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Gas pricing demystified

Simple answers to confounding questions about gas pricing.

By Balaji Chandramouli        Print Edition: October 21, 2007

Early this month, the government approved a gas price for Reliance Industries’ (RIL) mega find in the KG basin, off the coast of Andhra Pradesh. Although this was taken in consultation with large consumers like power and fertiliser sectors, the way in which the energy ministry communicated the pricing rationale to the general public left several aspects of the deal in the dark. Subsequently, the pricing fine print has been studied hard by several industry experts on behalf of some business publications, which have hinted at deliberate obfuscation of the deal details. That has raised several questions, including whether RIL has been allowed to flout norms and book unreasonable profits. Here, BT provides some simple answers to confounding questions about RIL’S gas pricing.

What does the approved price formula signify? Is this the price consumers will pay? If not, does it reflect the floor price as several media reports suggest?
The government has set a floor price of $2.5 per million British thermal units (MMBTU) for all RIL consumers. Further, it has approved a formula that applies strictly to only 12 companies in the power and fertiliser business that bid for RIL gas two months ago. Since the formula is capped at $60 per barrel, the price is capped at $4.22 per MMBTU. For the rest, the formula offers only an indicative price.

If this is not the consumer price for all of the gas that RIL produces, what is the government approving and why?
Fundamentally, the formula approved by the government will determine the valuation of ‘rent’ that RIL will pay to the government, also called profit petroleum (PP), for exploiting the latter’s natural resources. While the formula yields the price of gas, the volume of gas is determined by the production sharing contract between the contactor (in this case RIL) and the government. It is this volume share that is a key determinant in the award of oil and gas blocks—the higher the share offered, the better the chances of winning. For instance, RIL offered to share with the government 10 per cent in the initial years and as much as 80 per cent in later years.

If the government is approving its ‘rent’, should it not maximise it? Instead, it has trimmed it from RIL’s proposal of $4.33 per MMBTU to $4.22 per MMBTU.
The government has trimmed the price, albeit marginally, owing to political compulsion. The dominant gas-starved consumers, fertiliser and power sectors, are largely in the government fold. Hence, while a higher price will improve the government’s take, it will also result in a higher subsidy bill in the case of the fertiliser sector, or higher fuel bill for state power utilities in the case of the power sector. Hence, it has succumbed to populism and not protected the interests of the tax payer—after all, if the exchequer’s rent receipts swell, it releases head room for the finance minister to consider tax cuts.

Are there precedents for such actions? After all, 15 per cent of gas supply in the market is from contracts similar to that of RIL’s production sharing contract (PSC) under the New Exploration Licensing Policy.
None. Moreover, in the case of the 15 per cent supply, gas has been auctioned at the highest price in an open bidding process. The reason it has not happened in the case of RIL is owing to the substantial volume of gas—to begin with, it meets half the prevailing deficit and in two years, nearly eliminates this gap.

Why, then, did RIL not undertake an open bidding process? Rather, it went in for a limited bidding process, which was criticised by the government. Where did RIL go wrong in its strategy?
It went about this process like it would in any other case involving government intervention—establish an informal connection with the government and sense the tolerance of the system, in the hope that it will ensure a good deal in quick time. Only that, this time around, this precisely was its undoing. Here’s why: Petroleum Secretary M.S. Srinivasan informally offered two pieces of advice to the CEO of RIL’s oil and gas division P.M.S. Prasad, for the proposal to sail through. First, keep the price low; second, ensure that power and fertiliser units are well covered. In keeping with this advice, RIL aborted an open bidding process, for which it had appointed Crisil as a consultant. Crisil had come back with a price affordability in the region of $5 per MMBTU. Srinivasan would have nothing more than in the whereabouts of $4 per MMBTU. Hence, it put in place filters and selected consumers to fit the bill. Having restricted the arena, it placed before the bidders a restrictive formula, hence, a near fixed price. This again was criticised by the PM’s economic advisory council. The council, however, was comfortable with the final price. However, fact remains that the contract allows for this prescription as well, so long as the transaction is at arm’s length.

What happens if, for the remainder of the gas, RIL sells at a price higher than the approved $4.22 per MMBTU?
In such an event, the government will compute its profit petroleum at the higher price. This, however, might attract the attention of the political class, if the volumes are large and the deviation from $4.22 per MMBTU is significant. After all, it caught their eye in the first place owing to the large volumes and the fact that close to 70 per cent of gas supply in the market is sold at an administered price of $2.5 per MMBTU. The producers: state-owned ONGC and Oil India Ltd (OIL).

Are there precedents of private gas producers selling at different prices to different consumers? And, if so, how does the government compute its share in such cases?
Yes, although the volumes are small compared to the RIL find. In the case of Panna-Mukta-Tapti fields or Ravva fields, the producers have resorted to differential pricing. Profit petroleum in each case is taken at the actual price at which the transaction has been done.

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