Vikram S Mehta
The price of oil has crossed $70/barrel and the trend is upwards. In contemplating its policy response to a high oil price scenario, the government should draw upon the lessons of the past.
Last year, I started an article on these pages with the sentence “the oil market has never been easy to call but these days it appears to be in no mans land” (‘Oil more slippery’, IE, May 1, 2017). I wrote that article a few weeks after American missiles had taken out Syrian airfields. The price of the benchmark Brent crude rose sharply in the immediate aftermath but a few days later, it gave up all the gains and more. The markers were fuzzy. Traders were sceptical about the production agreement between OPEC and Russia to take out 1.8 mbd from the market and the robustness of demand. They expected the agreement to fray and demand to drop off.
Today, a few weeks after a second US attack on Syria, the market is less ambivalent. The general sentiment now is that prices will harden even more. This is, in part, because supplies have appreciably tightened. The OPEC-Russia agreement is holding; the Venezuelan oil industry is in free fall and production has come down by approximately 500 kbd from the levels achieved when Hugo Chavez was president; the Middle East is a bubbling cauldron with domestic chaos in Libya, Iraq, Syria and Yemen stirring the pot; and then there is US President Donald Trump with his cohorts, Secretary of State Mike Pompeo and NSA John Bolton, arguably the two most hawkish men in the US administration. It is generally expected that Trump will pull out of the Iran nuclear deal (JCPOA) later this week. But what is not clear is whether he will reimpose sanctions. If he does, crude oil exports from Iran might drop by half a million barrels a day. To compound these supply side factors, oil demand in China and India has been unexpectedly robust and inventories have depleted to the five-year long-term average. The combined impact of tightened supply, higher demand and reduced inventory is a tightly balanced market which could easily spiral out of control in the event of a geopolitical disturbance. This is why, despite US shale production going gangbusters — it has crossed 10mbd — there are currently more bulls than bears on Wall Street.
This oil market outlook must be a cause of great concern to the government. The timing is unpropitious. There are several state elections around the corner and the general elections are barely a year away. What should it do? The political backlash of high retail prices cannot be ignored. But the consequences of reimposing administrative price controls could have far-reaching systemic ramifications.
The government has effectively three options. One, it can continue with the current market-related pricing system but nudge the companies to move prices incrementally and imperceptibly. Two, it can reduce the indirect taxes on petroleum products and forego its commitment to limit the fiscal deficit to 3 per cent of the GDP. And three, it could contemplate a variant of the old (and discredited) system of fixed returns with companies paying into an account (call it the “price stabilisation account”) as and when returns/margins exceed a predetermined cap and drawing down from the account when returns/margins fall below a stipulated minimum. These are not mutually exclusive options and each is rife with complexity. The purpose of this article is not to debate the pros and cons of these options. It is, instead, to remind the decision-makers of the adverse consequences of a policy misstep.
The price of petroleum products was last fully deregulated by the Atal Bihari Vajpayee government in April 2001. Three years on in July 2004, the UPA government reversed, de facto, this decision. They did so in the face of rising international prices. From 2004 to 2014, the price of products was effectively set by the Ministry of Petroleum. The political logic was understandable. The international market was on the boil and the government did not have the political will or the numbers to pass on the price increases to the consumer. The petroleum PSEs were directed to bear the burden. They were compelled to sell below cost and whilst their balance sheets were kept whole through government-issued IOUs, their cash balances were totally wiped out. To sustain operations, they were forced to borrow at commercial interest rates and their share price lagged well behind the Sensex. It is estimated that in 2012 and 2013, the PSEs “under-recovered” (a euphemism for loss) in excess of Rs 100,000 crore annually.
The financial plight of these companies was widely commented upon at the time. But what was not given sufficient attention was the consequential longer-term implications. This was, however, potentially even more damaging. ONGC, for instance, had to cut back on its exploration expenditure because it received only 55 per cent to 60 per cent of the revenues due to it from the sale of its crude oil. The balance was sequestered for “financing” the losses. And, IOC, BPCL and HPCL were compelled to cut back or delay investments for the upgradation of refineries to meet global emission norms, pipeline and other infrastructure facilities and R&D. It would be a stretch to claim that this policy decision is the reason India’s dependence on oil imports has steadily increased — it is now around 83 per cent — and/or why 14 of our cities are in WHO’s list of the 15-most polluted (PM 2.5) cities in the world. But it would not be a stretch to suggest that it has been a contributory factor. The policy slowed down our exploration efforts; it encouraged wasteful consumption and it led to the “dieselisation” of the economy.
The government must not repeat this mistake. Whatever it does in response to a high oil price regime, it must not ask the PSEs to bear the burden. It must not weaken the sinews of a competitive petroleum industry.