7/31/2019 Administered Price Mechanism in Oil Sector

1/3

Administered Price Mechanism In Oil Sector: Bane Or Boon?Pradeep Puri / BSCAL May 20, 1997, 00:00 IST

Drive to any of the well-lit petrol stations renovated by foreign oil majors like Shell, Mobil

or Esso and you could be driving to any gas station in California. The neon lights, sleekdispensing machines, the automatic car wash and a well-stocked Bazzar give the

impression that foreign oil czars are back in oil retailing.

but it is not so, not yet. Indias oil sector, dominated by government-ownedenterprises continues to operate under the administrative price mechanism (APM).Foreign oil firms have been allowed only in the decontrolled lubricants sector. Theinvestment in the petrol pumps is obviously in anticipation of the dismantling ofAPM when the entire oil sector would be thrown open to private Indian and foreignoil companies.

Q. How does APM work in India?A. Under the APM, prices in the hydrocarbon sector are controlled at four stagesproduction, refining, distribution and marketing on the principle of compensatingnormative cost and allowing a pre-determined return on investments.The national oil producing companies like Oil & Natural Gas Corporation (ONGC) andOil India Limited (OIL) are compensated for their operating expenses and allowed a 15per cent post-tax return on the capital employed. Both ONGC and OIL sell crude torefiners at $7-8 per barrel as against the prevailing international price of $17-18 perbarrel.Sourcing and import of crude and petroleum products is fully canalised through thegovernment-owned Indian Oil Corporation and controlled by the empowered standingcommittee of the Centre.The refining sector is also regulated wherein the refiners are fully compensated for theacquisition cost of crude and other raw materials as well as operating costs with aguaranteed 12 per cent post-tax return on the net worth.In the third stage, consumer prices are fixed under a similar cost-plus formula whereinthe marketing and distribution costs are fully compensated for, and a return oninvestment at the rate of 12 per cent post-tax on net worth is guaranteed.

At the distributors level, the dealers commission and margins are regulated by thegovernment to maintain uniformity in the commission rate. Freight for import of crude ispaid to Indian shipping companies at a cost-plus rate, which is much higher than themarket rate.

Q. How is APM operated?A. The entire administered pricing system is operated through a complex oil industrypool account wherein inflows and outflows of the pool account are to be kept in balance.Due to international price variation, statutory levies and devaluation of rupee, ad hocprice adjustments have to be made from time to time to balance the oil pool account. To

7/31/2019 Administered Price Mechanism in Oil Sector

2/3

maintain the prices of kerosene and domestic LPG as well as naphtha and furnace oilfor fertiliser inputs at a lower level, the prices of gasoline, naphtha and furnace oil forindustrial usage are kept disproportionately higher.

Q. What are the disadvantages of APM?A. The experience of existing public sector undertakings (PSUs) shows that providingreturns on a cost-plus formula does not always encourage efficiency in operations.Since all investments and costs are reimbursed, there is no incentive to make profitableinvestment decisions and to run the refinery in a cost-effective manner.In the upstream sector, PSUs have inadequate incentive to invest in risky but potentiallyrewarding ventures to develop future oil and gas reserves. It also leads to inefficientexploitation of the countrys exhaustible resources. Moreover, so long as the players inthis sector were PSUs, it was possible for the government to effectively control theinvestments and costs. With the entry of the private sector, however, the cost-plusformula will encourage gold plating of the plant and inflate costs which the consumer will

have to bear.

Q. Is APM a hurdle to fresh investment in the oil sector?A. Investors will be reluctant to commit large funds in the petroleum sector of APMcontinues because under the administered pricing regime a decision of the governmentcan influence the profitability and market shares irrespective of the efficiency with whicha company operates. Therefore, investors prefer a free market setup with minimumgovernment interference in investment and operating decisions.

Q. Does the government plan to dismantle APM?A. The government-sponsored R (restructuring) Group has suggested a phaseddismantling of APM. The group has drawn up a six-year timetable for total deregulationof upstream and downstream sub-sectors of oil industry. The report is yet to be formallyaccepted by the government.

Q. Can the total decontrol lead to global dumping?A. The prospects of foreign petroleum products swamping the domestic market under adecontrol scenario could be seen as the biggest foreseeable threat to the local refiningindustry. Based on existing conditions, however, such a threat seems a remotepossibility. The extent of threat will depend upon whether the products are producedlocally or just sourced abroad or both simultaneously.If international oil majors set up grassroots refineries in India, they would be on thesame economic basis as currently planned new capacity and would suffer the samecost disadvantage which would restrict their ability to price aggressively. The directimport of products from existing refining capacity could be seen as a more realisticthreat.However, importing and distributing petroleum products on a grand scale requires

7/31/2019 Administered Price Mechanism in Oil Sector

3/3

tremendous infrastructure, which currently only the existing players control. To buildeven a fraction of the required infrastructure will require massive resources, a longgestation period and ability to bear losses in the short to medium term. The Indian oilmajors have built such a widespread and well-established distribution network that theycan face a threat only if the government forces them to share their distribution

infrastructure with new entrants