The government has authorized state-run oil marketing companies to raise diesel prices in small amounts from time to time. Unfortunately, though, it has left the quantum of price hikes and the time frame to everybody’s imagination. Nevertheless, here’s a look at what it means.
1. Impact on sentiment: Importantly, the measure is yet another of the many small steps that the government has taken towards reform and will therefore be positive for market sentiment. Improving sentiment in the market is the cornerstone of the government’s strategy for reviving the economy. A buoyant market is needed not just for allowing the government to raise money through disinvestment and rein in the fiscal deficit, but also to allow companies to tap the markets and lower the cost of capital to repair balance sheets and expand.
2. Impact on fiscal deficit: The move, if implemented properly, will mean a pruning of the fiscal deficit. It will also send a positive signal to rating agencies. It is unlikely, though, that small increases in the price of diesel will make an impact on the deficit this fiscal, given that there’s a huge gap between what it costs oil marketing companies to import and refine crude, and the price at which they sell diesel (they lose Rs9.60 per litre on diesel currently). But the benefits of the move are likely to accrue from the next fiscal year. The government’s divestment programme includes upstream oil company Oil India Ltd (OIL) and the move should be helpful to it.
3. The effect on inflation: The hike in diesel prices will have both a direct and indirect impact on inflation. RBS economist Gaurav Kapur says that all told, it should add another 30-40 basis points (or 0.3-0.4 percentage point) or so to the headline inflation figure. He points out that this is the right time to make the move as wholesale price inflation is on a downward trajectory and the base effect till October this year should keep headline inflation low.
4. Impact on RBI policy: The movement towards deregulation of diesel prices strengthens the Reserve Bank of India’s (RBI) hand in reducing rates—the central bank has been highlighting for some time the need to reduce the fiscal deficit. True, inflation will rise on account of higher diesel prices, but that should be offset by the lower deficit.
5. Impact on the current account: Diesel deregulation would also augur well for the current account deficit. For the September quarter, India’s current account deficit increased to as high as 5.4% of the gross domestic product. Diesel deregulation offers a possibility of rationalisation in crude imports in the country. Oil imports grew 23.56% in December 2012 from a year ago. Anyhow, the World Bank forecasts that average crude oil prices will decline a bit this year, which is another positive.
6. Impact on the oil industry: Stocks of OMCs – Bharat Petroleum Corp. Ltd, Hindustan Petroleum Corp. Ltd and Indian Oil Corp. Ltd --rose 4-6.6% on Thursday following news of the government’s move. Sure, cash flows will improve for OMCs if diesel prices are freed, but the fact remains that while the subsidy sharing is not clear, in the past OMCs have been compensated by the government or the upstream oil companies – Oil and Natural Gas Corp Ltd and Oil India Ltd – eventually. Given that, upstream oil companies should benefit more as the overall subsidy reduces for them provided the government does not increase their subsidy sharing. Still, a re-rating has happened and sentiments have turned for the better for these stocks. At the same time, the government has increased the cap on the annual supply of LPG to nine cylinders per household from six earlier from April 1, which is a negative development.
To conclude, the partial diesel deregulation is an important step forward, provided of course it is implemented properly.