Implications Of Deregulation

Exploration & production

Under the current administered regime, NOCs are being paid artificially low prices as compared to their international peers. The entire compensation mechanism is a cost to the producer rather than a replacement cost of similar crude. This issue is being partially addressed through the new exploration licensing policy (NELP), where the NOCs are entitled to recover comparable international price of crude. The R-Group has also proposed for total withdrawal of APM for upstream and this would mean that there would be a one-time sharp upside in the earnings of the NOCs. Based on various assumptions, the estimated additional earnings of the two NOCs have been worked out and the details are given in the following paragraphs.

Crude oil

The likely scenario that will emerge due to crude being priced on import parity basis on a fully de-regulated scenario is given below and is based on the following assumptions.

• The production levels of NOCs for the year 1995-96 will continue in the near future
• The NOCs will be paid import parity prices net of cess and royalty.
• The composition of cess and royalty in the total price will continue in percentage terms as it is today
• The import parity price is US$19/ bbl
• The exchange rate is US$1 = Rs36
• Sales tax on crude would continue @ 4%.
• Excise duty on crude would continue to be NIL as it is today. Customs duty to be NIL or at a negligible percentage not materially affecting the import parity price.

The additional earnings that would accrue to ONGC and OIL are estimated to be
Rs23.99bn and Rs2.29bn respectively. Ceteris Paribus, additional realization would vary by about 18.0%, with change of US$1/ bbl, 2.78% with every change in exchange rate by Re1 to one US$ and 16.7% with every 5% variation in custom tariffs. The earnings in a de-regulated scenario would thus be extremely sensitive to all these changes and could result in volatility in earnings as is witnessed worldwide.

The price of natural gas has been artificially low and is vastly different from region to region. The royalty on natural gas is 10% and there is no cess on gas. Based on calorific equivalents, the price of natural gas is less than one-fifth the prices of LPG. (1000 cubic meter of natural gas = 0.90 kg of oil equivalent, 1 kg of LPG = 1.13 kg of oil equivalent at Rs2.40/ cum, the price of 1 mt of LPG works out to US$53/ mt as against the prevailing price of about US$275/ mt). The price of natural gas is bound to increase several folds once the sector is fully de-regulated. The R-group has recommended that the price payable to the producer should be market determined taking into account the value of alternate fuels adjusted for operating costs, licensing procedures, royalties and fiscal levies. Given the limited availability of natural gas, the limited nos of users and the significant price differential of natural gas compared to alternate fuels, it would be easier for the NOCs to increase prices to market determined levels. The final realization would however depend on royalties and fiscal levies, for which the R-Group has given no specific recommendation. However, any price increase cannot ignore the fact that nearly 40% of the natural gas is presently used by fertilizer industry as feedstock and nearly 30% is used for power generation. The issue of subsidies to these industries, wherever applicable would also have to be addressed before pricing is done on a market determined basis.

Based on the production figures of 1995-96, an increase in price of natural gas by every Rs100/ tcm(a nominal 5% increase in prices) the revenues of ONGC and OIL are estimated to increase by Rs2,088mn and Rs143mn respectively. Notwithstanding the uncertainties on the royalties/ fiscal levies, in our opinion, natural gas could be a key driver of one-time upside in earnings of the NOCs.

The deregulation of the upstream sector would substantially shore-up the bottom-lines of the NOCs and give them adequate financial strength to pursue more risky ventures with state-of-the-art technology. It would definitely enable ONGC to become a global giant in its own right.

The R-group has recommended withdrawal of retention concept for refineries in Phase I. This would mean that the companies would be free to import crude of their choice, produce goods as per the pattern they decide and market goods at import parity prices. In case of inland refineries, the companies would be entitled to retain the freight differential.

Based on the following assumptions, the gross margin of various refineries have been worked out in five different scenarios with customs duty on crude at 5%, 10%, 15%, 20% and 25% and customs duty on finished products also at 5%, 10%, 15%, 20% and 25%. Yet another scenario with likely tariffs has also been worked out.

• Crude throughput and product pattern are as per actuals of 1995-96.
• Workings are done assuming that the refinery is at coastal location and freight differentials (transportation cost of crude vs. products) have been ignored.
• The landing price of crude ie cif price excluding customs duty is taken at
  US$19/ bbl.
• Additional charge for crude mix and other receiving charges have been taken as US$0.68/ bbl and US$0.82/ bbl, as given in SRG report.

The value of finished products has been taken from Platts for supplies ex-Arab Gulf, representing the weighted average of ruling spot prices for the 15 months period from Jan '96 to Mar '97, moderated for abnormal price increases.

The likely customs tariff would be as under

• 20% on crude
• 0% on SKO
• 5% on naphtha, FO, LSHS and bitumen
• 20% on HSD
• 25% on MS & ATF
• 15% on others

For the sake of comparison the margins under APM (1990-93 period) have been increased by 50% to reflect the impact of increase in costs for the subsequent pricing period, incentive claims, costs separately reimbursed like increase in cost of power/ chemicals/ utilities, additional wages under long-term settlements etc.

The gross refining margins are therefore set upside in a fully de-regulated scenario. However, while analyzing the upside potential of refiners in a de-regulated scenario, one has to exercise a little caution because of the following reasons.

The actual returns earned by the refiners is much more than the retention margins For eg: Incentive claims of refineries for better product pattern are not part of retention margin but are reimbursed separately. It may be noted that currently this forms substantial part of current earnings at least for some of the refineries.

In the case of bulk products like naphtha, FO/ LSHS, the actual realization could be lower than C&F of imported products as direct imports by consumers would not attract sales tax and discounts may required to be given to the extent of sales tax differential

The actual throughput of the refineries and more importantly the product pattern can undergo significant change and the earnings under the de-regulated scenario could be vastly different.

Infructuous/ unproductive assets, which are currently forming part of capital employed and thus earning returns, may stop doing so.

A part of costs, like additional wages payable to employees on account of long- term settlements, increase in lease rentals, cost of chemicals, catalysts and utilities etc. These are compensated separately under the APM, in addition to the retention margins of the past pricing period and these costs would have to be borne by the companies post deregulation. This could again be a significant item, not apparent today, the presented accounts of the oil companies, can erode the de-regulated margins to a large extent.

Large investments are needed for optimization of product pattern, improvement in product quality, adoption of pollution abatement measures and improving energy efficiencies of operating equipment. Though some of these investments are likely to fetch additional returns, investments made in environmental friendly projects may not fetch any additional returns. One has to specially consider the Diesel Hydro-desulphurisation projects in which each of the refineries are required to invest around Rs6bn by the end of this century to reduce the content of sulphur in HSD. The refineries would thus be foregoing a return of about Rs1.20bn that they would have otherwise earned under APM.

The earnings of stand-alone refineries like CRL, MRL, MRPL and BRPL to a certain extent are dictated by the marketing companies, and given the difficulties in setting up distribution infrastructure, this anomaly is likely to continue.

The returns of inland refineries could be higher to the extent of freight differential.

As against the steady earnings of the refiners today, the earnings in a de-regulated scenario could be volatile and can violently swing with variations in crude / product prices and exchange rates.