Oil the economy’s problems

Indian Express, 6 November 2004

After long delays and political pressures, the Government has finally hiked the price of petrol and diesel. ILA PATNAIK helps you through the oil field

What are the major types of crude oil?

Crude oil is classified as ‘sweet’ and ‘sour’, depending upon its sulphur content. Sweet crude has less than 0.5 per cent sulphur content whereas sour crude has more than 0.5 per cent. Sour crude oils are cheaper than the sweeter variety. They are more complex and expensive to refine. Some of the well-known varieties of crude oil are Brent (sweet), Dubai (sour), Nigerian Bonny Light (sweet), West Texas Intermediate (sweet), Urals (CIS) (sour) and Suez Blend (sour).

What does India import?

India largely imports the sour variety. The overall basket is much cheaper than Brent. Environmental standards in India permit higher sulphur content in petrol and diesel.

What are the price differences between major varieties of crude oil?

The average price of Brent per barrel in October was $50, of Dubai crude was $38.

How much crude oil does the world produce?

Approximately 72 million barrels per day. (7.33 barrels make one tonne.)

How much crude oil does India produce and import?

India extracts approximately 20 million barrels per month. This is inadequate to meet domestic demand. We import around 50 to 60 million barrels of crude per month.

How much crude oil does India consume?

India consumes about 2.5-2.8 million barrels of crude oil per day.

How much crude oil is refined in India?

India processes about 10 million tonnes of crude oil every month. Of this, it produces around 9.5 million tonnes of petroleum products, viz petrol, diesel, kerosene, naphtha etc. The annual production of petroleum products in India amounts to around 117.6 million tonnes, out of which around 13 per cent is exported. Refineries export mainly petrol, diesel and naphtha.

What is the ‘gross refining margin’?

Suppose a refinery buys one barrel of crude oil at $50. It breaks this down to various quantities of petrol, diesel, aviation turbine fuel, naphtha, kerosene, furnace oil etc. Suppose these products, as a basket, are sold at $55. In this case, the ‘gross refining margin’ is said to be $5 per barrel. The refining margin is thus the difference between the total value of petroleum products produced by the oil refinery and the price of the input i.e. crude oil.

How do customs duties on petro products determine gross refining margins?

For petro products manufactured by them, oil refineries in India are paid the ‘import parity price’, the international price plus the insurance and freight cost plus the customs duty. Thus, higher the customs duty, higher will be the gross refining margin.

What would happen if customs duty on petro products is reduced?

If the customs duty is cut, say, to 10 per cent, the domestic company would reduce its price from 15 per cent above the landed cost to 10 per cent above the import parity price. In case it does not do so, the customer, that is the marketing company, will import the product. India does not import petrol, but a cut in customs duty on petrol reduces the domestic price of petrol.

Why are differential rates of customs duties imposed on different stages of production?

Higher duties on products are imposed to encourage the growth of the refining industry. In this case, the intention is to encourage the domestic refining industry, by ‘‘protecting’’ it.

How is protection to an industry measured?

Protection to an industry is measured by the Effective Rate of Protection (ERP). It is the rate of tariff measured as a percentage of not the value of output but the value addition by the industry measured at international standards. In the simplest case, if the duty on crude is zero and internationally refineries add Rs 100 of value to get to an end product, the price of the end product will be Rs 100 higher than the input cost. An import duty of Rs 100 allows a domestic company to price the product at Rs 200 over the input cost. It can be twice as inefficient as the international company. This means the domestic industry is provided effective protection of 100 per cent; it can be 100 per cent more inefficient than the international company.

What is the effective rate of protection for the refining industry in India?

Today crude has a customs duty of 10 per cent, but the customs duty on petro products is 15 per cent. The value addition in the refinery business is around 10 per cent; the duty differential of 5 per cent means that the ERP is very roughly 50 per cent. When the customs duty was 20 per cent, before the recent cuts, the effective rate of protection was even higher.

What does a higher ERP mean for profit margins?

A higher ERP allows for higher profit margins. Since value addition in refining petroleum is low, the ERP is high even at low rate differentials. Apparently small differences in customs duties can have explosive ramifications.

Should custom duties on crude oil be cut?

Cutting duties only on crude oil will not reduce the domestic price of petroleum products. It will only increase the profit margin of domestic refineries.

What can the Government do if world oil prices keep rising?

The first step should be to eliminate rate dispersion by bringing down the duties on petro products. When the customs duty on crude oil and petroleum products is equal, then this anomalous profitability of Indian refineries would be removed.

What should the duties on petroleum and its products be?

Duties on oil and petro products still involves penalising Indian consumers owing to the presence of tariffs. Hence, for the consumer, the best thing is zero customs duties. In this case, Indian refineries would have to compete with international refineries. Refineries in India are already major exporters of petro products. This shows that they already have the engineering capability to compete with the best refineries of the world. However, if after decades of protection, refineries in India are still not efficient, there is no reason why consumers should bear the burden of their inefficiency.

What is the component of tax in the petrol pump price of petrol and diesel?

Nearly 50 per cent of the price of petrol that we pay at the petrol pump goes to the Government as excise and sales tax. For diesel, nearly one-third goes as tax. The discrepancy is because the excise on petrol is 63 per cent of import parity price (23 per cent + Rs 7.50 per litre) and on diesel is 16 per cent (14 per cent + Rs 1.50 per litre).

Would the cut in customs duties on petrol and diesel reduce the customs revenue collected by the Government?

No. The Government will not lose any customs revenue as India does not import petrol or diesel. The custom duties unfairly protects the refinery and penalises the Indian consumer, who has to pay prices higher than in the rest of the world.

But once customs duties are brought to zero, how can the Indian consumer be protected from the rise in world oil prices?

While all agree that low inflation is a desirable objective, it is not desirable to achieve low inflation by artificially keeping the price of oil products low. As world oil prices rise, and show no particular signs of going back to the old levels, the economy needs to adjust itself to higher prices. If not, the Government will not only end up bearing the subsidy bill, whether itself or impose it on oil companies, but also in encouraging the consumption of oil in a world where its price is much higher.

What will be the impact of a rise in petroleum product prices?

The short-run price elasticity of oil, the amount by which consumption of oil changes in the short run when its price changes, has usually been observed to be low. Given technology in use, consumers can reduce the consumption of oil by making some behavioural changes. However, the long-run price elasticity of oil has been observed to be high. Over the long run, a higher price of oil creates incentives for adoption and development of technology which is not intensive in its use of oil. Either the use of alternative sources of energy becomes more profitable, or companies invest in fuel-efficient technologies. This has been seen in the automobile industry in which significant R&D went into the development of small, fuel-efficient cars and when consumers all over the world were seen preferring more efficient cars.

Ila Patnaik