Upsetting Oil Pricing Conundrum

Earlier post on the subject: Oil Pricing in India Vikram S Mehta, chairman of the Shell Group of companies in India, provides the structure of the price build up for petrol and diesel by the public sector companies in India. Indian Oil Corporation (IOC) calculates inter alia the landed import duty paid price of petrol and diesel every fortnight. This calculation is based on a formula that is linked to international prices. IOC’s landed price of petrol in Mumbai for the second fortnight of May was, for instance, Rs 38.1 per litre and for diesel Rs 48.8 per litre. The marketing companies had to, in other words, pay this amount to the refiners to buy the products. Next, the Central government imposes an excise and educational cess on the purchase cost. In May, this was Rs 14.4 per litre and Rs 0.4 per litre for petrol and Rs 4.6 per litre and Rs 0.1 per litre for diesel respectively. The total cash required by the marketing companies to purchase petrol and diesel in May was, therefore, Rs 52.9 per litre for petrol and Rs 53.6 per litre for diesel. The companies then sell these products at the ministry of petroleum mandated price of Rs 49.7 per litre for petrol and Rs 35.6 per litre for diesel (Mumbai prices). As such, they lose Rs 3.2 and Rs 18 for every litre of petrol and diesel sold respectively. That, however, is not their total loss. They have to also pay sales tax to the state governments. In Mumbai, this tax is Rs 10.6 per litre and Rs 7.1 per litre for petrol and diesel respectively. Thus, the total cash loss suffered on account of the sale of 1 litre in Mumbai is Rs 13.7 and Rs 25.1 for petrol and diesel respectively. This is, in other words, the amount by which prices would have to be increased at the retail outlet for the companies to simply break even on a cash basis. Such a hike is, of course, out of the question.[Indian Express] Many in the public domain believe that the imbalance can be redressed by reducing the central and local taxes to make the public sector oil companies profitable. However, it is actually not about reducing the taxes to bring the prices down. That is just an indirect way of maintaining the subsidies. On one hand, the balance sheets of the oil companies might look healthier and higher profits might allow theme to disburse handsome dividends. On the other hand, the government revenues would come down and higher revenue deficits will bring the finance ministry into the FRBM dragnet. It is not a Morton’s fork but a Hobson’s choice for the government — to link the retail rates of petroleum products with the market rates. In case of most other commodities, the high consumer price checks demand. This helps restore the supply-demand balance. As prices are not linked to the rising market rates, oil demand is not checked commensurate with the price change. It obviously creates an asymmetry in the supply-demand balance and can be only restored at much higher prices. By then, it might be already too late for the Indian economy. Now let us look at two sensible, yet asynchronous, viewpoints on resolving this pricing conundrum. In the same piece, Vikram Mehta prescribes the policy framework for a comprehensive petroleum policy. First, we should accept that high oil prices are here to stay. This does not mean we will not see sharp declines from present levels. What it does mean is that we will not see prices stabilising at levels significantly below a triple digit number. Second, we must create a mechanism that leads to a ‘graduated’ reduction in subsidies, an orderly alignment of domestic prices to international levels and a more efficient disbursement of financial support to the poor. Third, we must reverse ‘dieselisation’. And finally, we must recognise that the sine qua non of energy security is a robust and competitive domestic petroleum and energy sector. Fellow blogger Atanu Dey has a much simpler, but more innovative solution to offer to redress this perverse subsidy for the rich. The basic economic truth is that there is really no such thing as a free lunch. Today’s subsidy comes at a cost that will only grow larger the longer the delay in pricing petroleum products at full cost. It is fairly simple to remedy the situation. Raising the price at the pump is the simplest but the most politically risky. The UPA government knows that and will definitely not risk losing power even if raising prices is for the larger benefit of the economy. But those subsidies have to be reduced, if not totally abolished overnight. A start could be made immediately to reduce the subsidy to the rich while continuing it for the poor. A mechanism for doing so would be to impose a tax on car owners which would reflect the full cost of the petrol they use. Depending on the size of the engine and average fuel consumption, an annual fee could be assessed which has be paid to maintain registration. So if a particular make and model of car typically consumes, say, 1,000 litres of petrol a year, the tax could be Rs 10,000. This type of a mechanism would leave all two-wheelers, three-wheelers, and buses untouched. Since it is usually the common man who uses public transportation, the common man would continue to enjoy the subsidy