Oil has been one of the most significant and vital industrial resource to any economy. When first and second waves of industrialization (pre and post WW I and II) happened across US and Europe during the beginning of 19th century, Oil played a very crucial role in fuelling the growth of world economies. India rely on primarily crude oil (32%), coal(52%), natural gas(10%), hydro(5%) and nuclear energy (1%) sources for its energy needs. There is no denying to this fact that as India ushers into a new age of growing competitive markets, there would be ever increasing reliance on scarce resources. However, if we have to understand the extent of this dependence, we first have to familiarize ourselves with the structure and economics of India Oil industry structure.
Structure of Indian Oil Industry
Oil industry exists at two different levels. "Upstream” players are involved in the site exploration and production of the primary component that gives all varieties of petroleum products i.e. crude oil. The major state-owned players in the upstream sector are Oil and Natural Gas Corporation Ltd. (ONGC), and Oil India Ltd. (OIL); the major private sector players are Reliance, Cairn Energy, Hindustan Oil Exploration Company Ltd. (HOEC), and Premier Oil. Upstream players perform following activities:
->Exploration for hydrocarbons.
->Production of crude oil and natural gas.
->Transportation of crude oil to downstream players refineries
"Downstream" players are involved primarily in operations such as refining, pipeline transportation, fuel marketing and R&D. These companies directly interface with the retail customers. The players include Hidustan petroleum (HPCL), Bharat Pentroleum(BPCL), Mangalore refinery and petroleum limited(MPCL), reliance Industries, Essar oil etc. These companies maintain a retail distribution network across the nation deploying retail outlets, bulk consumer pumps, LPG distributorships and plants, aviation fuel stations etc.
India is a net importer of crude oil. What that means is, more than 50% of its petroleum needs are fulfilled by sourcing and import of crude and petroleum products. This import is fully controlled through the government-owned Indian Oil Corporation and controlled by the empowered standing committee of the Centre.
Petroleum prices in India are affected by three broad factors:
-> International price of crude oil and petroleum products in terms of dollars - as the downstream players import crude oil from international markets;
-> Rupee - dollar parity - rupee/doller fluctuations significatly impacting the prices;
-> Inflation within India
How are petroleum products priced?
In India there are four highly consumed (> 60%)petroleum products are petrol, diesel, kerosene and LPG. The country operates under an Administered Pricing Mechanism for petroleum products. Under the APM, product prices are directly administered by the GoI, based on an opaque and complex “cost of operating capital plus” formula.This system is based on the retention price concept under which the oil refineries, oil marketing companies and the pipelines are compensated for operating costs and are assured a return of 12% post-tax on networth. Under this concept, a fixed level of profitability for the oil companies is ensured subject to their achieving their specified capacity utilisation. Upstream companies, namely ONGC,oil and GAIL, were also under retention price concept and were assured a fixed return.
The administered pricing policy of petroleum products ensures that products used by the vulnerable sections of the society, like kerosene, or products used as feedstocks for production of fertilizer, like naphtha, may be sold at subsidized prices.
In simple terms, what that means is government controls the prices of crude oil and basket of derived products under APM which provide a cushion to the consumers against the oil shocks in the global market.
How increase in international oil prices trickle down to consumer petroleum products?
The downstream players import more than 80% of the crude oil from the global markets. Any increase in crude oil prices globally would affect the petroleum prices. The downstream companies(OMC/refineries) deal with two kind of prices. One is crude oil price which refiners pay to purchase the crude oil (either from domestic or foreign producers). While 'refinery gate price' is the price at which the refiners “sell” the petroleum products to the next stage of the industry. So its easy to understand that as more than 80% of the crude oil requirements are met through imports, the prices of the petroleum end products are bound to get hit by international crude oil prices.
There are other important prices at various stages of the product journey to the end cosumer:
-> Pre-tax prices- This price can be arrived at by adding marketing, storage and transportation costs to the refinery gate price of the relevant petroleum product.
-> Retail prices - Adding excise duty (a form of tax levied by the Central Government) and sales tax (levied by State Governments) to the pre-tax price gives the final retail price of petroleum products, the price, for instance, that you or any of us pay at the petrol pump.
So, Retail price = crude oil price+ refinery gate price(refining cost+profit)+ pre-tax price(marketing and storage cost+profit)+ distribution cost+ dealers profit+ excise duty+sales tax
Why does Government provide cushion?
Refining of crude oil is a process industry where crude oil constitutes around 90% of the total cost. Since value added is relatively small, determination of individual product-wise prices becomes problematic. The oil marketing companies (OMCs) currently source their products from the refineries on import parity basis which then becomes their cost price which is the refinery gate price. The difference between the cost price and the realized price(i.e centrally determined sales price) called the 'under-recoveries' of the OMCs. This is the indicative measure of the subsidization of prices by GoI. In simple terms, OMCs are selling the products at prices much lower than their free market prices in a price control regime by government through subsidization.
Other sensitive products such as kerosene and domestic LPG are provided to the below poverty line consumer through Public Distribution System (PDS) on the ground that these were fuels of mass consumption largely consumed by “economically weaker sections of society”. The subsidy on these two products was to be continued on a flat rate basis financed from the budget and was to be phased out in three to five years.
When crude price increase is not passed through to consumers, the cost will have to be borne by oil marketing companies (OMCs). Since private OMCs would get out of a business if they made losses, it would be left to public sector OMCs to supply petroleum products at prices below their costs. If the OMCs are asked to bear the losses, they would go bankrupt. This would seriously compromise our energy security.
Under-recoveries of OMCs were at Rs 46,000 crore in 2009-10 !! But how does that contribute to the overall government budget deficit??
Structure of Indian Oil Industry
Oil industry exists at two different levels. "Upstream” players are involved in the site exploration and production of the primary component that gives all varieties of petroleum products i.e. crude oil. The major state-owned players in the upstream sector are Oil and Natural Gas Corporation Ltd. (ONGC), and Oil India Ltd. (OIL); the major private sector players are Reliance, Cairn Energy, Hindustan Oil Exploration Company Ltd. (HOEC), and Premier Oil. Upstream players perform following activities:
->Exploration for hydrocarbons.
->Production of crude oil and natural gas.
->Transportation of crude oil to downstream players refineries
"Downstream" players are involved primarily in operations such as refining, pipeline transportation, fuel marketing and R&D. These companies directly interface with the retail customers. The players include Hidustan petroleum (HPCL), Bharat Pentroleum(BPCL), Mangalore refinery and petroleum limited(MPCL), reliance Industries, Essar oil etc. These companies maintain a retail distribution network across the nation deploying retail outlets, bulk consumer pumps, LPG distributorships and plants, aviation fuel stations etc.
India is a net importer of crude oil. What that means is, more than 50% of its petroleum needs are fulfilled by sourcing and import of crude and petroleum products. This import is fully controlled through the government-owned Indian Oil Corporation and controlled by the empowered standing committee of the Centre.
Petroleum prices in India are affected by three broad factors:
-> International price of crude oil and petroleum products in terms of dollars - as the downstream players import crude oil from international markets;
-> Rupee - dollar parity - rupee/doller fluctuations significatly impacting the prices;
-> Inflation within India
How are petroleum products priced?
In India there are four highly consumed (> 60%)petroleum products are petrol, diesel, kerosene and LPG. The country operates under an Administered Pricing Mechanism for petroleum products. Under the APM, product prices are directly administered by the GoI, based on an opaque and complex “cost of operating capital plus” formula.This system is based on the retention price concept under which the oil refineries, oil marketing companies and the pipelines are compensated for operating costs and are assured a return of 12% post-tax on networth. Under this concept, a fixed level of profitability for the oil companies is ensured subject to their achieving their specified capacity utilisation. Upstream companies, namely ONGC,oil and GAIL, were also under retention price concept and were assured a fixed return.
The administered pricing policy of petroleum products ensures that products used by the vulnerable sections of the society, like kerosene, or products used as feedstocks for production of fertilizer, like naphtha, may be sold at subsidized prices.
In simple terms, what that means is government controls the prices of crude oil and basket of derived products under APM which provide a cushion to the consumers against the oil shocks in the global market.
How increase in international oil prices trickle down to consumer petroleum products?
The downstream players import more than 80% of the crude oil from the global markets. Any increase in crude oil prices globally would affect the petroleum prices. The downstream companies(OMC/refineries) deal with two kind of prices. One is crude oil price which refiners pay to purchase the crude oil (either from domestic or foreign producers). While 'refinery gate price' is the price at which the refiners “sell” the petroleum products to the next stage of the industry. So its easy to understand that as more than 80% of the crude oil requirements are met through imports, the prices of the petroleum end products are bound to get hit by international crude oil prices.
There are other important prices at various stages of the product journey to the end cosumer:
-> Pre-tax prices- This price can be arrived at by adding marketing, storage and transportation costs to the refinery gate price of the relevant petroleum product.
-> Retail prices - Adding excise duty (a form of tax levied by the Central Government) and sales tax (levied by State Governments) to the pre-tax price gives the final retail price of petroleum products, the price, for instance, that you or any of us pay at the petrol pump.
So, Retail price = crude oil price+ refinery gate price(refining cost+profit)+ pre-tax price(marketing and storage cost+profit)+ distribution cost+ dealers profit+ excise duty+sales tax
Why does Government provide cushion?
Refining of crude oil is a process industry where crude oil constitutes around 90% of the total cost. Since value added is relatively small, determination of individual product-wise prices becomes problematic. The oil marketing companies (OMCs) currently source their products from the refineries on import parity basis which then becomes their cost price which is the refinery gate price. The difference between the cost price and the realized price(i.e centrally determined sales price) called the 'under-recoveries' of the OMCs. This is the indicative measure of the subsidization of prices by GoI. In simple terms, OMCs are selling the products at prices much lower than their free market prices in a price control regime by government through subsidization.
Other sensitive products such as kerosene and domestic LPG are provided to the below poverty line consumer through Public Distribution System (PDS) on the ground that these were fuels of mass consumption largely consumed by “economically weaker sections of society”. The subsidy on these two products was to be continued on a flat rate basis financed from the budget and was to be phased out in three to five years.
When crude price increase is not passed through to consumers, the cost will have to be borne by oil marketing companies (OMCs). Since private OMCs would get out of a business if they made losses, it would be left to public sector OMCs to supply petroleum products at prices below their costs. If the OMCs are asked to bear the losses, they would go bankrupt. This would seriously compromise our energy security.
Under-recoveries of OMCs were at Rs 46,000 crore in 2009-10 !! But how does that contribute to the overall government budget deficit??
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