A one-sided bargain that hurts
Oil companies base their pricing decisions for the critical fuels that drive the country on prices that prevail in markets abroad. Photo: Nagara Gopal

It is a vital infrastructure industry that fuels the economy, literally. Yet, when it comes to such critical issues as pricing, the oil industry is about as transparent as the crude oil that it processes. It probably pinches your purse when you tank up your vehicle but are you even aware that the price that you pay for a litre of petrol has no relation whatsoever to what it costs to produce that for the oil company?

If that shocks you, here’s more. Decisions to increase or decrease retail prices of products such as petrol, diesel and cooking gas are made based on an arcane concept called under-recovery, a clever invention by the oil companies that drags international prices into the domestic pricing structure. So, what is this strange animal called under-recovery?

It is the difference between the price that the oil company would like to charge for say, petrol, based on its international traded price, and the price at which it supplies the fuel to pumps, excluding taxes. There is a formula that is used to compute the desired price which takes 80 per cent of the landed cost (including duties, taxes, insurance and freight) of petrol and 20 per cent of the export price. Invariably, the price that the oil company desires is higher than the domestic selling price leading to what is called as under-recovery.

For instance, as per data of the latest fortnight (domestic prices are computed on a fortnightly basis based on international prices and rupee-dollar rate), the oil companies, left to themselves, would have liked to charge Rs. 46.07 a litre of diesel (at Delhi) but in reality, dealers pay Rs. 37.01 per litre leading to an under-recovery of Rs. 9.06 per litre to the oil companies. After adding taxes and dealer commission, consumers in Delhi now pay Rs. 47.15 a litre.

The critical point to note here is that under-recovery is not equal to loss for the oil companies. And that is simply because they do not import petrol or diesel. Rather, the oil companies import the raw material, crude oil, which is refined in the numerous refineries in the country owned by the oil companies to produce various fuels ranging from petrol and diesel to cooking gas, aviation turbine fuel, furnace oil and kerosene.

Oil companies, thus, base their pricing decisions for the critical fuels that drive the country on prices that prevail in markets abroad. For instance, for petrol, the base price for comparison is the Singapore oil market price while for diesel and aviation fuel, it is based on Arab Gulf (Dubai) traded prices. In an ideal world, the oil companies ought to be taking the price they pay for crude oil that they import as the basic input cost and add to it the costs of refining, marketing and then the margin to set the final retail selling price.

So, why do oil companies follow this strange pricing policy that is unfavourable to consumers?

There are two different explanations for this. This policy was first adopted by the government to encourage investment in new domestic refineries. The lollipop was the higher margins that the oil company could get by charging global prices for their fuel.

Such a policy made sense when India was short of refining capacity and had to import petroleum products. However, in the last decade, the situation has reversed with refining capacity rising and running past demand leading to some players such as Reliance Industries and Essar Oil exporting petrol and diesel. Against a refining capacity of 206 million tonnes as of 2010-11, domestic demand was just 154 million tonnes for petroleum products. It is clear that the policy has achieved its objective and it is now time to reassess it.

The other explanation to the question above is that since there are several products such as petrol, diesel, cooking gas and aviation fuel that are produced by refining crude oil, it is difficult to apportion costs to each of them in order to arrive at their selling prices. In other words, the cost-plus-margin approach is difficult to apply here.

This is indeed a practical problem but it is not insurmountable. It is possible to arrive at the value of each finished product applying costing theory. Process industries around the world that produce several joint products from a single raw material have found ways to price the final product applying scientific principles. The point though is that adopting this approach could mean a loss of protection to the oil companies. But do they need it?

If you go by the astounding figures that they quote as under-recoveries, yes. But if you look at their annual financial numbers, they don’t appear any the worse due to the under-recoveries. Profits have been showing a rising trend (see graphic) for the three companies — Indian Oil, Bharat Petroleum and Hindustan Petroleum — if you compare 2008-09 and 2011-12. Of course, the last two years have been tough with rising interest costs leading to lower profits but the fact is that they are not posting losses.

It is clear therefore that we need to reassess the pricing policy for petroleum products. While at it, we also need to introduce much-needed competition among the oil companies which is non-existent today. The oil companies co-ordinate their pricing actions and the price of petrol is the same in all outlets irrespective of which company owns them. This is akin to a collusive cartel and if it were to happen, say in the tyre or cement industries, the companies would have been accused of cartelisation. Indeed, in countries with a competitive market such as the U.S. and Japan, petrol prices vary across even neighbouring outlets.

Taxation policy

The government also needs to reassess its taxation policy for petroleum products. Higher taxes on petrol are driving consumers to diesel vehicles which in turn is increasing the subsidy burden on the government. It is a travesty that someone driving a two-wheeler pays more for his petrol than one driving an SUV who pays less for his diesel, all thanks to the skewed policy on subsidies.

What we need is a comprehensive relook at the structure of pricing, taxation and subsidies for petroleum products in this country.

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