UPA’s oil crisis
by G K Pandey on 20 Jul 2008 1 Comment

r     The actual costs incurred in producing the most expensive oil is only $70 or $80 a barrel, implying that around $50 of the current price represents the markets’ risk premium and speculative buying – Larry Chorn, Chief Economist, Platts

r     Price of oil should be between $50-55 per barrel – J Stephen Simon, Executive Vice President, Exxon Mobil


The current oil spike, which shows no real signs of abating, has already spelt ruin for the United Progressive Alliance (UPA) government – its dream run of record low inflation and high GDP growth has gone for a toss. If inflation continues at double digit levels as the finance minister’s advisor has been quoted as saying it will till the end of the year, the chances of the UPA coming back to power look quite bleak. And this is without even taking into account any backlash from voters, particularly Muslims, if various political parties are able to convince them the 123 Nuclear Deal is nothing but a deal with George Bush. Things could get a lot worse as there are few indications that global oil prices are going to cool off. Indeed, as the quotes cited above show, the huge build up in prices is very largely fuelled by speculative activity.


So far, the UPA has managed to keep oil prices under relative control, but this has happened only at a very large cost for future taxpayers (over a third of the subsidy is picked up by the government) and by bleeding the Navratna oil PSUs to death – in the last six months, the PSUs have lost nearly Rs. 125,000 crores of market capitalization, thanks primarily to the policy of not allowing them to charge the market prices of petrol, diesel, LPG and kerosene. Even with oil PSUs bearing a huge burden, the subsidy on oil, among others, has ensured that the combined fiscal deficit of the state and the centre is currently around 9 percent, a figure lower than the 11 percent of the 1991 crisis period, but one high enough to ensure credit rating firm Fitch Ratings downgraded India’s outlook to negative a few days ago.


Speculation or increased demand


While President George Bush has blamed rising demand in countries like India and China for increased oil prices, this is hardly true. While it is true oil demand from China has risen in terms of its share in global demand (surely an economy growing at 10 percent a year for so long would result in that?), the share of demand from the developed world has leveled off, leaving the overall situation virtually unchanged. Nor, despite all talk of disruption in oil supplies after US adventurism, has oil supply really fallen off precipitously.


















So what is causing oil price rise? Some argue that due to a long period of low prices, there wasn’t adequate investment in finding fresh reserves. This is certainly partly responsible for the spurt in prices. As a result, while earlier estimates were that, in 2002, the world had about 40.5 years more of supplies left, this estimate is now down to around 38.1 years.



Perhaps a bigger reason is the sharp hike in speculation. While several economists and commodity traders argue that speculation has no impact on prices, this seems at odds with basic principles of demand and supply – if, as is true, vast sums of money are now being pumped into commodity market speculation, prices will rise. Indeed, an analysis by broking firm KR Choksey shows that while China’s consumption of petroleum products rose by 920,000 trillion barrels over the past five years, the increase in demand from speculators rose by 850,000 trillion barrels - almost the same amount. And, as compared to 180 energy hedge funds in October 2004, this figure is now over 630 – during 2003 to 2008, the investment in commodity index funds, not just oil funds, has risen from $13 bn. to $260 bn.


In other words, until oil producers conclusively see that global oil demand is going to reduce following the sharp spurt in prices, the prices are likely to keep rising. So far, like India, several countries have kept oil prices under control, but now that most have started hiking local prices, and India has done amongst the least, demand should level off. A statement by Fed chief Ben Bernanke about how high oil prices were a factor that could extend the US slowdown saw oil prices climb down just a few days ago. The US financial crisis should also help reduce speculative interest, but it is really anyone’s guess as to when prices will come down to reasonable levels.


UPA incompetence


If the rise in global fuel prices wasn’t bad enough, the UPA’s competence has added the proverbial fat to the fire. By not allowing PSU oil marketing firms to charge market prices, it has done various things. The burden on the fiscal deficit and the oil Navratnas has already been talked of. By distorting the relative prices of fuels, it has ensured adulteration of fuel has increased dramatically. While only kerosene was used to adulterate diesel earlier, diesel prices are now so low, industrial units have even stopped burning the low-quality furnace oil and low sulphur heavy stock in furnaces (both fuels are priced at market rates), replacing this instead with the vastly subsidized diesel. In the last one year, as a result, diesel consumption rose 11 percent as compared to a historical average growth of 1-2 percent. In the last quarter, growth was an even higher 20 percent! In other words, government policy has ensured the subsidy bill has risen a lot more than it needed to.


Related to this is another anomaly that is peculiarly Indian. While even a blind man can see that the Navratna oil companies are being bled to death, the extent of actual bleeding is anyone’s guess. The way the so-called under-recoveries are calculated provides a perverse incentive for oil firms to not keep costs under control. Normally, you’d expect benchmark costs would be used to estimate under-recoveries, and that this benchmark would be raised each year, reflecting the efficiencies a firm must bring in each year – look at Reliance Industries’ latest balance sheet and you’ll see that thanks to superior refining practices and efficient buying of crude oil, its Gross Refinery Margin is more than double that of several competitor refineries and much higher than those of our PSU refiners.


Instead of doing this, the government allows PSUs oil refiners huge leeway. Though we import virtually no petroleum products (we import crude and refine it locally), the government assumes for under-recovery calculations, that petrol, say, is being imported. It then adds another 10 percent or so to this in the name of import duties and transport and insurance costs. This cost is then assumed to be the benchmark and the price charged to retail customers is then subtracted from this to arrive at the under-recovery! In addition, the state-owned ONGC is forced to sell its production to PSU oil refining companies at a discount of around 40-50 percent – this amounts to around a fourth of the total oil these firms purchase. So, while calculating their ‘under-recoveries’, this discount needs to be factored in, but is not. So while it is true that oil companies are bleeding, it is equally true that the extent of their bleeding is probably 10-15 percent less than what is popularly believed.  


An article in Business Standard brought this out eloquently when it pointed out that, till a few days before the government raised prices of petroleum products, a figure of Rs 245,000 crore was said to the under-recovery or subsidy the government gave the people of India. But when the Prime Minister addressed the nation, he mentioned an under-recovery figure of only Rs 200,000 crore! On LPG, the gap was supposed to be Rs. 350 per cylinder before the Rs. 50 price hike; yet the PM spoke of just Rs 250 under-recovery remaining; on kerosene, a figure of Rs. 36 per litre was mentioned while the PM said it was under Rs. 20! Are figures just made up?


But how can prices be raised, especially in an election year, is the obvious question. And rightly so, since consumers are also voters and will never forgive a government that raises their expenses. This is where political management comes in. The NDA was smart enough to begin freeing up prices at a time when global crude oil prices were actually falling (they were around $10 a barrel during the early NDA years. So, the first few times that prices of petroleum products were changed in keeping with the global market, the prices were actually revised downwards! This ensured that when prices went up, people didn’t pay too much attention either. For one, initially, the prices were only rising to levels from where they were cut. Later, price hikes were so gradual, no one even noticed. But all told, NDA raised prices by more than what UPA has (33 times during its tenure, as per an official website), and hardly got any flak for it. This included raising kerosene prices 2.5 times – clearly unheard of in a country where kerosene for the poor is treated as a holy cow.



NDA versus UPA: More hikes, less noise



(all prices at Delhi)












Crude Oil







$ per barrel


Initial price







End price







Increase (%)














Initial price







End price







Increase (%)






NDA came to power on March 19, 1998 and UPA on May 22, 2004


Source: Business Standard





In conclusion, there is little so far to convince us that global prices are going to stabilize, especially since the US recession isn’t expected to be very deep (it is likely to be quite long though). In which case, it is just a matter of time before the government will once again need to hike petroleum prices – otherwise, as happened in June, the oil firms will run out of cash and will have to stop petroleum product sales. The UPA is caught in a pincer and doesn’t have either the ability or the time to extricate itself.


The author is a senior journalist

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