Reforms in oil & gas may be key

If the government has to rationalise fuel subsidies, PSUs across the energy chain will benefit

 

The biggest item on India's import list is crude oil and gas. India imports a little over 80 per cent of its crude oil and roughly 33 per cent of its gas. Domestic demand for both fuels is steadily rising. The need to import places dual pressure on national finances.

On the external side, it means imports cannot be reduced beyond a certain point because energy demand is not easily compressed. This leads to a current account deficit because exports are considerably less than imports.

On the domestic side, the government massively subsidises retail prices of various fuels. Some of that subsidy burden is borne by public sector units and by the central government. Overall, this adds to the fiscal deficit. It also subsidises fertilisers that require petro-chemical feedstock.

If the rupee falls, as it has, or international prices of crude oil and gas rise, those subsidies also rise. In addition, various state governments also set power charges which are lower than the cost of producing gas-based electricity.

One of the good things about the current crisis is that it has forced the government to start rationalising fuel subsidies. It has done so unwillingly and through staggered steps. At the same time, it has raised the price of domestic gas through a formula that will become effective in April. The rupee has slid so much, however, that the rationalisation has not been enough and, in fact, PSUs are losing more money now via "under-recoveries" than they were earlier.

Also, unless power charges are rationalised, allowing the extra cost of gas-based power to be passed on, the power sector cannot use gas-based capacities. And, unless the government rationalises fertiliser subsidies, the fiscal deficit will swell further on that account.

Things might just get bad enough for the government to consider taking steps on these accounts. It will not want to free up the energy sector, nor will it wish to cut fertiliser subsidies but there is a chance it might be forced to do so. Even so, it will do as little as it possibly can, to rationalise subsidies. Yet, even that little could have an effect on the energy chain.

As it happens, the entire energy sector, from oil and gas producers to refiners and marketers, gas transporters, city gas distributors, downstream power producers, etc., is extremely beaten-down. It is also among the most highly-controlled of sectors, both in terms of government policy and also on account of being dominated by PSUs across the entire value chain. The government will try to retain as much control over it as possible. A glance at the historical share price records of PSUs will tell you that government control is very bad news for any investor.

However, enforced reform across the energy value chain could be the silver lining in the cloud if the crisis intensifies. The government might be forced to liberalise some of the pricing mechanisms. If indeed it does so, there will be a positive revaluation of these companies. This will not necessarily make these a good investment in the long run. However, it could set up a series of excellent trades.

If this process of reform happens at all, it will have to be triggered by certain key events. The rupee will have to drop considerably further or the dollar price of crude oil will have to shoot up, or both. If the fiscal deficit hits intolerable levels or the current account deficit swells beyond say, 5.5 per cent of GDP, the government could be forced to look at reform in the energy sector.

If those circumstances occur, and the government is forced into reform, there would be a big bounce in the share prices of PSUs across the energy chain. What is more, if it occurs at all, it would happen at a point when the economy was in really serious trouble and it might well be one of very few plays with an upside. Bear that in mind if things get really bad.