6/24/13

Mrunal [Economy 4 Newbie] Govt. Price control on Petroleum Products- Why Print

[Economy 4 Newbie] Govt. Price control on Petroleum Products- Why

Background
80% of our oil is imported. 2008 saw an unprecedented rise in oil price on the world market. Crude Barrel price increased from US$ 36 / barrel in May 2004 to US$132.5 / barrel in July 2008, government did not permit Public Sector Oil Marketing Companies (OMCs) to pass the full cost of imports on to domestic consumers of major oil products, i.e., petrol, diesel, domestic LPG & Kerosene. Since it doesnt fall from sky,somebody has to pay for it. Govt. paid it- via issuing bonds to Oil making Cos. So what we are getting is subsidized product and this is how Govt. controls the prices of petroleum products

Bad Consequences of Governments Price control on petro-products

If Petrol producer cant sell the petrol @ high price, he has no interest in expanding / upgrading his factory. so Artificially low prices can widen long term supply-demand imbalances by discouraging refiners and marketers to expand capacity and, on the other hand, encouraging demand growth. Since Petro is cheap, every Tom, Dick and Harry around is going to fill his bikes tank full and loiter around the city & colleges with out doing any productive work. People are going to use vehicles even for short distance travel which they could cover on foot/bicycle or public Bus/Railway So Fuel shortages are nearly universal when prices are kept low. Since petrol is cheap, people dont use extreme parsimony /care in its use. Subsidizing domestic consumers also doesnot incentivize them to economize on use of petroleum products. Market malpractices like hoarding, black marketing, and adulteration thrive when prices are controlled arbitrarily. Especially for Kerosene, I see long lines of Rickshaw drivers in front of those Kerosene vendors every evening why do they come there? Major oil exporters that subsidize petroleum product prices can actually become product importers for lack of investment in the downstream sector. Iran, Iraq, Nigeria and Mexico are prime examples.
mrunal.org/2010/02/economy-4-newbie-govt-price-control-on.html/print/ 1/5

6/24/13

Mrunal [Economy 4 Newbie] Govt. Price control on Petroleum Products- Why Print

Cross-border price difference trend to widen when prices are kept low; it encourages fuel tourism/ Smuggling especially for Kerosene.

Whats the consequence of Oil Subsidy?

They put stress on governments finances. Lot of Govt.s money goes into subsidizing these things which could have been used for other projects. Oil cos have to sell their product @ the price determined by Govt. thus, they dont have big cash surplus to invest in finding new oil wells in country or buying oil fields abroad. Govt. doesnt issue oil bonds to Oil cos on time, they created cash flow problems for OMCs who had to borrow from the market, which increased interest payments and reduced their surplus. only the OMCs were provided financial support, the private sector companies withdrew from oil marketing. This not only made infructuous the large investments they had made in setting up retail outlets, it also reduced competition in oil marketing. And low competition amongst manufacturers is bad for consumers.

People earn more, yet pay less for petro

In last 10 years, Petrol prices are almost constant, around Rs. 40-50 bracket. while income of people has increased (+ the 6th Pay Commission) so, lot people buying cars and bikes. so, the demand for petroleum products such as petrol and diesel recorded double digit growth -higher than the GDP growth. Continuation of the present policies is not viable, particularly once oil prices rise again Note: these are the observation of Parekh Committee! Since Govt. pays money to keep petrol cheap, it puts money shortage for Govt. (which is under lot money burden already thanks to pakis weve to maintain huge army, make test new missles every week)+ naxals + insurgency in N.East = lot money going into Revenue Expenditure instead of capital Expenditure.

Why Should the government intervene at all in the market and set prices?
because poor people need cheap kerosene to cook food, else theyll chop down the trees. = climate change they also use kerosene lamps, because they have no electricity. suppose LPG & Kerosene were sold on high prices then? Poor Girls will be forced to collect firewood all day= cant go to school
mrunal.org/2010/02/economy-4-newbie-govt-price-control-on.html/print/ 2/5

6/24/13

Mrunal [Economy 4 Newbie] Govt. Price control on Petroleum Products- Why Print

Deforestation = climate change + global warming. Villagers using Cattle-dung but Cattle dung has better use a manure.

If you use wood / dung for cooking then?

indoor pollution respiratory disease, eye burns. thus, Life-Expectancy of women + infants reduced.

if Diesel was expensive then?

truck owners will demand higher fees for transporting veggies + milk. = inflation ! But Parikh Committee reports it is not entirely true. (petro-diesel control will be in next article)

Cycle of Inflation even if petro prices go down

suppose today World Oil Barrel price is say 10,000 Rs./ barrel. Govt. lets the market forces decide the oil price so here theyll sell Dieasel @ 100 Rs. / litre inflation in milk/veggies price. but even after few weeks when world price goes down to 5000 Rs/barrel the middleman wont let the price of milk/veggies go down.(even if truckers reduce their fees.) thus, complete pass-through of increase in world oil prices may cause inflation which may persist even when oil price comes down.

Ultimately even Cheap Petro is bad for everyone!

Petro doesnt fall from sky, somebody has to pay for it. in this case, Oil cos sell petro cheap and Govt. pay for it. But, Govt. cant print more money just to give it to Oil cos. (thatll create inflation) so where does the money come from? general increase in taxes, or by increasing fiscal deficit or by cutting other government expenditure so ultimately someone is suffering in some way. tax rise = rich & middle class MRP of products increase due to higher VAT on other things so on one hand you get cheap petro on the other you get costly soap/toothpaste. and even poor are affected because everyone buys matchsticks. Fiscal deficit= (its consequences are discussed in my old article on public debt.) Suppose they chop down Govt. Expenditure on girl education to release some subsidy money for cheap petro= society suffers in long term.
mrunal.org/2010/02/economy-4-newbie-govt-price-control-on.html/print/ 3/5

6/24/13

Mrunal [Economy 4 Newbie] Govt. Price control on Petroleum Products- Why Print

kills the innovation

Price control means setting prices price calculations involve rigid specifications of items to be considered and their costs. today most people get gas via cylinders have to wait after booking the cylinders. but if they laid the pipelines in every town and city , gas connection to every homethatd make the life of a middle-class man very easier. but initial cost of setting the pipelines is high, and since Govt. doesnt let the LPG sold @ higher prices, Oil cos have no money for it and Govt. pays for petro-subsidy, instead of using that money to lay down gaspipelines- to settle the problem atleast in major cities.

Other impacts
if diesel is cheap, it may encourage freight movement by trucks rather than by train. When the price difference between petrol and diesel is high, diesel driven vehicles may be preferred. If there is a large difference between the prices of diesel and kerosene, kerosene may be used to adulterate diesel. In 2008, we have even seen diesel being used in place of furnace oil. Thus, Price control, subsidies and taxes can introduce distortions which may not be desirable.

What happens if Govt. stops regulating?

if international crude oil price rise from $60/barrel to $120/barrel then price of petrol in Delhi is required to be increased by Rs.20/litre, the price of diesel by less than Rs. 20/litre and LPG by around Rs. 200 per cylinder.

Conclusion
In order to shield the Indian economy and consumers from the adverse impact of a volatile international oil market, the government decided to fix the consumer prices of four sensitive petroleum products, viz. petrol, diesel, domestic LPG, PDS kerosene. As the prices of these products were below their cost, government devised a compensation mechanism for the public sector oil marketing companies (OMCs). This mechanism essentially involved financial support to OMCs from other public sector upstream companies, viz. ONGC, OIL and GAIL by way of price discounts and from the government through issue of bonds. Parikh Committee suggests that at current levels of prices of petrol, diesel, PDS kerosene and domestic LPG, the financial burdens on the companies as
mrunal.org/2010/02/economy-4-newbie-govt-price-control-on.html/print/ 4/5

6/24/13

Mrunal [Economy 4 Newbie] Govt. Price control on Petroleum Products- Why Print

well as on the government will be unsustainable. Therefore, there is a need to change the existing policy which can strike a balance between the capacity of the consumer to bear higher prices and fiscal stability of the government. Explicit formula-based pricing mechanism of petroleum products is not conducive to establishing a long-term viable and globally competitive oil industry in the country. As more than 3/4th of the current domestic crude oil requirements is met by imports and is expected to go upto further in the future, the domestic consumer prices of petroleum products should be increasingly aligned with movements in international oil markets. Any ad hoc system of price fixation by the government may provide a semblance of domestic price stability in the immediate-to-short term, but give rise to serious long-term instabilities in the demand-supply conditions in the country, competitive functioning of oil companies, and fiscal soundness of the government. A viable and sustainable pricing system for petroleum products is a key requirement of stable, long-term growth of the economy. Similarly, a financially strong and globally competitive oil industry provides an enduring platform to strengthen energy security of the country. It is therefore important that oil companies should have the freedom to set prices based on competitive market conditions. The government needs to extend subsidy to the targeted consumers in such a manner which does not impinge on the freedom of oil companies to set prices in the market place.

URL to article: http://mrunal.org/2010/02/economy-4-newbie-govt-pricecontrol-on.html Posted By On 04/02/2010 @ 11:32 In the category Economy

mrunal.org/2010/02/economy-4-newbie-govt-price-control-on.html/print/

5/5