The oil factor

At a demonstration in New Delhi. - RAVEENDRAN/AFP

In deciding to increase the oil prices, the government has exercised the soft option, contrary to the claim that it has taken a hard decision.

IN a victory for the Finance Ministry, on November 4, the government hiked prices of petroleum products. Petrol prices were increased by Rs.2.20 a litre and diesel prices by Rs.2.10. In addition, the price of liquefied petroleum gas (LPG) was increased by Rs.20 a cylinder with immediate effect and is slated to rise subsequently by Rs.5 each month. Despite opposition to the move from within and outside the government, the so-called "hard decision" was taken on the grounds that the restoration of the link between the domestic prices of petrol and diesel and global crude prices, as required under the liberalised pricing scheme, was inevitable.

It hardly bears stating that increases in the prices of a universal intermediate like oil, whose direct and second-order effects on the domestic price level are bound to be substantial, need special justification. Those increases result in cost-push inflation in the prices of commodities and services (such as transportation) consumed by the poorest sections of the population, placing a burden precisely on those who are losers from the government's liberalisation policy. Further, they result in cost increases in areas like agriculture that squeeze the low levels of net incomes of already distressed farmers.

The official case for the increase in prices sounds simple: the average price of the basket of crude imported by India has risen from less than $30 in February to more than $50 a barrel; and imports account for 70 per cent of India's crude requirements, which have been rising rapidly from 81 million tonnes in 2002-03 to an estimated 91 million tonnes last fiscal. Given this, if the government does not raise domestic prices of oil, either the oil companies would have to suffer huge losses or the government would have to dole out huge subsidies. Neither is acceptable, so prices must rise.

The problem with this reasoning is that it misses out on three important aspects of the current oil scenario. First, the increase in global crude prices is not "natural", but reflective of a shock resulting from factors as diverse as the unwarranted war in Iraq, engineered civil strife in Venezuela, and conflicts over control of Russia's oil major, Yukos. A responsible government is one that attempts to deal with such, hopefully transient, shocks in a manner that buffers their impact on vulnerable sections.

What is more, there is reason to believe that speculators cashing in on these developments have had a major role to play in the recent price increases. It must be noted that much of the increase in the price of oil has occurred quite recently. The average monthly price of crude imported into the United States rose from a low of $17.87 a barrel in February 2002 to around $25 a barrel in May 2002 and fluctuated around that range until December that year. It then rose sharply during the winter months to touch $31.89 in February 2003, only to begin its decline again to reach the $25 level by April-May 2003.

It is only after June 2003 that oil prices have once again been on the rise, with the U.S. import price climbing to around $31 a barrel by February. Even this figure is way below the spot price of more than $50 recorded recently. Thus most of the increase in price has occurred over the last six months, when there has been a surge in oil prices because trends warranted by supply-demand balances have been significantly amplified by speculative factors.

While the fact that OPEC (Organisation of Petroleum Exporting Countries) producers are running up against their capacity limits could have generated fears that rapid increases in demand may not be matched by corresponding increases in supply, as of now the oil market is hardly characterised by a situation of unmet excess demand. The key to understanding oil price increases, therefore, is the role of the speculative factor. Most predictions of where oil prices are headed are based on trends in oil futures or derivative instruments that involve a bet on the likely trend in oil prices. Long positions, involving current access to the commodity held with the intention of selling it later indicate that speculators are betting on a price increase. This implies that available stocks are being held back with future trade at a profit in mind. To the extent that this affects the actual demand-supply balance at any given point of time, these expectations of a price increase tend to get realised.

A revealing development noted by most observers is the presence of hedge funds and pension funds in the market for oil futures. It must be noted that it is not just what happens in oil markets that determines speculative activity there. Recent months have seen hedge and pension funds seeking new avenues for investment because of losses being suffered in financial markets. Long positions in commodities have increased because of declines in Japanese and emerging market securities prices and indices and the adverse consequences of the dollar's rally. Many fund managers see oil as a saviour in this context because profits from long positions in oil derivatives have offset losses in other markets.

Thus, to argue that increases in domestic oil prices in tandem with international oil prices are inevitable amounts to declaring that international speculators can hold the government to ransom. It is indeed true that under the reformed and liberalised oil pricing regime, a fortnightly adjustment of domestic oil prices to reflect international price changes is a must. But, what the determinants of the current oil shock make clear is that the shift away from an administered price regime was an error, because it reduces the manoeuvrability of the government to deal with the debilitating effects of non-economic factors and speculative activity in international markets. In order to manage them, the prices of commodities like oil should be seen as one instrument in the government's overall tax-cum-subsidy regime, so that prices can be held down if necessary and financed with revenues garnered from elsewhere. This is needed to ensure that the distributional effects of international shocks and speculation are not adverse in an already unequal society.

A second feature questioning the "inevitability" argument is the fact that oil companies have been recording huge profits, suggesting that there is substantial fat in the current parity formula. Hence, it would be reasonable to call upon the oil marketing companies to accept a reduction in excess profits to achieve larger goals.

Finally, and most crucially, domestic oil prices include a huge component of ad valorem duties or duties levied as a proportion of factory prices. When international prices rise and domestic prices are adjusted in tandem, the government's revenues also rise substantially. Thus, if duties are reduced to neutralise the price increase what is "lost" is not actual revenues but notional revenues that are far in excess of what was originally expected.

CONSIDER the following back-of-the-envelope calculation. When the current increase in global crude prices began, central excise on petro-products stood at 30 per cent plus Rs.7.50 a litre. In the case of diesel, the rate of excise was 14 per cent plus Rs.1.50 a litre. Further, the ad valorem customs duties on petrol and diesel amounted to 20 per cent. The duties on kerosene and LPG were no doubt lower at 18 and 26 per cent. So, for simplicity, treat the average level of duties to be around 35 per cent on oil products.

The average price of imports of crude oil is estimated to rise from around $27 a barrel in 2003-04 to over $40 a barrel this year or by around 50 per cent. India's oil bill in 2003-04 stood at $20 billion. Even if prices were constant this would have risen to $22 billion this year because of increases in the volume of imports. Add on the effects of a 50 per cent increase in oil prices and the import bill would have risen to $33 billion. If the average rate of duty had remained at around 40 per cent, the government would have obtained $13.2 billion as revenues as compared with $8.8 billion - an excess of $4.4 billion or Rs.19,800 crores.

In practice, of course, duties have been reduced to help hold domestic prices. On June 16, soon after it assumed office, the government reduced the ad valorem excise duty rates on petrol from 30 per cent to 26 per cent, on diesel from 14 per cent to 11 per cent and on LPG from 16 to 8 per cent so as to neutralise partially the effects of price increases by the oil marketing companies on the consumer prices of these products. Further, on August 18, the customs duty on both petrol and diesel were brought down from 20 per cent to 15 per cent. The excise duty on petrol was reduced from 26 to 23 per cent while that on diesel has been reduced from 11 to 8 per cent. And, the customs duty on LPG and kerosene sold through the public distribution system (PDS) was halved to 5 per cent. In addition, the excise duty on PDS kerosene was reduced from 16 per cent to 12 per cent.

The net result of all this is that the average duty is possibly in the range of 30 per cent over the year as a whole. This would make the revenue received by the government around $9.9 billion, or $1.1 billion (Rs.5,000 crores) more than originally expected. Needless to say, these are all back-of-the-envelope calculations, and the actual figures would be different. But what they do suggest is that in all probability the government has thus far had to suffer no revenue losses in its effort to manage the effects of the oil shock on domestic prices.

Figures of "revenue losses" routinely reported by the financial press are notional and reflect the wrong presentation of information in an effort to lobby for the play of market forces. In fact, the government may still be taking in additional revenues to keep expenditures higher than those warranted by the deficit targets set by the irrational Fiscal Responsibility and Budget Management Act.

It is all this that makes the recent hike in the prices of petroleum products, including diesel, completely unwarranted. In choosing to hike prices the government has taken the spot option, though it defends it on the grounds that it was an inevitable and hard decision.