Gas and hot air

The government will soon reveal its decision on gas pricing, which will shape India’s energy landscape for the foreseeable future. The Kelkar Committee has recommended that gas producers be paid “market-determined” prices. But what does this mean?

Unlike oil, there is no global gas price. There are regional markets, where prices are determined by demand and supply. Gas supply contracts, which were typically hitched to oil prices, are increasingly linked to these regional market prices, reflecting a growing consensus that gas market dynamics are different. The three prominent markets used as price benchmarks are the US (Henry Hub), the UK (National Balancing Point) and Japan (Japan LNG), which imports liquefied natural gas. Gas prices are based on calorific value, measured in millions of British thermal units (mmBtu). Consumers in the US and UK pay prices three to four times lower than Asian consumers because Asia produces little gas and has to rely on imports, which are restricted by price and destination clauses.

In India, the producer price of gas is set according to the terms of the contract signed between the government and the operator of the producing field. Broadly, there have been three different contractual regimes. Two of these, the “nomination regime”, which covers production from pre-liberalisation-era fields by national oil companies, and the “new exploration licensing policy”, which covers production under India’s current liberalised policy, account for 60 per cent of the supply of gas. Under these, prices have been set at $4.20/mmBtu since 2010. In contrast, Asian LNG import prices range from $12-17/mmBtu So why the fuss? First, the pricing formula is linked to the price of crude oil up to a cap of $60 per barrel. But oil prices have persistently ranged around $100. Second, the price of rigs is set by the international market and capital costs of production have doubled in the last decade. Given the static domestic price, national oil companies, which produce the majority of India’s gas, have insufficient capital left over for reinvestment. For instance, ONGC’s production cost is such that it just breaks even. Since it cannot reinvest to produce more gas to meet India’s rising consumption, the deficit has to be met by importing LNG at three times the domestic price.

The Rangarajan Committee had recommended basing the producer price on the average of the Henry Hub, National Balancing Point, Japan LNG and Indian import prices. While this is a somewhat arbitrary price-formation mechanism, it attracted the greatest criticism for its impact on the price level as it would have pushed up prices for the domestic consumer, particularly in the fertiliser and power sectors, which account for 70 per centof gas consumption. In fact, governments of countries with underdeveloped gas markets tend to confuse “price formation” with “price level” and often concentrate on the latter for political reasons. Price formation refers to the use of a sound mechanism for setting and adjusting prices. It should reflect not only opportunity costs (the cost of imports), but also the cost of the fuels that gas is meant to replace in the domestic market — for instance, coal and diesel, which are used to generate electricity. In China and South Africa, the formulae take prices of competing fuels into account in order to promote the use of gas. The price level can be managed with policy instruments. For instance, once a price-formation mechanism is established, if fertiliser subsidies are increased, the hike can be offset by using the extra revenues from royalty and taxation. Fear of the price level has led governments to ignore the core issue of price formation. For instance, some Asian governments are keen to link domestic gas prices with the Henry Hub price, which has remained low ($2-4/mmBtu) due to the shale revolution. But this ignores the fact that the Henry Hub price is underpinned by the dynamics of the North American market and will therefore change, and even rise, independent of Asia’s fundamentals. India’s reforms reflect a wider move towards marketisation. In China, an economy undergoing similar changes, gas is being promoted to replace environmentally harmful coal. A roadmap for gas pricing reform was implemented in 2011, moving the country from a controlled cost-plus (production cost plus margins) system to a dynamic price-formation mechanism that reflects the prices of fuel substitutes. To manage the price level, the roadmap includes a two-tier system with different prices for existing and incremental (new) gas. The price of existing gas will rise to eventually converge with that of incremental gas. The roadmap also aims to establish a national benchmark price at Shanghai. The adoption of a clear price-formation mechanism and roadmap has led to a five-fold expansion in Chinese gas consumption over the last decade and boosted production. The Indian government needs to take a bold decision. There are costs either way — whether it reforms gas pricing to increase domestic production while risking consumer price hikes or continues to control prices while importing growing quantities of LNG at three times the domestic price to mitigate shortages.

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