Energy firms warn against cost-plus pricing for gas

Written by PTI | New Delhi | Updated: Aug 24 2014, 17:34pm hrs
Ahead of a panel of secretaries beginning work on a new gas pricing mechanism, an association of top energy firms has warned that going back to cost-plus pricing will be a retrograde step that will lead to rewarding inefficiencies.

The Association of Oil and Gas Operators, which is made up for over two-dozen members including the likes of Reliance Industries, ONGC, Cairn, BP, BG, BHP and Essar, on August 18 wrote to Oil Minister Dharmendra Pradhan listing out pricing challenges and how a market driven pricing will boost output.

In an uncertain and highly probabilistic business like oil and gas exploration and production where only one in 10 efforts is successful, it is best left to the market to decide which fields under what conditions will be viable, it said.

In a Production Sharing Contract (PSC) regime, like the one under which RIL got KG-D6 block in Bay of Bengal, the risk of failure is borne by the contractor for which the investor does not get any compensation. Only upon a discovery is a contractor allowed to recover his cost from sale of oil/gas.

In a cost plus regime, all costs of failed exploration, appraisal as well as development efforts besides the cost of capital will be factored in to calculate the gas price, AOGO wrote.

A four-member panel of secretaries from different ministries will hold its first meeting on Monday to work out a new gas pricing mechanism, as the Rangarajan formula of doubling rates to USD 8.4 per mmBtu did not find many takers.

Stating that the government bears real risk in a cost-plus regime, AOGO said: "It is incomprehensible that the same people who oppose cost recovery system under present PSCs on the ground that the investment multiples gets affected, should be arguing for cost plus pricing where the attendant risks are far higher for the government.

"It is indeed to be considered that when the government is finding it difficult to manage PSCs run on a Cost Recovery basis, introducing cost-plus pricing will only further atrophy the process of grant of approvals and bring decision making to a standstill."

The government had disbanded cost plus prices even for nomination acreage given to state-owned firms way back in 1997 due to unending disputes about cost which needs to be considered for calculated price.

Stating that gas pricing cannot be based on vintage of production, it said such a move would "severely compromise" the PSC promises of market linked gas prices.

Also, oil and gas projects are not typical infrastructure projects where a tariff can be fixed at the start of the project based on expected life cycle costs.

"Extraction of all economic reserves is only possible through sustained investments over the project life. In fact most fields require heavy investments for enhancing recovery toward the end of field life," it said, adding that fixing of lifetime tariffs will only ensure that all economical reserves are never extracted. AOGO said: "Furthermore, economics of E&P business is not based on individual successful projects but on a portfolio of both successful projects and failed exploration, so fixing price of a successful project based on upfront investment will severely undermine ability of the investors to invest risk capital in exploration and production.

"This would result sub-optimal recovery of discovered hydrocarbon resources."

In the letter -- copies of which were also marked to Finance Minister Arun Jaitley, Cabinet Secretary and Principal Secretary to the Prime Minister -- it said it was disquieting to note that even as domestic producers of natural gas are given regulated prices, gas is being imported at market price of around USD 13-16 million British thermal unit.

"Through our policy we are actually facilitating transfer of nation's wealth and economic activity abroad," it said.

Quoting an IHS CERA study, the association said that onshore gas development projects can be economically viable at a price of between USD 6-8, while offshore projects would need USD 6-12 per mmBtu price.

While any price increase of domestic natural gas may led to increase in subsidies on urea and power, increased government profit share, royalty, dividends and income tax from the increased price would almost neutralise them.

"Any move away from free market pricing will be seen as a violation of contract and its sanctity," AOGO said. "It is thus imperative and crucial that Government Policy should encourage investment that maximises domestic oil and gas exploration and production."

AOGO said it is willing to accept the Rangarajan formula which doubles the current gas price of USD 4.2 per mmBtu, as a first step in the move to a market price. "This pricing mechanism needs to be implemented immediately."

"Even as we implement the notified natural gas price guideline, a comprehensive review of the pricing policy should be undertaken to firmly establish the transition to a market that determines gas prices based on demand and supply," it added.