Birth of a monopoly

The acquisition of the public sector Indian Petrochemicals Corporation Limited by the Reliance Group threatens to unleash a domineering monopoly in the Indian petrochemical industry.

THE recent acquisition of a controlling stake in the public sector petrochemical major, Indian Petrochemicals Corporation Limited (IPCL), by the Reliance Group did not surprise many people. Events since three years ago, after the Central government decided on divesting its stake in the company, had indicated that Reliance was inching towards the takeover of IPCL, a pioneer in the field of petrochemicals in India. (Prior to the deal, the government held 60 per cent of the shares in IPCL.) Reliance's winning bid for the 26 per cent stake of the government, at a price of Rs.231 a share and aggregating Rs.1,491 crores, effectively makes it a monopolist in the petrochemicals business. After the takeover, on an average, taking into account the range of products of the merged company, Reliance controls more than two-thirds of the production capacity in the petrochemicals business. In some segments the control is absolute. The implications are mind-boggling. The control of a wide range of crucial intermediates which go into the production of an array of downstream products implies that the monopoly power of the merged entity will be awesome. The implications for Indian business could be serious, particularly for the hundreds of small and medium units in the plastics and chemical industries.

Reliance's winning bid was way ahead of the other two bids. While the public sector petroleum major, Indian Oil Corporation Ltd. (IOCL), bid Rs.128 a share, Nirma, better known as a soap-maker, offered Rs.110 a share. After the winning bid was announced on May 18, the Disinvestment Ministry revealed that the adviser on the IPCL deal, UBS Warburg, had presented the government with four alternative valuations based on four different methods. The evaluation committee of the government fixed the reserve price at Rs.131 a share by valuing the company on the basis of the discounted cash flow method. The total cost of Reliance's acquisition would be Rs.2,641.45 crores, including the mandatory 20 per cent open offer that it has made at the same price of Rs.231 a share to public shareholders. Reliance will also have the first right of refusal when the government divests its remaining stake.

In the run-up to the IPCL sale, the government sweetened the offer by making three concessions to the short-listed bidders. Reliance, as the winner, is set to take advantage of all these. The Excise Department in the Finance Ministry withdrew a Rs.600-crore excise duty claim on IPCL. The government justified the move, claiming that if this was not done the contingent liability on account of the excise claims would have depressed the price to be quoted by the bidders. Earlier, the Disinvestment Ministry had taken the initiative by sorting out issues relating to IPCL's long-term contract for supply of gas and its pricing with the Oil and Natural Gas Corporation (ONGC) and Gas Authority of India Limited (GAIL). The widespread perception among sceptics was that the Disinvestment Ministry had pressured the two public sector companies to offer a deal favourable to the bidders. In particular, there was criticism about the fact that the two public sector companies were entering into a long-term negotiated kerb-side transaction even as the administered pricing mechanism in the petroleum sector was being dismantled. Another sop for bidders came by way of the Finance Ministry's decision to extend sovereign guarantee to IPCL on its World Bank loan of about $100 million.

ESTABLISHED in 1969, IPCL represented India's attempt to develop self-reliance in the field of petrochemicals. Until then the Indian market was dominated by multinational companies such as Hoechst, ICI (then the Imperial Chemical Industries) and Union Carbide. The economies of scale associated with the industry and its capital-intensive nature were significant barriers to the entry of private firms. IPCL specialised in the production of the basic building blocks, where manufacturing scales were crucial. This led to the establishment of hundreds of small-scale units producing other downstream products.

By 1979, IPCL had established the first integrated petrochemical manufacturing complex at Vadodara in Gujarat. Several state-owned companies - among them IOCL, the State Trading Corporation and Engineers India Ltd. - provided crucial support to IPCL at this stage. In the early 1980s, IPCL established its second plant at Nagothane, to use natural gas from the Bombay High oil fields as a feedstock. In the early 1990s the company established its third complex at Gandhar in Gujarat.

As a result of the takeover, Reliance gains control of IPCL's two gas-based crackers with a total capacity of 700 lakh tonnes per annum and one naphtha-based cracker with a capacity of 130 lakh tonnes per annum. In a petrochemical complex, feedstock (either natural gas or naphtha) is chemically reacted in a cracker. Cracking breaks larger molecules into smaller ones, resulting in the production of the basic building blocks of chemicals such as ethane or propane. There are two types of plants producing base chemicals, olefin plants and aromatic reformers. Olefin cracker produces the base chemicals, ethylene, propylene and butadiene. Aromatic reformers produce benzene, toluene and xylenes.

The acquisition of IPCL by Reliance implies that the merged entity will dominate the market in several ways. The acquisition of cracker capacities using both kinds of feedstock means that Reliance will now enjoy greater flexibility in the use of feedstocks. Moreover, the notionally depreciated value of IPCL's assets means that Reliance will enjoy the cushion of significantly high barriers to entry of fresh capacities in the industry. The replacement cost of its existing assets would well exceed Rs.10,000 crores. The merger enables Reliance to enhance further economies of scale in operations and reduce costs.

Prior to the takeover, IPCL sourced about Rs.100 crores worth of feedstock from IOCL annually. This will now be captive to Reliance's own petroleum refining capacity of 27 million tonnes a year, located at Jamnagar. Reliance's takeover of IPCL ensures that it has denied space to competition. By acquiring IPCL, Reliance has effectively denied IOCL the opportunity to move downstream and gain a footing in the petrochemicals industry. The acquisition also enables Reliance to access IPCL's free reserves, currently about Rs.2,700 crores. Significantly, this is more than what the Reliance Group would pay for the takeover.

The most significant result of the acquisition is that in terms of production capacities Reliance will dominate the market in a range of products. For instance, the merged entity holds two-thirds of the ethylene manufacturing capacity in India. Amongst the olefins, ethylene is one of the most important building blocks. Indeed, most plant capacities are measured in terms of their ethylene output. In India, ethylene is used to manufacture polymers, which constitute 70 per cent of the demand for all petrochemicals. Ethylene goes into the production of polyethylene, poly vinyl chloride and ethylene glycol. According to investment analysts such as J.P. Morgan, Reliance is now the largest producer of ethylene in Asia. Reliance, which already dominates the market for intermediate chemicals that meet the demand of the textile industry, will now enjoy an unassailable leadership along the entire petroleum-petrochemicals chain.

J.P. Morgan has welcomed the acquisition, pointing out that "the new petrochemicals giant will wield pricing power in the Indian petrochemical products market". In fact, an interesting aspect of Reliance's own reaction to the fears of monopoly dominance after the merger is that it addresses the concerns of IPCL's shareholders - notionally at least, the public at large - and its own shareholders in two different voices. It has sought to allay the public's fears of a rising monopoly by arguing that the threat of "freely importable" petrochemicals and the government's commitment to reduce tariffs will restrain Reliance's ability to impose prices on consumers. It has also highlighted the subtle distinction between dominance and "abuse of dominance", which it says is what is bad for business. One analyst summed up the deal thus: "We think the intricacies of this deal are beyond the obvious."

However, Reliance, while addressing investment analysts, has pointed to the "science" and "art" of its valuation of IPCL. In particular, it has sought to address the concern in some quarters that it has bid much too high for IPCL. Explaining the "science" of the deal, Reliance pointed out that its valuation rested on its assessment of IPCL's overall earnings - not taking into account interest costs, depreciation and taxes - EBITDA, in short. Reliance explained to analysts that since the Indian petrochemicals industry was entering a recovery phase, IPCL's earnings were projected to increase by about 20 per cent in the next three to four years. The net value of equity was estimated to be Rs. 6,120 crores, implying Rs.240 per IPCL share.

The "art" of Reliance's valuation is more interesting because it reveals the company's own assessment of its monopoly status and the opportunities it provides for profits. Reliance pointed out that the "value of the IPCL share should be even higher" because the assessment of values was based on global and Asian parameters "where growth is much lower than in India." Reliance estimates that the Indian market for polymers is likely to grow at a rate of 15 to 20 per cent in the next decade and that it is likely to grow into the third largest in the world, after the United States and China. "Accordingly," explains the note, "the value of a company like IPCL, which is a leader in the field in India, would naturally be much higher than a global/Asian company, which contends with much lower growth rates of barely 5 per cent per annum."

Media reports since the takeover have quoted Reliance officials as expecting the payback time for the IPCL acquisition to be less than two years. This is sought to be achieved by making capacities work in tandem. According to media reports, Reliance is poised to rationalise products in order to enhance its "dominant market position in the polymer market". Industry analysts say that Reliance's pricing power in the domestic market is the key to the expectation that the payback period will be short. The normal payback time for a petrochemical plant varies between three and 10 years, depending on the point at which entry is made in the business cycle. There is general consensus that Reliance has timed its acquisition right because import duties are still high (ranging from 35 to 50 per cent for most categories). "Even if Reliance does create a monopoly, India does not have strong anti-trust laws to tackle the problem," says an investment banker. "Other than Haldia Petrochemicals Limited, there are very few who will match Reliance's capacities."

Disarmed of the "art" of the IPCL valuation, Reliance's logic is simple: the key to acquisition lies in the assertion of the monopoly power that the takeover provides. Shorn of economic jargon, this means the assertion of the monopolist's ability to command prices for a wide range of petrochemical products in the Indian market. Reliance has argued that the scope for abuse of monopoly power is restrained by a regime of free imports and that tariffs have been steadily coming down. However, this is a generalised argument, not backed by trends and developments in the sector in the recent past. For instance, in his last Budget, Finance Minister Yashwant Sinha doubled the import duty on paraxylene, the market for which was monopolised by IPCL and Reliance. Since December 2001, prices of products in the IPCL-Reliance portfolio have increased substantially. Between December 2001 and February 2002, the price of polyester staple fibre (an old Reliance mainstay) increased from Rs.42,000 a tonne to Rs.48,000 a tonne in February. Polypropylene prices increased from Rs.37,000 to Rs.43,000 a tonne in the same period. Polyethylene prices also increased by a similar magnitude during this phase.

The valuation of an acquisition is always difficult, but when the takeover establishes a monopolist, it is even more so. This is because the merged entity is capable of setting the price in the market without challenge. The point is that, post-merger, the dynamics that governed the valuation prior to the deal are changed beyond recognition in the new situation. The privatisation process will remain controversial as long as public sector companies, particularly those that hold the "commanding heights" in their areas of business, are sold to monopoly interests. The price just cannot be right because the valuation cannot account for monopoly power.

Invoking the stereotype of a stepmother may be politically incorrect, but it best conveys the perception of those who believe that the government has systematically undermined IOCL's attempt to extend its operations along the value chain, especially in the context of the recent opening up of the petroleum sector. The perception that the government, despite being the owner of the company, has not provided IOCL a level playing field has only gained currency in the aftermath of the IPCL sale. In May 1999, when the government announced that IPCL would be put on the block, IOCL, Reliance and Mitsubishi were the only serious contenders. Although IOCL formed a joint venture to undertake the acquisition and completed due diligence on IPCL's assets, the bid documents were not issued by the government.

In early 2001, the government responded favourably to IOCL's suggestion that it acquire IPCL's main and oldest plant at Vadodara on "nomination basis". Documents available with Frontline reveal that the government "agreed that this nomination will not come in the way of Indian Oil's bid for the remaining units of IPCL". IOCL's decision to acquire IPCL's Vadodara plant was based on its assessment that the move will enable the company to integrate its refining operations with the petrochemicals business and generate value addition - from crude to naphtha to polymers. IOCL's assessment after the due diligence process was that the technology employed at the Vadodara plant was "highly unlikely to be superseded by a new breakthrough in the next 10 years". The Vadodara plant also caught the fancy of IOCL because it was a "significant producer" of high-value polymers. The fact that the IPCL plant and IOCL's own flagship refinery in Vadodara are adjacent to each other was also a factor in IOCL's decision to acquire the plant.

Critics allege that while the government, citing fears of an emergent monopoly, has prevented IOCL from bidding for a controlling stake in either Bharat Petroleum Coporation Limited (BPCL) or Hindustan Petroleum Corporation Limited (HPCL), the two public sector oil companies that are to be privatised, the same concern has not been reflected in the government's decision to hand over IPCL to Reliance. In February, M.A. Pathan, then chairman of IPCL, had asked the Petroleum Ministry to provide it a level playing field, enabling it to bid for the two oil majors. He said that if the government intended to prevent the formation of monopoly interests, it ought to be consistent and apply it to the case of IPCL also by barring Reliance from bidding.

Although Reliance has issued statements - including one from Anil Ambani, RIL managing director - to the media, welcoming the 14,000 workers into "the family", the staff say they have not heard anything first-hand. A general manager at the IPCL headquarters in Vadodara remarked: "What you tell us is what we know." Referring to the IPCL disinvestment, he added that "these were share holders' decisions, taken at the Ministry level".

The sale of IPCL under the stewardship of Disinvestment Minister Arun Shourie must have been doubly sweet for the Ambanis, the family that controls the Reliance Group. In the mid-1980s, Arun Shourie, as Editor of a prominent English daily, launched a series of scathing attacks on the Reliance Group, exposing the manner in which Congress(I) governments had favoured the group, notably by way of tax policies. The wheel has turned fully since then for the Ambanis.