Indian oil industry: Shift towards administered pricing

This piece is the fifth of the series of articles on development of the Indian petroleum industry since its inception in 1867. In this article, we shall focus on the pricing policy followed by the Government of India during 1970-89, for petroleum products. This historical perspective is essential to understand the present petroleum pricing system of the Indian government which, to a large extent, determines the minimum support price (MSP) of agricultural products.

Pricing policy till the early 1970s

Historically, domestic petroleum product price had been linked to import parity levels. After independence also, the government maintained the same basic logic. From 1948 onwards, petroleum product price was determined as per import parity principle with Ras Tanura (Persian Gulf) as the basing point.

Most of the petroleum products consumed in India in the 1950s were imported. Burmah Shell acted as the price leader. The price was calculated on the basis of total c.i.f. cost of products to which remuneration, import duties etc. were added. The whole procedure was termed as 'Value Stock Account' (VSA).

In 1959, N Krishnan, the then Chief Cost Accounts Officer of the Ministry of Finance, Government of India, in his report, stated that the VSA procedure resulted in unduly high prices, and recommended a new pricing formula covering only bulk refined products and bitumen. The new formula was derived on import parity principle and f.o.b. price quotation based on Platt's Oilgram Price service, with Abadan (Iran) as the basing point.

The third Oil Price Committee of 1969 (Shantilal Shah Committee) recommended that discounts of posted price of products should be increased by 4% for every 10 extra discounts on crude oil. With effect from March 1974, the ex-refining price of products was revised on the basis of the recommendation of Shantilal Shah Committee (1969) and was linked to the weighted average price (pool price) of imported and indigenous crude.

'Import parity' to 'retention'

Though different price inquiry committees suggested successively higher discounts to be charged on foreign oil companies, 'import parity' remained the basic principle of the pricing mechanism. This principle remained in vogue till February 1974. From March that year, the 'retention' concept was introduced. The cited reasons for scrapping the 'import parity' principle were: (i) the import had come to constitute less than 10% of the total demands for petroleum products; (ii) the future demand would be more than adequately met by indigenous refining capacity; and (iii) the percentage of export of products from West Asia (with which domestic price was linked) accounted for a very small part of the total exports of crude and products from the region.

By 1975-76, all the major foreign oil companies engaged in refinery and marketing of petroleum products were nationalised. Domestic production increased substantially. In their final report (1976), the fourth Oil Price Committee recommended the 'retention' concept which was basically a 'cost plus' pricing concept. It may be recalled that, in the same period, the 'cost plus' pricing concept suggested by the World Bank was also introduced in determining the marine freight of crude oil tankers.

In July 1983, another pricing committee — Oil Cost Review Committee (OCRC) — was set up by the government to review the OPC pricing arrangements. OCRC submitted its report in July 1984. With few modifications, the government accepted their recommendations w.e.f. 1 April 1984. The OCRC had retained the 'retention' concept of petroleum pricing, as adopted by OPC, and had largely adhered to the OPC principles and methodology.

In OPC, a return at the rate of 15% on capital employed consisting of net fixed assets and working capital was recommended. In OCRC, the return was calculated on net worth. Capital employed was computed by adding the net fixed assets and working capital. Thereafter, the actual net worth of the individual company was deducted from the capital employed and the balance amount was deemed to be a borrowed fund. 12% post-tax return was allowed on the net worth element and a weighted average rate of actual interest was allowed on borrowings.

Price calculation

The pooled price of crude was adopted for determining the retention prices of petroleum products. The retention prices for each product and for each refinery was worked out taking into account the average level of throughput and the standard pattern of production, percentage of own fuel consumption and loss, the relevant delivery cost of crude oil, the average refining cost and a return of 15% on capital employed (net fixed asset and working capital) — using a set of indices for allocation of the total cost of each refinery among the products.

At the refinery level, the long-run average cost (LAC) plus a rate of return was the basis for calculating the retention price per tonne of refined products. OPC separately worked out the average cost of a refinery for each refinery. To the average cost, a rate of return of 15% was added. The refining cost varied widely between refineries. For example, as per OPC (1976) figures, the refining cost of one tonne of crude in 1976 of MRL was Rs 16.61 compared to Rs 80.46 of Digboi refinery.

Thus, retention price was equal to pooled crude price, refinery cost and 15% return on capital employed. The delivery cost of crude to different refineries varied from the pooled price. The difference was adjusted from the crude oil price equalisation (COPE) account. Similarly, return on investment also varied for different refineries. For Digboi refinery, 15% return (for processing one-tonne crude) in 1976 worked out to Rs 9.25 compared to Rs 45.30 for Haldia refinery.

The joint cost of refining one tonne of crude was then distributed between different products on the basis of an index. The index was calculated on the basis of the weighted standard production pattern of all refineries and certain distributional equity considerations. Kerosene was given a weightage of 1 (reference point) since it was a mass consumption good. The indices for different products ranged from 1.25 (industrial spirit) to 0.73 (bitumen). As per OPC (1976), those indices reflected the national requirements of the product. An index for naphtha was calculated at 0.98 which was closest to kerosene. This indicates the importance of naphtha in the total management of petroleum products. On the basis of such indices, the ex-refining price for respective products was estimated. As there had been differences in prices between refineries, depending on their retention price, a weighted average was used for arriving at the ex-refining price of different products.

The World Bank formulae

Between 1970 and 1989, two pricing committees were set up by the government. The 'retention concept' (cost plus formulae) which OPC advocated, had its origin in 1972 when the government obtained a loan of USD 106 million for setting up an oil terminal at Haldia Port for handling crude and petroleum products. Part of that loan was extended to the Shipping Corporation of India (SCI) to acquire crude oil tankers. The World Bank had prescribed that the charter hire rates should be fixed on the basis of capital recovery with a guaranteed rate of return of 12% on equity capital and three per cent on loan capital over and above the rate of interest for the loan. The retention formula recommended by OPC was based on the same logic of the freight determination formula advised by the World Bank.

Cross subsidisation

In addition to the COPE account, many other pool accounts were created by the government for the management of the pricing system. The OPC (1976) recommended that the surplus of one account should be available for setting off the deficit in another pool account. The important aspect of the administered pricing mechanism was 'cross subsidisation', which was formalised and managed through various equalisation funds i.e., pool accounts.

Few important pool accounts were:

Cost and freight adjustment account (C & F account): This account received the debits/credits representing the short/excess on account of variations between the actual amount incurred and those included in the price build-up, covering various elements of cost of transportation. The OPC (1976) had recommended a C & F surcharge on all petroleum products at the rate of Rs 25 per KL/MT to be imposed to meet the net debits in the C & F adjustment account which was raised in phase up to Rs 555 KL/MT in February 1983. The government raised the surcharge further to Rs 750 per KL/MT in 1985.

Freight surcharge pool account (FSP): Each refinery had an economic supply area earmarked for it. As the demand logistics and the production of the refinery located in the area did not always match, movement of the products within and outside the economic supply area was necessary to meet the demands. Those out-of-zone movements involved under-recovery in transportation costs. To compensate the oil companies for those under-recoveries, an additional amount, at Rs 15 per KL/tonne, was included in the ceiling selling price build-up as per OPC (1976) recommendation. It was revised to Rs 40 per KL/MT on all petroleum products in the mid-eighties.

Product price adjustments (PPA) account: The difference between the ceiling selling price and the price built up on the basis of norms and parameters was adjusted by a balancing account termed as PPA. Also, the system of differential pricing of various products for different consumers was operated through this account.

Thus, from the mid-seventies after the nationalisation of foreign refineries, the government had formulated an 'administered pricing mechanism' for crude and petroleum products which ensured some moderate returns to crude-producing companies, refineries and marketing companies. Uniformity and economic balance were maintained through the operations of various pool accounts.

Thus, the pricing policy formulated by the government allowed all oil companies to earn profit irrespective of their level of efficiency. It also helped the union government to earn substantial revenues. As on March 31, 1987, a surplus of Rs 11,300.82 crores was generated. Since the mid-seventies the oil sector had become a 'cash cow' for the government.

The surplus funds were not credited to the oil development fund but were kept with the public account. The pool accounts became a major source of extra budgetary revenue to the government. No purposeful review of balance was conducted annually to adjust the rate of surcharge. In 1989-90, the government took Rs 4,429 crore out of the oil pool account to balance its budget.

Drawbacks

The main drawback of the cost-plus 'retention' concept of petroleum pricing policy was that it did not offer any incentive to operational efficiency, fund management and cost control — particularly when the demands of the products were inelastic. The guaranteed return on investment encouraged inefficiency which, in the long run, made all oil PSUs suffer in a competitive environment.

The moderate guaranteed return on capital — though safeguarding the interest of the government investment and creditors — discouraged the genuine private investors who expected higher returns (interest was very high at that time) through efficient management and cost control. In a study conducted by R Vedavalli on the gross profit in 1970-71, as a percentage of capital employed by foreign refineries and public sector refineries in India, it was observed that Burmah Shell, Esso and Caltex earned 46.30%, 18.72% and 20.96% respectively, and Indian Oil Corporation refineries at Guwahati, Barauni and Koyali earned 1.03%, 7.47%, 16.84% (average 9.62%) respectively. Thus, a return of 15% as per the OPC formula was a bonanza to PSU refineries.

In 20 years between 1970-71 and 1989-90, consumption of petroleum products increased by over three times from 17.9 MMT to 54.1 MMT. In this period import of petroleum products increased from 1.1 MMT to 6.5 MMT. And during the period of 'administered pricing mechanism', (from 1975-76 to 1989-90), the increase was over 241% from 22.4 MMT to 54.1 MMT.

In the next article, we shall discuss how the 'administered pricing mechanism' and policy of 'cross subsidisation' had helped petroleum products to emerge as the major energy source and a crucial feedstock for fertiliser production in India

Views expressed are personal