How real are oil companies' profits?

A simple question: When the public sector oil marketing companies (OMC) have shown huge profits in their recent results, how are they supposed to be bleeding?

The answer may not be so simple.

True, the OMCs — Indian Oil Corporation, Bharat Petroleum Corporation and Hindustan Petroleum Corporation — reported profits after tax of Rs 3,955 crore, Rs 1,311 crore, and Rs 911 crore, respectively, in 2011-12.

But this was possible mainly because of the Rs 83,500 crore compensation that they received from the Government, apart from discounts of Rs 55,000 crore on products and crude oil from the ‘upstream' oil companies — namely, ONGC, Oil India, and GAIL (India). The Government and upstream companies shoulder the revenue losses that OMCs suffer for selling petroleum products below the market price.

The Government's argument is that they are compelled to sell petroleum products below the normal market rate only “to protect the common man” from volatility in international crude oil and product prices. The Government's cash compensation is, then, basically the taxpayers' money that goes for reimbursing the companies.

Fiscal performance

A look at the fiscal performance of these companies, indeed, shows that their net profits for 2011-12 have fallen compared to the previous fiscal. This had to do with the delay in getting Government compensation, forcing their borrowings to go up and resulting in high interest costs.

For Indian Oil Corporation, the largest public sector refiner, the borrowings currently stand at Rs 86,000 crore, marginally below its overall borrowing limit of Rs 1,10,000 crore. The company's interest cost in 2011-12 was Rs 2,918 crore, which pulled down its profit by almost 47 per cent annually.

The high interest cost was clearly on account of compensations not coming on time.

But then comes the argument about these companies being integrated refinery-cum-retailing entities: What they lose on retailing, they apparently make profits from refining. The earnings from the refinery operations, however, are not enough to sustain their overall business. Even big global oil players — BP, Exxon and Shell — have integrated businesses, with almost two-third revenues coming from upstream and another 10-15 per cent contribution from refining.

Besides, the mismatch between the high crude oil prices and product prices has resulted in a squeeze on gross refining margins (GRM) of the companies. Indian Oil Corporation's refining margin in 2011-12 stood at $ 3.63 a barrel, down from the previous fiscal's $ 5.72.

The GRM basically represents the difference between the price of the raw material (crude) and the end product prices (diesel, petrol, etc).

As much as $2-2.5 of the GRMs go to meet the operating costs, including manpower, power and other utilities. Apart from this, there are the financing costs, depending on the age and overall configuration of the refinery. Experts say that today any refinery with a GRM of less than $ 6 a barrel would find it very tough to even breakeven.

Impact on consumer

But, how does all this affect the consumer of petrol and diesel? For the end consumer, what matters is the price at which the product is available.

Given the current inflationary situation of the economy, every increase hurts the consumer. Because of its large consumption base, every increase in diesel price has impact of 14.67 per cent weightage on WPI. The impact of petrol is miniscule with just 1.09 per cent weight age on WPI.

The most disliked word in the downstream sector is ‘under recovery'. One often hears that because of selling petroleum products below the market price, the companies are incurring under-recoveries.

Now, what is this under-recovery? Is it loss?

The OMCs pay trade parity price to refineries when they buy petrol and diesel, and import parity price in the case of PDS Kerosene and domestic LPG. It is on these prices that the required retail prices are computed.

The difference between the required price based on trade parity / import parity and actual selling price realised (excluding taxes, dealer commission) represents the ‘under-recoveries' of OMCs.

The above concepts of “under-recovery” and “loss” were examined in detail by the Committee on Pricing and Taxation of Petroleum Products, headed by Dr C. Rangarajan, Chairman of the Prime Minister's Economic Advisory Council.

The committee observed that: “…The oil marketing companies are currently sourcing their products from the refineries on import parity basis which then becomes their cost price. The difference between the cost price and the realised price represents the under-recoveries of the OMCs.”

The under recoveries are different from actual profits and losses of the oil companies, as per their published results. These take into account other income streams like dividend income, pipeline income, inventory changes, profits from free priced products and refining margins in the case of integrated companies.

Price distortions

Compelled to sell products below the required retail price, the companies incur under-recoveries. In 2002, the administered price mechanism for petroleum products was dismantled and it was decided that prices of all products, except PDS kerosene and domestic LPG, would be market determined.

The primary object was the growing imperative for fiscal consolidation, the need for reducing the subsidy burden on petroleum products, so as to allocate more funds to social sectors schemes for the common man, and for ensuring country's energy security.

For a brief period, the companies kept raising prices in tandem with international prices. Since, the increases ranged between 50 paise to a rupee, it did not hurt the consumer much.

However, since 2004-05, the Government, in order to protect the ‘common man' from high volatility in international prices, went back to controlling the retail prices of petrol, diesel, PDS kerosene, and domestic LPG.

In June 2010, the Government decided to deregulate petrol prices, while agreeing in-principle to free that of diesel. But, the controls continue. Today, the difference between petrol and diesel retail prices works out to over Rs 30 a litre.

And as they say ‘politics knows no logic'. So, on some pretext or the other, companies haven't been allowed to increase prices. When the price hikes do happen, they are steep.

The need of the hour is to do away with these price distortions and allow competition, which would lead to the market determining the best prices.