Rise in fuel prices has made govt vulnerable; how can it manage oil risks?

A sharp rise in retail prices of petrol and diesel in the last five months has exposed the political vulnerability of the Bharatiya Janata Party (BJP) that leads the government at the Centre. BJP insiders concede privately that the rise in retail prices of petroleum products is one of the more potent issues that can adversely impact the ruling party’s electoral fortunes in the five forthcoming Assembly polls and even in the general elections in 2019.
 
It is time, therefore, for an assessment of the pattern of the rise in retail prices of petrol and diesel in the last five months and what steps, if any, have already been taken or could be taken by the government in the coming days. Three broad trends are too obvious to be missed.
 
Retail petrol prices in Delhi have risen by 12 per cent between the first week of April and the last week of September. For diesel, the increase has been over 14 per cent in the same period. Note that this increase is an outcome of two major factors — a 15-16 per cent rise in the cost of the two fuels for the refineries (including freight and processing charges) in this period and a depreciation of the Indian rupee against the dollar during the same period by over 11 per cent.
 
This was a double whammy for the Indian economy, quite unlike the way the last time crude oil prices had shot up in 2010-11 and 2011-12. If the exchange rate had not depreciated as steeply and at the same time as the crude oil prices rose, the impact on India’s retail prices for petrol and diesel would certainly have been far less. But then there is little that the government can do to contain the rise in crude oil prices. Nor can it reverse the fall in the Indian rupee in a sustainable way. The only thing it can hope to do is to facilitate its steady depreciation without volatility.

 
The second trend that needs to be noted is the asymmetrical movement in the cost and freight (C&F) incurred by refineries and the prices they charge the dealers while supplying them petrol and diesel. For instance, the C&F prices for petrol and diesel in April 2018 were Rs 31.08 and Rs 33.16 per litre, respectively. By the end of September, these C&F prices for both the products went up by 27-28 per cent. However, there was no commensurate increase in the prices that refineries charged from the dealers in the same period. The increase in the dealers’ April prices of Rs 35.05 and Rs 37.31 a litre for petrol and diesel, respectively, was much less at 20-21 per cent.
 
What this suggests is that the oil refineries have already squeezed their margins significantly. In April, the prices charged by the refineries from their dealers were higher than their C&F prices by about Rs 4 a litre for both petrol and diesel. But by the end of September, that difference has shrunk to about Rs 2-3 a litre. In other words, refineries have taken a hit by not passing on the entire cost of higher crude oil prices to the dealers. It is reasonable to assume that the refineries have not volunteered to squeeze their margins and instead were gently pushed to absorb the higher costs. So much for pricing freedom enjoyed by the country’s state-owned oil refiners!
 
Third, higher crude oil prices have already begun to strain the government’s finances as far as its subsidy bill on account of kerosene and cooking gas is concerned. According to one estimate, the annual petroleum subsidy bill for the current year may rise to Rs 414 billion, an increase of 62 per cent over Rs 255 billion in 2017-18. The government had budgeted for a petroleum subsidy expenditure of Rs 249 billion in 2018-19, assuming that the crude oil price will hover at around $65 a barrel and the dollar will rule at around Rs 65 during the current year. But both these projections have gone awry. The implications for the government’s fiscal deficit are serious.
 
So, what can the government do? Cutting excise duty on petrol and diesel can push the government’s finances into a bigger fiscal crisis. This is also no time for exploring the option of bringing petrol and diesel under the goods and services tax (GST) regime. Any transition to bring petrol and diesel under the GST has to be adequately thought through as this will have implications for tax collections, given the huge dependence of the Centre and states on these two items for their indirect tax revenues.

 
Three steps are worth exploring at this stage. The C&F prices for petrol and diesel are derived from a trade-parity-based formula, reflecting the import and export prices of these products in an 80:20 ratio. It is time the refineries were forced to move away from such an inefficient and lazy pricing formula. Instead, they should be asked to follow a transparent cost-plus formula based on the actual landed price of crude oil and refining expenditure. That system will be more efficient, more transparent and will also hopefully bring down the C&F prices of petrol and diesel, which will provide some relief to consumers.
 
Second, the GST Council, instead of exploring the option of including petrol and diesel under the GST, should examine if states could be persuaded to switch over to a specific rate of value added tax on the two petroleum products. The Centre’s excise on these products is already levied at a specific rate.
 
Retail prices of petrol and diesel would have been 2-3 per cent less than what they are today, if states had converted their VAT into a specific rate at the same level that prevailed in April. It is still not too late for the GST Council to persuade states to switch over to a specific rate of VAT, instead of continuing with the current ad valorem rate, which gives states windfall gains even as crude oil prices rise.
 
And finally, the government must recognise that there is merit in conservative budgeting for the oil economy. An aggressive oil economy budget, as was done for the current year (dollar at Rs 65 and oil prices at $65 a barrel), gives rise to fiscal risks that could have been avoided through conservative budgeting.