Wednesday, August 20, 2008

Oil price hikes in India-A Necessary Step

Peak pricing
Suyodh Rao
Posted online: Thursday, August 14, 2008 at 0124 hrs
Want energy and food security? Let oil prices head towards market rates

The Chaturvedi Committee final report recommends a phased increase in crude distillates’ prices and the cutting down of subsidies, and is a step in the right direction. These include a monthly increase in the price of a litre of petrol by Rs 2.50 (until March 2009), and of a litre of diesel by Rs 0.75 (until 2010). Another recommendation of direct consequence to the middle class is the limit of 6 subsidised refills of LPG cylinders per consumer/connection over a year and the gradual removal of the LPG subsidy over a three-year period. Other recommendations attempt financial re-engineering, at the macro level, of measures already put in place after the sudden, sharp increases in global crude oil prices. These relate primarily to the medium- and long-term viability of the governments’ oil bonds and their ultimate discontinuation; the inappropriateness of taxes on any “windfall gains” accruing to oil refiners and extractors; tinkering with the excise and customs rates and moves towards replacing the cylinder-based LPG system with piped natural gas.

The loss due to the difference between cost and consumer price is currently borne by the oil marketing companies (OMCs) which are in turn compensated by oil bonds. These are little more than a band-aid, and will certainly tell on the fiscal health of the nation. When the OMCs pledge those bonds and raise money to sustain their critical operations liquidity will be sucked out of the banking system and impact investible funds across the board.

If the committee’s recommendations are not accepted, the estimated loss on sale of crude distillates will be Rs 2,11,400 crore in the current year alone. The revenue deficit in this year’s budget is about Rs 56,000 crore. These are large numbers: it is hardly surprising that the report says that “the government should disengage from the process of pricing of petroleum products, and allow pricing to be an outcome of a competitive market process”.

The steps the committee envisages will go a long way in improving India’s fiscal health. Painful as they doubtless are going to be, and as heartless as they may seem, we really do not have many options. The whole world has been taken aback by the sharp rise in crude oil prices. We were not sufficiently vigilant about our energy supply situation. There is a price to be paid for the lack of visionary leadership and a lack of awareness of the critical role of energy in our economic systems.

David Strahan, the author of The Last Oil Shock, wrote in the The Daily Telegraph out of London last week: “It is endlessly reported that the demand for oil in Asian countries has soared since the turn of the century, and that China’s thirst has been especially prodigious. What is less realised is that global oil production has been essentially stagnant, at around 86 million barrels a day, since early 2005.” He was referring to the concept geologists call “peak oil” — the time when the world reaches a maximum in oil supply and thereafter sees terminal declines in oil extraction.

No leadership saw this coming. And it is this stagnant supply encountering a growing demand that is behind the sudden, sharp price increases in crude. Need for increased efficiency of use and conservation of our precious energy resources is thus a given.

Continued subsidisation of crude distillates is financially unsustainable. Such subsidies will lead to our budget deficits, public debt and other macro variables rising to much higher levels, leaving the economy prone to macroeconomic instability. If we wish the Indian economy to withstand external shocks, the sooner we start re-engineering our production, communication, economic, political and social systems, the better. For that, we need to ensure economic agents receive appropriate signals from the market; and in this case, those are higher fuel prices.

In fact, not only do we have to allow prices do be determined by the market as the committee notes, but we also will have to seriously consider putting a floor to crude distillates’ prices. This will have to be done so that prospective alternative energy entrepreneurs can plan for assured prices for the energy they generate. Given that the crude demand-supply situation is as taut as it is, crude prices will be as volatile as they have been, in both directions. Such volatility in price will provide mixed signals since alternative energy has to compete with fossil fuels.

Taut energy markets have been having a significant impact on the most essential form of energy, namely food. Food prices have been rising in the face of rising demand, stagnant yields, rising energy, fertiliser and other input prices and finally diversion of food for bio-fuels. Delaying price increases of crude distillates will mean hampering our food security. With a population of a billion plus, that is like playing with fire.

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