Oil Price Hike June 2010 – The Facts and Myths

June 25, 2010 saw the first “big-bang” reform policy by the Congress-led UPA government, which was re-elected last year with a strong mandate and with increased hopes of taking firm steps towards economic development of India. The Government took the first step towards decontrolling petroleum and petroleum products prices by completely freeing petrol and partially freeing diesel and reducing the subsidies on other products and subjecting its prices to be determined by market forces. With surprise to none, the strong and bold step was taken by a Government headed by Dr. Manmohan Singh, the person who was the mastermind behind the Indian Economic Reform of 1991.

The freeing up of petroleum prices resulted in the hike of petroleum products and it led to a wide spread protests against the Government move from all opposition parties. To this raging opposition, the Prime Minister Dr. Manmohan Singh reacted sharply by stating, “The fact that petrol prices have been set free, and the same is going to be done to diesel prices, are much-needed reforms. Any increase in prices does hurt some people, but we have to take a long-term view. It is high time to end excessive populism, for the cause of the economic development of the country.”  In this scenario, I decided to probe into the economics behind the issue, to analyze the reasons behind the Government’s decision and the facts behind the allegations raised by the opposition.

It all began on August 26, 2009 when a five member committee headed by Dr. Kirit S.Parikh was constituted by the Government of India, to advice the government on the most viable and sustainable system of pricing the petroleum products. The other committee members were Isher Ahluwalia (Chairperson, Indian Council for Research on International Economic Relations), Suman Bery (Director General, National Council of Applied Economic Research) and the secretaries of finance and petroleum. The Kirit Parikh Committee submitted its report to the Petroleum Ministry on February 03, 2010. The committee has recommended that prices of petrol and diesel to be market-determined, both at the refinery gate and retail levels, whereas the prices of kerosene and domestic LPG can be partially raised by Rs.6 per liter and Rs.100 per cylinder respectively. The panel also recommended for linking the prices of cooking fuels- LPG and Kerosene with the increase in the per-capita GDP of Urban and rural population. The committee has accepted the subsidy formula proposed by Oil and Natural Gas Corporation (ONGC) aimed at reducing burden of oil companies. The formula suggests an incremental rate of taxes on higher crude oil price realization from the nomination blocks of ONGC and Oil India Ltd (OIL).  Thus in the light of the Kirit Parikh Report, the Government of India freed the price of Petrol and partially freed the price of Diesel, from the Government control. The decontrolling resulted in the hike of price of petrol by Rs.3.50, that of diesel by Rs.2, kerosene by Rs.3 and LPG by Rs.35. But even after this hike, though prices of petrol has been completely decontrolled, Diesel is still under priced at Rs.1.50, Kerosene at Rs.15.07 per liter and  LPG at Rs.226.90. Government has declared that the complete decontrol of diesel prices will be undertaken slowly.

 The opposition parties in India have responded strongly against this fuel price hike. The fact is that in India the changes in petrol and diesel prices are treated more as a political matter than as an economic matter.

Prices are controlled forever in a communist system, but the burden such an absolute control infests on a Government is mammoth and it can push the economy into the abyss of public debt and ever increasing fiscal deficit. Price controls can provide short-term relief to consumers, but act as longer-term disincentives to production and efficiency. It was the cumulative impact of all these which led to the collapse of USSR. Countries without price controls have far outperformed those with controls, in terms of poverty removal and GDP growth.

The Opposition claimed that the inflation rate will rise and common man will be pushed into poverty and privation by the price hike, while farmers and agriculture will be ruined. However, the fact is that despite price controls, India has 10% wholesale price inflation and 14% consumer price inflation. In contrast, the inflation is just 2 to 3 percent in countries like US, Europe, Japan and other countries where there exists no price control. When the crude oil prices had doubled last year from $40 to $80 per barrel, the consumers of these places had to bear it full. It is fiscal, monetary and trade policy that control inflation in these places and not fuel price control. India Government did not exercise fuel price control as late as 1980s. In the 1970s, during the first oil shock, when the oil prices had increased from $1.20 a barrel to $3.65 a barrel, and in 1980s during the second oil shock, when the price increased from $10 a barrel to $30 a barrel, the then Prime Minister Mrs.Indira Gandhi had passed on almost all of the burden to the consumers. The consumers adjusted and the economy stood without collapse. It is also worth mentioning here that the Government has not completely decontrolled the prices of diesel considering the cascading effect it can have on Food article inflation.

In India, the state owned Indian Oil Corp., Hindustan Petroleum and Bharat Petroleum have been losing over Rs.200 Crore per day on selling fuel below the import cost. They sell petrol at a loss of Rs.3.35 a litre, while that for diesel is Rs.3.49, Rs.18.82 for Kerosene and Rs.261.90 for every 14.2 kg LPG Cylinder. If the oil prices were kept unchanged, these oil companies estimated loss could have touched Rs.90000 Crores for 2010. How will oil companies buy oil without money? India would be in deep trouble if the oil companies were not to survive.

India imports nearly 70 percent of its crude oil requirement. In June 2008, when the crude oil prices went upto $130 per barrel, the Government were giving a subsidy of Rs.25 per litre of diesel and Rs. 15 to 17 per litre of petrol. This induced great burden on the government’s Fiscal deficit. Due to the Global recession the International Crude Oil price has eased out from a 2010 high of around $85 a barrel to around $70 a barrel, which has given the government some room to bring domestic oil prices in parity with international crude oil price. Even with the complete decontrol of petrol prices, the petrol prices increased by only Rs.3.50, thanks to the low fuel price in international market, which is very much affordable by the people. In turn the complete deregulation of petrol and reduction in the subsidies of the other petroleum products would help the government in reducing fiscal deficit of the Government and thus curtail its borrowing.

The consumption of crude oil in India has been increasing in the past few years.  Consumption in crude oil has increased from 127.42 million tones in 2004-’05 to 160.77 million tones by 2008-’09. According to an International Energy Agency(IEA) forecast in 2006 the demand for oil in India would increase by 2.9% per year, reaching 5.6 million barrels a day in 2030. This expected level of consumption would make India the world's third largest oil consumer. The increase in the fuel prices could halt this uncontrolled increase in the oil consumption. While speaking to the National Italian American Foundation, Washington D.C. on October 15, 2004, the then US Federal Reserve Board Chairman Mr.Alan Greenspan had said, “The higher prices of the 1970s brought to an abrupt end the extra ordinary period of growth in U.S. oil consumption and the increased intensity of its use that was so evident in the decades immediately following World War II”. Between 1945 and 1973, consumption of petroleum products rose at startling  4.5% average annual rate, well in excess of growth of real gross domestic product. However, between 1973 and 2003, oil consumption grew on an average only at 0.50 % per year, far short of the rise in real GDP.

Thus on one hand, the decontrolling of fuel prices will decrease the Government’s fiscal deficit, reduce the loss of the petroleum companies, reduce the unwanted usage of a scarce and fast depleting resource like petroleum and make people aware of the importance of saving oil, all at time when the international fuel price is low, which will give only minimum burden on the shoulders of the people in the form of a price hike. 

 But still on the other hand it has to be said that if the tax levied on the oil is cut, it could still serve the purpose without hurting the life of common man.The reduction in the fiscal deficit may not be as big in such a case, as a cut in  tax will have its impact on the revenue side. In addition, the tax relief on oil means that other non-oil consuming sectors will be taxed at a higher rate to make up for the shortfall in revenues from oil consumers. Those not consuming oil will be taxed to subsidize those who consume more oil. This will encourage greater consumption of expensive oil.

Still, going by the welfare objectives of public finance, the government cannot be all non-populistic. In Gujarat, VAT on diesel is 29.13 per cent and on petrol it is 29.88 per cent. VAT on diesel is 20.62 per cent and on petrol is 27.66 per cent in West Bengal; in Andhra Pradesh, VAT is 33 per cent on petrol; and in Punjab, VAT is around 30 per cent on petrol. The West Bengal government has kept 4 per cent tax on kerosene and 4 per cent on LPG gas bottles.  If the States decrease this tax a little, it could well compensate for poor people, the price hike resulting from decontrol. However, the truth is that the State governments do not want to decrease their VAT at all!