After nearly nine months of vacillating, the government finally increased retail prices of petroleum yesterday. While prices of petrol has gone up by Rs4 per litre and diesel is costlier by Rs2 per litre, prices of kerosene and LPG remains unchanged.

The last price hike was in September 2005, when crude oil prices were below $60 per barrel. Crude prices touched record highs of above $75 per barrel in April before retreating modestly in May. NYMEX near month futures closed at $72.60 per barrel yesterday. The Indian crude basket, a mix of Brent and Middle East crude, is currently priced at around $66 per barrel.

Impact on oil companies
The latest price hike will only partly offset the retailing losses being incurred by oil marketing companies, as the average under-recovery during May was nearly Rs9 per litre in the case of petrol and almost Rs10 for diesel. At retail prices which prevailed till yesterday, total under-recoveries of oil marketing companies for the current financial year would have been over Rs73,000 crore at average NYMEX grade crude oil prices of $70 per barrel.

Even after the price hike and indirect tax adjustments, upstream oil companies like ONGC, Gail India and Oil India will have to fork out Rs24,000 crore during the current financial year as subsidy sharing. Standalone refiners like Reliance Industries would share up to Rs3,000 crore in subsidies.

Oil marketing companies will continue to incur losses, even after the price hike, reduction in indirect taxes and oil bonds, though the extent of losses will come down. Companies like Indian Oil, HPCL and BPCL are expected to face a further decline in their refining margins, which will keep their overall financial position still precarious. Any further rise in crude prices would make them even more vulnerable.

Rangarajan Committee Proposals
The committee set up under the chairmanship of former RBI governor C Ranagarajan to study oil pricing had made several recommendations, which were till now ignored by the government. Finally, the government decided to implement at least two of the recommendations.

To reduce the tariff protection to domestic refiners, the government could reduce import duty on either crude oil or refined products. Import duty on crude is already at a low 5 per cent while there is no duty for products like kerosene and LPG. On petrol and diesel, the committee had recommended a reduction in import duty to 7.5 per cent, which has now been implemented.

The committee's proposal to move from import parity to trade parity for fixing refinery-gate prices of refined products has also been accepted. The concept of import parity, or allowing domestic producers to price their products at the total landed cost including import duties as if the same products are imported, has been applied in many cases to protect domestic manufacturers in a controlled price scenario.

However, import parity allows domestic producers to profiteer at the cost of the consumer. The imported price would include ocean freight, handling charges, duties etc. Rangarajan Committee estimated that effective tariff protection to Indian refiners was as high as 40 per cent. The country has become a net exporter of petrol and diesel, indicating that domestic refiners are sufficiently competitive and do not need such high tariff protection.

Trade parity suggested by the committee involves adopting a weighted average of import and export parity prices for fixing refinery-gate prices of petrol and diesel. The committee had recommended an 80:20 ratio between import and export parity prices.

Trade parity price was recommended only as an indicative ceiling and refiners are free to price their products lower. Adoption of this pricing principle would further reduce the tariff protection on domestic refining and erode the margins being enjoyed by refiners.

The committee had estimated that after the reduction in import duty on petrol and diesel and adoption of trade parity in product pricing, effective tariff protection for the refining sector would come down to 20 per cent.

Excise duty and sales tax rationalisation
The fact remains that the government continues to look at the oil and gas sector as a lucrative source of revenue. Various duties and taxes constitute nearly 55 per cent of the retail price of petrol and nearly 35 per cent of the price of diesel. Nearly 40 per cent of excise duties colleted by the central government come from the oil and gas sector.

Excise duty on petrol, including road cess, is 8 per cent plus Rs13 per litre and that on diesel is 8 per cent plus Rs3.25 per litre. This combination of fixed and ad-valorem rates have remained unchanged even as prices of crude oil hit the roof.

The government raised retail fuel prices four times during 2004-05 and three times during 2005-06 before yesterday's increase. Every time it increases prices, a portion of the higher revenues go into the government's kitty because of the ad-valorem rate.

Though the Rangarajan Committee had questioned the retention of an ad-valorem duty when prices were increasing substantially and had recommended adoption of a fixed rate of duty, the government has ignored it, in order to protect its own kitty.

If the central government has excise duties, the state governments have sales tax on petroleum products to boost revenues. According to some studies, up to one-third of the tax revenues of state governments come from sales tax on petroleum products.

Sales tax rates vary substantially across states, between 20 per cent and 34 per cent in the case of petrol and 9 per cent to 38 per cent for diesel. These differences in sales tax rates force consumers in Mumbai to pay Rs53.50 per litre for petrol while those in Delhi pay at a considerably lower Rs47.51 per litre.

So the next time the Left parties argue that the government is fleecing you through high taxes and duties on petroleum products and it is indeed possible to save oil companies without raising retail fuel prices, don't dismiss it out of hand. For a change, there is some logic in what they say.

Kerosene and LPG remain holy cows
The government has refused to raise prices of kerosene and domestic LPG even this time. The only decision has been to limit PDS kerosene only for BPL families.

It is estimated that under-recoveries in kerosene and LPG alone amount to over Rs30,000 crore per annum. Of this, more than 65 per cent is on account of kerosene and balance on LPG.

The decision to limit PDS kerosene supplies only for BPL families is estimated to save more than Rs6,000 crore in subsidies. But actual savings would be much lower as the subsidised kerosene would continue to be diverted into the open market and for adulteration of petrol and diesel.

Meanwhile, the middle class can continue to enjoy subsidised gas and LPG dealers can continue to prosper by creating artificial shortages and supplying cylinders to commercial users. The new breed of entrepreneurs who transfer LPG from domestic gas cylinders to tanks fitted on cars for a fee will continue to prosper.

Deferring the problem through oil bonds
By refusing to increase prices or lower duties, the government has pushed PSU oil companies into deep financial troubles. The best of the PSU blue chips started struggling to find finances to fund expansion plans as their cash flows had dwindled and credit ratings lowered.

If the government wants to be benevolent and keep the voters happy through lower fuel bills, then it should be prepared to foot the bill as well. But how can it foot the bill now when it has numerous other programmes like the job guarantee scheme to keep them happy?

Like most governments do when faced with a financial dilemma, the present government has also decided to charge the expenses to the credit card. Unlike ordinary citizens, governments can issue credit cards to themselves. In this case, the credit card was in the form of oil bonds.

The oil bonds were government bonds of varying maturities, carrying fixed interest rates. The oil companies receive them free of cost, so they account it as income to shore up their finances.

For the government, the oil bonds conveniently convert a current expense to a future liability. Elected governments are not generally worried about future liabilities as any addition can be only a small percentage of the overall liabilities and does not alter the total indebtedness dramatically.

Hence, the government would issue oil bonds worth another Rs28,000 crore to oil marketing companies during the current financial year. These bonds would be issued in four instalments of Rs7,000 crore each.

Inflation, interest rates to rise
Even before the price hike, inflation has been rising for the past three weeks and stood at 4.74 per cent for the third week of May. After the fuel price hike, inflation for the month of June would move beyond 5 or even 5.5 per cent.

The finance ministry and RBI have already fixed the comfort zone of inflation at between 5 and 5.5 per cent. Rising inflation would most certainly force the RBI to raise short-term interest rates in July. A hike of 25 basis points is almost certain while a 50 basis points increase is possible. If the US Fed raises its rates by the end of this month, then RBI is likely to go for a 50 basis point hike especially since liquidity remains strong.