High oil prices should be passed on to consumers

The best argument for using market driven rates is the utter disrespect that Indian consumers have in splurging on oil in the past few years in spite of raising oil prices around the world. Car and bike sales have increased tremendously for the consumers are not feeling the pinch of the oil price. We hear news of US consumers switching to compact cars, dumping SUVs and hitching to public transport. If the rise in oil prices were passed onto the consumers in India, I'm sure there would have been more care taken in spending less. It could also have had some lessening effect on the auto pollution in our metros. So continuing with the current oil policy is not just a matter of fiscal issue but also physical!

--Vj

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3 May, 2008, 0301 hrs IST,Cuckoo Paul, TNN

For a government which is preoccupied with tackling inflation, OPEC president Chakib Khelil’s observation couldn’t have come at a worse time. The OPEC president, in a recent statement, warned that crude oil could hit $200/bbl with the dollar losing its lustre. That too when oil prices have already climbed 100% to top the $120 a barrel mark over the last one year. With alternative sources of energy becoming a rage, land is being sacrificed for bio-fuels, pushing food prices to new highs.

For a country which is critically dependant on overseas sources for its energy needs and whose appetite for oil is insatiable, these developments are clearly worrisome — especially for emerging economies like India, China, Russia and Brazil.

“If we look at the BRIC countries, India looks like a sore thumb. We are the only country out there which is not in the pink of health when it comes to oil as all the other countries have their own resources or finances to manage the situation,” says Ajit Ranade, group chief economist with the Aditya Birla Group.

There are several others like him worried about the management of the oil economy. With polls round the corner, pump prices are unlikely to be hiked significantly to pass on the burden of the crude price rise. India is still among a handful of countries where kerosene is still being sold at $20/bbl levels, when international prices are ruling close to $125/bbl.

Over the years, when it comes to raising the prices of petrol, diesel and LPG, governments, irrespective of political hues, have uniformly chosen not to take any hard decision. This is because a decision on this issue can hurt them politically, never mind the fact that retail prices do not reflect international realities and that it can drill a hole into government finances.

The NDA government and its finance minister Yashwant Sinha started issuing oil bonds to skirt the issue. Since then these bonds which are IOUs guaranteed by the government of India and given to oil marketing companies (OMCs) to compensate them for their losses have proved to be a convenient tool to postpone solutions to the problem.

The OMC problem

Earlier these bonds compensated one third of the losses of the marketing companies. Over the years these bonds now offer up to 42% of the losses. When the bonds were originally issued, the plan envisaged was to gradually decontrol oil prices and make them market-related by the end of 10 years.

But as prices went up, the political cost became too high. Now with oil touching new highs every week, doubts are beginning to surface again whether the current mechanism of price-redress can be stretched beyond a point. Economists have already warned that postponing the problem would have long-term implications for the economy.

India’s fiscal deficit works out to 3.2% of the GDP and if the outstanding oil bonds are added to this number, the same fiscal deficit to GDP ratio escalates to 4.4%.

In general, under-recoveries are moving up faster than the jump in crude oil prices and this is again a cause of worry as it impacts all segments of the economy. In FY07, marketing companies had under-recoveries to the tune of Rs 50,000 crore which are expected to vault to Rs 1,00,000 crore in FY09, a rise of 100% in two years. During the same period average crude oil is expected to go up by 60%. For every $1 increase in price of crude, the under recoveries go up by Rs 3,000 crore.

Like American shoppers, the Indian government has followed a ‘consume now and pay later’ philosophy that is obviously unsustainable, feels an economist with a brokerage firm. The questions now being raised are: Does the government have any option? And how do other countries handle the same issue?

Options for the future

S Narasimhan, the finance director of India’s largest oil retailer Indian Oil, is one man who battles the fallout of high-oil prices on a daily basis. With the oil-major’s borrowings going up to Rs 36,000 crore, it is not surprising that his energy is focussed on finding ways to improve cash flow.

When oil prices increase, management of working capital also becomes a tricky issue as everything from inventory to cost of transportation needs to be reworked. One solution he can offer is to sell off the government issued oil bonds as soon as possible. Indian Oil holds bonds worth Rs 14,000 crore and is very keen to sell them, albeit at a loss. Narasimhan says, “Cash flows are severely constrained by the low retail prices of petroleum products.”

The marketing companies have no option but to sell these bonds at a loss as these bonds are not liquid. Again, since these bonds do not have statutory liquidity ratio (SLR) status, banks are lukewarm to the idea of picking up these bonds. To compensate for the lack of SLR status and liquidity these bonds offer a 25 basis extra coupon over the gilt rates.

One of the solutions to make these bonds attractive is to grant them SLR status. This way the marketing companies can obtain the right price for these bonds as banks would line up to buy them given the higher yields. If these bonds do get SLR status, then the extra 25 basis coupon will have to go and thus may not have the same attraction for banks. Since the government has a borrowing programme every year and banks are captive buyers of government paper, there is a scare that if oil bonds are given SLR status, the borrowing programme of the government will get impacted.

Banks will always find the oil bonds more attractive in terms of maturity as well as liquidity compared to other instruments floated by the government. Today the oil companies use the CBL route where the OMCs do the borrowings by using these bonds as collateral. This is turning out to be more efficient for the OMCs in many ways.

Gilt funds are allowed to invest in oil bonds, as these funds are mandated to invest in any security issued by the government of India. However, oil bonds are not included in the basket of securities, which banks invest in to meet the statutory requirements. According to IDBI Gilts’ head of fixed income S S Raghavan, “The main issue with gilt funds is that these securities lack trading interest and hence, are illiquid. First of all, banks do not prefer to invest in oil bonds because they do not carry an SLR status.

Secondly, provident funds and pension funds, which comprise the large set of investors in these securities, hold these bonds till maturity. Hence, there is no trading interest from these superannuation funds. Due to these reasons, most gilt funds which are professionally managed, do maintain an internal cap on investments in oil bonds.”

Typically, on the shorter end, these bonds carry a 25-30 basis point spread over the government bond of a similar tenor. On the longer end, the spread extends to over 50-100 basis points over the government bond. Currently, oil bonds of a 15-year tenor carry a coupon of 9%, almost 100 bps over the corresponding g-sec.

Much of the trading is now concentrated on the shorter end, where yields have witnessed a sudden spike on account of monetary measures such as the recent hike in the cash reserve ratio. On the longer end, trading interest is restricted given the illiquid conditions.

Apart from the financial management part, there are other issues which needs to be addressed. One of the best options would be for state governments to lower the sales taxes on fuel,the Rs 50 or so that a consumer pays for a litre of petrol, about 60% is the tax component, for diesel it is roughly 40%.

Oil revenues form a major chunk of earnings for the governments, both at the centre and in the states, so the measure has not found favour yet. The centre has cut taxes to an extent on some petroleum products, but the states have not yielded ground at all. There is a lot of scope on sales tax reductions, the taxes are currently linked to retail prices and hence increase each time prices go up.

Oil analysts say China has tackled the high oil problem by capping levies to a single tax rate. Duties on transportation fuel are a uniform 13% all over China, much lower than the Indian rates. Of course, the additional advantage that countries like China, Brazil and Malaysia have is that they produce more oil domestically.

India now imports close to 70% of its oil needs and domestic production has been stagnant for over a decade. Narasimhan says the second option to deal with the situation is an oil cess. Oil companies have proposed that the government levy a 3% cess on income tax on the lines of the education cess. This could raise close to Rs 15,000 crore every year, which could be used to stabilise oil prices.

Targeted subsidies

The third option is to have targeted subsidies; which means passing on the subsidy only to economically weaker sections instead of all the consumers. The huge under-recoveries by the oil companies are on the sale of four petroleum products — petrol, diesel, LPG and kerosene. “Of these, LPG and petrol are products that are consumed by a vast swathe of urban population that can afford to pay much more,” says an oil company official.

Subsidised LPG and kerosene can be sold to families below the poverty line, but why should everyone enjoy this benefit? he asks. This can be done through the issue of pre-loaded oil-cards, on the lines of the Kisan cards. This would ensure that the under-recoveries come down by almost half, according to estimates. This is something some economists have also endorsed.

The new president of CII KV Kamath says, “While the situation on inflation does not make it possible at present to consider a greater pass through of oil prices, this is a measure which would have to be taken sometime in the near future, based on the situation on inflation.

The situation on oil prices also mandates that the country set a target for itself in terms of conservation. Demand management of energy consumption including greater efficiency in utilisation is a must for the country.”

The impact

The impact of the high prices is being felt by oil companies more than anyone else. Consumers of aviation fuel, naptha and furnace oil too are bearing the brunt. For the rest it is of little consequence. However, the slowdown in oil company spends may soon start impacting growth.

For 2007-8, the government expects to issue oil bonds worth about Rs 32,000 crore. The figure is not fixed yet and bonds for the fourth quarter of the year are yet to be issued. In 2008-9, the figure is likely to be higher, depending on actual prices through the year.

The under-recoveries of the oil marketing companies, are currently shared between the companies themselves, oil producers (ONGC) and the government (through the issue of bonds). As oil prices went up, the central government has taken a larger share of the losses which meant greater recourse to oil bonds.

Weighed against the backdrop of these developments, it is amply clear that the government may have to soon bite the bullet. The options are limited. Either the political managers would have to take some hard measures or the other option would be to settle for lower economic growth rate. Issuance of oil bonds was fine as long as the economic growth was robust.

However, exercising such a relatively easier option may be far more difficult when the economy slows down. That is the time when these bonds can be a heavy burden. There is no escaping the fact that oil prices will have to be passed on to consumers. Many countries have done it. India may not have much of a choice. The longer the government delays it the greater will be the collateral damage.

(With inputs from Pravin Palande and Preeti Iyer)


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