Impact of reform in the oil pricing mechanism

Business of oil to be buttressed with bonanza


While reform in the oil pricing mechanism will improve the financial health of PSU companies, they will have to face tough competition from private players, writes Aditya Raj Das The much-awaited bold reform measures initiated by the Congress-led UPA government to decontrol pricing of petrol along with an across the board hike in prices of three mass consumed petroleum products—diesel, domestic LPG and kerosene— will no doubt give some relief to state-owned Oil Marketing Companies (OMCs)—currently incurring massive losses due to selling petroleum products below cost prices. Soon diesel will also be decontrolled.

The new move will not only improve the financial health of state-owned OMCs but will also be favourable for future expansions needing large investment. It will also encourage new focus on retailing, exploration and production. Currently, the government is compensating the under-recoveries of the state-owned OMCs through a complex subsidy sharing mechanism. The decision on decontrolling of auto fuel price was in line with the recommendations of the Kirit Parikh Committee set up to suggest a road map for a sustainable oil pricing model that will strike a balance between the need to take care of the financial health of state-owned OMCs and protect the vulnerable section of society from volatility of global crude oil price.

Under the existing three-pronged burden sharing mechanism some portion of under-recoveries is compensated with government giving direct subsidy and certain percentage of remaining portion is being squared off with state-owned oil exploring firms, like ONGC, selling crude to state-owned OMCs at a discount. The PSU OMCs absorb the remaining under-recoveries themselves. Apart from straining the overall fiscal fabric of the economy this complicated subsidy formula has muddied the operations of the petroleum sector and has virtually forced private companies out of retailing petroleum products.

Positive impact
As far as immediate impact of these measures on financial health of the three state-owned OMCs—Indian Oil Corporation (IOC), Bharat Petroleum Corporation Limited (BPCL) and Hindustan Petroleum Corporation Limited (HPCL)—are concerned they all stand to gain as they will now be able to wipe out at least revenue losses being incurred by them by selling petrol below cost prices. But they will continue to incur losses by selling three other mass-consumed petroleum products—diesel, domestic LPG and kerosene—below cost prices. Till recently (prior to EGOM decisions) PSU OMCs had been selling petrol at a loss Rs 3.73 per litre, diesel at a loss of Rs 3.80 per litre, kerosene at Rs 18.82 a litre and domestic LPG at a discount of Rs 261.90 on every 14.2-kg cylinder.

These prices were calculated keeping the global crude oil price at 60 dollars per barrel as against the current average level of 75 dollars per barrel. According to the estimate made by the Petroleum Secretary S Sundareshan the decontrolling of petrol price alone will cut down under-recoveries by Rs 7,000 crore this fiscal. As per a projection made by the economic research body of Crisil, decisions are likely to reduce gross under-recoveries made by the IOC by about Rs13,000 crore and for BPCL and HPCL by about Rs 6,500 crore and Rs 5,500 crore, respectively. Upstream oil exploring companies like the ONGC and the Indian Oil Limited, which are currently sharing the burden of under-recoveries, will also benefit because the extent of support they are required to provide will now come down. The Petroleum Ministry estimated that if the global crude oil price hover around 75 dollars per barrel in the remaining period of the current fiscal 2010-11, the impact of the EGOM decision would lead to reduction of Rs 24,000 in under-recoveries to Rs 53,000 crore from Rs 77,000 crore.

Lowering revenue losses
Though optimistic about their future, none of the state-owned oil companies have so far come out with any estimate of their savings. As the IOC Chairman B M Bansal says “It is too early to say what would be exact impact on our finances. The fact remains that we will get some relief. We expect our current daily gross revenue loss on sale of auto and cooking fuels to fall to about Rs 85 crore from Rs 120 crore. Thus our cash flows will increase and our dependence on subsidy payouts will fall now.”

Similarly, BPCL—expects some relief with the cutting down of its revenue losses. “We company hope to reduce gross revenue loss on auto fuel sales to about Rs 6,000 crore for the nine months starting July, compared with Rs 4,200 crore in the April-June period. This will help us in improving our cash flows,” said BPCL Finance Director S K Joshi.
The BPCL Chairman and Managing Director Ashok Sinha visualized greater opportunities for the OMCs to improve their profit margin with the deregulation of auto fuel prices. “We are moving towards a more competitive pricing wherein oil companies will set their own prices. When we know that there is excess of products available around the world, in India we are hoping that we will go ahead and set our own prices, which will vary in any periodicity depending upon where we see our profitability is required. This will provide much-needed flexibility to improve our financial performances,” added Sinha.

Market bonanza
In fact, indicating better future prospects for the OMCs, the EGOM decisions have already led to appreciation of stocks of oil and gas companies in the range of 15 and 20 per cent. As an analyst said, from an investment perspective this run-up has been in line with potential earnings upgrades. According to industry experts, a spin-off effect of the government’s decisions the state-owned OMCs could see earning upgrades in the range of 20-25 per cent during the current fiscal and next fiscal 2011-12. This up-gradation in valuation of OMCs will immensely enhance their credit worthiness in both domestic and global financial markets. This will help them raise resources easily at competitive price, which in turn will further sharpen their overall financial performances. But analysts also feel that the overall impact of the reform on finances of state-owned upstream and downstream companies will depend upon subsidy-sharing mechanism, which is yet to be worked out.

ONGC Chairman and Managing Director R S Sharma says, “the existing formula was just ad-hoc on quarter to quarter basis. We still remain clueless as to what are the details of the new formula. But apparently one thing is obvious we do foresee a big relief for the sector at large.” The reduction in subsidy burden will leave more funds in the hands of PSU oil exploring firms to invest in exploration as well as oil field developmental activities, he said.

Shared responsibility
It is overwhelmingly felt that the overall financial health of OMCs will continue to be dependent upon the contours of subsidy-sharing formulae. Over the past few years, under-recoveries have been shared among upstream companies, the government, and OMCs. The absence of an institutionalized mechanism for meeting OMCs’ under-recoveries has often resulted in delays in support. Due to such delays, the OMCs have faced volatility in cash flows, necessitating large short-term borrowings.

Crisil report suggested that either full decontrol in the entire spectrum of petroleum products or an institutional mechanism that compensates the OMCs for under-recoveries in a timely manner, is critical to restore the financial health and credit quality of the oil-marketing companies. As most of the state-owned OMCs expect the new move would help them enhance their overall profit and cut down short-term borrowing, their expansion projects will get a boost. “IOC will review its future investment plans and prepare feasibility reports for the projects that had been put on hold,” IOC Finance Director S V Narasimhan said.

The company is now executing projects worth Rs 47,000 crore including a 300,000-barrels-a-day refinery in Paradip, Orissa. The IOC had deferred two petrochemical projects in view of its mounting revenue. With future looking brighter and financial position stronger, other OMCs like BPCL and HPCL are also gearing up to push forward their future projects. But at the same time introduction of market-driven reforms in the petroleum sector will pose other kind of problems for state-owned OMCs. Post deregulation, many analysts believe that private players would be able to challenge the near-monopoly of state-owned OMCs.

Market-driven pricing of auto fuel would also mean bigger thrust in the oil retail market by private players such as Reliance Industries Limited (RIL), Essar Oil and Shell, intensifying competition in an otherwise state-run monopoly. Reliance, in fact, is one of the largest oil refiners in the world and one of the most efficient producer of oil products. Thus state-owned OMCs will have to intensely focus on operational efficiency and cost savings to remaining competitive. This will, no doubt, pose a formidable challenge for them.
Source:From the pages of Deccan Herald newspaper.