COMMENTARY

Natural Gas Price Hike

Subsidising Producers Prots?
E A S Sarma

The government, on the basis of a very questionable methodology, has doubled the price payable to natural gas producers. Through this decision as with a similar one in 2009, the government has compromised economic reasoning at the altar of crony capitalism and political expediency. In the absence of a homogeneous gas market which throws up a market price, the only option should have been for an independent, professional and quasi-judicial regulator to compute efciency-based costs and determine the price on the basis of a reasonable return. Instead, a Group of Ministers has taken a decision which could transfer up to Rs 26,000 crore a year to producers, especially one private company.

n 27 June, the Cabinet Committee on Economic Affairs (CCEA) decided to increase the price of natural gas from the Krishna Godavari (KG) Basin and other areas on the basis of Rangarajan Committees recommendations from the existing level of $4.20 per million British thermal units (MMBTU) to $8.4 per MMBTU, effective from 1 April 2014. Facing all-round opposition, the union government defended the decision by saying that in the absence of remunerative prices, no investment had been made in domestic exploration and production, resulting in a fall in natural gas production from 143 million standard cubic metres per day (mmscmd) in 2010-11 to 111.44 mmscmd in 2012-13 (Hindu 2013). This, in turn, led to a sharp rise in expensive liqueed natural gas (LNG) imports, threatening Indias energy security. According to the government, even the new and higher price would still be below the international gas price. The government also hinted that both the affected consuming sectors, namely, electricity and fertilisers would be subsidised. Earlier, the union minister for petroleum had criticised all those who opposed the gas price hike as belonging to an import lobby. Bonanza for Producers The gas price hike has given an unearned bonanza for gas producers, especially the one private company in the KG Basin whose persistent overtures, threats and pressures pushed the government into taking such an imprudent decision. Assuming that the concerned company will produce 80 mmscmd as originally promised, the latest price increase would give it an annual largesse of Rs 26,000 crore! If the rupee continues to depreciate in the coming years, the
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E A S Sarma (eassarma@gmail.com) is a former Secretary, Ministry of Power, Government of India.

dent on the public exchequer would be far more debilitating. To understand the dynamics of decisionmaking on gas pricing, one should look at the track record of implementation of the Production Sharing Contract (PSC) in the KG Basin. In 2006, the franchisee company declared to the regulator that the franchised area had 11.3 trillion cubic feet (tcf) of probable gas reserves and the company would produce 80 mmscmd, on the basis of an approved development plan involving drilling of 50 wells and investing $8.8 billion, which, in terms of the PSC, would be reimbursed later by adjustment against the gas sales revenue as the rst charge (CAG 2012, Chapter 4). The gas discovery had generated an all-round euphoria. Thousands of small investors invested their savings in the companys equity. Several power companies invested heavily on downstream gas-based electricity generation facilities. The companys shares looked up. After the power plants were set up, gas production started dipping, going even below 20 mmscmd, forcing the power plants to idle. This, in turn, triggered a serious power crisis in Andhra Pradesh and elsewhere. In a way, the fall in the countrys gas production from 143 mmscmd in 2010-11 to 111.44 mmscmd in 2012-13, as referred to by the government, was largely accounted for by the production shortfall in the KG Basin itself. In June 2012, the companys Canadian partner revealed that the gas resources in the basin would be only 1.93 tcf (Indian Express 2012) implying that the originally declared reserve gure was overstated by a factor of ve! This created a serious setback to small investors whose savings were locked up in the companys equity. In terms of the PSC, the government should have penalised the company for the cutbacks in reserve estimation and shortfall in production. The government not only acquiesced in these contractual infringements but also allowed the company to violate Articles 4.1 and 4.2 of the PSC which required the company to relinquish a certain proportion of the exploration area at the end of each phase of exploration. The government
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thus became a willing party to a series of contractual infringements committed by the company. Lobbying for a Higher Gas Price Instead of being on the defensive, the company, knowing well the frailties of the government, made it appear as if the government was to be blamed for its own failures. It continued to place heavy and sometimes unreasonable demands on the government, including the demand for a steep hike in the gas price. The price of $4.20/MMBTU applicable to gas from the KG Basin till the end of March 2014 was in itself based on a questionable methodology, as explained below. The company also placed several obstacles in the way of the Comptroller and Auditor General (CAG) of India carrying out a comprehensive audit of implementation of the PSC. It is interesting to see how the company had stepped up its campaign to obfuscate its past failures and build up a frenzy to prompt a willing government into deciding on the next big gas price hike. Whether it is by coincidence or otherwise, every time a conscientious union petroleum minister tried to discharge his legitimate responsibility of overseeing enforcement of the PSC, he would be replaced by another, making it clear that when it came to dealing with inuential industrial houses strict compliance with the contract would never be on the agenda of the reform friendly government. In June 2013, the Canadian partner of the franchisee company announced a new discovery in D6 Block in the KG Basin and a consequential upgrading of the gas reserve by 160%, which pushed up the share values of the producer companies once again (NDTV Prot.com 2013). It is signicant that this announcement more or less coincided with the decision of the Ministry for Petroleum and Natural Gas to overrule the Director General of Hydrocarbons on a proposal that the producer should relinquish 86% of the franchise area as per the PSC (PTI 2013). It also coincided with the latest decision of the government to consider the Rangarajan Committee report and increase the price of gas. The government simultaneously argued that a higher price of
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gas would automatically incentivise the gas developers to make additional investments and add to the countrys capacity to produce gas, which was a dubious proposition. According to press reports prior to the CCEA meeting (Indian Express, 26 June 2013), it looked as though the petroleum ministry would moderate the impact of the Rangarajan Committees recommended price and settle at $6.77/MMBTU. At the CCEA meeting, however, apparently, there was an intense pressure for a higher price. After all, an increment of $1.63 over and above $6.77/MMBTU would yield an unearned bonanza of more than Rs 10,000 crore! Why deprive the company of it? That is how the CCEA seemed to have decided on a price of $8.40/MMBTU. One should not be surprised if the actual price charged with effect from 1 April 2014 works out to be more than $8.40/MMBTU. KG Basin Gas Controversies Gas production in the KG Basin has remained controversial right from the inception of the project. Apart from complaints against gold plating of the project, overpricing of the gas and extracontractual concessions given to the producer, the local farmers are agitating against land subsidence caused by gas extraction. The matter is presently under adjudication by the Andhra Pradesh High Court (WP No 13341/2008). It is possible that land subsidence in itself has caused irreversible damage to the gas eld. It has certainly caused a setback to agriculture in the fertile KG delta which contributes signicantly to the states granaries and its sustenance. The silence on this on the part of the Union Ministry of Environment and Forests demonstrates the fragility of environment governance in the country. It is ironic that the gas price hike should come at a time when the government had recently allowed private power producers to pass on the cost of imported coal to electricity utilities, throwing to the winds the tender ethics of an elaborate competitive bidding process adopted by the utilities (Economic Times, 22 June 2013). Also, the state electricity distribution companies are already reeling

under accumulated losses exceeding Rs 2.5 lakh crore and the power ministry has proposed to bail them out with a huge nancial relief package. Taking into account the existing gas-based capacities in the electricity and the fertiliser sectors, the subsidy cost arising from the latest gas price increase would be Rs 33,000 crore (The Hans India, 29 June 2013). It is the taxpayers money that is in jeopardy in the hands of the Union Ministry of Finance, though it will be the gas producers who will reap the real benet. Among them, the private producer in the KG Basin will be the primary beneciary. International Gas Price? The high costs of storage, liquefaction, regasication, pipeline transportation of gas, etc, have rendered the global gas markets opaque and fragmented. For example, in 2011, 1,025.5 billion cubic metres (BcuM) of gas was traded globally (BP Statistical Review 2012). Out of this, 694.6 BcuM was through pipeline transport and 330.9 BcuM was in the form of LNG. It is LNG that is traded globally, whereas piped gas is traded within each region. Prices of piped gas, and even LNG, depend on regional supplydemand pressures and suppliers and consumers options on long-term contracts and spot transactions. As far as pipeline trade is concerned, the regions that contributed largely to net exports were former Soviet Union (168.4 BcuM) and Africa (36.9 BcuM). The net importing regions were Europe (187.8 BcuM) and Asia Pacic (13.3 BcuM). The Russian Federation, Norway and Canada are the major exporters of piped gas. The net major LNG exporting regions were the Middle East (125.8 BcuM), Africa (57 BcuM) and South and Central Americas (13.1 BcuM). The net LNG importing regions were Asia Pacic (109.5 BcuM), Europe (71 BcuM) and North America (15.4 BcuM). Qatar, Malaysia and Indonesia are the major LNG exporters (ibid). In this scenario, during 2011, India imported 17.1 BcuM of LNG from the Middle East, out of which 13 BcuM was from Qatar alone [BP Statistical Review 2012] against a long-term contract of Petronet. There have been complaints that Petronet has
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been overcharged for this. A part of the Qatar LNG is lean gas, stripped of propanes, butanes, etc, but is perhaps charged as though it is rich gas (India Oil and Gas 2012). From the above, one can see the futility of referring to any international gas price. It is therefore inappropriate to benchmark the domestic gas price with reference to the prices applicable to either piped gas in different regions of the world or LNG imports by different consuming countries. Rangarajan Methodology Though fully seized of this aspect, it is ironic that the Rangarajan Committee should rely heavily on prices prevailing at regional trading hubs (the Henry Hub in the US and the National Balancing Point (NBP) hub in UK) and net-back well head prices for LNG imports in India and Japan. Those familiar with gas trade patterns know that spot-transacted prices could be as low as half of the hub prices in a given region. When producers vie with each other to sell their gas, a prudent buyer can negotiate a price that lies somewhere between the hub price and the spot price. The net-back prices, derived by subtracting the costs of liquefaction and transportation from the delivered prices, can be equally misleading. The Rangarajan Committee has recommended a two-step approach to determine the domestic gas price. First, it envisaged working out a weighted average of the previous 12-month averages of prices indicated by the Henry Hub and NBP, and LNG imports made by Japan. The second step is to average this (not a weighted average this time) with the previous 12-month average of the price of LNG imports made by India. Averaging out prices applicable to fragmented markets with their own dissimilar supply-demand characteristics does not make much economic sense. Further, considering that there have been complaints against overcharged LNG imports from Qatar, the Rangarajan formula would capture whatever distortions that existed in it in determining the price of domestic gas. It amounts to perpetuating a mistake once committed. Moreover, averaging two numbers, one derived from a
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complex weighted average of three regional market prices and the second, a number derived from a few lines of Indian LNG imports, makes little statistical sense. In North America, the price of gas touched a low of $2/MMBTU in 2012 and temporarily recovered to $4/MMBTU. Increasing shale gas availability in the US, Canada and China has already started exerting a downward pressure on gas prices all over the world. In such a scenario, to rely exclusively on the hub prices and calling it, as the CCEA has done, the basis for competitive, arms length price, to the benet of parties to the Contract as envisaged in the PSC, would be grossly erroneous. While the global gas markets are looking downwards, the Indian gas policy analysts seem to be looking upwards! The PSC for the KG Basin mandates that the gas price formula/basis be approved by the government. Evidently, whatever gas pricing formula that the government approves should reect competitiveness and be mutually benecial for the parties to the contract. In a perfectly competitive market, the producers price will be no more than an efciencybased unit cost plus a reasonable rate return. If no competition exists, an independent regulator should necessarily determine such an efciency-based price. There can be no intermediate solution. Had the government entrusted the responsibility of xing the contractual competitive, arms length price to an independent statutory regulator, the process of price determination would have become transparent, affording an opportunity to the aggrieved parties to seek judicial remedies. On the other hand, by arrogating to itself this onerous responsibility, the government has introduced an undesirable political dimension to price xation. Gas Development Costs Knowledgeable persons place the actual unit cost of exploration and development of gas in the KG Basin below $1/MMBTU. The Rangarajan Committee has admitted that
a proposal of RIL in 2006 to approve the price of $2.34/MMBTU, which was the contractual price with RNRL, was rejected by the Government on the ground that the
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price was not derived on the basis of competitive arms length sales in the region for similar sales under similar conditions.

There cannot be a more perverted argument than this! In fact, the National Thermal Power Corporation (NTPC) did receive a similar price bid of $2.34/MMBTU from the same company for KG Basin gas but, under duress, it was not allowed to accept it. A Group of Ministers (GOM) ignored these clear price signals and, for reasons best known to them, xed the price in 2009 at $4.20/MMBTU, ironically, on the basis of bids obtained by the producer from a few power companies which had no incentive to quote a lower price, as they knew that whatever price they had quoted would anyway be allowed to be passed through in the cost-plus regime of electricity regulation. As a result, the government knowingly passed on a largesse of $1.86/MMBTU to the producer at the expense of the electricity and fertiliser consumers. The latest price increase doubling this further is a part of this continuing municence to the producer. Reform vs Crony Capitalism In the earlier decision in 2009 and once again in 2013, the government has compromised economic reasoning at the altar of crony capitalism and political expediency. In the absence of a homogeneous gas market, the only alternative open to the government is to allow an independent, professional, quasi-judicial regulator to compute efciency-based costs and determine the price on the basis of a reasonable return. It is improper to entrust this task to a GoM which is merely a political entity. By allowing PSC violations, the government has conveyed an inappropriate message to all prospective investors that they could mock at the sanctity of contracts and the law of the land. Such investors will do more harm than good to the society. The government has erred by extending the new gas prices to the already developed gas elds in the KG Basin and elsewhere. Finally, natural gas is a public resource and the government is merely a trustee for the people. The Doctrine of Public Trust obligates the government to ensure that gas resources
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are developed on scientic lines and that the social returns maximised. In the case of the KG Basin, the government has failed this test.
References
B P Statistical Review of World Energy (2012): www. bp.com/statisticalreview, June. Comptroller and Auditor General of India (2012): Performance Audit of Hydrocarbon PSCs.

Economic Times (2013): Power Producers Can Raise Prices to Match Cost of Imported Coal; CCEA Decision Will Raise Tariffs, 22 June. Economist (2013): Nuclear Power: Fracked Off Thanks to Cheap Natural Gas, Americas Nuclear Renaissance Is On Hold, 1 June. Government of India (Rangarajan Committee) (2012): Report of the Committee on the Production Sharing Contract Mechanism in Petroleum Industry. Hans India (2013): PC Defends Hike in Gas Pricing, 29 June.

Hindu (2013): Power, Fertiliser Sectors May Get Subsidised Gas Rates, 28 June. India Oil & Gas (2012): Qatar Ploy: Quo Vadis at PLL?, Vol 19, No 18, 25 December. Indian Express (2012): Reliance KG-D6 Reserves Est off 80% Niko, 21 June. (2013): Gas Producer Price in New Regime to be $8.55: Petroleum Ministry, 26 June. NDTVProt.com (2013): Reliance Industries Gains on Reserves Hopes, 14 June. PTI (2013): Moily Hints of Relief to RIL on KG-D6 Relinquishment Issue, 16 June.

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