OIL SUBSIDY BURDEN:

Why The Kirit Parikh

Committee
Recommendations
Should Be Taken
Seriously By The
Government?
Rama Krishna Vadlamudi February 5, 2010

What is Oil Subsidy?

In India, fuel oils – petrol, diesel and kerosene and domestic LPG cylinders are sold at a price
much lesser than their cost price. The subsidy is the most in case of diesel and PDS Kerosene.
The prices at which public sector oil marketing companies (OMCs) have to sell the prices of
these petroleum products are set by the Government of India. Public Sector OMCs – IOC,
BPCL and HPCL – do not have the freedom to sell at a price over and above the cost price.
Successive governments at the Centre have been prevaricating on the issue of oil subsidy for
more than seven to eight years. The oil subsidy all these years has run into lakhs of crores of
rupees.

India depends on imported oil to an extent of about 80 per cent of its total requirements. Crude
oil prices have gone up substantially from a level of USD 20 per barrel in 2002 to an all-time
peak of around USD 148 a barrel in July 2008 and plunged to a low of USD 35 per barrel by
December 2008 before rising to the present level of around USD 73 per barrel (around 1.00 AM
IST today) on the Nymex. Nymex crude oil price is the most widely tracked price in the world.
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Oil subsidy is the difference between the fuel cost incurred by the OMCs and the sale price. As
given above, crude oil price has gone up by up to four times in the last eight years. Fearing
inflation and political backlash from low-income and middle classes, the Governments have
done precious little to cut down this oil subsidy all these years. The Central Government lacks
the political will to cut down them, which has adversely impacted India’s fiscal deficit.

How much is the subsidy burden?

The oil subsidy burden for OMCs is the most for Kerosene, which has been kept at an artificially
lower price of Rs 9/litre for several years. The kerosene subsidy works out to around Rs 18/litre.
The subsidy burden amounts to Rs 4.70/litre for petrol and around Rs 2.30/litre for diesel and
around Rs 290 in case of an LPG cylinder. The downstream OMCs have been making huge
losses for several years due to this heavy burden on them. The compensation for this subsidy
has been coming from the Central Government partially and some portion is coming from
upstream PSU companies, ONGC, GAIL India and Oil India Limited (OIL). As a result of this
heavy oil subsidy burden, all these public sector have been suffering massive losses despite the
compensation from Government in the form of oil bonds, which have to be sold by OMCs to
meet their working capital requirements.

The total under-recoveries (a euphemism for subsidies) for six years between 2003-04 and
2008-09 amount to Rs 2.99 lakh crores – out of which, diesel accounts for Rs 1.21 lakh crore;
while PDS kerosene, domestic LPG and petrol account for Rs 92,800 crore, Rs 68,000 lakh
crore and Rs 17,400 crore respectively for the six-year period. From the total of these six years
subsidies, around 60 per cent is from 2007-08 and 2008-09 only.

The burden of this oil burden is shared by the Government with Rs 1.42 lakh crore in the form of oil
bonds and by three upstream public sector oil companies (ONGC, OIL and GAIL) to an extent of Rs
1.01 lakh crore in the form of a subsidy sharing formula for the six-year period. The OMCs have
absorbed losses to the tune of Rs 56,000 crore.

Who are the beneficiaries of this oil subsidy?

The political spin given to justify the continuance of these subsidies is that the burden will be very
high on the poor and low income group classes. The government wants to insulate the domestic
consumers from volatile oil prices. However, the biggest beneficiaries are the rich classes who have
got a vested interest in keeping the subsidies intact. In a city like Bombay, all the wealthy, people in
positions of power, big executives and well-heeled people use their own cars or hired taxis to travel
long distances – like from Borivali to Nariman Point, the one-way distance of which is around 35 km
by road. They use their own BMWs, Mercs, Innovas or other gas guzzlers. The public transport is
extremely poor in Bombay. The question that comes to your mind is: Do these affluent people
deserve this burden? As prices are below cost, we do not have any responsibility towards
environment and we tend to consume more of these fuels and increasing the release of green house
gases into the climate affecting the pollution levels in the country.

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What is the cost of this oil subsidy to the economy?

As mentioned above, the OMCs have absorbed losses to an extent of Rs 56,000 crore for six
years between 2003-04 and 2008-09; which means these oil subsidies have crippled them
completely. These losses have forced them to slow down their investments in creating new
capacities or participate in new exploration activities. Even upstream PSU oil companies had to
share a burden of Rs 1.01 lakh crore in these six years. This has also hampered the ability of
these companies to make new investments.

Our dependence on oil imports is going to increase to 90 per cent (from the present 80 per cent)
by the end of 2030 which would be extremely perilous for our country which is on a high growth
trajectory. This clearly indicates the poverty of ideas from India’s political classes, who have
really disappointed the Indian masses. Our Prime Minister is fond of telling the people that we
have the potential to achieve double-digit growth, but he never tells us how he is planning to do
that miracle with woeful infrastructure and dithering policies.

The cost of this oil subsidy (the fancy term used as the official lingo for oil subsidies is under
recoveries) is on the common man (aam admi) only as he is the ultimate bearer of this subsidy
in the form of higher fiscal deficit. OMCS have not been able to upgrade their fuels to higher
Bharat IV norms (cleaner fuels from an environment point of view) and they could not create any
new capacities for cleaner fuels. And they are not yet ready to meet the deadline for Bharat IV
norms (in line with Euro IV norms).

While private sector companies, like Reliance Industries, Essar Oil and Videocon Industries,
have made large investment in exploration and created big refining capacities; OMCs, ONGC
and Oil India have not been able to make much headway as far as new investments are
concerned. With lesser investment for several years, ONGC pays an income tax of around 32
per cent (of its Profit Before Tax); whereas Reliance Industries pays around 20 per cent only.
The big difference is due to RIL’s high depreciation resulting from higher investments as
compared to ONGC.

With lesser investments from public sector behemoths, the country’s dependence on imported
oil, instead of reducing, has gone up substantially. The result is that India is poor in energy
security and we are vulnerable to volatile crude oil prices and the politics of OPEC and oil world.
This lack of energy security will be heavy on India as we are susceptible to shenanigans that
are played out in case of wars in the Middle East Asia or the kind of oil shocks we witnessed in
the early part of 1970s and 2008 when oil reached a peak of around USD 148 a barrel. While
China has been investing strategically in Africa and Latin America for their raw materials needs,
we have failed to make any attempts at energy security. The only minister who made some
noises about energy security and travelled across the US is Mani Shankar Aiyar a few years
back. But, this dynamic minister was removed from his position for reasons best known to the
Congress party. If my memory is correct C Raja Mohan, an expert on defence affairs, was
writing about energy security in 1993 in a column he used to publish in The Hindu in those days.

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In that article of 1993, he strongly advocated that India should woo Bangladesh for its vast gas
reserves. We did not seem to have done much in this regard. However, the government of
Khaleeda Zia, who is extremely hostile to India, has not helped matters much. Only the Tatas
had tried to tap Bangladesh’s potential in natural resources. But even they could not make much
headway there, I think. Now, with a friendly Haseena Begum in power, we can be optimistic
about some progress in this regard if our government takes any initiative towards exploiting their
gas reserves.

What is the difference between under recoveries and losses of OMCs?

Refining of crude oil is a process industry where crude oil constitutes around 90% of the total
cost. Since value added is relatively small, determination of individual product-wise prices
becomes problematic. Internationally, there is not much of a difference between the sale price of
diesel and kerosene; whereas, petrol prices are lesser than that of diesel/kerosene by about
four per cent! In India, our policy is just reverse. While the sale price of petrol is the highest and
that of PDS kerosene is the lowest. And one fails to understand what kind of logic is there in
following such a distorted policy.

The OMCs are currently sourcing their products from the refineries on import parity basis which
then becomes their cost price. The difference between the cost price and the realized price
represents the under-recoveries of the OMCs. The under-recoveries as computed above are
different from the actual profits and losses of the oil companies as per their published results.
The latter take into account other income streams like dividend income, pipeline income,
inventory changes, profits from freely priced products and refining margins in the case of
integrated companies. OMCs have been showing nominal profits due to sale of their cross-
holdings in other oil companies.

What are the demerits of following such a skewed oil pricing policy by the Government?

1. The public sector OMCs and upstream oil companies have suffered financially as their
balance sheet strength has deteriorated considerably and they have lost their
competitive edge at the market place
2. The working capital loans of the public sector OMCs has gone up from Rs 23,000 crore
in 2004-05 to Rs 1.07 lakh crore by December 2009 – forcing them to borrow heavily
from banks with massive rise in interest costs. Moreover, the government is extremely
slow in granting oil bonds to the OMCs resulting in the heavy bleeding of these
companies.
3. The adhoc system has resulted in speculation, hoarding and adulteration of diesel with
kerosene which is available at a cheaper rate or Rs 9 per litre compared to a high price
of Rs 35 per litre for diesel
4. Even domestic LPG cylinders are diverted for commercial and industrial purposes
5. The private sector oil companies, Reliance Industries, Essar Oil and Shell India have
closed their retail petroleum outlets

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6. The less expensive fuel cost has made the users complacent about the perils of green
house gases and users have failed to understand the reasons for saving fossil fuels
7. The artificially low fuel prices have encouraged auto manufacturers to be complacent
about developing fuel-efficient vehicles in India

What will happen if we do not raise domestic prices of sensitive petro products in
line with rise in world crude oil prices?

At a crude oil price of USD 80/barrel, the total under-recoveries of OMCs on sale of petrol,
diesel, LPG and PDS kerosene work out to Rs.1,57,000 crore by 2020-21. If oil prices rise by 25
per cent to USD 100/barrel, the under-recoveries will rise higher by 77 per cent. Likewise if oil
prices rise to USD 120/barrel (50 per cent increase) the under-recoveries will rise by 155 per
cent. Higher the growth rate of GDP and longer the period beyond 2020-21, the much higher will
be the under-recoveries. Can India’s economy absorb such shocks in future?

What is Kirit Parikh Committee and why did the Government set up the
Committee?

India’s consumption of petroleum products has recorded an annual compound growth rate of
around four per cent between 2002-03 and 2008-09. This is in line with India’s GDP growth
which has reached levels of between six and nine per cent during the period. At this rate of
growth, our dependence on oil imports is projected to grow to 90 per cent (from the present 80
per cent). The volatility in international crude oil prices has been a big headache for the
Government in fixing the prices of the four sensitive petroleum products, namely, diesel, petrol,
PDS kerosene and domestic LPG.

In the background of this heavy oil subsidy, Government of India has set up a committee to look
into the problem and suggest a way out of this logjam. The expert group has been asked to
submit its recommendations for a viable and sustainable pricing policy of the four petro
products, which constitute 63 per cent of the country’s total consumption of petro products. An
expert group, under the chairmanship of Kirit Parikh, a former member of the Planning
commission, was set up at the end of August 2009 by the Ministry of Petroleum and Natural
Gas. The group submitted its report on February 2, 2010.

What are the recommendations of Kirit Parikh Committee?

1. Domestic petroleum product prices have to reflect that of international prices. The
government should allow pass-through of international oil prices to domestic users. This
will enable the public sector OMCs and upstream oil companies to remain financially
stable and solvent.
2. There is no justification for continuance of subsidy for diesel and petrol and as such their
prices should be raised by Rs 2.33 per litre and Rs 4.72 per litre respectively
3. An additional excise duty of Rs 80,000 per vehicle should be levied on diesel car owners

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4. Smartcards should be used to provide subsidy to the target/needy group on kerosene

and 14.2 LPG cylinders. Subsidy on LPG cylinders should be discontinued immediately
except for the below the poverty line households.
5. The price of kerosene should be increased by Rs 6 per litre and that of LPG by Rs 100
per cylinder. The kerosene price increase should be in line with the nominal growth in
agricultural GDP. LPG price should be increased in line with per capita income.
6. The government’s policy of incurring a cost of Rs 1.42 lakh crore towards compensating
the OMCs for the under recoveries is a complete failure. The compensation burden has
reached a level of 25 per cent of total revenue receipts in 2008-09, which is totally
unviable and perilous to the long-term health of the economy.

Whether the Government will accept and implement these recommendations?

This is a million-dollar question considering the spiraling food inflation and the fear of the
political repercussions for the ruling Government. To examine this aspect further, let us go back
a little and see what the successive governments have done since the first Oil Shock of 1973.
The Administered Price Mechanism (APM) existed from 1976. And it was abandoned in 2002.
The then NDA government said it would link the domestic prices with that of international levels.
It had followed this free policy for a few months and could not muster the courage to follow
further its own policy when world oil prices started rising in the wake of the invasion of Iraq by
the George Bush-led USA and other friendly countries, like, Great Britain.

In 2005, Rangarajan Committee was set up to examine the taxation and pricing policies. But the
government had kept the report in cold storage. Another committee headed by BK Chaturvedi
was constituted to examine the oil pricing policy in 2008. Not much has happened since then.
Now, we have another committee to bother about.

If one goes by the experience of the past, it is very difficult to believe that the Government will
bite the bullet and start tightening the belt by implementing these latest recommendations.
Simply, the political classes do not have the courage to take decisions that are in the long-term
interest of the nation. They are looking toward the next elections; but not the next generation.
Basically, the decision will have to be a political one, but not an economic one.

The most important conclusion of this Kirit Parikh panel is that Indian Economy only has been
bearing this massive oil burden through higher fiscal deficit which would push up the interest
cost of the government and the people have to bear the burden in one way or the other. There
is no benefit to any one by following the existing opaque pricing policies for these four sensitive
petro products. The panel finds no compelling reason to justify the continuing subsidies for
diesel and petrol. One only hopes that the Government will muster all political courage and take
the recommendations seriously and implement them in letter and spirit in order to encourage
transparency, viability of OMCs, investment in exploration and production activities and reduce
the fiscal burden keeping the long-term interest of nation in high priority.

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ABBREVIATIONS USED:

BPCL : Bharat Petroleum Copn Ltd

HPCL : Hindustan Petroleum Corpn Ltd

IOC : Indian Oil Corpn Ltd

Nymex : New York Mercantile Exchange

OMC : Oil Marketing Companies (public sector)

PDS : Public Distribution System

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