OIL SUBSIDIES: Are we stealing from future generations ?

-Case Study Challenge

Team Basilisk
Amit Kumar Pandit Ankur Yadav Anubhav Tiwary Gourav Prakash Ahirwar

Indian Oil Subsidy An Overview

Subsidy: it is any discount usually by governments on the cost of any item to its citizens

Pricing Scheme in India

A very crude way of representing oil pricing mechanism in India is given below: Petrols Pricing Structure: Petrols Pricing Structure: Fuel Component-52% Customs Duty 4% Excise Duty -25% Sales VAT -17% Dealer Commission-2% Diesels Pricing Structure : Fuel Component-66% Customs Duty 7% Excise Duty -13% Sales VAT -12% Dealer Commission-2%

As shown in the above graph, the consumption of petroleum products is on the rise in India but the production is unable to meet the rising domestic demand. Hence, India is a net importer of crude oil among world countries

As shown above, though crude oil imported amounts to greatest contributor to oil prices in India, the taxes levied by central and state governments are not less either Under recovery: it can be termed as the notional losses incurred by OMCs (Oil Marketing Companies) in India. Indian Oil Corporation, Hindustan Petroleum and Bharat Petroleum are OMCs which import and market oil in India. The price of oil these companies quote in India is the price quoted on the Singapore Exchange. So the price these companies quote is not the actual cost of oil in India. It is rather the price of oil in Singapore. The difference between the Singapore price and the actual selling price can be said as recovery (losses)

The reasons for Governments intervention in the form of subsidies are:

to protect consumers to provide merit goods to consumers such as clean cooking fuels like natural gas, LPG and kerosene to replace use of biomass-based fuels such as firewood and dung to insulate the domestic economy from the volatility of petroleum prices in the world market, For keeping domestic oil firms viable and in good financial health and providing an environment in which they can grow, to have an efficient and competitive oil economy that promotes efficient use by consumers , appropriate choice of fuels among substitutes and a proper choice of technique.

Since, OMCs run in huge losses due to under recovery, government provides aid to these public companies in the form of fiscal subsidies. But these subsidies hit government budget in a huge way

Benefits of Oil Subsidies to End Consumers

Currently flat subsidies are provided on LPG, Diesel and PDS Kerosene Not much variation seen in welfare impact of subsidies as a percentage of household consumption Flat rate subsides lead to greater subsidization of the groups who can consume more of the product It effectively transfers greater quantum of subsidies to rich who directly and indirectly consume more subsidized fuel products Rich consume more of subsidized fuel products directly (e.g.. LPG) Rich accrue more subsidies indirectly as they consume larger quantum of other goods This is Progressive Subsidization Benefits of most of Diesel subsidy accrue indirectly which is 1% of household consumption

The per capita monthly benefit to the poorest quartile is less then Rs. 38 The top 30% of earning population are subsidized by 0.4% of GDP which is 50% of total subsidies (see appendix 1) The bottom 45% get only 25% of fuel subsidies

Diesel Subsidies and Economy

8% of the total diesel consumption goes into Power Generation; Since electricity prices are regulated the benefit directly passes on to consumers 12% of the diesel goes into agriculture related activities and directly subsidizes the input costs by Rs. 9743 crs. This is also a regressive subsidy and the richer farmers make most use of it 65% of diesel is used in transportation sector 37% goes in to trucks and subsidizes freight by Rs. 30,041 crs. 15% in cars which is a direct benefit to end customer discussed above 12% and 6% in buses and railways resp. but the prices of most PSU roadways and railways are regulated to pass the benefit to consumers Industry consumes 10% of diesel ; subsidies worth Rs. 8119.17 crs.

Diesel Consumption in India

10% 6% 15% 37% 12%
Agriculture Trucks Power Generation Buses Cars Railways

12%
8%

Industry

Gains & Losses of Major Stakeholders

Central government receives corporate tax, customs and dividends worth Rs.117,000 crs and in return give a fiscal subsidy of Rs. 100,000 crs making a net gain of Rs. 17000 crs in FY 2013 State governments were largest gainers making Rs. 1,26,512 crs by taxes Consumers paid state and central taxes and got subsidies worth Rs. 161029 crs from OMCs effectively gaining Rs. 19076 crs in subsidies The Oil companies had under recoveries of Rs 161029 crs and paid Rs. 117,000 crs. in taxes along with a subsidy of Rs. 100,000 crs thus losing a total of Rs. 1,78029 crs The biggest gainers of oil subsidies are the state governments and those amongst the citizens are the richest of the society who were never intended to be the beneficiaries.

Net Gains/Losses of Stakeholders (2012-13) (Rs. Lakh Crs.)

2.00 1.00 0.00

Centre
-1.00 -2.00 Revenue

State

Consumers

Oil Cos.

Tax Paid

Subsidy Received

Net

Financial Impact of Subsidy on Upstream Companies

Increasing Under Recoveries
Under Recoveries of Upstream Oil Companies (in crore)
55000

High Burden % of Subsidy

Particular (2011-12) Oil Bonds/Cash Assistance by Government Under-recovery borne by OMCs Upstream Total under recovery by the OMCs Rs Crore %

Profitability of Upstream Companies

32000 25708 20507 14000 5947 14430

30297

83500 40% 41 0.03% 55000 60% 138541 100%

Total subsidy borne by upstream oil companies has been increasing continuously This is expected to rise further with increasing oil demand in India

With time the under recovery burden has shifted from oil marketing companies to upstream oil companies In 2011-12, Upstream Companies bear 40% of the subsidy with under recovery of INR 55 thousand crore

Under recoveries does not mean the companies are running in loss However, they lose revenue which hit them negatively in many ways

Implication of Increasing Subsidy Burden for Upstream Companies

Financial Uncertainty In Q1 of FY14, ONGC got USD 40.17 per barrel with cost of production as USD 40.08 resulting in only 13-14 cents net realization per barrel of oil production Initially, subsidy to be borne by upstream companies was set at 1/3 (33.33%) which was further increased to 38.7% Uncertainty regarding future pricing mechanism, expected assistance from government and future burden of subsidy causes difficulty in deciding future plans and growth opportunities Debt & Interest Burden Loss of revenue and uncertainty of working capital increases dependency on market borrowing to fund projects thus increasing the debt and interest liability According to A K Banerjee, director of finance, ONGC, the company might have to borrow Rs 6000 crore within a few months of September 2013 if the subsidy continued at current level. Working Capital Problem Upstream companies are losing big amount of revenue which is impairing their working capital management and thus finding it difficult to sustain and expand current production operation ONGC reserve cash balance has dipped to Rs 7000 crore from Rs 9500 crore in FY13 since it contributed Rs 49,421 crore for subsidy. Over the last 10 years, ONGC has contributed about Rs 2.16 lakh crore to under-recoveries Negative Stock Performance Being a public and listed, upstream companies are responsible to their shareholders. Hence, subsidy burden has affected their valuation ONGC underperformed both the BSE Sensex and the BSE Oil and Gas indices since August 23, 2013 with a fall of about 6% on account of rise in estimated gross subsidies to Rs 130,000-140,000 crore for FY14, compared to the Rs 80,000 crore estimated at the start of FY14 Reduction of Oil E&P Upstream companies are also involved in oil exploration and production Due to lack of funds the companies are finding in hard to invest in this area thus reducing the possibility of increased production in India ONGCs expected internal accruals in 2013 to be much lower at Rs 27000-28,000 crore postsubsidies in comparison to planned expenditure of INR 35,000 crore on capex

Total Exploration Capex (2000-2010, $Bln) US China Canada Brazil Australia UK Angola Norway Russia Mexico India

177 72 52 37 33 25 21 21 18 14 12
Indias expenditure on oil ecploration is quite low keeping in view that it ranks 4th in consumption

Financial Stress on Indian Government Budget

Crude oil Import (million in US $) 139690 144293 100,080 76876 79553 35290 41000 26000 Share of Govt in Subsidy (Rs in Crore) 83500 71292

2008-9 2009-10 2010-11 2011-12 2012-13

2007-8

2008-9

2009-10 2010-11 2011-12

Crude oil account for about 90% of Indias oil import Import of crude oil has been continuously increasing with growing demand

Subsidy borne by government has increased substantially

Increased subsidy borne by Govt. has reduced contribution from taxes in oil sector This has caused current account deficit and worsening of economy

Implication of Subsidy on Oil Demand and Import

Supply Because of lost revenue upstream companies are not able to invest in oil exploration thus worsening the oil reserve with respect to the growing demand Also, oil marketing companies and refineries are not able to make capital expenditure to introduce new technologies and equipment to improve production facility Both these factors affects the oil supply adversely thus making India more dependent on oil import Reduced Interest in Alternate Energy There is a growing threat of reduced interest in investment in cleaner energy sources Because of artificial lower prices, the other sources of energy e.g. solar energy are expensive for consumers and Hence it promote use of petroleum products while discourages use of other renewable sources This further tends to affect India in long run in terms of being self sufficient in energy and reducing dependency on oil Barrier to Entry Bringing in private players as OMC and thus promoting competition can help better performance of oil industry Superior technologies, hedging strategies, high-sea deals in crude procurement and strategic coastal locations can result in higher efficiency and reduced under recovery burden thus improving Indias position as oil importer However, subsidy acts as barrier to private players from entering the market because, unlike the state-owned OMCs, the government won't bear compensation burden for them. This discourage competition result in apparent cartelization among OMCs and market inefficiency

Increased Demand and Consumption Subsidy artificially reduces the price for end consumers This encourages oil demand and consumption If the consumers are exposed to full pricing then it will encourage them to use fuel efficiently and judiciously e.g. use of public transport and use of more efficient devices and vehicle This will bring down the import bill for India and hence improve Indias position as oil importer

Should subsidy be abolished or reformed ?

Subsidy should be abolished slowly by removing the under recoveries by bringing in reforms over period of time Analyzing the impact of removing subsidy on Diesel Progressive decontrolling of diesel Price Eliminate UnderRecovery Passive Regulation -Variable Taxation
Increase price regularly over period of year by increasing diesel price at 1 INR/ Lt to match market price. Not a feasible option as it could result in price. Use of variable taxes to increase the diesel price and control the volatility . Could be feasible option in order to eliminate underrecovery.

Variable taxation reform to abolish subsidy

Variable taxation can be used to smooth the prices in diesel. Government can regulate the price paid by end consumer by regulating the variable tax paid by the consumer. This reform will be revenue neutral reform. Tax Rate can be calculated by comparing the 2-week average to the 5-month average. Eliminating Under-recovery will not have any impact on Federal Tax but only Provincial Tax will be increase due to higher price but will have significant impact on oil companies especially upstream oil companies. This price can be adjusted by decreasing the Sales Tax to reflect the higher diesel price. Movement to General Sales Tax (GST) to reduce the cascading effects of taxation.

Tax Component in Diesel Pricing

Description Diesel (INR / Ltr)

Retail Selling Price (RSP)

Federal Tax: Specific Excise Duty (including Education cess) Provincial Tax : VAT@12.5% Under Recovery by OMCs Total Tax/RSP (%) Federal Tax/RSP (%)

51.40
3.56 5.96 10.22 18.5 37.4

Impact of Diesel Subsidy Reform

Provincial Tax/RSP (%) 62.6 Calculation done on latest Diesel price in Delhi

Stability against international oil price fluctuation using variable taxation reform. 10% increase in diesel price will lead to 0.47% increase in price level due to weight of diesel in WPI; but will attain equilibrium in future due to change in demand, goods and production factors. Inflation : As per the E3MG model estimate , removal diesel subsidies to vehicle using diesel will increase consumer price by 0.7% which can be balanced out by reinvesting the extra income generate in improving the infrastructure and making availability of key goods and consumer staples. Political Impact : Increase in Diesel price being sensitive issue can lead to political issue . This issue can be handled through proper communication and dialogue between various political parties and spreading the message regarding benefit of removing the subsidy. Fiscal Impact : Due to less spending on subsidy , government can reduce its fiscal deficit and improve the GDP of the country by investing the subsidy amount in development of Infrastructure and other development projects. Rise in public transport fare : Direct cash payment to public transport companies can address this issue and control the price of fare.

Reforms for removing subsidy on LPG & Kerosene Subsidy should be removed progressively to prevent price shock and economic instability. Short Term
Link LPG price & Kerosene with international crude oil price by slowly increasing the LPG price over period of time. Online registration system for customer to keep track of LPG cylinder usage. Collection of data on the basis of demographic profile of consumer to understand consumption pattern

Medium Term
LPG : Introduction of maximum usage cap on LPG cylinder by households on the basis of data obtained . Start with average 8 subsidized cylinder annually for household which can be brought down later on. Savings of INR 4089 Crore ( 17.24%) of total subsidy can be done (2011 estimate)

Long Term for LPG & Kerosene

Implementation of Direct Cash Transfer System to BPL households. Increasing financial inclusion Indexing payments to change in price level for other consumers. Improvement of supply chain of PDS Kerosene and domestic LPG

Initiative for reforms Direct Cash Transfer Mechanism 3 Step Reform

Transfer amount on the basis of subsidy

% subsidy distributed as DCT 100% 80% 50% Transfer amount available(in INR) / BPL Household/annum 3131 2505 1566 Transfer amount available(in INR) /BPL Household/annum 261 209 130

Identification & Targeting

Creation of unified database of BPL & AAY categories households needed to be done. Use of UIDAI database to identify beneficiaries Identification of head of the family (preferably women) who will be responsible for receiving the benefit .

Computerization of PDS System

Web-based application software to accessibility in remote areas Bar coded & smart-card based ration cards Biometric verification of transaction through UIDAI Automated monthly allocation through webbased application based on real time price variation GPS tracking of trucks SMS Alerts Govt plan to distribute mobile phones in rural areas. Strong Grievance redressal System

Direct Cash Transfer

Creation of Bank account for each household and linking it with UIDAI. Consumer to pay full price for LPG or Kerosene. Difference between subsidized price and selling price to be credit to beneficiary account. Size of cash transfer should be based on monthly price fluctuation , negative impact of subsidy and inflation. Advance transfer (2 months ) of subsidy amount to create confidence .

Impact of Subsidy Reforms

Source: Teri (2012)

Savings on subsidy will have huge impact on Indian economy , government can be use this saving and invest on infrastructure projects. Inflationary Impact : LPG & Kerosene are part of CPI and WPI commodity. Increase in LPG & Kerosene price will increase Inflation. Exposure to price volatility : Decrease in value of cash transferred due to rise in price of goods.

Against or for subsidy ?

For Short Term : Subsidy With Reform to Give Maximum Advantage To Target Beneficiary
Increasing Diesel Price will have impact on two important group : Public Transport : Direct fiscal transfer over a period can be implemented for State transport companies to reduce the impact of diesel price. Goods/Freights transporters : Rations of fuels for a limited time to reduce opposition to reforms and inflationary impact There is large percentage (22%), about 27crore people in India who lives below poverty line Removing subsidy abruptly will impose an extreme pressure on their survival Moreover, there is a huge middle class which will find it difficult to manage their house hold budget Hence, removing subsidy at once will reduce their purchasing capacity with sudden rise in inflation So, for short term subsidy should be continued to be a tool of social welfare However, reforms, as described in the previous slides, are needed to make this activity regressive so that as the wealth of people increases the benefit of subsidy reduces

Impact of 25% increase on Diesel price

Affected Group
Large public Transport Operators road Goods/Freights transporters road Rail transport (freight and passenger) Industry (fuel consumers) Agriculture

Impact of Diesel price Rise of 25% on costs

+8% ( State Road Transport Corporations (SRTCs) +10% +2.5-3.5% +0.25% (median diesel inputs across industry) Costs of cultivation : Wheat + 2.75%, Sugar cane + 0.75% Source: Anand(2012)

For Long Term : Gradual Subsidy With Reform to Give Maximum Advantage To Target Beneficiary
Going forward, removing subsidy in the time horizon of 10-15 years is the only sustainable solution Within this time it needs to be insured that petroleum product remains affordable for the masses Subsidy will have to removed gradually and step wise but not abruptly to avoid any panic or putting sudden pressure on economics Also, at time of removing subsidy it has to be insured that underprivileged classes continue to prosper and have advantage of growing economy

Subsidy free economy Gradual removal of subsidy

Empowering lower and middle classes to sustain without subsidy More benefits to poor classes Subsidy Reform

Appendix 1

References
http://articles.economictimes.indiatimes.com/2013-09-

08/news/41855389_1_oil-companies-under-recoveries-oil-subsidy-bill http://articles.timesofindia.indiatimes.com/2013-0122/india/36483253_1_diesel-consumption-diesel-demand-diesel-prices