oil pool pricing

8/2/2019 Oil Pool Pricing

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CHAPTER VIIILATER MODIFICATIONS IN THE P R I C I N G S Y S T E M

A ND T H E P R E S E N T P R I C I N G M E C H A N I S M

The present pricing system was evolved on the basis of therecommendations of the earlier oil price comm ittees, repo rts of which were examinedin the previous chapter. The system has been considerably modified by later oil pricecom mittees and in response to the develop men ts that took place in the world oilindustry. The present chapter examines the impact of the oil shocks on the Indianeconomy and the later modifications in the pricing system. It also gives a detailedaccount of the present pricing mechanism for petroleum products.

Imaact of Oil Shocks on the Indian Economy

A second oil crisis shook India in 1979-81 when the world oil pricesdoubled. The price which stood at S 13.34 a barrel in January 1979 increased to $26.00in January 1980. This exogenous shock change d India 's current account position fromnear ba lance in 1978 to a deficit of 2 per cen t of GDP (30 per cent of exports) in 1981.There was hardly any current account adjustm ent after 1982, despite favourabledevelopmen ts such as a softening of oil prices and rising domestic oil production. Thecurrent deficit averaged 25 per cent of exports from 1982 to 1984; from 1985 to 1990it averaged no less than 40 per cenl o f exports. The deficits were covered by a large


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132loan from the International Monetary Fund which was disbursed between 1982 an d1984 and by heavy borrowing from commercial ~ o u r c e s . ~

The third oil crisis occurred in 1986 when the international oil m ark etchanged from a sellers' to a buyers' market. From $29 a barrel in December 1985, oilprices fell to $9 a barrel in July 1986 and stayed at $15 a barrel in August 1986.

The latest oil shock came with Iraq's invasion of Kuwait in August 1990.The oil prices nearly doubled from around $16-17 to over $30 per barrel. It shouldhave been possible fbr lndia to weather this oil shock to a large extent, but failure tocut dow n on the current accou nt deficit culminated in the macroeconomic cris is thaterupted in early 1991 which w as brou ght to a head by a steep fall in foreign exch ang ereserves to about $1 billion, a sharp downgrading of India's credit rating and a cutoffof foreign private lcntling. The b asic underlying features of the crisis w ere hig hinflation, large fiscal and current deficits and a heavy and growing burden of domesticand foreign debt."

T h e use of pricing system as a means of oil conservation was em phas izedin various policy pron ouncem ents of the Governm ent, but the realisation of this goa l

n Joshi: "Macrovconornic Policy and Economic Refonn in India". 1994, p .271 Ibid.. p.2


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was only marginally successful. The Sixth Five Year Plan adopted pricing as a strategyfor reducing dependence on oil. It stated:

Through the pursuit of appropriate pricing policies and otherrelated measures, the rate of growth of consumption of oil productsmust be curbed, particularly of diesel and kerosene which have shownunacceptably higher rates of growth in recent years. Utmost economyand maximum efficiency in the proper use of petrol, diesel and otherpetroleum products should be effected and public should be made moreaware of the nature of the oil crisis and what it means for the averagecitizen.'*

Table 8 .1 Perceutaee share of Different Fuelsin Commercial Energy Consum~tiori

Coal 79.6 74.1 59.1 52.6 39.0Oil & Gas 17.1 20.9 31.3 35.7 43.4Electricity 3.3 5.0 9.6 11.7 17.6-

Source: Eighth Five Year Plan, Vol 11 , p. 162

Still, the consumption of oil and its share in commercial energyconsumption kept on increasing as shown in Table 8.1. In the early years, coalaccounted for 80 per cent of the total energy consumption. With the construction ofhydro-electric projects, the share of electricity multiplied several times, but still lags farbehind coal and petroleum. Oil and gas overtook cod as India's most important fuelby the late 1980s. in spite o f the planners laying more emphasis on coal.7 1 Si.rtli ve Year Plan, 1980-85. p 44


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Recognising the danger of overdependence on oil imp orts, the EighthPlan cautioned:

The share of oil in the total commercial energy consumption hasthus increased contrary to the recommen dations of the Working Groupon Energy Policy. One of the major factors contributing to this was therelatively lo we r prices and easy availability compared to alternate fuels.This led to a rapid growth in the consumption of LPG, Kerosene oil,motor spirit and diesel oil (both HSD and LDO) .......HSDOand SKOtogether constituted about 54 per cen t of oil consumption in 1990-91 andtheir sha re is likely to increase further unless measures are taken tocontain this trend. ''

In spite of this warning, the share of middle distillates continued to grow ,HSDO and SKO toge ther constituting 57 per cent of oil consumption in 1994-95. (See

Table 5.1).

The failure to use the oil pricing policy as a means of reducingdependence on oil imports should have been enough to persuade the Governm ent tochange th e enti re pricin g StNctUrC of both crude oil and products. As early as 1981, theplanners had cautioned:

In the past, the pricing of energy has not always reflected the truecost to the economy or helped to ensure the financial viability of theenergy industries. It is wrong to think that an adjustment in the prices ofa basic inpu t like energy would aggrav ate the inflationary situation; thecosts to the economy are not reduced by not reflecting them in properpricing. Indeed , the continuance of wrong pricing policies has a far more

' I L~eIl thFive Year Plan, 1992-97, Vol 2, pp. 164-165


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deleterious effe ct on the health of the econom y than is often realised.Given the pressure of the international oi l prices and rising domes ticenergy costs, a high priority will have to be given early in the Planperiod to the evolution of a structure of energy prices which reflects truecosts, encourage economy in energy use and promotes replacement ofscarce fuels."

Modifications in the Pnclng Svstem.The pricing system of petroleum produ cts have undergone some

deviations on the basis of recomm endations of successive Oil CostIPrices ReviewCom mittees. The first one was the Oil Cost Review Committee (OCR C) headed byJ.S .lye r, Chief Advisor (Cost), Ministry of Finance (Department of Expenditure) setup on 18July 1984.The Committee was to examine and make recommendations uponthe following:

(i) A comprehensive review of costs which form the basis of the currentpricing arrangemen t of petroleum pro duc ts, including the need forworking out formula to enable quick calculations of changes in costfactors.(ii) A re-examination of the current concept of return on capital employedand the desirability of adopting return o n net-worth for refiningoperations at least on a limned scale in the context of the recent steepincrease in interest rates.

(iii) The desirability of including Inore petroleum products in the category offormula products for which basic ceiling selling prices have beendetermined.(iv) The feasibility of introducing uniform pric es on an all India or onregional basis , for all or some petroleum produ cts, particularly in view

of the steep increase in railway freight during the past few years.76 Sixth Five Year Plan, [email protected]


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(v) A review of the commission applicable to dealers1 distributors of MS,HSDO, LDO, kerosene oil and LPG.

(vi) The feasibility of charging differential p rice s for products like naphtha,LSHS and Furnace Oil depending upon end-use.(vii) Th e need to introduce adequate incentives into the pricing mechanismfor inducing refineries to operate efficiently in the matter of productpattern , fuel and loss, ocean loss, stock loss, etc.

(viii) The need for providing adequate com pensation to the marketingoperations for the opening of independen t storag e and bottling plants forLPG with separate infrastructure and associated facilities.

(ix) The need for simplifying the present mec hanism of pool accounts.

This Com mittee studied the com parativ e refining cost of variousrefineries and found the variation to be between Rs. 21 .86pe r m t in the case of CRLand Rs. 21 1.78p er mt in the case of Bongaigaon. In view of svch wide variation, theCom mittee found no alternative but to continue the retention concept fo r therefineries. How ever, they recommended that efficiency norm s be developed in specificareas either on industry basis or separately for each refine ry. Although the variationin marketing costs of major marketing companies was not very wide, the consensus wasto continue the retention concept for marketing companies also. In place of return oncapital employ ed, the Com mittee preferred return o n net worth to ensu re a fair returnon the owners' funds.

'The OC RC fixed standard throughput and product pattern for eachrefinery based on technical assessments. h u ~ ecided to retln the system of allocationof cost on the basis of indices. The Committee. however, revised the indices used for


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137determining retention prices by taldng into account the prevailing demand and supplyposition in the co un try , ability o f products to bear additional c harges, their end-useprofiles, international prices of various petroleum products and the need to encourageproduction of deficit products with a view to conserve foreign exchange. The presentpricing mechanism described later in this chapter are based on the recommendationsof the OCRC.

The latest in the series of the price review committees was the Oil PricesReview Committee appointed in 1989. A price revision on the basis of therecommendations of this Comm ittee was effected in September 1992. This Comm itteehas essentially recommended a cost plus return formula with some normativejudgements on cost s of various operations and a return on capital employ ed. Th e finalconsumer prices include, apart from such cost plus return to producing, refining, andmarketing com pan ies, a t various levels, royalty payments to the States and the 01 1Development Cess.

Even in an imperfect market, the price structure sends signals to theproducers and consumers which enable them to optimize their decisions and employthe resources efficiently. There is no substitute mechanism which can do this. Distortedprices lead to misu tilization of scarce resources and lower their produc tivity . Tounderstand the inadequacy of petroleum pricing in India as an instrument for theefficient utili7,ation of this precious natural resource, a detailed exam ination of thecurrent pricing mechanism is necessary.


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The Present Pricing Mechanism

Under the "retention price concept" refineries are allowed mainly thefollowing three elements:

i) Cost of cmdeii) Refining cost

iii) Return on capital

Marketing companies are entitled to:

i) Ex-refinery price of the product payable to the refineriesii) Installation/ Distribution1 Adm inistration co st

iii) Return on capital

The methodology adopted for pricing petroleum is as follows: (Alw see

Appendices 111 & IV).

A. Crude Oil Price: 'The standard co st of crude oil is determined on theestimated weighted average price of impo rted and indigenous crude oil. The price ofindigenous c ~ d eil, both from onsh ore and offshore areas, has been fixed at Rs. 3169per tonne for 34" API Gravity crude with effect from 1 April 1993. The price build-upis as follows:


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139Basic Price Rs. 1741 per tonneRoyalty Rs.5 28 -do-Cess Rs.900 -do-

B. Pooled price of c r ude oil: The price charged for crude from therefineries is determined by pooling the price of indigenous and imported crude oil . T heprocessors of indigenous cm de pay the difference between the pooled price of crud eoil and indigenous crude oil, while the processors of imported cmde oil claim thedifferential between approved price of cru de oi l and the pooled price of crude oil. Th etwo transactions are expected to balance each other so that a uniform price is paid bydifferent refineries.

C . Cost of c rude oil at the refine ries: The cost of cmde oil at therefineries is the sum of the pooled pr ice , transportation costs incurred in bringing thecrude oil to the refineries by tankers or pipelines , losses involved in transportation andhandling, insurance paid to the marine companies, wharfage charges payable to portauthorities and auxiliary duty payable to the govenun ent (including royalty and cesspayments). Ocean freight is worked out on the basis of the rates under the contractcommittee and Shipping Corporation of Indialother Indian shipping companies on acost plus profit basis. In case of transportation by pipelines, the compensation is basedon actual costs and certain nornrs of operation. The actual annual cost of operationcomprises wages and salaries, rcpair .and maintenance and depreciation including acertain rate of return on net worth. In order to encourage efficiency in utillsation of


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140facilities, a certain norm of capac ity utilisation is adopted for determining thetransportation rate. Ocean loss refers to the difference in quantity loaded in thetankers at loading ports and the quantity received at the port of destination. The OilPrice Committees of 1976 and 1984 have laid dow n a norm of O.Sper cent for oceanloss fo r imported crude oil. To impr ove the performance in this respect, any lossexceeding the ceiling is not debitable to the oi l industry pool account. At the same timeany benefit accruing from a reduction in these losses will be credited to refineries asan incentive for an effective control on losses.

D. Cost of refining: The c os t of refining consists of raw material cos t,i.e. the delivered cost of crude oil to va rious refineries, refinery cost and return o ninvestment. The refinery cost includes expenditure on chemicals, catalysts,consumables, utilities, salaries ar~dwa ges, repair and maintenance, overheads anddeprec iation of fixed assets. These a re fixe d by OCCI Government on the basis ofactuals with suitable provision made for periodic revision on the basis of past trendsand projections given by the refining companies for future escalation in different costcomponents. T he return to the refinery is allowed at 12 per cent post tax on theaverage net worth at the beginning ,and close of the year as per the balance sheet andinterest on adjusted borrowings (net fixed asset + 35145 days' value of crudethroughput = net worth) at the we:shted average interest rate for the company.

E. Ex-refinery price\: On the above basis the cost of processing pertonne of oil for each refinery o r the re tention price per tonne of crude is worked ou r.


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141The retention price is allocated to the various products on the standard pattern ofproduction through a set of indices using kerosene as the base and the retention pricesfor each product is thus worked out. The weighted average retention price is arrivedat, to form the basis for ex-refinery prices of each product, which is common for allthe refineries. For the refineries processing crude. oil beyond the standard levels also,retention price is paid at the same rate. The ex-refinety prices are converted fromweight to volume by adopting conversion factors. To this a certain flat sum is addedto avoid frequent revisions in ex-refinery prices following variations in the price ofcrude oil.

F. Cost of marketing and distribution: There are separate pipelinesfor the transportation of crude oil and products. For the crude oil pipeline, thetransportation cost is built up recognising 12per cent post tax on the average net worthat the beginning and close of the year as per the balance sheet and interest on adjustedborrowings (net fixed assets + 30 days operating expenses less depreciation = networth) at the weighted average interest rate for the company and the operatingexpenses inclusive of depreciation to be claimed on moderated capacity of the pipelineor the capacity of the refineries receiving such crude oils as the case may be. In thecase of product pipelines also the transportation cost is built up on similar lines andbased on 80 per cent capacity utilisation or as estimated. The marketing anddistribution cost comprising of installation, administration and distribution margins areworked out for each oil company and a weighted average "industry margin" underthese heads is evolved. Also specific expenses pertaining to handlinglstock loss and


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142bridging expenses are assessed. The profit margin is evolved on the basis of 12 per centpost tax on the average net worth at the beginning and close of the year as per balancesheet and interest on adjusted borrowings (net fixed assets + 30 days inventory cost= net worth)

G: Basic ceiling selling price ex-storage points.. On the aboveprinciples, ex-storage ceiling prices are evolved for the major petroleum products likeMS, HSD, SK, LDO, furnace oil etc. at primary pricing points, by adding excise dutyand freight surcharge.

H. Consumer Prices: To the basic ceiling selling prices the railway

freight is added to anive at the various inland depot prices. Subsequently,transportation, octroi, sales tax, dealer's commission and other local levies, if any, areadded to arrive at the retail selling prices of products like SK, HSD, MS and LDO.However, the actual prices charged from the consumers are fixed on the basis of'differential pricing' concept.

The administered pricing policy incorporates cross subsidy to makekerosene used by vulnerable sections of society and naphtha for the fertilizer industrycheaper. LPG is subsidised for domestic consumers to wean away kerosene users toLPG. Fuels like petrol are priced in such a manner as to promote their economic andefficient use.


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The successive Oil Price Committees have introduced and retained theconcept of Pool Accounts in the pricing mechanism for petroleum products. Theprimary objectives of such Pool Accounts include:

a) To maintain uniform prices throughout the country recognising the need toimport crude and finished products to meet the deficits in indigenousproduction;

b) to provide retention margins to refineries and marketing companies operatingat various cost levels;

c) to even out imbalances caused by some of the States in local levies such as salestax. octroi etc.

The pool accounts are expected to be self balancing over a period, theinflow into which being regulated mainly by the surcharges included in the productprice build-up and the outgo from which being confined to the under-recoveries whichthe refining and marketing organisations incur on various factors so as to ensureretention margins to them as provided for.

'The pool adjustments are carried out under the following main heads:


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1441. The Crude O il Price Equalisation Account2. Crude & f.0.r Adjustment Account3. Product Price Adjustment Account (PPA)4 . Freight Surcharge Pool (FSP) Account5. CSTlSales Tax Surcharge Scheme

1. The Crude Oil Price Equalition Account

The f.0.b . cost of imported crude o il is generally higher than that ofindig eno us crude oil. The difference between the indigeno us crude oil price and thepoo led f.0 .b. price is surrendered by the refineries processing indigenous crude oilwh erea s the difference between the price of imported cru de oil and the pooled priceis claim ed by the refineries p rocessing imported c rude o il. Refineries processing bothtypes of crude oil work out the weighted average cost of crude processed by them andthe difference between this weighted average cost and pooled f.o.b .cos t is adjusted to

the Crude Oil Price Equalisation Account.

2. Crude & f.0.r Adjustment Account

Various crude & f.0.r elements such as the difference between thedelivered cost of crude and that actually incurred by refineries, difference between theretention price and the ex-refinery transfer price, cos t variation due to deviation fromstandard pattern, incentives for achieving superior product pattern, for reducing fuel


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145and loss and for bgher crude throughput, underlover recovery on account ofLPGlbihunen filling, bitumen drum cost variations, crude & f.0.r surcharge collectedby marketing companies on sale of products, special surcharges like the Gulf Surchargelevied from 15October 1990,differences between the landed cost of imported productsand ex-refinery price, difference between the selling price of bunkers and inland sellingprice, difference between export price and domestic price of exported products,difference between marketing margins and the ceiling selling prices, the differencebetween the dealers' commission and RPO surcharge built into the ceiling selling pricesand the actual commission payable to dealers, etc are adjusted into this pool account.

3. Product Price Adjustment Account (PPA)

The ceiling selling prices of petroleum products are changed from timeto time keeping in view socio-economic considerations. Unless the built-up of ceilingselling prices are revised starting from the retention pricelex-refinery price, thedifference on account of increases allowed in the ceiling selling prices of petroleumproducts are adjusted in the PPA Account. In the long term, however, PPA Accountis supposed to be self-balancing. The negative PPA as in the case of SK, LPG(domestic) and naphtha for fertilizers is balanced by cross subsidy by way of positivePPA on products like MS etc.


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1464. Freight Surcharge Pool (FSP) Account

W ith the establishm ent of primarylsecondary pricing points within thecou ntry, the need was felt fo r disciplining the movem ent of petroleum products fromone pricing area to another mainly to avoid cross haulage of products and the resultingtie-up of railway tank wagons. Consequently FSP Scheme w as introduced permittingthe oil com pan ies to seek reimbursement from the indu stry pool account for anyadditional cost incurred in the movement of products from one pricing area to anotheron authorization from OC Cl Government. To cater to such additional cost, anincidence of FS P Surcharge which is currently Rs.40 per selling unit in the sellingprices of petroleum products is included.

5 . CSTISales Tax Surcharge Scheme

Th is scheme was introduced to compensate the under-reco veries sufferedby oil companies on account of Central Sales Tax (CST) and Sales Tax surchargeslevied by certain states.

A typical computation of retention price of differe nt products is givenin Appendix 111.

oil pool pricing

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