Economics and Politics of Petroleum Product Pricing

Pricing of petroleum products in India is a controversial and tenacious issue with far reaching ramifications. To understand the complexity of fuel pricing, we need to understand the economics and politics behind it.

International Petroleum Prices in historical perspective

The genesis of fuel pricing in India can be traced to international crude oil price which has a direct bearing on domestic petroleum product prices. With stagnating crude oil production and surging demand in the growing economy, imports account for nearly 80 % of petroleum demand in the country. The crude oil prices in the world, though highly volatile, have registered an upward trend ever since 1972. Until the 1972, global crude oil prices were fairly stable at about $2 a barrel (159 litres). An oil embargo by major oil-producing countries in 1973 led to the first steep increase in crude oil prices to $12 a barrel. Following the Iran revolution of 1979 and the Iran-Iraq war, crude oil prices rose to $35 a barrel by 1981. However, by 1986 the OPEC cartel’s control over global crude oil prices began to falter, dropping prices to around $10 a barrel. Prices gradually rose over the next decade but the South-East Asian economic crisis of 1998 drove prices down as demand dropped. Prices rose to $25 a barrel by the end of the 20th century, but a variety of factors made crude oil prices spiral to $70 a barrel in 2005.The record peak in international crude price was reached in July 2008($145 a barrel). After that the price of oil underwent a significant decrease when petroleum traded between US$35 a barrel to US$82 a barrel in 2009. On 31 January 2011, the Brent price hit $100 a barrel for the first time since October 2008. Presently the price of Indian basket of oil is hovering around $105.

Rising international crude oil price is a major problem; the other factor   compounding the problem is the rupee depreciation. Rupee tumbled in 2013 to reach the historic low of Rs 68.80 in August and is now hovering around Rs 61-62 against dollar. Rupee depreciation is bound to put pressure on domestic petroleum product prices.

Price setting mechanism in India

For petroleum products ‘Import parity’ type of pricing policy has been followed in the country ever since independence.  Import price of crude oil is taken as the base to which refining, transport and marketing costs, dealers’ commission etc. are added for the determination of prices of petroleum products in India. Based upon the cost calculations govt. has been artificially fixing and revising petroleum product prices from time to time. This policy of Administered Price Mechanism (APM) eventually boils down to ad hoc price setting. With the objective of moving towards market determined prices, NDA Government announced the dismantling of the Administered Pricing Mechanism with effect from April1, 2002 for all the petroleum products barring kerosene and LPG. But actually fuel prices have never been free from Govt.’s control. In June 2010 Petrol prices were officially deregulated by the UPA govt. but in practice the oil companies have to wait for the govt.’s nod to revise petrol price. Despite rising international oil prices and falling rupee against dollar, the petrol prices remained unchanged from Nov.2011 to May 2012 when petrol prices were eventually revised by Rs.6.28 per litre excluding the local taxes. However, since 2013 petrol price has witnessed more frequent revisions in the country -both upward and down wards, though in small doses.

Another landmark decision of the govt. towards deregulation of the petroleum sector has been to allow oil companies to raise the price of diesel in small doses with a view to reduce and wipe out their losses on diesel sales. Ever since January 2013, oil marketing companies have been raising diesel price by 50 paise every month. The revision announced on February 7, 2014 has been 14^th revision in diesel price since then.

Rationale behind Economic Pricing

There is strong economic rationale behind economic pricing of petroleum products so as to   minimize the petroleum subsidy burden. When the domestic sale price is less than the cost, there is implicit subsidy which balloons due to unrelenting crude oil price and rupee depreciation. The three public sector oil marketing companies viz. Indian Oil Corp (IOC), Hindustan Petroleum Corp (HPCL) and Bharat Petroleum Corp (BPCL) incur losses which are partly shared by upstream oil companies ONGC, OIL and GAIL but the rest has to be compensated by the budgetary support.

But the question is to what extent and how much can the govt. go on subsidizing the fuel prices? After all there is huge cost of oil subsidy bill reflected in large fiscal deficit which itself is inflationary. To provide for the subsidy govt. has to squeeze the flow of funds to critical infrastructure development and ambitious social sector schemes. Pruning subsidies does not only help the govt. to keep the deficit under check but also enables it to spend its precious resources on development programmes. Of course, with the reduction in fuel subsidies, users will have to shell out more but the move is beneficial to the economy in the long run.

Also the economic pricing of petroleum products is important for the financial health of the oil marketing companies. With the deterioration of their finances, Government not only forfeits taxes and dividends from these companies but these financially crippled companies are unable to make the much needed capital expenditure required for expansion and modernization. Yet another justification for economic pricing of fuel is to keep the demand in check and help in oil conservation. Larger the gap between the economic price and the subsidized price more is the wasteful use.

Politics behind fuel pricing

Govt.’s predicament on petroleum products prices can be summed up in the statement made by then  Petroleum Minister Jaipal Reddy while announcing fuel price hike on 24 June 2011. “I am sandwiched between economists and populists. The economists say why aren’t you doing it (raising petrol price) and populists say why are you doing it.” Clearly the complexity of fuel prices extends from economics to politics. The fear of public backlash had been the major factor discouraging the govt. from taking hard decision. Political compulsions, fear of public backlash have been the main reason for Govt.’s hesitation in raising fuel prices.

Of course, there is a genuine concern about the inflationary impact of fuel price hike which always spells electoral disaster. In the times of rising prices, government avoids fuel price hike as it adds fuel to the fire of inflation. However, it is wrong to believe that inflation can be curbed through subsidies since the subsidies result into higher fiscal deficit which proves inflationary.

Impact of taxes petroleum products

Taxes on petroleum products are a major source of revenue for the state and central govts in India. In fact, governments all over the world tend to depend heavily on petroleum products as a convenient means of raising revenues because of their inelastic demand. But the high levels of taxes put pressure on prices of petroleum products. The various taxes levied by the central and the state governments:  custom, excise, sales tax/VAT and cess constitute significant proportion of the fuel retail prices in India. The present tax regime on petroleum products includes ad valorem and specific duties. Instead of the ad valorem duties which are price based, the govt. should impose specific duties (based on quantity) which are price neutral.  Not only ad-valorem levies exacerbate the burden on the consumer, but give ‘windfall gains’ in revenue to the govt. through higher tax yields at the expense of consumer. Govt. of India has evolved excise duty on petrol and diesel from ad valorem to specific as the basis of taxation but the same does not apply to the state levies. On the top of central levies; heavy value based sales tax is imposed by the state govts leading to a high degree of cascading. Hence, there is a strong case for specific sales tax regime which is not only moderate but also uniform in all the states so as to remove wide variation in inter-state petrol and diesel prices.

Disparity between Petrol and diesel prices

For reducing the cascading inflationary impact of fuel prices, diesel price has been kept relatively low. Also historically; there has been a wide variation in the excise duty on petrol and diesel in our country. This is contrary to world wide trends where the excise levies on both products are more or less equal. Indeed, in some countries, diesel is costlier than petrol. The contrary trend in our economy has led to inefficient substitution of one fuel for the other and has also been responsible for the surge in demand for  cars and SUVs running on  diesel. It is important that the rich, who can afford to buy cars, should not enjoy the subsidy on diesel and must pay economic price of fuel. In lieu of the subsidized fuel, diesel car owners should be made to pay annual charges. In fact, heavy taxation should be used as a tool to discourage private diesel vehicles.

Over the past two years, diesel sales had been galloping towards double digit growth, leading to higher government’s subsidy burden. On January 18 the UPA government at the Centre bit the bullet and changed its diesel pricing policy in a desperate attempt to rein in the rising fiscal deficit. The new policy approved by the Cabinet allows oil companies to increase diesel prices by 50 paisa per litre every month.

Conclusion

Across the board subsidies not only result in inefficiencies, wastage, leakage and adulteration but also place undue burden on strained fiscal situation. Subsidies should be minimal, targeted and restrained by a monetary ceiling. Ideally, government should decontrol petrol and diesel price in true sense as liberalization leads to de-politicization of petroleum product pricing. In a regulated environment, people tend to see domestic fuel prices under the government’s control and therefore tend to blame it for price increases. Deregulation is required but it is important that there should be transparency in fuel price fixation mechanism. Under no circumstances the inefficiencies of the public sector oil companies should be passed on to the consumers in the form of higher prices.

 

Published in New Horizons, A research Journal of MCM DAV College

Volume XI 2014