Wednesday, Sep 17, 2014

Fuelled by ignorance

The important point to note is that the price announced by the government effective April 1 is based on sound economic and market logic.  PTI The important point to note is that the price announced by the government effective April 1 is based on sound economic and market logic. PTI
Written by Vikram S Mehta | Posted: February 15, 2014 12:05 am

The AAP-led debate on gas pricing betrays a lack of understanding of the industry.

I have been prompted to write this article by the FIR filed by the Delhi chief minister against the minister of petroleum, chairman of Reliance Industries and a number of others. I am not concerned about the specifics of the charges.

Some are sub-judice and others will no doubt be investigated by the relevant authorities. I am also not concerned about the ulterior drivers behind these charges. I have no political axe to grind, nor any commercial involvement with the hydrocarbons industry. I left Shell more than a year ago.

What I am concerned about is the lack of understanding of the oil and gas industry shown by people in power in their public pronouncements. In and of itself, this would not be cause for worry, but given that these statements have received wide currency, I am concerned at the negative signals this sends to investors. I have 35 years of experience in the hydrocarbons industry, and draw on this experience to provide an objective answer to the four questions that have been raised. Hopefully, these answers will elevate the quality of debate.

One, is there economic logic for increasing the price of gas from $4.20 per million British thermal unit (mmBtu) to $8 per mmBtu on April 1? The answer is yes. Unlike oil, there is no world price for gas. Oil has a global reference marker (Brent crude, West Texas Intermediate) and so there is little debate about its market price. There is no such marker for gas. It is currently sold for approximately $4 per mmBtu in the US; $6-8 per mmBtu in Europe, and around $16 per mmBtu in the Asia-Pacific region. When asked to determine a gas price for India, the Rangarajan committee decided to base it on a formula approximating the weighted average price across these three regions. This average was around $8 per mmBtu. Rangarajan could, of course, have adopted a different methodology.

The committee could have considered the price major customers of gas would have been prepared to pay. Thus, a power plant fuelled by naphtha or LPG would be willing to pay at least $16 per mmBtu (as some are doing currently), given that the cost of liquid fuels is currently in excess of $20 per mmBtu on an equivalent basis. A power plant run on coal, on the other hand, would not pay more than $5-6 per mmBtu (and probably less), as coal is relatively cheap and it would not make economic sense to pay a higher price. A fertiliser company would be incentivised to manufacture fertilisers rather than import if it were assured of secure and reliable gas supplies at around $8 per barrel (bbl).

Had Rangarajan adopted this approach and taken a weighted average of these different customer price points, he would again have come to a number close to $8 per mmBtu. The important point to note is that the price announced by the government effective April 1 is based on sound economic and market logic. It is not a number plucked out of thin air, or one that reflects monopolistic collusion. I should point out that the main beneficiary of this price hike will be ONGC. It produces 85 per cent of domestic gas and will receive this higher price. I should also point out that under the terms of the production-sharing contract, the government will be the major recipient of the incremental profits generated by the price hike.

Two, does wilful underproduction make economic sense? I have no idea why production from the KG basin has slumped so sharply. But I can cite many examples of comparable variance between original estimates and eventual production. Production from the Ladyfern field in Canada fell by 96 per cent over eight years. The Golfinho field in Brazil was slated to produce 1,75,000 barrels a day. It plateaued at 55,000. ONGC bought the Imperial field in the North Sea in the expectation it would produce 80,000 barrels per day. It is currently struggling to produce 15,000.

The fact is that every company, including the most technologically sophisticated, has had to at one time or another eat humble pie in the face of the uncertainty of geology and nature. Some companies have on occasion held back production in expectation of higher prices but, given the volatility of the market, the uncertainties of reservoir management and the penalties of wilfully breaching approved development plans, prima facie, this is not prudent economics.

Three, what are the finding and development costs of a gas field?. This is, of course, a silly question. But I pose it because there was a suggestion by the chief minister that Reliance was handed over gas wells at $1 per barrel. The question is silly because there is no one answer. The costs depend on the location, geology, size, etc of the field.

What can be said, however, is that the total cost of exploration, development and production of an offshore gas field a la the KG D6 discovery would be several billion dollars. One offshore deep-water well could, for instance, set a company back by between $50 to $100 million. The probability of success is one well in 10 drilled. It is of course possible that once all the facilities have been built and the field is producing steadily, the operating cost per well could be around $1 per barrel. Even so, this is not a number on which one can hang the charge of windfall profits.

Four, does a contract structure that allows a company to first recover its costs and thereafter only share the profits encourage gold plating, that is, deliberate over-investment? There is no knowing what individual companies might do but many experts, including, most recently, the Kelkar committee, have concluded that when the net present value of investment for both the company and the government falls, the fall is more rapid for the company when capital expenditure increases. This is because the companies contribute 100 per cent of the risk capital. There is little, if any, economic incentive for companies to gold plate their expenditure.

The writer is the chairman of Brookings India and senior fellow, Brookings Institute.

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