Administered Price Mechanism In Oil Sector: Bane Or Boon?

Pradeep Puri / BSCAL May 20, 1997, 00:00 IST

Drive to any of the well-lit petrol stations renovated by foreign oil majors like Shell, Mobil or Esso and you could be driving to any gas station in California. The neon lights, sleek dispensing machines, the automatic car wash and a well-stocked Bazzar give the impression that foreign oil czars are back in oil retailing.

but it is not so, not yet. Indias oil sector, dominated by government-owned enterprises continues to operate under the administrative price mechanism (APM). Foreign oil firms have been allowed only in the decontrolled lubricants sector. The investment in the petrol pumps is obviously in anticipation of the dismantling of APM when the entire oil sector would be thrown open to private Indian and foreign oil companies.

Q. How does APM work in India? A. Under the APM, prices in the hydrocarbon sector are controlled at four stages production, refining, distribution and marketing on the principle of compensating normative cost and allowing a pre-determined return on investments. The national oil producing companies like Oil & Natural Gas Corporation (ONGC) and Oil India Limited (OIL) are compensated for their operating expenses and allowed a 15 per cent post-tax return on the capital employed. Both ONGC and OIL sell crude to refiners at $7-8 per barrel as against the prevailing international price of $17-18 per barrel. Sourcing and import of crude and petroleum products is fully canalised through the government-owned Indian Oil Corporation and controlled by the empowered standing committee of the Centre. The refining sector is also regulated wherein the refiners are fully compensated for the acquisition cost of crude and other raw materials as well as operating costs with a guaranteed 12 per cent post-tax return on the net worth. In the third stage, consumer prices are fixed under a similar cost-plus formula wherein the marketing and distribution costs are fully compensated for, and a return on investment at the rate of 12 per cent post-tax on net worth is guaranteed. At the distributors level, the dealers commission and margins are regulated by the government to maintain uniformity in the commission rate. Freight for import of crude is paid to Indian shipping companies at a cost-plus rate, which is much higher than the market rate.

Q. How is APM operated? A. The entire administered pricing system is operated through a complex oil industry pool account wherein inflows and outflows of the pool account are to be kept in balance. Due to international price variation, statutory levies and devaluation of rupee, ad hoc price adjustments have to be made from time to time to balance the oil pool account. To

maintain the prices of kerosene and domestic LPG as well as naphtha and furnace oil for fertiliser inputs at a lower level, the prices of gasoline, naphtha and furnace oil for industrial usage are kept disproportionately higher.

Q. What are the disadvantages of APM? A. The experience of existing public sector undertakings (PSUs) shows that providing returns on a cost-plus formula does not always encourage efficiency in operations. Since all investments and costs are reimbursed, there is no incentive to make profitable investment decisions and to run the refinery in a cost-effective manner. In the upstream sector, PSUs have inadequate incentive to invest in risky but potentially rewarding ventures to develop future oil and gas reserves. It also leads to inefficient exploitation of the countrys exhaustible resources. Moreover, so long as the players in this sector were PSUs, it was possible for the government to effectively control the investments and costs. With the entry of the private sector, however, the cost-plus formula will encourage gold plating of the plant and inflate costs which the consumer will have to bear.

Q. Is APM a hurdle to fresh investment in the oil sector? A. Investors will be reluctant to commit large funds in the petroleum sector of APM continues because under the administered pricing regime a decision of the government can influence the profitability and market shares irrespective of the efficiency with which a company operates. Therefore, investors prefer a free market setup with minimum government interference in investment and operating decisions.

Q. Does the government plan to dismantle APM? A. The government-sponsored R (restructuring) Group has suggested a phased dismantling of APM. The group has drawn up a six-year timetable for total deregulation of upstream and downstream sub-sectors of oil industry. The report is yet to be formally accepted by the government.

Q. Can the total decontrol lead to global dumping? A. The prospects of foreign petroleum products swamping the domestic market under a decontrol scenario could be seen as the biggest foreseeable threat to the local refining industry. Based on existing conditions, however, such a threat seems a remote possibility. The extent of threat will depend upon whether the products are produced locally or just sourced abroad or both simultaneously. If international oil majors set up grassroots refineries in India, they would be on the same economic basis as currently planned new capacity and would suffer the same cost disadvantage which would restrict their ability to price aggressively. The direct import of products from existing refining capacity could be seen as a more realistic threat. However, importing and distributing petroleum products on a grand scale requires

tremendous infrastructure, which currently only the existing players control. To build even a fraction of the required infrastructure will require massive resources, a long gestation period and ability to bear losses in the short to medium term. The Indian oil majors have built such a widespread and well-established distribution network that they can face a threat only if the government forces them to share their distribution infrastructure with new entrants