A small big idea for reform

I believe we must now look beyond the systemic blockers that have been so often discussed to finding the incremental opportunities for value generation. We must, in short, avoid the avoidable cost. This would have been my ‘idea’ and I would have drawn on the current discussions on the price of natural gas and whether or not the recently discovered gas reserves offshore East India should be sold at a market price or a discounted regulated price. I would have argued that if indeed the government decided to regulate, it would be akin to an avoidable shot in the public foot.

But first a disclaimer. I work for a company that imports Liquefied Natural Gas (LNG). But I hope the reader will agree that my arguments against price regulation are based on objective logic, not driven by a corporate agenda.

Three reasons underpin my argument against price regulation: One, the Production Sharing Contract (PSC) that defines the financial relationship between the petroleum companies and the government is so structured that beyond a certain level of profits earned by the companies, the incremental revenues from increased production and/ or value is split disproportionately in favour of the government. Thus, if the profit split between the government and the oil company were 50:50 at a gas price of $3/mmbtu, then more likely than not, the government’s take on incremental earnings would increase to 70 per cent if the prices increased to $4 and to 90 per cent at prices beyond that.

I would hazard the calculation that if indeed the domestic production from the East Coast fields increases, as has been reported, from 20 mmscmd in 2008 to 40 mmscmd in 2009 to a plateau production of 80 mmscmd by 2010, then the revenue gain for the government from an increase in the price from $2.50/mmbtu (which is the price that the fertiliser and power companies are reportedly looking for) to $4.33/mmbtu (which is what the producers have reportedly asked for) could be somewhere between US $8-10 bn over the life of the project. Contrarily, this would be the loss to the public exchequer if the demand of the fertiliser/power companies were accepted. Incidentally, the international price of gas is around $6/mmbtu; several producers of domestic gas from fields in western India are currently charging more than $4.33/mmbtu.

Two, we must not forget the inherent risks in petroleum exploration. Commercial success rests on overcoming three uncertainties — that a given geology contains hydrocarbons; that the hydrocarbons will be located and that once located, the hydrocarbons can be commercially developed. The petroleum companies accepted these risks on the assurance that if they did locate the hydrocarbons the government would entitle them to sell the discovery at prices linked to the market and determined through an arms length process. This assurance was contractually secured through the PSC.

Were the government to now review this assurance and regulate the price it would be in breach of the spirit of the contract if not the letter. It would also call into question the government’s commitment to contract sanctity and drive an avoidable nail into its further efforts to attract private risk capital into petroleum exploration. The timing would be particularly unpropitious as after so many years of indifference, the international petroleum companies including the majors are now seriously interested in Indian geology.

Finally, price regulation has an awful track record. All past efforts at controlling petroleum products have failed to deliver the intended result. The subsidy on kerosene was supposed to be for the poor. It ended up providing the incentive for dealers to spike it into diesel. The cap on domestic LPG was also for the underprivileged. The benefits have accrued disproportionately to the middle class and it has encouraged companies to divert sales from the ‘unprofitable’ domestic segment into the market-based commercial segment. The delegation of discretionary authority to allocate a scarce and ‘cheap’ commodity was premised on the assumption that officials would allocate to secure the greatest good for the greatest number. In fact, it’s simply encouraged cronyism and adhocism.

An irony of economic change is that often those who otherwise depend on the market for growth will adopt a generically anti-market position to defend their privileged access. The potential customers of gas have often been the loudest votaries of deregulation and market economics. But in this case they are vigorously lobbying for a handout. The government must not lose sight of this irony. They must not compound the systemic hurdles that have enabled only ‘opportunistic reforms’ by creating avoidable potholes on the road to economic efficiency.

The writer is chairman, Shell Group in India. Views are personal