Oil price, of bandhs & reality

This post is spawned out of a twitter series I did a day earlier. Given the nature of the medium that is Twitter, a lot of information gets lost or misinterpreted. As such, I decided to lay out my thoughts in a detailed blog.

The Congress party called for a Bandh (or stoppage of all work) in response to the rising fuel prices in India. While the call for bandh failed, it might make sense to look at what is driving the fuel price in India. The objection is that they why can the Government not reduce taxes on fuel, to bring down the price of petrol and diesel. For those who may not know, the taxes charged by central and state government account for about 35-50% of the price of petrol or diesel that the common man buys in retail. While actual mix may change based on several factors such as exchange rate, crude price etc, the charts below will give the reader a good approximation of what it looks like.

Source: https://www.indiatoday.in/india/story/high-prices-of-petrol-and-diesel-explained-why-onus-lies-on-govt-1238609-2018-05-22

A common refrain by the opposition has been that the Government refused to reduce prices even when crude prices fell precipitously in 2016. Indeed, the crude prices did dip even below US$30/ bbl (bbl, i.e. barrell = 159 litres of crude oil). But, is it logical to assume that large oil companies are operating on spot purchases of crude oil? What if price spikes up? What if supply is not available? 

As such, many Companies purchase crude on long term contracts, which brings in a modicum of stability to their business. In fact, Indian Oil during that period used to buy 80% of its requirement on term contracts instead of the spot market. 

As such, the purchase price of Crude never went to US$30/bbl for India at all, and this argument by Congress supporters, is itself moot. Note, as per the data from The Petroleum Planning and Analysis Cell (PPAC), the lowest the Indian crude basket went to was ~US$46/bbl (in FY16), a full 53% higher than the number detractors have hung their hat on.

Source: PPAC; Note: The composition of Indian Basket of Crude represents Average of Oman & Dubai for sour grades and Brent (Dated) for sweet grade in the ratio of  crude processed during previous financial year

Even this decline to US$46/bbl was not smooth, but back ended. One can appreciate that Oil Cos do not have the mandate to speculate with public money on such volatile movements in the price of an international commodity. They will (indeed, they must) always forego a contingent gain to ensure that the public will not bear a contingent loss.

Source: PPAC

Not many recall that it was in late 2015, early 2016 that Saudi oil producer Aramco had announced its intent for an IPO. The Company was eyeing a US$2 trillion valuation and the markets were expecting Saudi to take steps to firm up oil prices that would make viable the IPO at desired valuations. Indeed, the price of the Indian crude basket did go up at a rapid clip from its bottoming at US$46 in FY16.

While Oil Marketing Companies (OMCs) fix the price of fuel, and the Government decides the taxes, one can understand their hesitation is changing rules and rates in the midst of volatile price movements that are difficult to forecast or model with any degree of certainty. 

There is however the option for the Government to cut taxes on petrol and diesel, i.e. forego revenue to reduce prices for consumers. This however presents a conundrum, as on one hand the Government wants to promote public transport, electric vehicles, lower pollution, but on the other it is  reducing the taxes to make petrol cheaper. Over 95% of petrol is used in private vehicles as per a 2013 Neilsen survey conducted for the GoI (nearly 25% for diesel sales goes to cars and UVs). Does it make sense for the Government to subsidize vehicle owners and absorb the cost in the larger budget and burden the common man? It does make political sense, but does it make economic sense?

Actually, there is little evidence that rising prices impacted the demand for petro-products at all, as the chart below will attest:

Source: Data from PPAC; Demand index is my calculation by aggregating volume of various petro products sold through the years and re-basing the data to 100 in FY03 to highlight the growth.

It is empirically clear that demand existed for fuel at these price levels. To a certain extent the international crude prices are unimportant for local fuel demand because Indians have always been sold fuel at administered prices till very recently. I doubt there is any domestic businessman or transporter who uses price of Brent crude in his cost calculations. He has always used the domestic price. 

So, the Government used part of the gains from the difference between international oil price and taxes earned on domestic price for two things:

• Servicing the hidden burden created by the previous government on account of Oil Bonds 
• Optimizing the fuel subsidy

Oil bonds (OBs) were an excellent example of innovative fiscal imprudence. During the days when the Central Government compensated OMCs for under-recoveries in oil price, OBs were conceived as a mechanism to pay OMCs but still not have a cash outlay. 

A commentator had in fact referred to OBs as a "mockery of fiscal responsibility and transparency". Notably, near its peak, it is estimated that OBs alone accounted for 4.6% of total liabilities for the Government.

Source: https://dea.gov.in/sites/default/files/StatusPaperGovtDebtSeptember2016.pdf,  https://www.ccilindia.com/Research/CCILPublications/Lists/CCILPubRakshitra/Attachments/284/RAKSHITRA%20AUGUST%202018.pdf

OBs in effect reflected the capitalization of losses. Unlike a normal debt taken by a Company/ Entity that goes towards creating an asset or paying down of an existing liability, the OB simply represented a loss. In fact unlike a cash subsidy given by the Government to the OMC, OBs were reportedly not included in the financials of the Government thus meaningfully understating the fiscal deficit. The current outstanding on account of each OB is as follows:

It is interesting to note that the Narendra Modi government will continue to pay out till well into the expected second term, the UPA largesse of a decade back! 

Notably, certain news mediums have reported that the Government has already paid off the liability, but I believe that this is not the case as evidenced by the holding statement from CCIL India monthly newsletter appended above. I think the Government is however footing the interest cost that runs up to ~Rs10,000 crore annually. A part of the 'perceived' excess received by Government on account of taxes has thus gone towards servicing liabilities created by previous regime.  (The total OB o/s account for nearly 50% of the tax received by the central government on fuel!). 

The second big area IMHO, that the Narendra Modi government has worked on is the reduction and optimisation of the fuel subsidy.  It is worth noting at this point that the fuel subsidy during the previous regime was excessive, to put it mildly, accounting for on average ~12% of the tax receipts by the central government. It went as high as 15-17% in several years:

Narendra Modi has done a commendable job of reining in the subsidy numbers from 15-17% to 1-3% of tax receipts. Additionally, he has targeted the subsidy to PDS kerosene and LPG which is largely used by the economically weaker section of society, and also women. 

It is a matter of introspection for Indians that despite ~70 years since independence, 10 crore out of the total 24 crore households in India used to rely on firewood and coal for cooking food. As per a WHO report quoted, smoke inhaled by women from unclean fuel is equivalent to burning 400 cigarettes in an hour. The Government has been able to provide 9 crore gas connections to households, include 3.5 crore for free under the Ujjawala Yojana. 

Now it can be argued that keeping the fuel price high, can result in inflation. It will no doubt contribute to inflation, but will it increase the cost experience overall for a household budget? The biggest component of cost for urban and rural households is food accounting for 36-54% of wallet. Fuel and light, on the other hand accounts for just 5.5-7.9% of expenses. Food inflation has been controlled beautifully by the Narendra Modi government, falling from double digits to ~1-2% levels in just four years:

Source:https://www.numberbasket.com/india/economy/consumer-price-index/cpi/detail/foodandbeverages

Therefore, despite the increase in fuel prices, it is unlikely that it will eat into the savings of the common man as a whole.

One would like to add, that if one wanted to make a political argument, just one chart was needed:

But I have added nuance to better understand the logic for Narendra Modi's move to hold the fuel taxes at current levels. It must be underlined that by doing this, he is taking the high road and not the convenient one. It  would have been very easy for him to buy cheap (well, it wont really be cheap!) popularity to reduce fuel prices by either outright increasing the fiscal deficit or surreptitiously by issuing oil bonds. But he has chosen to not kick the can further down the road but to pick it up right away. In fact, this is a question a genuine detractor would have asked, "Why is Narendra Modi risking unpopularity by not artificially reducing fuel prices?". Unfortunately, there are more motivated minds than questioning ones.

So in return my question to them is, assuming Modi reduced petrol prices, where should he make up the revenue short fall from? Reduce pensions? Reduce defence expenditure? Stop building roads, perhaps? Not electrify villages? Issue oil bonds and push liability to the next generation? Or have a huge fiscal deficit that ruins the economy? Take your pick.