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Oil PSUs: Decoding the math of loss or under-recovery and what it means-Avinash Celestine
-The Economic Times

How right was the government when it stated that the under-recoveries posed a threat to 'our national economy'? Or when the government says that it gave more to the sector in the form of subsidies than it earned as fuel taxes? The government would also like you to believe that the under-recoveries, dependent as they are on the price of crude in the international market, and the exchange rate, are beyond its control. To what extent is that true?

The losses faced by public sector fuel companies due to a controlled price on diesel are quite real, but there's also a fair amount of mythmaking mixed in with the reality. ET Magazine takes a sceptical look at the 'under-recovery' problem, and follows the money.

Box: India's GoI-PSU Oil Complex

Who the players are, and their role in fuel subsidy

'Upstream' Companies

These include companies such as ONGC and OIL, which supply crude to the oil marketing companies. Importantly, they also bear a significant part of the fuel subsidy by giving discounts on the crude they sell to the refiners. In 2011-12, for instance, such discounts accounted for about 40% of the total assistance to oil companies.

Oil Marketing Companies

The 'refiners-cum-marketers' companies like IOC, BPCL and HPCL(called 'OMCs') buy crude from upstream companies, and refine it into diesel, petrol and other 'products'. The 'refinery' arm of the OMC then sells it to the marketing arm of the OMC at the international benchmark price, which sell it to the end-customer. By selling at controlled prices, the marketing arm of OMCs sustain a loss.

Central Government

Mobilised about Rs 83,700 crore in taxes on various fuel products in 2011-12. The total subsidy payout, on the other hand, to the oil companies to compensate them for under-recoveries, was about Rs 70,000 crore. In 2011-12, it bore around half the total 'under-recoveries' of oil companies.

State Governments

In 2011-12, following cuts by the Centre in customs and excise taxes on the sector, the state became the bigger revenue earner from oil. But that's only if you don't include so-called direct taxes, such as income-tax, paid by OMCs to Central govt.

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Are they Losses?

What the ad didn't mention was that the latest price hikes would also lead to an increase in central government revenue from the oil sector, of about Rs 1,500 crore a year. Not very much money when compared to overall government revenues, or the large losses faced by oil companies even today but the move was emblematic of the complexity with which fuel is priced in India. 

The idea of under-recoveries is actually pretty straightforward. Let's assume that it costs a refiner-cum-marketer like Indian Oil $2 to produce a unit of diesel from crude. This includes all costs — the cost of the crude itself (which forms the bulk of costs), as well as the costs of refining, manpower and even financing costs. But due to price controls in the Indian market, IOC is forced to sell that diesel to you and me at $1. Thus, the loss to IOC, as you and I would understand it, from selling diesel at a subsidised price below its costs, is $1 ($2-$1).

But suppose the global market price for diesel, and the cost at which India can import it, is $4. While the 'loss' to IOC is $1, the under-recovery as the government calculates it, is $3 ($4-$1). What the under-recovery approach assumes, is that the 'right' price in India is actually the international market price for diesel, and that Indians should pay a rate equal to the cost of importing diesel from the international market and selling it here, with no subsidy.

Crude Numbers

The main point is this — and it accounts for the basic distinction between under-recoveries and losses: India imports crude, refines it into diesel, and sells it to the end consumer. What India doesn't do is import diesel and sell it to the end-consumer (at least not on a large scale).

That key distinction — between importing crude oil and importing diesel, is what makes all the difference. In early-September, the price of the kind of crude that India imports, traded in the international market at about $112 per barrel (it has fallen since then). Diesel traded at a substantial premium to this — at about $135 per barrel. That's a difference of $23 or roughly Rs 8 per litre.

It's a bit akin to assuming that a T-shirt manufacturer in Tirupur decides to price his T-shirts in India, not taking into account his own labour and other costs, but the price at which a similar piece of clothing sells for, in a Gap store in New York or London. This is not to say that fuel companies are not suffering (actual) losses — they most probably are, though with the latest hikes and the recent falls in the price of crude, those losses have come down.

The real problem is that it's not at all clear what those actual losses might be. For instance, IOC reported a quarterly loss of Rs 20,000 crore for the first quarter of the financial year — does this reflect the 'actual' loss it faced on selling fuel below cost?

As a report by a committee on fuel pricing headed by C Rangarajan pointed out a few years back: "The under-recoveries are different from the actual profits and losses of the oil companies as per their published results. The latter take into account other income streams like dividend income, pipeline income, inventory charges, and profits from freely priced products and refining margins in the case of integrated companies." In short, no. 

In the below table, ET Magazine reports a calculation of what the actual loss could be, in the case of diesel, and following the latest price hikes. It assumes that India imports crude and refines it to diesel (and other so-called 'products' which are the industry-speak for the output of the refining process, such as petrol, aviation fuel, or kerosene) and sells it at a controlled price to the end-consumer, rather than importing diesel.

OIL
 
The table reports an actual loss of about 70% of the official under-recovery for diesel. But because this is such a rough calculation, it's hardly reliable — the correct figure could be 50% or it could be 90%. The real point is: we don't know.

The government, interestingly enough, uses the term 'losses' interchangeably with the words 'under-recovery', to make the claim highlighted earlier, that there was a serious threat to the national economy.

The Fuel Price Logic

Strange as it might seem, this system of pricing had, and still has, a logic to it. Before 1998, the government compensated oil companies on a 'cost-plus' system — essentially allowing them to charge a price(subsidised to the end-consumer) which accounted for costs as well as a 12% profit margin. This gave little incentive to oil companies to undertake crucial investments or even exercise cost control, since they were guaranteed a minimum return.

The switch to the current system of pricing, which is benchmarked to the international market was completed in 2002. Since then, claims the government, refinery capacity in the country has risen to 213 millions from 114 million tons, with about 40% of capacity in the private sector. 

In fact, India today has more refining capacity than it needs, and is a net exporter of petroleum products to the international market — net exports of petroleum products were about 45 million tons in 2011-12. In 2001, India was a net importer of petroleum products. Interestingly in the five years till 2011, about three-fourths of the increase in refinery capacity was accounted for by the private sector — Reliance and Essar.

Put another way, in the eight years following 2002, the output of petroleum products from the public sector grew at 4.1% per annum, compared with a growth of 3.9% between 1990 and 1998 — a minor increase. In the private sector, the output increased at 15% per annum in the eight years after 2002. If India's output of petro-products has grown by leaps and bounds in the last decade or so, it's disproportionately due to private sector capacity addition.

Making it Complicated

But even as India shifted from being a net importer of petroleum products to being a net exporter, some of the more arbitrary aspects of the 'trade parity pricing' regime became apparent. These seem like technical details to an outsider, but taken together they have a not insignificant impact on what that 'under-recovery' number is.

Take the international benchmark price of diesel used by the government — this is hugely important in arriving at the final value of under-recoveries. What the government does is start with the price of diesel in the Arabian gulf, add freight, transport costs and insurance charges and a customs duty of 2.5% (imposed on diesel, though it's worth noting that crude oil, which is what is actually imported, attracts no duty) to arrive at a final import price. This constitutes the bulk of the benchmark (or 'trade parity') price used to value under-recoveries.

As Mukesh Anand, assistant professor at the National Institute of Public Finance and Policy (NIPFP), who has written a paper on diesel pricing argues, the high weight assigned to an import price, "is inadmissible when India is emerging as a competitive producer and exporter of certain refined products, particularly diesel.

Further, inclusion of customs duty in [import price] apart from offering unwarranted protection is inconsistent with the notion of international prices." According to Anand, the price at which Indian diesel is exported, would be more appropriate.

Using the export or FOB price as a benchmark reduces diesel under recoveries by about Rs 2 a litre, or about 13% — that's about Rs 15,000 crore(annualised) for 2011-12. The broader point is not that the government should use one price or the other, but that an important part of the under recoveries number depends on what prices you use, and what assumptions you make.

Following the Money

A parliamentary committee which looked into petroleum pricing last year said that adding in such charges such as insurance, freight or customs duty to the import price was purely notional and only added to the under-recoveries figure. It said: "the Committee had found no justification in including the components other than FOB [free on board] price of petroleum products at Arab Gulf on the reasons that these costs have been incurred by refineries while importing crude oil."

It argued: "The switch over [to trade parity pricing] was to reflect the competitive conditions and help refineries to optimise turnover and bring efficiency in their operations. The Committee are of the opinion that by adding other costs to FOB [the price of diesel in the Arabian Gulf] which are notional, will defeat this objective besides inflating the refinery gate price."

Interestingly, in its response to the parliamentary committee's observations, the ministry argued that such charges formed a small part of the overall 'desired' price and were to ensure that, "refineries recover their cost of imports and various other levies such as octroi, entry tax etc,".

Further, a benchmark based on export prices would, "not cover the cost of refining crude oil particularly by the older refineries of PSU OMCs and would not be adequate to meet their CAPEX requirements towards capacity addition, Quality up-gradation, etc." 

In other words, the aim of including such charges was to protect the cost base of less efficient refineries. What the ministry left unsaid was that by doing this, it was also protecting the more efficient refineries, including those in the private sector, as well. And the statement also went against the spirit of the original aim of the new fuel pricing system, which was to force refineries to be efficient and minimise costs.

Who Pays?

In its ad, the government made another claim. It said that it collected about Rs 83,700 crore of tax revenue from the oil sector. "However, the government, to provide fuel to the common man at subsidised rate, had to reimburse the entire subsidy burden of Rs 1,38,500 crore. The government was therefore a net loser by Rs 54,800 crore."

The claim about the tax revenue earned by the government is true enough, though it reflects only the taxes and duties on petroleum products. If you include other contributions, such as dividends paid by public sector oil companies, and income and dividend taxes, the amount rises to Rs 119,850 crore.

But even assuming that the tax revenues figure is correct, the statement that "the government had to reimburse the entire subsidy burden of Rs 1,38,500 crore," is at variance with government's own data in the budget papers.

According to the budget numbers, the total reimbursement, out of the government budget to the oil companies, was Rs 68,481 crore in 2011-12 — about Rs 70,000 crore less than the under-recovery burden. And it's about Rs 15,000 crore less than the tax it collected from the sector in the form of duties.

The government rarely if ever reimburses the full amount of the under-recovery in any year to the oil companies from its budget. A substantial chunk of under-recoveries — in 2011-12, it was 40% (around Rs 55,000 crore, according to the annual accounts of the OMCs), are actually reimbursed by the so-called upstream companies such as ONGC and GAILBSE -0.82 %, by selling crude at a discount to the oil marketing companies — an implicit transfer of cash to the OMCs, in other words.
 
And there is a balance amount of under-recoveries which are not reimbursed at all but are borne by the oil marketers themselves as a loss. The statement that the government 'had to reimburse the entire subsidy burden', is only true if you interpret the term 'government' very broadly to include the PSU sector.

Centre vs States

The centre has also claimed that the states mobilised about Rs 1,12,900 crore from duties on petro-products, without having to bear any subsidy burden. Till last year, the centre mobilised more than the states but following cuts in the customs duty on crude, and excise on diesel, it now earns less in taxes and duties on petro-products than the states.

But in the ad, the centre also says that the recent price hike for diesel will yield an additional Rs 8,200 crore per annum in tax revenue to the states. That's because state duties are often in the form of a percentage of the price — increase the price, and the revenue automatically increases too.

What the centre didn't say in the ad, was that its revenues would rise too, because of the way that the diesel price hike was set up. Rs 1.50 of the Rs 5 per litre hike in diesel prices was an increase in central excise duty on the fuel and would go straight into government coffers. Based on the average monthly consumption of diesel across the country between April and July, that hike in excise translates into an additional revenue to the central government of about Rs 13,100 crore.

But the government also cut the excise duty on petrol by about Rs 5.3 per litre, without changing the end price to the consumer, thus ensuring that that money could be claimed by oil companies towards under-recoveries. By reducing excise on petrol, the government stands to lose about Rs 11,550 crore a year. Put those two tax changes on diesel and petrol together, and the government actually comes out ahead by over Rs 1,500 crore.

Like many subsidy schemes, the trade parity pricing regime in the fuels sector has taken on a certain life of its own, with each tweak leading to changes elsewhere. This is perhaps inevitable in a sector as sensitive and political as this one, and it's perhaps in that light that the government ad should be seen — as a political statement, rather than one that describes facts.