Can we afford high oil prices?

Can we afford high oil prices?

The price of crude oil is nearing a historical high of $100 per barrel. The market is conveniently ignoring bearish factors while bullish factors are getting promptly reflected. While the recent cut in Organization of Petroleum Exporting Countries’ (Opec’s) forecast of non-Opec supply added to the trend, every potential supply chain disruption is also doing its bit. What are the implications for India? Can we continue to absorb high prices? Surprisingly, the short-term implications are graver than the long term.

In the short term, domestic prices with the ad valorem levy component will lead to economic stress in the supply system. The subsidy on LPG has crossed Rs200 per cylinder and can touch Rs300 if the recent run-up in LPG prices is any indication. The total subsidy bill for kerosene and LPG in the public distribution system (PDS) may cross Rs30,000 crore this fiscal. With the inability to raise retail prices, rising under-recoveries on petrol and diesel are hitting the oil marketing companies (OMCs) hard. Their cash position will soon get affected. Even the current high refining margins may not help enough.

The government has been trying to tackle this problem in three ways. The first is oil bonds. The second is letting prices for end-consumers rise and the third is discount by upstream companies. Last fiscal’s under-recoveries at around Rs49,000 crore barely bothered OMCs, thanks to upstream companies shelling out Rs20,570 crore and the government issuing oil bonds worth Rs24,121 crore. But this year’s under-recoveries could be a staggering 30-50% higher.

This means there’s need to raise retail prices by nearly Rs20 per litre for kerosene, Rs200 per cylinder for LPG and Rs9-10 per litre for petrol and diesel. Socio-political reasons won’t allow this.

Oil bonds are no longer seen by oil companies as a quick fix as these have not proved to be very liquid. Some of these may even have to be sold at a discount. Besides, there are limits on how much of these bonds can be monetized in a quarter. A hit of Rs24,000 crore on government receipts or a similar rise in expenditure would worsen the fiscal deficit by a good 50 basis points. In a cash loss position, therefore, bonds may not be very helpful. There also are “natural" limitations on how much can be passed on to upstream companies.

So, in the short term, the petroleum economy would be substantially stressed—be it the government, OMCs, upstream companies or the end consumers. The government may be forced to consider a combination of all options, viz. hike retail prices, cut duties and raise the burden on upstream companies. OMCs may have to bear a greater part of under-recoveries than last fiscal.

Let’s not forget that both the Centre and states earn substantial revenue from the petroleum sector through taxes and levies. This amount (net of corporate tax and dividend) was close to Rs135,000 crore in 2006-07 and has more than doubled in the last five years. So, will they let go of this assured revenue stream?

Of course, tax rates on petroleum products are high in many other countries as well. At present, the tax component is close to 54% in petrol and about 32% in diesel in New Delhi and even higher in most of the other parts of country. This actually is a long-term cushion against increasing oil prices—provided the government can find ways to offset the lost revenue once it lowers taxes. In a tax-free world, an oil price of $90 per barrel corresponds roughly to a fuel price of about Rs26 per litre while an oil price of $150 per barrel would correspond to Rs41 per litre, assuming moderate refinery and retail margins. These prices are still below the prevailing retail prices of petrol.

The question that begs an answer is, what will the government do to alleviate the effect of rising oil prices in the medium and long term? The country’s GDP is now close to $900 billion and despite higher oil prices, the spending on crude oil is within 10% of GDP.

Better administrative controls, coupled with improvement in standards of living, would reduce the consumption of PDS kerosene. In fact, the consumption of kerosene has been steadily declining from 12.2 million tonnes in 1998-99 to less than 9.5 million tonnes in 2006-07. Consumption of LPG, which grew at almost 10% during most part of the last decade, has seen a moderate growth of just about 3% over the last two years . The next few years would see expanding city distribution of the cheaper natural gas, which would further moderate the consumption of LPG. This would help contain the subsidy bill on PDS kerosene and LPG.

Note that the government has been decreasing its ad valorem revenue from the petroleum sector. This contribution to the exchequer has not been rising in proportion to the increase in oil price. One could assume that as oil prices climb further, the political economy of India would pressurize the government for a tripartite sharing of the increased burden, rather than a linear increase in retail prices. The end result in the medium term could very well be the continuation of the current scheme of things.

In the long run, the direct tax collection is expected to increase, and the government’s financials would improve as a result. Petroleum products are also expected to be brought under the VAT regime, which would make it easier to administer any change in state level levies on these products.

The government of the day would find it easier to decrease taxes on fuels in the long run. As mentioned earlier, even $150 per barrel of crude oil sans taxes can be absorbed by the country without much pain. Should we, therefore, be concerned about rising oil prices? The answer is yes. Should we be worried to our teeth? Probably no!

Arvind Mahajan is executive director, advisory services, KPMG Advisory Services Pvt. Ltd. Comment at