Right pricing petrol & diesel

companies should price their products according to their own cost structures

Fuel pricing has been the bugbear of many a government in India. Though de-licensing of oil refining and marketing, and decontrol of products such as naphtha, fuel oil, lubricants and aviation turbine fuel were one of the first accomplishments of the reform process in the early 1990s, freeing the pricing for transportation fuels — petrol and diesel — remained a challenge.

Last week’s decision by the Centre to deregulate diesel prices has to been seen in this context. For the first time since the short-lived experiment in 2002 when petrol and diesel prices were freed for a short period, oil companies will have the freedom to manage retail price of diesel on their own and adjust it at periodic intervals to reflect market levels. Petrol prices were deregulated in June 2010 but fortnightly revisions have been a reality only since January 2013.

Both petrol and diesel are politically sensitive commodities but unlike petrol, diesel price changes have a cascading effect across the economy on everything from bus and rail fares to vegetable and fruit prices. Governments have, therefore, been wary of freeing diesel pricing and the sustained rise in global oil prices from 2002 until the crisis in 2008 did not help matters. The Modi government has now grabbed the opportunity provided by a falling global oil price regime — prices of benchmark Brent have fallen from around $105 a barrel in April to about $86 a barrel now— to push through deregulation of diesel and it needs to be complimented for this. Yet, deregulation of diesel, noteworthy as it is, is only the first step in much-needed reform of the oil sector.

What we immediately need is some transparency and reform of the methods followed by the oil companies while setting fuel prices, whether petrol and diesel or cooking gas and kerosene. The concept of ‘under-recovery’ has to be jettisoned and competition between the different players — public and private — needs to be encouraged. That alone will allow proper price discovery for these economically sensitive fuels.

The concept of ‘under-recovery’ is unique to India. ‘Under-recoveries’ are nothing but the difference between the oil companies’ ‘desired’ price of a fuel, say diesel, and its prevailing retail price in the domestic market. This ‘desired’ price is calculated on trade-parity basis that takes into account the landed cost of imported fuel and the price at which it is exported by domestic refineries. Presently, the ratio is 80:20 in favour of landed cost. For instance, if the price of a litre of diesel as calculated on trade-parity basis is, say, Rs.70 a litre and the oil companies are selling diesel in the retail market at Rs.65 a litre, the ‘under-recovery’ will be Rs.5 a litre.

‘Under-recovery’ is not the same as a loss which happens when a producer is forced to sell his product below cost. Oil companies refine crude oil to produce diesel (and other products such as petrol, cooking gas and kerosene) in their own refineries in India. They have not been importing diesel or petrol for a decade now, thanks to a sharp increase in domestic refining capacity.

Given this, why should the landed cost of imports, which includes items such as freight, insurance, handling charges and, of course, customs duty, be considered for fixing domestic retail price? This is the unfair part about ‘under-recoveries’, a word that is often cleverly used interchangeably with losses. Let this be clear: ‘under-recovery’ is a notional concept and does not necessarily mean a loss. The only exception when it could include a loss is where global crude oil prices surge to abnormal levels and the retail price of fuels remains unchanged. There has not been such a situation in recent years.

But why do oil companies harp on ‘under-recoveries’ and demand that domestic price should be linked to that? Simply because the landed cost, which includes duties and other levies, offers them protection to cover up possible inefficiencies in their operations. This protection is unnecessary and unfair to domestic consumers and all it does is promote inefficiency. It is no secret that the public sector oil companies are saddled with high costs for reasons ranging from excess staff to duplication of facilities between them. By linking retail price to ‘under-recovery’ all that the government does is ensure that such inefficiencies are passed on to consumers. Again, global prices of crude oil and refined fuels such as petrol and diesel do not always move in tandem. The forces that drive their respective markets are different. For instance, the international market price of petrol and diesel can spike if there is a refinery outage somewhere in the world causing supply disruption. There have been instances in the past when refined fuel prices have surged due to a fire or a maintenance shutdown by a particular refinery. Crude oil prices are not affected by such factors. By taking into account landed cost of refined fuels rather than crude oil, the oil companies may be forcing consumers to pay a higher price when there is really no supply problem within the country.

Cost-plus pricing

The ideal way to go is for oil companies to price their products according to their own cost structures. Each company has a unique cost structure which is a factor of its refining efficiency. The final market price should be discovered on the basis of the cost of crude plus refining costs and the margin of the oil company.

This can happen only in a competitive environment where the oil companies compete with each other and against the three private players — Reliance Industries, Essar and Shell. As of now , the PSUs operate as a cartel when pricing their products, which is an anti-competition practice. Clearly, the next item on the agenda for the government should be to push the oil companies truly into the market era where fuel prices are linked to efficiencies and vary not just between the different players but between petrol stations of the same player based on which one is more efficient. That will be real reform.