Oil shock

In Visakhapatnam, a protest by autorickshaw drivers belonging to the Visakha Auto Workers Union against the fuel price hike.-C.V. SUBRAHMANYAM

The fuel price hike has been ordered ignoring sensible alternatives and warnings about serious economic consequences.

THE Indian economy has been at tipping point for some time now, poised to enter a period characterised by slow growth and high inflation. The governments decision to hike the prices of petrol, diesel and liquefied petroleum gas (LPG) could well be the final push. In the governments view the hike was inevitable, given the sharp increase in the international prices of crude and Indias dependence on imports to meet much of its consumption. If the hike came only when it did, it was because electoral compulsions and the opposition forced the government to hold back.

The government has argued that since under-recovery by the oil marketing companies (OMCs) or the shortfall in the price at which certain petroleum products are sold relative to the cost of acquiring and distributing them was leading to huge losses, it had no option. It could, for a time, compensate the oil companies with tradable oil bonds on which it paid interest. But that merely postponed the problem and increased its dimensions. A price hike was inevitable.

By opting to hike the price of petrol and diesel by more than 10 per cent and that of LPG by more than 15 per cent the government has transferred on to the domestic consumer a significant share of the burden of increased international oil prices. This could not have occurred at a worse time. Inflation is already running at more than 8 per cent. Since oil is a universal input that directly and indirectly enters into the cost of production of almost every other commodity, the announced increases would have effects that are likely to take inflation to double-digit levels.

In different circumstances, the government may have chosen to reduce sharply its own expenditure to cool the system and dampen inflation. It could have argued that even though this would reduce the rate of growth of the economy (with GDP, or gross domestic product, growth running at 9 per cent a year) such a reduction is an acceptable trade-off to keep prices in check. But reduced government expenditure would trigger a recession, increase unemployment and curtail allocations to crucial social sectors, worsening poverty and deprivation. That would affect the poor extremely adversely.

Given that this is an election year, the governments expenditures are likely to rise rather than fall, which is one cause for comfort. But this also means that although growth may not collapse, inflation may soar even further.

Obviously, the government cannot avoid responding to the huge rise in international oil prices, which has been generated by a combination of conflict-induced supply shortfalls, rising demand and rampant speculation. The question is whether a sharp hike in retail prices is the best response.

Since the weighted average price of the basket of crudes imported by India has risen to above $130 a barrel, as compared with $30 plus a barrel four years back and $60 plus a barrel two years ago, some action was inevitable. Inaction would have meant that the burden of the divergence between changes in the higher international price of oil and in the domestic prices of oil products would have fallen solely on the three oil-marketing companies (Indian Oil Corporation Limited, Hindustan Petroleum Corporation Limited and Bharat Petroleum Corporation Limited). But action need not have meant just a price hike.

The under-recoveries or losses suffered by the oil companies are computed by assuming that these companies access the petrol, diesel, LPG and kerosene they market at prices that reflect international crude prices, international conversion costs and margins in the refineries and current international transport costs. But it is only when oil is actually imported, processed domestically and then marketed to the oil-marketing companies at a cost-plus price defined by international standards that the latter suffer such losses. To the extent that crude is not imported, the losses are only notional.

In 2006-07, Indias consumption of crude oil was around 147 million tonnes, of which 34 million tonnes (or just short of a quarter of crude consumption) was produced domestically. If it is assumed that domestically produced crude and products derived from domestically produced crude are supplied to the oil-marketing companies at international prices, then two implications follow.

First, it is being assumed that the oil producers are making super-profits because of the global rise in crude oil prices and that the earning margins of refineries are comparable with those of international producers, which would make them extremely profitable, too. If the upstream oil companies and the refineries share the burden of adjusting to the current oil shock, then the price at which products would be available to the oil marketing companies would be lower than assumed, which indeed is the case.

Second, projections of under-recoveries and losses are based on the assumption that the level of consumption remains more or less what it was prior to the price increase. Aside from the fact that the price increase itself could reduce demand (even if only marginally), what this ignores is the policy alternative of directly curbing consumption. As is argued by Prabhat Patnaik in an accompanying article, the most reasonable policy option in the face of the steep increase in oil prices is a curb on aggregate consumption and the use of rationing to allocate the targeted volume. That would obviously reduce imports and the notional losses of the OMCs.

The government, given its predilections, has chosen to ignore this policy option, resulting in under-recoveries that are estimated to rise to as much as Rs.250,000 crore in 2008-09 as against Rs.77,000 crore last year. Even if the actual figure is lower (say, Rs.200,000 crore as claimed by some), it is true that the viability of the OMCs will be at stake if they are not compensated in some way.

But posing the problem in this way obfuscates the real issue, which is the need to curb consumption. As a result, the discussion gets diverted to assessing how the government should share the burden of an increase in international prices.

There were at least six alternatives available to the government in terms of adjusting to the oil price shock. These were : (i) raising retail prices; (ii) reducing customs and excise duties even with unchanged retail prices, so as to transfer the benefits of the duty reduction to the oil marketing companies; (iii) generating revenues by taxing the super-profits of oil companies that are involved in the production and export of crude at the current high prices, so as to compensate the marketing companies; (iv) generating resources through additional taxes on, or lower tax concessions for, Indias super-rich individuals and the corporate sector, so as to pay for subsidies that protect the ordinary consumer from the effects of the global oil price shock; (v) borrowing money through the issue of oil bonds to compensate oil marketing companies for their losses; and (vi) getting State governments to reduce sales tax so as to neutralise partly the impact of increases in prices charged by the oil companies to retailers.

These alternatives reflect varying answers to the basic question of how the burden of financing the additional cost of import could have been shared.

The Central government claims that it is relying on a combination of some of these measures (price increases, duty reductions and oil bonds) to reduce the burden on the consumer. Many State governments have pitched in with sales tax reductions at the expense of their already limited revenues. The difficulty is that despite these claims and efforts the price hike finally resorted to is by no means moderate and its effects come when the ordinary citizen is already shouldering the burden of rising inflation. It would have been more sensible and fair to opt for a combination of the other means of adjusting to the oil shocks, so as to keep prices constant.

The government did reduce duties on petroleum products, but only by a small amount. While the 5 per cent customs duty on crude oil has been scrapped, the customs duty on petrol and diesel has been reduced from 7.5 per cent to 2.5 per cent and the customs duty on other petroleum products from 10 per cent to 5 per cent. But the heaviest taxes on petrol and diesel, namely the excise duty of Rs.14.45 a litre on petrol and Rs.4.60 a litre on diesel, have been reduced by just Re.1 a litre in both cases.

The use of petrol and diesel as sources of tax revenue has meant that the retail prices of these products include a substantial duty component. Prior to the recent duty adjustment and price hike, the tax component in the retail selling price of petrol and diesel was placed at 53 per cent and 34 per cent respectively. As a result, in 2006-07, out of the proceeds from the retail sale of petroleum products Rs.10,043 crore accrued to the government as revenue from customs duty and another Rs.58,821 crore as revenue from excise duty.

After the changes, in the retail price of Rs.50.52 a litre, the actual price (Rs.27.96) still accounted for just 55.3 per cent of the price paid, excise duty (Rs.13.45) for 26.6 per cent and State-level sales tax, dealers commission and delivery charges for the balance 18.1 per cent. State-level sales tax accounted for the bulk of the last figure and several States reduced it to neutralise part of the price increase. (The relevant proportions in the case of diesel (price Rs.34.76) were 77.5, 10.4 and 12.1 per cent respectively.)

It hardly bears stating that if the government had chosen to forgo its oil revenues completely, but the retail price had been kept at its earlier tax-inclusive level, the losses of the oil marketing companies would have been far less. These losses could have been compensated for substantially with direct payments financed by additional taxes and a dose of borrowing in the context of an emergency.

What is more, the oil producing companies could have borne a far greater share of the burden. The president of the Centre of Indian Trade Unions (CITU) and CPI(M) Central Committee member, M.K. Pandhe, had written to Prime Minister Manmohan Singh advancing the following argument: With crude oil prices now exceeding $100/bbl, it is necessary that windfall gains be recovered from private oil and gas producing companies like M/s Cairns, Reliance, etc., who are contractors extracting oil and gas in India through Production Sharing Contracts (PSC). When these contractors participated in the famed NELP [new exploration licensing policy] policy, none of them could have envisaged crude oil prices beyond $30/bbl. It would be a failure on the governments part to allow such upstream contractors additional gains of $70/bbl-$80/bbl in the name of import parity without any link with actual production cost.

In support of his case that these windfall profits should be taxed and the proceeds used to compensate the oil marketing companies directly, Pandhe quotes the view of Senator Patrick J Leahy, chairman of the United States Senate Committee on Judiciary, who reportedly argued: Of course, the bottom line is very simple: People we represent are hurting. Your companies, the foreign oil interests, are profiting. And we need to get this somehow into balance. We look at the past profits of oil companies and what theyre making on previously discovered oil; oil that was very profitable for them at $55 to $65 a barrel is obviously making them windfall profits at $130 a barrel.

That is not all. Many of the refineries in India are charging conversion costs far in excess of what is warranted by economic costs based on best-practice technologies. Normative costing would help reduce prices as well as force these companies to reduce costs and accept reasonable returns.

The government can afford to lose more of the revenue it obtains in the form of taxes on oil. Further, the losses of the OMCs could have been compensated with additional taxes on, and reduced tax concessions to, those companies, businesses and individuals who have benefited hugely from the high growth of recent years. The argument of the opposition, too, is that this could have easily been done, and they have accordingly offered many suggestions. They are, indeed, right. If the government chose to ignore their suggestions, it must be because it believes that taxing the rich to pay for protecting the poor and the middle classes from the effects of an unprecedented oil shock is not acceptable. What also seems to have been ignored is that this biased belief could cost this government a victory in the next elections.