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Crude Oil Hot Spots Globally Economics Essay

Petroleum or crude oil is a naturally occurring, toxic, flammable liquid consisting of a complex mixture of hydrocarbons of various molecular weights, and other organic compounds, that are found in geologic formations beneath the Earth’s surface. Petroleum is recovered mostly through oil drilling. It is refined and separated, most easily by boiling point, into a large number of consumer products, from gasoline and kerosene to asphalt and chemical reagents used to make plastics and pharmaceuticals. The term petroleum was first used in the treatise De Natura Fossilium, published in 1546 by the German mineralogist Georg Bauer, also known as Georgius Agricola.

COMPOSITION

In its strictest sense, petroleum includes only crude oil, but in common usage it includes both crude oil and natural gas. Both crude oil and natural gas are predominantly a mixture of hydrocarbons. Under surface pressure and temperature conditions, the lighter hydrocarbons methane, ethane, propane and butane occur as gases, while the heavier ones from pentane and up are in the form of liquids or solids. However, in the underground oil reservoir the proportion which is gas or liquid varies depending on the subsurface conditions, and on the phase diagram of the petroleum mixture. An oil well produces predominantly crude oil, with some natural gas dissolved in it. Because the pressure is lower at the surface than underground, some of the gas will come out of solution and be recovered (or burned) as associated gas or solution gas. A gas well produces predominately natural gas. However, because the underground temperature and pressure are higher than at the surface, the gas may contain heavier hydrocarbons such as pentane, hexane, and heptane in the gaseous state. Under surface conditions these will condense out of the gas and form natural gas condensate, often shortened to condensate. Condensate resembles gasoline in appearance and is similar in composition to some volatilelight crude oils.

The proportion of light hydrocarbons in the petroleum mixture is highly variable between different oil fields and ranges from as much as 97% by weight in the lighter oils to as little as 50% in the heavier oils and bitumen.

The hydrocarbons in crude oil are mostly alkanes, cycloalkanes and various aromatic hydrocarbons while the other organic compounds contain nitrogen, oxygen and sulfur, and trace amounts of metals such as iron, nickel, copper and vanadium.

Crude Oil Hot Spots Globally

Oil In India

According to oil and gas journal, India had approximately 5.6 billion barrels of proven oil reserves as of January 2010, the second largest amount in the Asia-pacific region after China. India’ s crude oil reserves tend to be light and sweet, with specific gravity varying from 38° API in the offshore Mumbai high field to 32° API at other onshore basins.

India produced roughly 880 thousand barrels per day (bbl/d) of total oil in 2009 from over 3,600 operating oil wells. Approximately 680 thousand bbl/d was crude oil; the remainder was other liquids and refinery gain. In 2009, India consumed nearly 3 million bbl/d, making it the fourth largest consumer of oil in the world. EIA expects approximately 100 thousand bbl/d annual consumption growth through 2011.

Indian Oil Imports (Past 5 years)

The combination of rising oil consumption and relatively flat production has left India increasingly dependent on imports to meet its petroleum demand. In 2009, India was the sixth largest net importer of oil in the world, importing nearly 2.1 million bbl/d, or about 70 percent, of its oil needs. The EIA expects India to become the fourth largest net importer of oil in the world by 2025, behind the United States, China, and Japan.

Nearly 70 percent of India’s crude oil imports come from the Middle East, primarily from Saudi Arabia, followed by Iran. The Indian government expects this geographical dependence to rise in light of limited prospects for domestic production.

Where Does India Get its Oil from?

India’s Crude Oil Imports By Source, 2009

The Indian Problem with Crude Oil

Crude Oil is the most ‘wanted’ commodity in the world. Crude oil accounts for 40 per cent of the world’s total energy demand. Daily, the world consumes about 76 million bbl of oil.

United States (20 million bbl/d), followed by China (5.6 million bbl/d) and Japan (5.4 million bbl/d) are the top oil consuming countries.

India ranks among the top 10 largest oil-consuming countries.

Oil accounts for about 30 per cent of India’s total energy consumption. The country’s total oil consumption is about 2.2 million barrels per day. India imports about 70 per cent of its total oil consumption and it makes no exports.

India faces a large supply deficit, as domestic oil production is unlikely to keep pace with demand. India’s rough production was only 0.8 million barrels per day.

The oil reserves of the country (about 5.4 billion barrels) are located primarily in Mumbai High, Upper Assam, Cambay, Krishna-Godavari and Cauvery basins.

Balance recoverable reserve was about 733 million tones (in 2003) of which offshore was 394 million tones and on shore was 339 million tones.

India had a total of 2.1 million barrels per day in refining capacity.

The government has permitted foreign participation in oil exploration, an activity restricted earlier to state owned entities.

Indian government in 2002 officially ended the Administered Pricing Mechanism (APM). Now crude price is having a high correlation with the international market price. As on date, even the prices of crude bi-products are allowed to vary +/- 10% keeping in line with international crude price, subject to certain government laid down norms/ formulae.

Disinvestment/restructuring of public sector units and complete deregulation of Indian retail petroleum products sector is under way.

India’s oil reserves to last another 19 years

http://www.thehindubusinessline.com/2007/06/17/images/2007061703280101.jpg

According to the BP Statistical Review of World Energy 2007India is in the company of Australia, Italy and Brazil whose reserves are also projected to last for 20-21 years from now.Iraq and Kuwait’s reserves are expected to last more than 100 years at their current rate of production, while that of Saudi Arabia is projected to last another 66 years.India has produced 0.807 million barrels of crude oil a day in 2006 compared with 0.780 million barrels in 2001. Meanwhile, consumption has grown by almost 13 per cent to 2.57 million barrels in 2006 compared with 2.28 million barrels in 2001 leading to higher dependence on imported oil.  India’s estimated domestic proven reserves is 5.7 billion barrels as of end-2006.  There have been some medium-size oil finds in the last five years including Cairn Energy’s discovery in Rajasthan.

What is APM all about?

The administered pricing policy of petroleum products ensures that products used by the vulnerable sections of the society, like kerosene, or products used as feedstock for production of fertilizer, like naphtha, may be sold at subsidized prices.

The country has traditionally operated under an Administered Pricing Mechanism for petroleum products. This system is based on the retention price concept under which the oil refineries, oil marketing companies and the pipelines are compensated for operating costs and are assured a return of 12% post-tax on net worth. Under this concept, a fixed level of profitability for the oil companies is ensured subject to their achieving their specified capacity utilization. Upstream companies, namely ONGC,oil and GAIL, are also under retention price concept and are assured a fixed return.

Reasons for Using APM

The first reason for intervention is to protect poor consumers so that they may affordkerosene for lighting, which is a necessity for those who do not have access to electricity.

Another objective may be to provide merit goods to consumers such as clean cooking fuels like natural gas, LPG and kerosene to replace use of biomass-based fuels such as firewoodand dung. These biomass based fuels create indoor air pollution that causes respiratory diseases,eye infections and result in many premature deaths, particularly of women and children. Also,use of firewood encourages deforestation and dung is better used as a fertilizer. Moreover, thetask of gathering these fuels keeps girls away from schools. Thus, use of clean cooking fuels hasmany social and environmental externalities, and as merit goods the government may promotethem through subsidies.

Another frequently reported reason for Government’s intervention is to insulate the domestic economy from the volatility of petroleum prices on the world market. It is feared thatcomplete pass-through of increase in world oil prices may cause inflation which may persist evenwhen oil price comes down. There is no clear evidence that in an increasingly open andcompetitive economy, price movements triggered by changes in the prices of oil products wouldpersist over the medium-run. In addition, attempts to insulate the domestic economy againstvolatility requires discriminating between a secular price rise due to demand-supply forces and aprice rise due to transient causes such as speculation in the world market. This is difficult to do.

What is APM dismantling all about?

One of the buzzwords for the government when it speaks of the reform process – besides divestment and telecom deregulation – has been APM dismantling.

You must have wondered whether this complex term (linked to the petroleum sector) would have any impact on your daily life.

Would the price of petrol, diesel, LPG, kerosene shoot up? Or does this actually mean that these products will actually cost less?

Indian government in 2002 officially ended the Administered Pricing Mechanism (APM). Now crude price is having a high correlation with the international market price. As on date, even the prices of crude bi-products are allowed to vary +/- 10% keeping in line with international crude price, subject to certain government laid down norms/ formulae.

The Government of India has moved away from the administered pricing regime to market-determined, tariff-based pricing. Free imports are permitted for almost all petroleum products except petrol and diesel. Free marketing of imported kerosene, LPG and lubricants by private parties is permitted. It is contemplated that in a phased manner, all administered price products will be taken out of the administered pricing regime and the system will be replaced by a progressive tariff regime in order to provide a level playing field for new investments in a free and competitive market

How petro products priced before APM were dismantled?

Prior to April 1, 2002 – when the new regime set in – domestic prices of some of the petroleum products were partially `insulated’ (protected) from volatile international crude oil prices (from which these products are derived) and certain products like kerosene and LPG were subsidized.

The oil companies were told how much to sell and at what price.

To get a clearer picture let us take a quick look at the selling mechanism of the four main petroleum products used in India – petrol, diesel, kerosene and LPG.

Petrol (motor spirit)

Earlier, due to government control, price of petrol was always higher than that of other fuels (like diesel). Petrol prices have been kept at Rs 33 per litre while for diesel it stands at Rs 17 per litre.

Further, over the years, both petrol and diesel have been amongst the highest taxed of all commodities through state-related sales tax and customs and excise duties.

All these factors have led to an overall higher consumption and usage for diesel compared to petrol. Petrol accounts for a sale of 9.3 m tonnes though margins on sale of petrol are higher than that of diesel.

A simple example

1)A two-wheeler consumes, on an average, 86 liters of petrol per year, for which the owner

spends Rs. 320 per month (Rs. 510 in Delhi). The fuel expenditure of car owners is much largerat Rs. 2210 per month (Rs. 4140 in Delhi). Motorized vehicle owners are largely well-offpersons belonging to the upper two/three deciles of the population. There is no reason tosubsidize this class of consumers.

2) Full price pass-through at US $ 80/bbl will increase the retail price of petrol by around

Rs.7/litre. The additional expenditure of a two-wheeler owner would be only Rs. 50 per month(all-India average). Even for two-wheeler owners in Metro Cities who drive more (around 10000KM per year), the increase on fuel expenditure will be around Rs. 80 per month. Even if thecrude price increases to $120 compared to the present price of around $70/barrel, the retailoutlet price of petrol, assuming the current tax regime, will increase by Rs. 23/litre (i.e.,Rs.20/litre on the basis of rise in indicative selling price of petrol from $70/bbl to $120/bbl ofcrude price + Rs.3/litre on account of the current price being below the estimated indicativeselling price) and the additional expenditure , assuming no reduction in use, will be around Rs.160/month on a two-wheeler user and less than Rs. 1000/month on a private automobile user (atall-India level).

3) If higher petrol prices lead to less driving, more fuel efficient vehicles and an efficiencyincrease by 20%, the additional cost would be that much less.

4) The cost increases can be borne by motorized vehicle owners andrecommends that petrol prices should be market-determined both at the refinery gate and retaillevels.

(High speed) Diesel

This is the highest selling amongst the fuels accounting for 85 per cent of the automotive fuels.

Sales are through two forms – at the wholesale level to state-owned corporations like the railways and transport companies, and secondly through retail pumps to heavy commercial vehicles and the agricultural sector.

User-wise percentage share in total diesel consumption, 2008-09

The burden of diesel price increase on agriculture depends on where it is used. In 2008-

09, 12 % of total diesel went to agriculture (i.e., to tractors, thrashers, tillers, harvesters, pumpsets etc.). The cost of diesel in agriculture would be accounted for by the Government whilefixing the Minimum Support Price (MSP) for major crops. Therefore, any increase in the cost ofdiesel will be reflected in the price and will not adversely affect farmers. However, those whouse diesel relatively more may not get fully compensated by MSP. Higher diesel price willinduce them to use less diesel which may reduce over-use of ground water prevalent in manyparts of the country. Of course, higher diesel price resulting in higher MSP will increase subsidyfor PDS, but it would be much less than the reduction in under-recovery on diesel.

Trucks and LCVs consume around 40% of diesel. It is reported that with industrial revival and higher economic growth, the truck owners generally raise their rentals in consonancewith growth. Therefore, long distance charge for a round trip between Delhi and Mumbai for a9-tonne truck is more than Rs. 40000 today whereas its diesel consumption works out to aroundRs. 22000. Higher diesel price would encourage fuel use efficiency as well as greater use ofrailways for freight movement. Railways consume around 1/4th as much diesel per net tone kilometer as trucks.

Even assuming that the truckers, power generators, industrial users etc.(other than thepassenger car owners) are able to pass on fully the additional cost of diesel, an increase of Rs. 4per litre would mean an increase of around Rs. 20,000 crore in their cost of diesel which wouldbe around 0.4 % of GDP in 2008-09. This should be compared with the

Car owners, who drive diesel vehicles, including Sports Utility Vehicles (SUVs), should be able to bear the additional cost. There is no economic or social reason to subsidize them. The price of diesel should also be market determinedboth at the refinery gate and retail levels.

With deregulated oil prices, once households and firms clearly see that international factors drive domestic petroleum product prices, and when monetary policy is seen to emphasizeprice stability, households and firms would be relatively relaxed. When there is a temporaryshock to oil prices, they would be much less likely to react to short-term fluctuations in pricesthrough wage hikes or increases in product prices. Thus, in OECD countries, from 1979onwards, where central banks have shifted into de facto or de jure ‘inflation targeting’, the greatcommodity inflation from 2002 onwards did not pass through into broad-based inflation in the2002-2008 period.

Petrol and diesel used in cars, including SUVs, are for final consumption. The higher excise duty on petrol compared to diesel encourages use of diesel cars. While greater fuel efficiency of a diesel vehicle should not be penalized, a way needs to be found to collect thesame level of tax that petrol car users pay from those who use a diesel vehicle for passengertransport. An additional excise duty on a diesel vehicle corresponding to the differential tax onthe petrol should be levied. At the present excise rates, the additional excise duty paid by apetrol vehicle owner who on an average drives 8000KM/year and gets an average mileage of13.5 KM/litre is around Rs.10000 per year. The present discounted value at 10% discount rateover the 10-year life of a vehicle would be around Rs. 67,500, and at 5% discount rate it wouldbe Rs. 81,000. An appropriate discount rate would be the rate on Government bonds. Anadditional excise duty calculation based on the following model, adjusted for the existingdifferential, if any, in excise duty between petrol-driven cars, and diesel-driven cars, should belevied on diesel car owners.

This is the market, which has caught the eye of most of the leading domestic and international oil companies, where they visualize greater expansion.

Superior Kerosene Oil (Kerosene)

This is sold through the public distribution system (PDS) of various state governments and through retail sales outlets. Because of its wide-scale usage the government has and will continue the subsidy for the PDS kerosene.

LPG (liquified petroleum gas)

This is one of the fastest growing segments for oil companies and the consumer base and the distribution/penetration of the product has grown over the past three years.

Growth In Urban India

Sector wise consumption

Oil consumed in the past eight years

How will pricing change for the retail consumer now? Will petrol and diesel cost less?

In India’s socio-economic climate, petroleum products have always and will continue to be looked at very closely by the government.

What this means is that even with the dismantling of the APM process, the government will continue to have an indirect say and view on the pricing of these key fuels.

This is not simply because the taxes levied on such commodities are crucial to the state governments but also because the government has still to take a clear view on how much foreign competition and free market pricing should be allowed.

The recent Exim Policy has still not allowed free imports of petroleum products. If free imports are allowed it would have an impact on petroleum prices in various parts of the country.

Existing oil companies (along with some of the government ministries) will continue to have a say on how pricing of these petro products should be.

So till then even as more players, both domestic and international, come in, the prices of diesel and petrol will not dip substantially. A pure free market scenario could arrive, but in India it is likely to take more time.

Then what does all this talk of deregulation for the oil industry imply?

We have seen that steps have been taken at the pricing level. The oil industry has witnessed deregulation in recent years through private players who have been allowed to market LPG products.

The big thrust will be at the retail level with the expected entry of large players like the Reliance group (with Reliance Petroleum having recently merged with Reliance) and the Essar group, through Essar Oil.

They will aggressively compete with public sector undertakings (PSUs) at the retail and marketing level and the overall distribution network map for petrol and diesel sales is expected to alter dramatically.

From a management perspective, the running of oil companies is also expected to change specially with the government announcing that it will divest its stake in petroleum giants Bharat Petroleum and Hindustan Petroleum.

Most of the leading private and public players are likely to bid for these as there are obvious advantages to gain in terms of existing network and distribution.

Recommendations include –

Free market pricing of Petrol and Diesel. The Kirit Parikh report suggests an additional levy of Rs. 80,000 on a diesel vehicle, citing that the higher excise must offset benefits vis-a-vis petrol vehicles. The report submits there is no need to subsidize users of diesel cars and SUVs, vehicles which are used for personal purposes.

Allowing periodic price increases for cooking gas (LPG) and Kerosene, based on performance of the agricultural sector and the rate of expansion of rural electrification. This will help rural India gradually adjust to the price hikes. Kerosene is used for lighting purposes in rural areas, so expanding rural electrification will reduce dependence on kerosene for lighting purposes

Excluding GAIL – the gas transmission behemoth from the under recovery subsidy burden.

Impact of APM on the Indian Economy

All in all, the ever expanding petroleum sector subsidies are proving to be a real drain on the finances of the Indian government.

Oil subsidies are currently treated as an ”off balance sheet item”.

Implementation of these recommendations will thus present a ”truer” picture of India’s fiscal deficit.

To give you an idea of just how large the oil subsidy has been: –

From 2003-04 to 2008-09 total under recoveries amounted to Rs. 2,99,222 crores.

The market capitalization of India’s largest private sector Giant – Reliance Industries is Rs. 3,23,235 crores!!!

The market capitalisation of the Benchmark BSE SENSEX index is Rs. 24,81,009 crores.

TAXATION

At present there is zero custom duty on crude oil, domestic LPG and PDS kerosene; 2.5

percent custom duty on Motor Spirit and diesel and 5 percent custom duty on other petroleumproducts. The excise duty on domestic LPG and PDS kerosene has already been reduced to zero.The basic excise duty on Motor Spirit and Diesel (other than branded) has also been reduced toRs. 13.35 per litre on Motor Spirit and Rs. 3.60 per litre on diesel. The already

recommended additional excise duty on diesel-driven vehicle corresponding to the differentialtax in the form of higher excise on petrol consumed by average petrol-driven car, which will actas the equaliser. There is also the cascading impact of taxes such as entry tax/octroi imposed byState Governments on crude oil, petrol and diesel. Almost 20 percent of the price buildup ofpetroleum products is attributed to state taxes. This needs to be rationalised in order to achievefaster adaptation of domestic price of petrol and diesel to international crude price. TheEmpowered Committee of State Finance Ministers is already working with the CentralGovernment to prepare a roadmap for the introduction of the Goods and Services Tax (GST)with effect from 1st April, 2010.

RECOMMENDATIONS

India’s imports of oil are increasing. Our import dependence has reached 80 per cent and is likely to keep growing. At the same time 2008 saw an unprecedented rise in oil price on theworld market. Oil price volatility has also increased. Though future oil prices are difficult topredict, they are generally expected to rise. Given our increasing dependence on imports,domestic prices of petroleum products have to reflect the international prices.

The Government has not permitted public sector oil marketing companies to pass global prices to domestic consumers. We have examined the impact of the formula-based prescriptivepricing of major petroleum products devised by the Government from time to time, particularly since 2002. The present system of price control on petrol and diesel in particular has resulted inmajor imbalances in the consumption pattern of petroleum products in the country, and has putundue stress on finances of the PSU oil marketing companies as well as of the Government. It has also led to withdrawal of private sector oil marketing companies from the market. This has affected competition in the domestic petroleum product market.Intervention through price control necessitates that someone bears the financial costs.The issue therefore is to assess the costs and incidence of the burden of alternative mechanismson different groups in the society. On whom the burden falls depends on the policy and theinstruments used.A viable long-term strategy for pricing major petroleum products is required. A viablepolicy has to be workable over a wide range of international oil prices and has to meet thevarious objectives of the government. It should limit the fiscal burden on government and keepthe domestic oil industry financially healthy and competitive.The petrol is largely an item of final consumption. An analysis of the trend of petrolconsumption by the automobile owners reveals that increase in prices of petrol can be borne bymotorized vehicle owners. Accordingly, we recommend that petrol prices should be marketdetermined both at the refinery gate and at the retail level.We have examined the implications of increase in retail price of diesel on various groupsof consumers and do not find any compelling reason to subsidize them. Therefore, werecommend the price of diesel should also be market determined both at the refinery gate and atthe retail level.Petrol and diesel used in cars, including SUVs, are for final consumption. The higherexcise duty on petrol compared to diesel encourages use of diesel cars. While greater fuelefficiency of a diesel vehicle should not be penalized, a way needs to be found to collect thesame level of tax that petrol car users pay from those who use a diesel vehicle for passenger transport., should be levied on diesel car owners.A transparent and effective distribution system for PDS kerosene and domestic LPG canbe ensured through UID/Smartcards framework. Until it becomes operational, the followingmeasures need to be taken.

There is disparity in per capita allocation of PDS kerosene amongst States, as also decline in the percentage of households using kerosene. Besides, households have flexibility in absorbing increases in price of PDS kerosene to certain extent. Therefore, PDS kerosene allocation across states should be rationalized, which will bring down all-India allocation by atleast 20%. Further reduction in PDS kerosene allocation can be done on the basis of progress ofrural electrification, LPG and piped gas availability which is expected to reflect much largerreductions in next NSSO surveys.

The price of PDS kerosene needs to be increased by at least Rs.6/litre so that the share ofexpenditure on kerosene in the total consumption expenditure of rural households remains at thesame level as in 2002. Thereafter, price of PDS kerosene be raised every year in step with thegrowth in per capital agricultural GDP at nominal price.

Our analysis shows that prices of domestic LPG can be increased by at least Rs. 100 per cylinder. Thereafter, the price of domestic LPG should be periodically revised based on increasein paying capacity as reflected in the rising per capita income. The subsidy on domestic shouldbe discontinued for all others except the BPL households once an effective targeting system is inplace.For calculation of the under-recoveries incurred by the OMCs on sale of PDS keroseneand domestic LPG, the extant methodology based on import parity pricing may be continued solong as the country remains a net importer of kerosene and LPG.Following the above recommendations, the under-recoveries of OMCs due to petrol anddiesel will be nil.A mechanism for financing under-recoveries on PDS kerosene and domestic LPG has been provided in Table UR2 in paragraph 4.49. This mechanism involves periodic reduction in PDS kerosene allocation, increase in prices of PDS kerosene and domestic LPG from time to time, and mopping up a portion of the incremental revenue accruing to ONGC/OIL from production in those blocks, which were given by the Government, and providing cash subsidy from the Budget to meet theremaining gap. The OMCs marketing PDS kerosene and domestic LPG should be compensatedfully for their under-recoveries based on this mechanism.A market-determined pricing system for petrol and diesel can be sustained in the longrun by providing level playing field and promoting competition among all players, public andprivate, in the oil and gas sector. Adequate regulatory oversight is critical to ensure effective competition.

MOPNG may decide suitable amendments to the existing notifications and orders prescribing IPP and TPP so that any individual company will have full freedom to decide its own basis, norm or formula to derive prices of petroleum products and compete with others in the market.



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