Over the barrel: On oil, let’s play the ‘what-if’ game

This column first appeared in Indian Express, on November 3, 2014.  Like other products of the Brookings Institution India Center, this is intended to contribute to discussion and stimulate debate on important issues. The views are those of the author.

Now is the time for the government to ask the question, “What should we do if the international price of crude oil were to reverse its current downward trend and start to rise again?” Should it re-regulate the price of diesel and petrol, as did the UPA government in 2004 after having gazetted deregulation in 2002, or should it find some alternative mechanism to shield consumers from the burden of high prices? These are relevant questions because the petroleum market is inherently volatile, and because we know that the decision of the UPA government created distortions that future governments must avoid. An alternative mechanism to safeguard
the interests of consumers should be contemplated now, when the market is soft.

The international price of crude oil has dropped by approximately 25 per cent from its peak of $115 per barrel in June this year to around $85 per barrel today.

This is because of the fundamentals of sagging demand and surging supplies. Demand in North America and Europe has been stagnant and it has slowed in China and the Middle East. Supplies, on the other hand, have received a fillip from the shale revolution in the US; the resilience of Libya, Iraq and Iran which, despite internal turmoil, have sustained and even increased indigenous output; the rise of production outside Opec and the dumping of “paper barrels” by Wall Street speculators who had gone long in expectation of increasing prices. Prima facie and based on these fundamentals, the price of oil can be expected to stay on this downward path for some time. But as anyone who follows the petroleum market knows, market fundamentals have all too often been overwhelmed by geopolitics and speculative sentiment. The Middle East is the repository of the largest accumulation of low-cost hydrocarbons but it sits on a powder keg of ethnic, religious and political conflict. All oil import dependent countries, and India in particular, must consider and prepare for the contingency that this keg may explode and prices may return to triple digits.
In April 2002, the government deregulated the petroleum market and the public sector marketing companies (PSUs) were given the freedom to set the prices of diesel and petrol. At that time, the price of crude oil was around $20 per barrel. Thereafter, the market conditions tightened, and by 2004, when the UPA coalition was elected to power, the price had moved up to around $35/ bbl and was trending upwards. In July 2004, the new minister of petroleum choked off the PSUs’ pricing autonomy. Administrative pricing was reimposed and the PSUs were directed to retail diesel, petrol, kerosene and LPG at subsidised prices, below the cost of acquisition.
This turned out to be a big mistake. The PSUs notched up huge losses; exploration activity took a dive because the ONGC was asked to bear part of the subsidy burden; competition was killed, as private companies that had received a marketing licence faced a skewed playing field and were compelled to close down their retail networks; the economy “diesel-ised” as demand for the subsidised product surged; the price differential between diesel and kerosene and petrol and naphtha incentivised fuel adulteration; and the subsidy bill of the Central government spiralled out of control. In financial year 2012-13, for instance, the subsidy on diesel alone was around Rs 80,000 crore. With the benefit of hindsight, it is clear that a decision to subserve the interests of the public created conditions that generated precisely the opposite result.

It is because of this backdrop that the present government should contemplate the counterfactual. It is also because of the political reality that if and when prices do rise, the government will have to intervene. No politician, whatever his ideological hue, can ignore the consequential impact of such a rise on his constituency. The question is, what should the nature of the intervention be? Who should the government intervene on behalf of? Who are the “poor”?

These are important questions because, until now, subsidies have not been targeted. Everyone has had equal access to this benefit, whether he be a relatively poor farmer in need of cheap fuel for irrigation, a truck owner carrying freight long distance, a telecommunications company with radio towers, an industry with captive diesel-powered generators or a tycoon driving a diesel-guzzling SUV. The question is also important because the impact of subsidies on energy security, efficiency, environment, technology and innovation has hitherto not been given sufficient consideration. A future policy must adopt a more granular, targeted and holistic approach.

What should the contours of such a policy be? The government should initiate a detailed study to answer this question, but I can offer four pointers. One, the subsidies should not be broadly spread. Only the poor should benefit. The criteria for identifying the beneficiaries should be economic and social, but politicians must sign off on it. Two, the prices of petroleum products should be multi-tiered. The targeted segment should pay a subsidised price. The rest should pay in line with the market. There will be leakages and diversions but with the GST, technology and the cooperation of manufacturers and retailers, it should be possible to manage and contain the inefficiencies. Three, the subsidies should be disbursed directly from the exchequer. The PSUs must not be brought into the process and their pricing autonomy must not be constricted. And four, a “subsidy stabilisation fund” to finance future subsidies should be created. This fund could be financed by channelling into it the “excess” profits earned by the PSUs. The definition of “excess” could be set through mutual discussion between the government and the PSU.

“What if” questions often get criticised for being an “idle parlour game”, to borrow historian E.H. Carr’s phrase. The decision-makers of the petroleum sector should, however, play this game. For it will help them prepare for the unexpected and, in particular, mitigate the avoidable costs of reactive opportunism.