MacroScan (Printable Version) - Oil Prices: Encashing an External Shock

On November 4, the government decided to link the domestic price of petrol to its import parity price while increasing diesel price by half of that warranted by its import parity. This effort to restore the link between the domestic prices of petrol and diesel and global crude prices as required by the liberalised pricing scheme, resulted in an increase of Rs 2.20 per litre in petrol prices and Rs 2.10 per litre in diesel prices. In addition, the price of LPG was increased by Rs 20 per cylinder with immediate effect and is slated to rise subsequently by Rs 5 each month.

It hardly bears stating that such increases in the prices of a universal intermediate like oil, whose direct and second-order effects on the domestic price level are bound to be substantial, are causes for concern. Such increases are reflected in the prices of commodities and services (such as transportation) consumed by the poorest sections of the population, placing a burden precisely on those who are losers from the government's liberalisation policy. Further, they result in cost increases in areas like agriculture which squeeze the already low levels of net incomes of farmers. It is surprising a government that uses the (self-contradictory) slogan of ''liberalisation with a human face'' should see no alternative to such increases.

The case for the increase in prices sounds simple: the average price of the basket of crude imported by India has risen from less than $30 a barrel in February to more than $50 per barrel; and imports account for 70 per cent of India's crude requirements, which have been rising rapidly from 81 million tonnes in 2002-03 to an estimated 91 million tonnes last fiscal year. Given this, if the government does not raise domestic prices of oil, either the oil companies would have to suffer huge losses or the government would have to dole out huge subsidies. Neither is acceptable to India's reformers, so prices must rise.

The problem with this reasoning is that it misses out on three important aspects of the current oil scenario. First, the increase in global crude prices is not ''natural'', but reflective of a shock resulting from factors as diverse as an unwarranted war in Iraq, engineered civil strife in Venuzuela, and conflicts over control of at Russia's oil major Yukos. A responsible government is one that attempts to deal with such, hopefully transient, shocks in a manner that buffers their impact on vulnerable sections.

What the current oil shock has made clear is that the shift away from an administered price regime was an error, because it reduces the manoeuvrability of the government in such situations. Prices of commodities like oil should be seen as one instrument in the government's overall tax-cum-subsidy regime, and prices need to be held down if necessary and financed with revenues garnered from elsewhere, so that the distributional effect of international shocks are not adverse in an already unequal society.

Second, it is known that oil companies are earning substantial profits and if need be they can be called upon to take a temporary reduction in excess profits to achieve larger goals.

Finally, and most crucially, domestic oil prices include a huge component of ad valorem duties or duties levied as a proportion of factory prices. When international prices rise and domestic prices are adjusted in tandem, the government's revenues also rise substantially. Thus if duties are reduced to neutralise the price increase what is ''lost'' is not actual revenues but notional revenues that are far in excess of what was originally expected.

Consider the following back-of-the-envelope calculation. When the current increase in global crude prices began, central excise on petro-products stood at 30 per cent plus Rs 7.50 per litre. In the case of diesel the rate of excise was 14 per cent plus Rs 1.50 per litre. Further, the ad valorem customs duties on petrol and diesel amounted to 20 per cent. The duties on kerosene and LPG were no doubt lower at 18 and 26 per cent. So, for simplicity, treat the average level of duties to be around 35 per cent on oil products.

The average price of imports of crude oil is estimated to rise from around $27 a barrel in 2003-04 to over $40 a barrel this year or by around 50 per cent. India's oil bill in 2003-04 stood at $20 billion. Even if prices were constant this would have risen to $22 billion this year because of increases in the volume of imports. Add on the effects of a 50 per cent increase in oil prices and the import bill would have risen to $33 billion. If the average rate of duty had remained at around 40 per cent, the government would have obtained $13.2 billion as revenues as compared with $8.8 billion - an excess of $4.4 billion or Rs. 19,800 crore.

In practice of course, duties have been reduced to help hold domestic prices. On June 16, soon after it assumed office, the Government reduced the ad valorem excise duty rates on petrol from 30 per cent to 26 per cent, on diesel from 14 per cent to 11 per cent and on LPG from 16 per cent to 8 per cent so as to partially neutralise the effects of price increases by the oil marketing companies (OMCs) on the consumer prices of these products. Further, on August 18, the customs duty on both petrol and diesel were brought down from 20 per cent to 15 per cent. The excise duty on petrol was reduced from 26 per cent to 23 per cent while that on diesel has been reduced from 11 per cent to 8 per cent. And, the customs duty on LPG and kerosene sold through the Public Distribution System (PDS) was halved to 5 per cent. In addition, the excise duty on PDS kerosene was reduced from 16 per cent to 12 per cent.

The net result of all this is that the average duty is possibly in the range of 30 per cent over the year as a whole. This would make the revenue received by the government around $9.9 billion, or $1.1 billion (Rs. 5000 crore) more than originally expected. Needless to say, these are all back of the envelope calculations, and the actual figures would be different. But what they do suggest is that in all probability the government has thus far had to suffer no revenue losses in its effort manage the effects of the oil shock on domestic prices. Figures of ''revenue losses'' routinely reported by the financial press are notional and reflect the wrong presentation of information in an effort to lobby for the play of market forces. In fact, the government may still be taking in additional revenues to keep expenditures higher than those warranted by the deficit targets set by the irrational Fiscal Responsibility and Budget Management Act.

It is this which makes the recent hike in the prices of petroleum products, including diesel, completely unwarranted. But perhaps not so for a government which speaks of a ''human face'' but persists with an agenda that is fundamentally inequalising.



Themes > Current Issues	17.11.2004


Oil Prices: Encashing an External Shock

C.P. Chandrasekhar

On November 4, the government decided to link the domestic price of petrol to its import parity price while increasing diesel price by half of that warranted by its import parity. This effort to restore the link between the domestic prices of petrol and diesel and global crude prices as required by the liberalised pricing scheme, resulted in an increase of Rs 2.20 per litre in petrol prices and Rs 2.10 per litre in diesel prices. In addition, the price of LPG was increased by Rs 20 per cylinder with immediate effect and is slated to rise subsequently by Rs 5 each month. It hardly bears stating that such increases in the prices of a universal intermediate like oil, whose direct and second-order effects on the domestic price level are bound to be substantial, are causes for concern. Such increases are reflected in the prices of commodities and services (such as transportation) consumed by the poorest sections of the population, placing a burden precisely on those who are losers from the government's liberalisation policy. Further, they result in cost increases in areas like agriculture which squeeze the already low levels of net incomes of farmers. It is surprising a government that uses the (self-contradictory) slogan of ''liberalisation with a human face'' should see no alternative to such increases. The case for the increase in prices sounds simple: the average price of the basket of crude imported by India has risen from less than $30 a barrel in February to more than $50 per barrel; and imports account for 70 per cent of India's crude requirements, which have been rising rapidly from 81 million tonnes in 2002-03 to an estimated 91 million tonnes last fiscal year. Given this, if the government does not raise domestic prices of oil, either the oil companies would have to suffer huge losses or the government would have to dole out huge subsidies. Neither is acceptable to India's reformers, so prices must rise. The problem with this reasoning is that it misses out on three important aspects of the current oil scenario. First, the increase in global crude prices is not ''natural'', but reflective of a shock resulting from factors as diverse as an unwarranted war in Iraq, engineered civil strife in Venuzuela, and conflicts over control of at Russia's oil major Yukos. A responsible government is one that attempts to deal with such, hopefully transient, shocks in a manner that buffers their impact on vulnerable sections. What the current oil shock has made clear is that the shift away from an administered price regime was an error, because it reduces the manoeuvrability of the government in such situations. Prices of commodities like oil should be seen as one instrument in the government's overall tax-cum-subsidy regime, and prices need to be held down if necessary and financed with revenues garnered from elsewhere, so that the distributional effect of international shocks are not adverse in an already unequal society. Second, it is known that oil companies are earning substantial profits and if need be they can be called upon to take a temporary reduction in excess profits to achieve larger goals. Finally, and most crucially, domestic oil prices include a huge component of ad valorem duties or duties levied as a proportion of factory prices. When international prices rise and domestic prices are adjusted in tandem, the government's revenues also rise substantially. Thus if duties are reduced to neutralise the price increase what is ''lost'' is not actual revenues but notional revenues that are far in excess of what was originally expected. Consider the following back-of-the-envelope calculation. When the current increase in global crude prices began, central excise on petro-products stood at 30 per cent plus Rs 7.50 per litre. In the case of diesel the rate of excise was 14 per cent plus Rs 1.50 per litre. Further, the ad valorem customs duties on petrol and diesel amounted to 20 per cent. The duties on kerosene and LPG were no doubt lower at 18 and 26 per cent. So, for simplicity, treat the average level of duties to be around 35 per cent on oil products. The average price of imports of crude oil is estimated to rise from around $27 a barrel in 2003-04 to over $40 a barrel this year or by around 50 per cent. India's oil bill in 2003-04 stood at $20 billion. Even if prices were constant this would have risen to $22 billion this year because of increases in the volume of imports. Add on the effects of a 50 per cent increase in oil prices and the import bill would have risen to $33 billion. If the average rate of duty had remained at around 40 per cent, the government would have obtained $13.2 billion as revenues as compared with $8.8 billion - an excess of $4.4 billion or Rs. 19,800 crore. In practice of course, duties have been reduced to help hold domestic prices. On June 16, soon after it assumed office, the Government reduced the ad valorem excise duty rates on petrol from 30 per cent to 26 per cent, on diesel from 14 per cent to 11 per cent and on LPG from 16 per cent to 8 per cent so as to partially neutralise the effects of price increases by the oil marketing companies (OMCs) on the consumer prices of these products. Further, on August 18, the customs duty on both petrol and diesel were brought down from 20 per cent to 15 per cent. The excise duty on petrol was reduced from 26 per cent to 23 per cent while that on diesel has been reduced from 11 per cent to 8 per cent. And, the customs duty on LPG and kerosene sold through the Public Distribution System (PDS) was halved to 5 per cent. In addition, the excise duty on PDS kerosene was reduced from 16 per cent to 12 per cent. The net result of all this is that the average duty is possibly in the range of 30 per cent over the year as a whole. This would make the revenue received by the government around $9.9 billion, or $1.1 billion (Rs. 5000 crore) more than originally expected. Needless to say, these are all back of the envelope calculations, and the actual figures would be different. But what they do suggest is that in all probability the government has thus far had to suffer no revenue losses in its effort manage the effects of the oil shock on domestic prices. Figures of ''revenue losses'' routinely reported by the financial press are notional and reflect the wrong presentation of information in an effort to lobby for the play of market forces. In fact, the government may still be taking in additional revenues to keep expenditures higher than those warranted by the deficit targets set by the irrational Fiscal Responsibility and Budget Management Act. It is this which makes the recent hike in the prices of petroleum products, including diesel, completely unwarranted. But perhaps not so for a government which speaks of a ''human face'' but persists with an agenda that is fundamentally inequalising.



© MACROSCAN 2004