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A quick-burning problem

The price of a barrel of crude has risen from a level of about $50 in the 2005 period to about $70-plus today.

Written by Suyodh Rao | Published: February 19, 2010 3:19 am

The price of a barrel of crude has risen from a level of about $50 in the 2005 period to about $70-plus today. The intervening period saw it go to $147 in mid-2008 and plummet to $34 in early-2009. Volatility in these markets is a given,as is an upward trend in price.

The under-recoveries suffered by the Oil Marketing Companies (OMCs) as a result of the government policy is estimated to be about Rs 45,000 crore for 2009-10.

The Kirit Parikh Committee recommended that retail prices of oil derivatives be increased to combat this trend. Since the government issues oil bonds to cover the OMCs’ under-recoveries,it is considering this option. The risk of raising prices is that inflation will be stoked. The concern and worry in some quarters about this risk is understandable.

However,the above is not a complete picture of the dilemma. One needs to look at the bigger picture if one is to formulate intelligent policy. Fixing one aspect of a problem is something that we are experts at,forgetting other equally important,but seemingly unrelated aspects.

Oil and energy prices directly impact many fronts of the economy. The big one,of course,is inflationary expectations. The often-unseen impacts lie in the realms of the fertiliser sector.

When crude prices increase,natural gas and other related fossil fuels follow suit. Those are the main feedstock of the fertiliser industry. One US GAO study put the correlation between natural gas prices and urea at 0.94,an almost perfect correlation. Oil price increases directly contribute to fertiliser industry cost increases. Therefore,asking whether we should increase oil derivatives’ prices is an incomplete question. The question rather should be: given that most analysts of the oil industry agree that globally,oil prices are only going to head higher,do we have any other option? What are the risks of not increasing prices?

The first question has a clear answer: no,we have no other option,given our fiscal imbalances. For 2009-10,major subsidies including food,fertiliser and petroleum are Rs 95,579 crore,about 30 per cent of the estimated revenue deficit.

Fiscal imbalances impact every part of our economy: price levels,interest rates,exchange rates,forex reserves and more. Subsidies are a big part of the problem. Today,15 per cent of subsidised diesel is used by luxury diesel cars,and that component is growing fastest. We need to ask,whom are we subsidising and can we target the subsidies and recipients more effectively? Trucks use 37 per cent of diesel,the railways another 6 per cent. Wouldn’t an increase in diesel price lead to more rail transport,since it uses diesel efficiently and is more cost-effective? Isn’t that a good thing?

Come now to the risks associated with maintaining the status quo and not increasing prices. Given that crude prices are only headed up,subsidies on that front will also head up,exacerbating the deficits. Second,the differential between the subsidised prices and market prices will only increase with time. Postponement merely means that citizens will be forced to put up with a higher price increase tomorrow than a gradual increase. Gradual price increases will permit production,communication and infrastructure to adjust with less pain than sudden large increases.

Finally,turning away from fossil fuel-based,fertiliser and chemical intensive-agriculture is a no-brainer. The sooner the better. Ensuring food security while reducing the fossil-fuel dependence of agriculture are two separate problems,both of which have to be tackled at their own levels. The emotional appeal of the first doesn’t diminish the reality of the second. The best signal the government can give to our farmers to tackle the former is to increase prices of chemical inputs into agriculture. Food prices will increase without a doubt,but it is unavoidable.

We cannot run away from reality: we are talking here about pricing non-renewable natural resources. Feynman had once said: “for a successful technology,reality must take precedence over public relations,for Nature cannot be fooled.” The technology that has been built upon fossil fuel-based energy has to be transformed. The only way the market will do that is if it is confronted with higher prices.

But,more fundamentally,can our leadership administer bitter medicine? Every time the oil pricing discussion surfaces,it is postponed — either due to some assembly elections or an impending general election. Despite these postponements,there have been increases and one completely irrational decrease in prices in the last five years. Procrastination and delay stem from fear. Cognition gets impaired when fear lurks. Decisions taken under impaired cognition are usually sub-optimal. Let us see some courage from policy-makers. 

 

The writer analyses macroeconomic and energy risks for Hyderabad-based ValueLabs

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