Posted by: Pradeep | May 25, 2008

Oil Subsidies in India

Oil hit a record $135/barrel last week, up from $51/barrel in January 2007. Taking a longer four-year perspective, the price of the crude is up 230%, but Indian petrol is up only 35%, diesel 46%, and kerosene not at all!

Why not? Because government diktat obliges oil marketing companies to provide massive implicit subsidies to consumers that may touch a staggering Rs 200,000 crore this year. Subsiding oil consumers — most of whom are middle class or rich — makes no sense in a poor country. The Arjun Sengupta Committee found that most people live on less than Rs 20/day. But the implicit petrol subsidy for many car-owners exceeds Rs 100/day. This offends both justice and economic sense.

Many politicians say a price freeze on transport fuels will protect the poor from inflation. In fact, it protects mainly car-owners. Higher fuel prices will push up transport costs and hence, overall prices a bit, but so will the deficit financing used to subsidise oil. We need to check the demand for oil by letting price rise. The refusal to do so is keeping demand artificially high. The subsidy for oil is also a subsidy for street pollution and congestion, and reduces the incentive to switch from private to public transport. The same politicians who lecture the US on global warming want to subsidise India’s own emissions.

Are speculators to blame for sky-high oil prices? World stocks of oil are falling, so speculators are not hoarding oil. Hedge funds have moved aggressively into the market for commodity futures and options, but for every buyer of such financial derivatives there has to be a seller. If the buyers have proved wiser so far, they have simply vindicated warnings of experts on global supply problems.

The petroleum ministry wants to raise the price of petrol by Rs 10/litre and diesel by Rs 5/litre, to recoup just half the under-recoveries of oil companies. But it faces enormous political resistance. Congressmen worry that with major state elections due in November and a general election due next May, any rise in petrol/diesel prices will be electoral folly, no matter what the economic cost. But in a democracy, elections keep coming without end, so the imminence of one election or another is no excuse for policy paralysis. The quicker fuel prices are raised, the faster people will adjust, and the more likely voters will forget about it and focus on other issues by the general election in May 2009.

A global slowdown has begun. If it spreads rapidly, the price of most metals and agricultural commodities could crash. But it seems unlikely that oil will fall below $100/barrel. Indeed, Arjun Murti of Goldman Sachs, who first predicted that oil would hit $100/barrel, now predicts that it could spike to the range $150-200/barrel. 

Why is oil so different from other commodities? Its response time is much longer. Farmers can respond to higher prices in just one growing season. For minerals and metals, opening major new mines used to take two years, but can now take twice as long because of environmental and rehabilitation issues. 

The response time for oil is longest of all. When the price of metals or fibres rises, governments rarely step in to subsidise consumers. The rising world price of copper, aluminium, cotton or rubber is fully reflected in Indian prices too. In these cases, the high consumer price checks demand, and helps restore the supplydemand balance. 

But in India and many other developing countries, rising oil prices are not passed on to consumers. So, oil demand is not checked commensurate with the price change. Hence, it takes much longer to restore the supply-demand balance. And balance may be restored only at much higher prices, because oil suffers from exceptional barriers to additional production. 

Production from existing major oilfields is declining sharply, by two million barrels/day, so huge new fields are needed just to compensate. The most accessible oilfields have already been found and exploited, and the future discoveries lie in deep waters and difficult geological structures miles underground. The world simply does not have enough equipment to drill in deep waters, and so exploration has been delayed in several countries. Even production from established new discoveries has been delayed for want of deep-sea equipment (as in Reliance’s offshore gasfield). 

Many countries do not want to expand drilling for oil. Saudi Arabia would rather conserve its oil for future generations. The US Senate has refused to permit drilling in the Alaskan Wilderness Reserve, and only three other states — Texas, Louisiana and Alabama — permit any offshore drilling, out of environmental concerns. 

Given these barriers to new production, high oil prices look here to stay. India must adjust to that reality. Record economic growth has provided the exchequer with additional tax revenue of Rs 120,000 crore per year. That must be used to build infrastructure and directly target the poor. For the Congress to spend Rs 16,000 crore on its flagship employment guarantee programme and Rs 200,000 crore on oil subsidies is bogus socialism that fully merits electoral defeat.
Reproduced from TOI writer SWAMINATHAN S ANKLESARIA AIYAR
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