, RIL utilised the widening light-heavy price differential in an even better way to increase its GRM for the Jamnagar refinery to $15 per barrel from $13 per barrel in the same time.

The government faces a serious dilemma over oil subsidy as international crude prices rise relentlessly, making the burden heavier. If it allows the OMCs to recover full price, it risks facing political backlash. And if the government decides to fully absorb the price increase, it might be left with little money for funding social programmes. Besides, it is also bound by the provisions of the fiscal responsibility act which requires to phase out fiscal deficit in a time-bound manner.

In its bid to meet the statutory fiscal responsibility target, the government has avoided making budgetary allocation for making upfront payment to the OMCs. Instead, it has found it more expedient to issue oil bonds. Since 2004-05, the government has issued oil bonds worth Rs 186,656 crore as compensation to the OMCs. The issuance of oil bonds to compensate the OMCs for their so-called under-recoveries raises a serious fiscal concern because it is like deferring one's debt liability to coming generations. And for that reason, it is also unethical.

On the other hand, the OMCs are unable to use these oil bonds as collateral while borrowing to meet their fund requirements because these financial instruments lack the SLR status. As a result, the OMCs often end up selling these oil bonds in the market at a deep discount to banks.

If the upward trend in the international crude market continues, the government might be forced to modify the trade parity pricing, just as it thought it prudent to abandon import parity earlier.