The petroleum pricing tangle

Updated: Oct 25 2013, 00:31am hrs

What bearing does the selection of a pricing methodology have on the calculation of under-recoveries

The Kirit Parikh committee is all set to recommend to the government the continuation of the trade-parity-pricing (TPP) model for calculating under-recoveries of oil-marketing companies (OMCs). Meanwhile, the pricing mechanism decision has pitted the finance ministry, which wants to bring into force the export-parity pricing (EPP) model, with the petroleum ministry that is backing the TPP model.

Different pricing methodologies can be adopted for calculating the under-recoveries suffered by OMCs from the sale of petroleum products (diesel, LPG and kerosene) at discounted rates. Under-recoveries are calculated by subtracting the prices arrived at (using any of the formulae mentioned below) for the products from the prices actually realised by OMCs. An OMC is then compensated by the government or upstream companies for this difference, or the under-recovery it has incurred. Therefore, selecting a pricing methodology is crucial in deciding the extent of the compensation due to the OMC. A higher pricing, as it is with the trade-parity pricing (TPP) model, will lead to higher under-recoveries and thus force the government to pay larger compensation amounts. On the other hand, the EPP model leads to lower prices for petroleum products, which automatically mean lower under-recoveries and, consequently, a lower subsidy compensation burden on the government.

What model is India using currently

The TPP model, which is a mix of the import-parity pricing (IPP) and the EPP models. Given that India is a major importer of crude oil and has surplus refining capacity, the government, factoring in recommendations of the Rangarajan committee, adopted the TPP model (80% IPP, 20% EPP) in 2006. While the export and import prices dont vary much, the IPP (landed cost)which includes tariffs, duties akin to those on domestic products and transportation chargesworks out to be higher than the EPP, which is exclusive of import tariff (basic customs duty) and transportation (port and shipping) charges. TPP is beneficial for OMCs but unfavourable for upstream companies and the government as they end up paying a great deal more.

Considering this, the Rangarajan committee felt that TPP, which is a weighted average of import (80%) and export parity (20%) prices, should be used. Such TPP also provides some degree of protection to the domestic refineries.

How is EPP calculated

It is the price of a product calculated on the basis of the price of importing a particular product processing it and then exporting the final value-added product. Since EPP is also the price at which a country will sell the product in the international market, it doesnt include logistics costs and duties. Hence, it is typically lower than the IPP. EPP represents the price which oil companies would realise on export of petroleum products, i.e. FOB price which is exclusive of import tariff (basic customs duty) and transportation (port and shipping) charges.

So, a shift to 100% EPP would mean a reduction in under-recoveries, as is being favoured by the finance ministry, and a correspondingly lower subsidy payouts. The finance ministrys backing EPP for diesel, PDS kerosene and LPG under-recoveries is aimed at reducing the governments burden of under-recoveries.

OMCs argue that EPP is logical in case of crude oil exporting countries, but not for India, where refineries process about 75-80% of the imported crude oil. This will increase the financial burden on OMCs as they would receive lower compensation owing to lower under-recovery numbers. They hold that several of their old refineries would become unviable if EPP were to be adopted.

What is IPP

IPP is the price that importers would pay in case of actual import of fuel at an Indian port. This includes the product cost, freight charges from a foreign country to the said port and customs dutyall transport costs and domestic taxes are, thus, factored in. Since the product is assumed to be imported, the price factors in other costs such as customs duty, transportation, etc, and, therefore, is usually higher than the actual price of the product.

If IPP is used, the extent of the under-recovery would be measured as the difference between the full cost of delivering the product to the retailer and the price at which it is sold. The model is ideal in a situation where there is no domestic manufacture of a product, where the cost of supplying it in the domestic market is the landed cost or the IPP.

However, even in a situation where there is domestic manufacture, IPP can be taken as the international competitive price that sets the ceiling for the domestic price.

What does the finance ministry want And why

Much to the displeasure of the petroleum ministry, the finance ministry mooted a shift to an EPP model of pricing of petroleum products. Since EPP makes products cheaper than TPP, a shift to EPP model is expected to reduce the subsidy burden by as much as R18,000 crore.

What would be the impact of such a move on upstream public sector companies

As upstream companies like ONGC contribute around 40-60% of the compensation to OMCs, they will also end up benefiting from the move to EPP.

For example, in the case of ONGC, the trailing one-year EPS currently stands at R22. And after accounting for the increase in profits due to lower subsidy burden, it would go up to the level of R34 per share. The PE ratio will come down from 12.9 to 8.44 (based on October 21 market rates).

And what would be the impact on the OMCs

Indian Oil (IOC), Bharat Petroleum (BPCL) and Hindustan Petroleum (HPCL)the three government sector oil marketing companies, with a total refining capacity of 110 million metric tonnes per annumreport an average gross refining margin (GRM) of close to $5-6 per barrel every year.

While they are forced to sell the fuel at controlled prices, their profitability figures are usually notional unless they are compensated by the government via the subsidy route. This subsidy is calculated in terms of TPP. However, with the finance ministry now insisting on a move to EPP, sector experts and company officials say this will reduce OMCs subsidy share by as much as $5 per barrel, essentially meaning that their average yearly GRMs could shrink to zero.

Why will this happen

When EPP is taken into consideration, the price is determined at the factory gate of the refineries. This means that the price at which a refinery will sell the product to the marketing company.

Experts say with the shift towards EPP, the price of the product, on an average, could fall by $4-5 per barrel, which means the refining companies will see a reduction in their prices by an amount equal to their average GRM, which is the difference between the buying price of a barrel of crude oil and selling price of a barrel of refined product such as petrol, diesel, etc, obtained after processing the crude oil. Since refiners are basically converters of crude oil into value-added products, this margin is their profit calculated in terms of dollars per barrel.

How will private refiners get impacted

There are only two private refiners in the countryReliance Industries and Essar Oil. With Essar largely focusing on the domestic market, the price of its products too are expected to come down, while for Reliance, it will be largely muted as it sells in the export market where EPP prevails.

Promit Mukherjee & Pranav Nambiar