INDIA depends on imported crude oil to meet a substantial part of its requirement since domestic production has remained stagnant. Furthermore, the pricing of petroleum products not only influences long term inter-regional economic growth but also the cost of energy for the economy. The pricing regime for petroleum products has invariably been influenced by the divergent interests of consumers, particularly the vulnerable sections, the producers, refiners, marketing companies and the government.

The pricing of petroleum products in India has witnessed several structural changes in policies since independence, moving through various stages from import parity to cost-plus and back to import parity during the last several decades. In 1948, the realization to oil companies was linked to the ‘import parity’ price of products, known as Value Stock Accounting (VSA). This was basically a cost plus formula based on import parity to which were added all elements of cost such as ocean freight up to Indian ports, insurance, ocean loss, remuneration, import duty and other levies and charges.

Given the huge outgo on imports, the government from time to time appointed committees to examine the whole gamut relating to petroleum pricing. The first of such committees, headed by K.R. Damle, was constituted in the early ’60s. It studied the question of foreign exchange conservation, particularly as the refining and product imports were in the hands of foreign oil companies and proposed incentives for the oil companies to increase gross profits by lowering their operating and other costs besides recommending that ‘discounts to be reduced from the FOB prices.’ Platt’s oil gram was taken as a reference to fix the FOB prices. In view of the multiplicity of products and usages, lubes and greases were kept out of the pricing formula, which was essentially applied to bulk products. For lubes and greases the committee recommended a block control system under which a ceiling was fixed for blending charges, packaging and marketing costs and profit margins.

Since the validity of the ceilings recommended by the Damle committee was only till March 1965, the government set up another committee under the chairmanship of T.N. Talukdar. The broad terms of reference were (i) the manner of determination of ex-refinery prices of products including bitumen produced by the refiners, (ii) the manner of determination of landed prices in respect of similar products which may be imported, (iii) determination of marketing and distribution charges of the products, and (iv) determination of ceiling selling prices in respect of lubricants, oils and specialities.

Broadly speaking the Talukdar committee extended the concepts laid down by the Damle committee, i.e. prices were to be based on the principle of import parity with fixed formula of buildup up to the CIF (carriage, insurance and freight). The price formula was firm and had the twin advantages of being reasonable and encouraged the oil companies to enhance their profitability by lowering costs. Additionally, it had the potential of a lower cost basis for fixing margins in the future.

 

The recommendations of the Talukdar committee were retained till December 1965, when the government appointed a committee under the chairmanship of Shantilal Shah. It was required to determine the landed cost of imported POL (petroleum, oils and lubricants), feasibility of making all refineries, including inland refineries, as pricing points, marketing and distribution charges, and profit on distribution and marketing operations product wise, and determination of dealer commissions for MS (petrol), HSD (high speed diesel oil), SKO (kerosene oil) and LDO (light diesel oil). The recommendations of this committee were to be implemented from June 1970 for a period of three years, continuing till the views of the next committee were known.

Interestingly, the Shantilal Shah committee did not regard import parity to be a sound basis for fixing prices, but were forced to adopt it because of the government’s commitment to the oil companies. As for lubes and greases, the committee recommended continuing with block control.

 

After the 1973 oil crisis the government constituted the oil price committee (OPC) under the chairmanship of S. Krishnaswamy in March 1974. It recommended the discontinuation of the ‘import parity’ principle and instead suggested the Administered Pricing Mechanism (APM) for pricing of petroleum products, both ex-refinery gates, as well as to consumers. Based on these recommendations, the APM came into existence in 1977. The mechanism was further amended in 1986 based on the recommendations of the Oil Costs Review Committee (OCRC). Under this system, the pricing of petroleum products was based on the retention concept wherein oil-marketing companies (OMCs) were compensated normative operating costs and 12% post tax return.

Under the APM, the refineries were also compensated on a cost plus formula, including acquisition cost of crude and other operating costs with an assured 12% post tax return on net worth. The question of price for imported crude oil and discounts thereof was to be negotiated by Indian Oil Corporation which was to import crude oil and finished petroleum products on behalf of the petroleum industry. To manage pool accounts on behalf of the government, an OCC (oil coordination committee) was set up.

At the distributor level the dealer commissions and margins were also regulated to maintain uniformity in commission rates. As part of the APM, freight for imported crude was paid to Indian shipping companies at cost plus rates. The market share of public sector oil companies was controlled through sales plan entitlements approved by the Ministry of Petroleum and Natural Gas.

The recommendation of the OPC were (a) the introduction of a retention price concept, (b) fixation of price of indigenous crude produced onshore and offshore and a separate price for imported crude, and (c) creation of a COPE account into which the difference between the normative imported price and the appropriate indigenous price of crude was funded by the concerned refinery and for which funds were provided in case the price of the imported crude was in excess of the normative price. This was to stabilize product-selling prices, enhance market stability and provide funds for the growth of oil companies.

 

In short, under the APM the price of crude oil and petroleum products was controlled by the government while the oil producers, refineries and marketing companies were insulated from international price fluctuations. The market share of all the players were fully protected. The indigenous crude oil was priced using a cost plus formula wherein producers like ONGC were compensated for their operating expenses and allowed a 15% post-tax return on the capital employed.

As mentioned above, APM operated a system of self-balancing accounts through which the entire mechanism was implemented. There were four major oil accounts in which the oil companies adjusted their claims arising out of administrative pricing and retention margins, viz. crude oil price equalization account, cost and freight adjustment (C&F) account, freight surcharge pool (FSP) account and product price adjustment (PPA) account.

The oil pool account was to help the OCC meet any claims from oil companies arising from the price mechanism. The pool was meant to be an equalization fund which absorbed inflows from favourable price fluctuations of imported crude and petroleum products. A special surcharge was inbuilt to recover some expenses from consumers on a uniform basis, while allowing actuals to the oil companies.

This arrangement broke down due to the one-way movement of surpluses to the government exchequer, who appropriated them while there was insufficient recovery under the various heads of pool accounts. Consequently, deficits in the oil pool account mounted and the burden was passed on by the OCC to the oil companies, which started defaulting in making timely payments of claims related to retention margins and approved audited costs. It resulted in the issuance of low coupon rated non-tradable oil bonds to the oil companies and was perhaps the beginnings of the dismantling of the APM regimes, which had served the country so well.

 

In 1996 the R group (strategic planning group on restructuring the oil industry) was created to suggest principles and a road map for phased deregulation of the downstream oil industry. Apart from planning the phased dismantling of the APM and marketing controls, the R group and its associate, the ETG Group, also proposed rationalization of the tariff structure and total freedom of refineries to decide their product mix to optimize profitability through better refinery yields and value added products. It needs to be stated that in a limited way the process of dismantling APM had started with the decontrol of pricing and marketing of lubricants as early as November 1993. This had been decided through an executive decision of the Ministry of Petroleum and Natural Gas (MOP&NG).

In November 1997, the government notified a phased dismantling of APM with full dismantling by April 2002. The prices of MS and HSD were to be fixed on import parity basis. The subsidy on SKO (PDS) and LPG (domestic), which under APM was cross-subsidized through MS and ATF prices, was to be met out of the government’s fiscal budget. Accordingly, the government announced the ‘PDS kerosene and domestic LPG subsidy scheme, 2002’ in January 2003. The subsidy was to continue for 3-5 years beginning 2002-03. The refinery transfer prices declared by oil companies post APM dismantling in April 2002, are based on the parameters provided in the subsidy scheme as explained in the following paragraphs.

The OCC was wound up consequent to the decision to dismantle the APM. For residual activities, the Petroleum Planning and Analysis Cell under the aegis of Ministry of Petroleum and Natural Gas was set up.

The deregulation of the oil industry and withdrawal of the APM regime was inter-alia aimed at making the domestic petroleum industry competitive, enhancing productivity, creating a free and competitive market, benefiting both consumers, producers and marketeers of petroleum products.

 

The system for pricing adopted by the oil companies post dismantling the administrative pricing mechanism was based on the import parity principle. The OMCs have two sources for obtaining petroleum products, viz. imports and/or procurement from domestic refineries. The pricing of petroleum products on ‘import parity’ basis at refinery gate brings parity in the cost of product procurement from various sources, thereby making a level playing field for all players.

The import parity price includes FOB at Arab Gulf plus expenses incurred in the process of importation like ocean freight, insurance, customs duty, ocean loss, bank charges, port wharfage, etc and reflects the most competitive alternative cost of sourcing the product. Prices are revised on a fortnightly/monthly basis to reflect international price trends to enable Indian refineries to be globally sensitive and structure their operations accordingly.

 

Pricing of MS and HSD – refinery gate: (i) Refinery gate prices at refinery ports, i.e. Jamnagar, Mumbai, Kochi etc and non-refinery ports of Kandla and Paradeep are determined on import parity price (IPP) principle as follows: The FOB prices are the average fortnightly price as per Platt’s Asia Pacific/Arab Gulf market scan and Petroleum Argus Asia product. To this is added the premium/discount for HSD/MS and the ocean freight based on basic freight as per World scale (WS 100) for sector Sitra to the respective ports adjusted for prevailing AFRA for MR size vessel. Additional AFRA of 50 points is added for Haldia port in view of higher crude freight cost due to port constraints. Next, customs duty is added at applicable rates, currently 10%. Also, other charges such as insurance, ocean loss LC charges, wharfage, etc have to be added. The Indian rupee price of IPP is determined on the basis of average exchange rates for the period of import.

(ii) IPP are fixed at smaller non-refinery ports like Goa based on coastal freight from the nearest port refinery.

(iii) Refinery gate prices at inland refineries, viz. Mathura, Panipat, Barauni and Koyali are fixed based on 75% of rail freight from the nearest refinery/non-refinery port. Refinery gate prices for North East refineries are at par with IPP for Haldia refinery.

 

Retail selling price of HSD and MS: While RTPs (refinery transfer prices) for all refineries are currently declared on an import parity basis, retail selling prices are fixed on the parameters applicable under APM with all refineries continuing to be the pricing points with common ex-storage point price. The current structure for working out the retail selling price of MS and HSD is as follows: Ex-storage price is considered the same at all refineries. To it is added a notional rail freight (NRF) at APM rates. Next, the state specific costs are added. This is to cover under recoveries with respect to sales tax etc in certain states. Then the RPO charges/surcharge at rates applicable under the APM regime are uniformly added to all markets. Next a state specific price rationalization is factored in, to which excise duty and education cess are added. For deliveries to the retail outlet point, a delivery charge is added. Finally, the sales tax/VAT and a dealer commission are added to make up the consumer price.

Although the refinery gate prices are worked out separately for each refinery port as stated above, refinery gate prices of inland refineries are arrived at after including freight from the nearest port location. In addition to the inland refinery production, products from coastal refineries are also moved to inland locations by rail/pipeline for which the marketing companies incur actual transportation cost.

However, under the existing pricing system, a uniform ex-storage price at all refinery locations, plus frozen notional rail freight (NRF) from the nearest refinery to the depot location is charged only to the consumers. Accordingly, the inland location prices do not include the full impact of transportation cost from the nearest port location to reflect the true import parity price. For example, the price of diesel in Delhi includes NRF of Rs 108.69/KL (Panipat to Delhi) instead of the actual transportation cost of Rs 1034.57/KL from Kandla to Delhi.

The under-recovery due to difference between actual freight up to inland locations and freight included in the price (NRF) is uniformly recovered from all customers based on all India average as a part of the uniform ex-storage point prices. The difference between refinery gate price and the ex-storage point price represents the recovery towards marketing costs, stock loss, working capital cost, marketing margin and average differential freight under recovery.

Post APM, the pricing of SKO (PDS) is governed by the PDS kerosene and domestic LPG subsidy scheme 2002, approved by the government.

 

Import Parity Prices at port refinery locations are worked out (i) based on the methodology provided in the subsidy scheme as follows: The starting point is the FOB which is computed similarly to that mentioned above for MS/HSD. (ii) As per the parameters of the subsidy scheme, refinery gate prices at inland refineries, viz. Mathura, Panipat, Barauni and Koyali are fixed based on 90% of rail freight from the nearest refinery/non-refinery port. Refinery gate prices for North East refineries are at par with IPP of Haldia refinery.

While kerosene RTPs for all refineries are declared on an import parity basis, all refineries (port as well as inland) continue to be the pricing points with common ex-storage point price. The current structure of working out the retail selling prices of SKO (PDS) is shown in Table I.

Subsidy: (i) The difference between the ex-depot prices and the issue price as of March 2002 level is given as subsidy for respective depots. As per the subsidy scheme, the subsidy is to be phased out in 3-5 years. The weighted average subsidy worked out on import parity basis as of March 2002 rates was fixed for the year 2002-03 at Rs 2.45 per litre. This was reduced by one-third for the year 2003-04 and by another third from 2004-05 onwards. The current average subsidy is Rs 0.82 per litre.

(ii) While the subsidy scheme envisages fixed subsidy at the March 2002 levels, any increase/decrease in cost price of SKO (PDS) due to changes in international prices, freight, customs duty, marketing cost and margins, dealer commission, etc is supposed to be passed on to consumers in the selling price.

(iii) The ex-storage selling price of SKO (PDS) was fixed by the government at Rs 6860/kl effective 1 March 2002 and was not revised thereafter. Consequent to recent reductions in excise duty on SKO (PDS), its ex-storage selling price was increased to Rs 7967/kl effective 1 March 2005. However, there is no change in the consumer price of SKO (PDS).

(iv) Due to non-revision in consumer prices of PDS kerosene in line with the increases in international prices and reduction in subsidy during 2003-04 and 2004-05, the additional impact has been absorbed by the oil companies. The extent of loss suffered by OMCs is reflected in the import parity price of SKO in September 2005 vis-à-vis March 2002 as detailed in Table II.

In October 2003 MOP&NG had approved a scheme for sharing OMCs losses on sale of PDS kerosene and domestic LPG by upstream oil companies and GAIL. The scheme was extended for 2004-05. For April-June 2005 upstream companies have also shared losses of OMCs on sale of all/some products.

 

The years 2004 and 2005 witnessed a sharp increase in the international price of crude in nominal terms. This had a major impact on the Indian oil industry, which is heavily dependent on import of crude oil, since such increases were not automatically passed on to end consumers due to the partial dismantling of APM and the government’s desire to insulate end consumers from international price surges. In view of this approach, while domestic upstream companies recovered international prices for the crude they supplied to domestic refineries, and the domestic refineries realized full gross margins linked to import parity and got tariff protection, the marketing companies incurred huge under-recoveries.

To moderate the under-recoveries of the marketing companies, the government decided to allow an increase in consumer prices effective 16 June 2004. These were Rs 2 per litre on petrol and Rs 1 per litre on diesel and Rs 20 per LPG cylinder, coupled with excise duty reductions of 4% on petrol, 3% on diesel and 8% on LPG (domestic).

Further, the government worked out a new methodology to mitigate the hardship of oil marketing companies. With effect from August 2004, companies were allowed to revise prices of MS/HSD within a price band. The notion of price band was based on the principle of rolling average prices of these products in international markets. Accordingly, oil marketing companies were permitted to autonomously adjust prices within a band of +/- 10% of mean of rolling average C&F prices of the last 12 months and the last quarter, i.e. three months.

 

In case of a breach of this band, the companies were to approach the Ministry of Finance to modulate excise duty rates so that spiralling prices in international markets did not hurt consumers. As part of the ameliorating exercise the government reduced customs duty by 5% in respect of petrol, diesel, kerosene (PDS) and LPG (domestic) and excise duty by 3% on petrol and diesel and by 4% in respect of kerosene (PDS).

Since international prices showed no signs of abatement, the under-recoveries of oil marketing companies continued to increase. Consequently, consumer price increases were announced by the government effective 5 November 2004. The retail price of petrol was fixed in line with the import parity price. The increase in diesel retail prices was pegged at 50% of the level of increase required on the basis of import parity. Since the international product prices somewhat weakened thereafter, the retail price of petrol was reduced on 16 November 2004. No downward adjustment was made for diesel.

With the government’s approval the retail selling price of LPG (packed domestic) was again revised on 5 November by Rs 20 per cylinder in view of the high prices of butane and propane, which go to make up LPG, in the international market. However, no change was made in the consumer price of PDS kerosene since March 2002, except for minor increases due to change in dealers’ commission/VAT by the state governments. The burden of the difference in the product import parity prices and retail selling prices were invariably passed on to the oil marketing companies, the ONGC and the Gas Authority of India in a predetermined ratio.

 

In the Finance Bill 2005, the government reduced customs duty on crude oil from 10% to 5%. There were changes in customs and excise duties in respect of major petroleum products. There was also a move to introduce specific excise duties to partially replace ad valorem duties. It was stated that the changes sought to be made were revenue neutral.

The international prices continued to rise and the Indian basket of crude oil touched USD 57.27/bbl on 8 July 2005. The trend in the international oil prices is shown in Table VII.

 

In conclusion, it is seen that an earlier concern was the foreign exchange repatriation by foreign oil companies who controlled the Indian petroleum trade. Several committees sat to evolve a rational petroleum pricing philosophy to suit the domestic industry. After some major discoveries in offshore oil, namely Bombay High, it was easy to manage the self-balancing pricing model. However, as domestic production failed to keep pace with growing demand, and due to appropriation of surpluses by government, the pool ran into a negative balance.

Although oil companies adopted import parity pricing to determine refinery gate prices after dismantling the APM, the structure of consumer pricing continues to be linked to APM.

The rationale for using the import parity pricing formula for petroleum products manufactured in India has resulted in high gross refining margins after the dismantling of the APM. In addition, the refineries have also benefitted from tariff protection.

As the marketing companies did not fully recover subsidies, their burden on the sale of PDS kerosene and LPG increased substantially. However, the marketing companies realized larger margins on products outside the price control, commonly known as free trade products, which constitute nearly 30% of the product slate, e.g. ATF.

During the APM regime, operating costs were audited and reviewed by OCC, resulting in cost management by the companies. However, post-dismantling, the companies pushed for greater market share, incurring extra marketing expenses and huge upgradation capital budgets.

The weighted average cost of the basket of crude used by public sector refineries also increased substantially because ONGC and OIL were allowed to recover international prices and charge notional freight on domestically produced crude while paying unadjusted economic rent to the government. Consequently, ONGC and OIL started to post high profits not related to increased production levels. The government intervened and made them (along with GAIL), partially share the subsidy burden.

After dismantling the APM there has been no coherence in policy or pricing methodology. Ad hocism rules consumer pricing, which appears to be influenced by political expediency rather than economic logic.