IT might appear that at the extreme end there are just two mutually opposed ways to look at how fixation of retail prices for refined petroleum products must necessarily be approached. One is the administered price approach – i.e., the mai baap sarkar knows what’s best for you; the other is the market approach – i.e., the invisible hand knows all that there is to know. The latter is perhaps not entirely untrue for a wide array of products, but it begins to falter when it comes to energy, particularly petroleum products. Let us briefly take the larger issue of energy, and then we can move on to petroleum products.

The problems with energy are many. First, it is a critical component of modern economic activity, accounts for very sizeable investments, and is an important element of the cost of production of most items. Second, there are multiple sources of energy – coal, petroleum, natural gas, nuclear, hydroelectricity and other renewables – that are fully substitutable at least in the medium to long term, and their relative prices determine the choice of the source, given a set of technological costs.

Third, each of the sources have powerful outcome externalities – atmospheric and water body pollution, carbon emission/climate change, inundation of river valleys and displacement of people, disposal of nuclear wastes, among others. Fourth, energy is partly an intermediate product – used in the manufacture and transportation of goods and services – and partly a final consumer good (in our homes); and in both uses (though more so in its use as an intermediate) there is a potential gain to be had from efficient use, the economics of which is driven by the price of energy and the benefits to be had from efficiency.

Fifth, there are in some cases, social costs for private use, as for example in the construction of highways which are financed from public funds, and there is considerable merit in charging for the use of the highway, which directs policy towards a cess on the fuel price to part finance the projects. That is, the road user pays proportionately more, by way of cess, towards the cost of constructing the road compared to the general tax payer. Finally, fossil fuels (coal, oil and natural gas) have been laid down over millions of years and there is just so much of it that is available for the use of humanity. Consequently, as we consume more, not only is there less available for future generations, the cost of extraction increases as more difficult deposits have to be worked.

Markets, when left entirely to themselves, are generally not very good at pricing in externalities, be it environmental costs (including the cost of human displacement) or for that matter in building the architecture for choosing strategic outcomes for the future.

The first concern is fairly straightforward, but the second merits some explanation. Let us suppose that there are two views on (a) the rate at which the supply of fossil fuels will grow (or fall), and (b) the workability of as yet unimplemented technologies that promise to make the use of energy more efficient.

In one situation, the government of the day thinks that the supply of fossil fuels will expand at a pace equal to its demand and that the technologies which promise more energy efficiency are not worth bothering about. In another, the government thinks that supply will be maintained only at higher prices and that in order to give energy efficient technologies a chance, it is necessary to make energy even more expensive by imposing additional taxes on it. In the first situation, energy saving technology is unlikely to make an appearance, while in the second it will.

One can dilate on the point – the policy on reprocessing nuclear fuel waste by civilian reactor operators in the USA is an excellent one – but it is perhaps clear what one is trying to get at. The architecture of the energy strategy is a policy issue, and once operational, the market mechanism works rather well in the great spaces that the policy architecture has defined.

 

Petroleum products differ in several ways from coal and other energy sources – both in quantitative, as well as in qualitative terms. First, petroleum will be the first fossil fuel to run out. Second, it is the most flexible of all fuels – easy to transport, easy to use, and with a surprisingly large number of applications. These applications differ amongst themselves in a way that invites policy response. Petroleum (and natural gas) is a source for industrial chemicals and that is a mundane affair raising no specific issues of social significance. Petroleum is, however, primarily a fuel – whether as gasoline to drive cars (and two-wheelers), diesel (for trucks, locomotives, ships and generators), aviation turbine fuel (ATF) in jet planes, fuel oil (mostly power generation), liquefied petroleum gas (LPG) and kerosene (virtually identical to ATF) in homes as cooking fuel.

Kerosene at one point was the most important petroleum product, used in lamps that till then were fired by animal or vegetable fats, and it has continued to be primarily a lighting fuel even after gasoline and diesel rose to prominence along with the automobile in the course of the first half of the twentieth century.

In India, it was only after Independence that kerosene began to morph into a cooking fuel, displacing wood, charcoal and dung-patties. With rapidly increasing population, particularly urban, the shift to kerosene was an important element in limiting pressure on our already depleted forests and reducing indoor and outdoor pollution. The shift to LPG as the cooking fuel of choice came some decades later, but kerosene continues to be widely used amongst the country’s poor. LPG could be substituted by piped natural gas and in theory by electricity, but this is not perhaps realistic without the appropriate infrastructure or relative prices. The point nevertheless is that in their application LPG and kerosene differ in a policy-relevant fundamental fashion from automotive fuels and thus deserve separate treatment.

 

We have already said that petroleum will be the first of the fossil fuels to run out. In addition, in India we are and will continue to be increasingly dependent on imported crude. It is a fact that the bulk of the world’s crude oil supply, as also future supply, comes from political hotspots (volatile, already unstable or in some danger of becoming so) – the Persian Gulf, North Africa, Caspian Sea region, Niger delta, and Venezuela. Oil is fungible and disruption in supply in one region will rapidly transmit through higher prices to other regions. In other words, in terms of energy security, India is more vulnerable in comparison to a comparable country that is much less dependent on imported petroleum.

 

What then are the core realities of the crude petroleum market in the years to come? First, world reserves will gradually decline in proportion to the extraction, and that in combination with the Organisation of Petroleum Exporting Countries (OPEC) cartel will ensure that oil prices remain high. Second, high prices will spur exploration for new reserves and enhanced recovery from existing ones, which in turn will expand supply and counteract to some extent the increase in price.

Third, by extending the source of supply, high oil prices will have the unintended consequence of stabilising prices at enhanced levels of supply. However, in the process the sustainable average oil price will settle at increasingly higher levels. Fourth, the global supply system for crude petroleum will continue to be threatened by supply disruptions due to the peculiar overlap of supply centres and political hotspot across the globe. Fifth, the pace of new reserve accretion in India is unlikely to keep step with the increase in domestic consumption, which means that the extent of the country’s dependence on imported oil can only go up.

For all of these reasons, it is imperative that the strategic direction of our petroleum policy should, as a desirable outcome, seek the limitation of the contribution of petroleum to our incremental energy requirements.

 

Earlier, we had described a situation where the government basically leaves the petroleum business to itself. In the advanced (OECD) economies, such was the situation in the years prior to the first oil shock in 1973. The policy response in the OECD varied in degree, but had in common some elements including higher taxes on automotive fuels (in order to encourage efficiency and mass transport). These initiatives were magnified with the second oil shock of 1980. The countries of Western Europe and Japan raised taxes much more than did the USA, Canada and Australia. The outcome on the growth of domestic consumption bears direct testimony to the efficacy of tax measures. (See Table)

 

The demand compression that arose from higher petroleum prices plus the higher tax regime completely altered both the direction and pace of growth of domestic consumption of petroleum products. In fact in Germany, domestic consumption was 3.34 million barrels per day (mbpd) in 1973, while presently (in 2004 and 2005) it is barely 2.7 mbpd. Even in USA where the taxation element in automotive fuels is much smaller than in the EU, it was not till 1989 that the level of domestic consumption that prevailed in 1973 was again reached. The combination of high international crude prices and high levels of domestic taxation worked to curb the appetite.

The 1980s was a period of rapid growth in Germany and Japan, and the other OECD member countries also grew, as indeed did South Korea. The fact that consumption growth was curbed in the context of economic expansion was the outcome of widespread technologies to enhance energy efficiency – from automobiles to lighting, and from domestic heating to industrial practices.

 

During the height of the second oil shock (Iran-Iraq war) the price of crude oil had risen to a level of over $37 per barrel (/bbl) which was not to be exceeded till 1990 in the run-up to the first Gulf war. After 1980, as demand fell sharply in Western Europe, as also in the other OECD economies, plus additional supply began to flow from Alaska and offshore platforms from the North Sea to the Gulf of Mexico to Bombay High, crude prices dropped to $18/bbl in 1989.

The price of crude continued to be soft through the 1990s, touching rock bottom in early 1999 when it nearly went below $10/bbl, before recovering over the next three years. We all know what has happened over the past year, when prices for Arab benchmark crude, such as Oman-Dubai, soared from $35/bbl to between $55 and $60/bbl over the past few months.

This is the nominal price of crude. In inflation-adjusted terms, the price of crude oil presently is still much less than what it had been in 1980, but nearly 50% higher than what it had been in 1974, in the aftermath of the first oil shock. That the impact of actual consumption levels had been so pronounced underscores the success of the policies of using high taxes on automotive fuels as an instrument to blunt demand.

The drop in crude oil prices through the 1980s and ’90s began to erode some of the sensitivity in regard to using price as a conscious policy instrument to induce energy efficiency. Some of the numbers are notable. In the US, the average mileage of cars was 5.8 kilometres per litre (km/l); in 1988 this had risen to 12.7 km/l, but dropped off to 12.1 km/l by the mid-90s and further over the next decade. That the compression of demand for petroleum automotive fuels has been more successful in the EU than in the USA is illustrated by the fact that in the post-1990 period, consumption grew at an annual rate in the USA that was three times higher than in the EU.

 

In our own case, please note that in the 1960-73 period domestic consumption of petroleum products had grown at an annual rate of 9.3%, when the economy was growing by only 3.4%. Over the three decades that have since elapsed, our domestic consumption has risen by an average rate of just 6%. In the past decade (1995-2005), the Indian economy grew at an average pace of nearly 6%, matching the rate at which oil consumption increased. In more recent years, the rate of increase in our oil consumption has moderated further to between 3.5 to 4.0% per annum.

The trend of declining rates of growth in domestic oil consumption occurring in tandem with an increase in the rate of economic growth is testimony to increase in use efficiency mediated through higher oil prices – a consequence of tax and price policies.

 

There is huge variation in the retail prices of automotive fuels (gasoline and diesel) across the world. The International Fuel Prices 2005 report (German Federal Ministry for Economic Cooperation and Development) has a wonderfully interesting map that divides the world into four groups: those with: (i) very high fuel subsidies, (ii) fuel subsidies, (iii) fuel taxation, and (iv) very high fuel taxation.

The first category with very high fuel subsidies are predictably the oil-exporting Middle Eastern and North African countries, Indonesia, Nigeria, Venezuela, Myanmar and some central Asian republics. The second category of those with moderate fuel subsidies include Russia (and most of the FSU), China, and some significant oil producers – namely, Mexico and Malaysia. The fourth category of countries with very high fuel taxation comprise basically of Western Europe, Japan, South Korea, and Hong Kong. The EU accession economies of Eastern Europe, as also Turkey (in its bid for EU membership) have taxation rates that conform to the EU standard.

The third category of economies are those with moderate fuel taxation, which includes USA, Canada, most of South America, Australia, New Zealand, South Africa, much of the rest of sub-Saharan Africa and India.

The countries with the most expensive automotive fuel are in Western Europe, which includes Norway and UK who have been net exporters of oil and gas ever since the development of the North Sea fields in the late ’70s. Roughly, gasoline retails at Rs 67 to 79 per litre, while diesel sells for Rs 60 to 75 per litre across almost all European countries. The tax component of the retail price in this region thus works out to 75% at the upper end of the price spectrum.

The tax incidence on automotive fuels in the moderate fuel taxation areas is significantly lower. In the USA, the retail selling price of regular gasoline is Rs 34-35 per litre and that of diesel is Rs 36-38 per litre, with the tax component at an average of 18% for gasoline and 20% for diesel. In Canada and Australia, both gasoline and diesel retail at about Rs 41 to Rs 43 per litre, that is, with an average tax burden of close to 30%. Although the taxation rates in Canada and Australia are about 50% higher than in the USA, while the latter needs to import 65% of its domestic oil requirements, Canada is a large net exporter of oil and Australian domestic output feeds almost all of the country’s requirements.

India falls in the same group as the USA, Canada and Australia (amongst others), and has a higher level of taxes, both on gasoline as well as on diesel. The total incidence of tax – including state VAT, highway development cess, customs duty on imported crude oil – on the retail price of gasoline works out to over 45%, while that on diesel is about 35%. Unlike Australia or Canada, India is dependent on imported crude to the extent of 77% of her requirements, and to an even greater extent than is the USA.

 

Indian consumption will increase much faster than in the developed world – whether in the USA, Western Europe, Canada or Australia. Assuming that we will be able to put in place policies that enhance efficiency in automotive fuel usage, the demand for petroleum products will minimally double over the next 15 years (2030). Even in an optimistic scenario, domestic production is unlikely to meet more than 15-20% of our future needs, that is, we will have to import some 80-85% of our crude oil requirements. Acquisition of overseas oil assets by ONGC and IOC is a good idea, but the equity oil which these investments will yield still has to be physically imported.

It is fairly easy to come to the conclusion that in our pricing policy, we have to be significantly more inclined towards minimising net increases in oil consumption, than say the USA or Canada or Australia, in particular because of our relatively weaker resource endowments, the certainty of higher future growth in consumption, and the greater opportunity we have (being in an earlier stage of development) to put in place more energy efficient technological choices.

 

On cooking fuel, it is easy to understand the discomfort about raising the sale price of PDS kerosene (Rs 9 per litre presently). However, plenty of our subsidised kerosene is going to adulterate diesel to the considerable detriment of the taxpayer, and as long as there is a sizeable difference between kerosene and diesel prices, the law of gravity will not be suspended. We also know that kerosene causes considerable indoor pollution. For both these reasons, we need to rapidly wean away the kerosene using householder to LPG or natural gas, and then discontinue subsidised kerosene supply. Currently, there is no central tax being levied on LPG. As for diversion to commercial use, if we intend to continue with below cost supply of LPG cooking gas, it is best that we make the package physically different – perhaps, bright blue 25 kg cylinders for commercial supply and the smaller red ones for household connections. Maybe different dimensions for the attachments also. It will make the work at the bottling plant more difficult, but control should become easier and money saved may make it worthwhile.