India Transformed

by Rakesh Mohan

  These internal shortcomings were compounded by a tightening international oil market. The price of crude had increased sharply over the previous two decades and with it the pressure on the balance of payments. To mitigate matters, the government had, in the early 1980s, relaxed its policy on oil exploration. They had allowed private companies to enter the upstream sector on the basis of a production-sharing contract. The company bore 100 per cent of the exploration risk but in the event of a commercial discovery, it received a predetermined share of the production. The terms were competitive but the areas offered to the private sector were not perceived by the international companies to be geologically attractive. The response to this initiative was consequently patchy and in the end it did nothing to arrest the widening demand–supply gap.

  So, in the 1990s and as the balance-of-payments situation worsened and the petroleum industry sank deeper into a financial and operational mire, the government was compelled to ask: ‘What must be done to create a world-class and competitive petroleum industry? Should the government withdraw from the role of arbiter of petroleum policy? What role should the private sector play? And how can the State meet its commitment to provide clean, reliable and affordable fuel without choking the dynamics of the market and/or jeopardizing the macroeconomic balance?

  The story of petroleum sector reform is in effect a story of how the government sought answers to these questions—the initiatives that it took in response and the contrarian forces that surfaced as a result.

  Deregulation Initiatives

  Three initiatives were taken by the Ministry of Petroleum during the 1990s to answer the above questions.

  The first and perhaps most far-reaching was the establishment on 18 January 1995 of the ‘Strategic Planning Group’ (hitherto referred to as the ‘R’—reforms—Group) under the chairmanship of Dr Vijay Kelkar, the then secretary, Ministry of Petroleum. The group had a broad-based composition. Its members included the chairmen of the major private petroleum companies (viz. Reliance, Shell, Essar, Aditya Birla Group), the CEOs of financial institutions (ICICI); consultants (McKinsey, BCG), academics, and the chairmen of PSEs (ONGC, IOC, etc.). The mandate of the group was to recommend the steps required to create a world-class and competitive petroleum industry.

  The R Group submitted its report to the Inder Gujral government in 1997. It recommended that the industry be fully deregulated but in phases and over a four-year period. Specifically, it stated that the government should abolish the ‘cost plus’ administrative pricing system and replace it with a market-based system; that it reduce and rationalize the subsidy regime relating to kerosene, LPG, diesel and petrol; and that it unshackle PSEs from bureaucratic control and grant its managers operational and financial freedom. Cognizant, however, of the power of the ‘status quoist’ economic and political interest groups, the report further recommended that the process be gradual and targeted towards a ‘soft landing’. It stated that in the first year, deregulation be limited to only those segments and transactions that did not tread on political turf. It identified these to be refining and the pricing of intermediate products like bitumen, paraffin wax and naphtha, and suggested that the private sector be permitted to invest in refining and the retail price of these intermediate products aligned to the market. It recommended that the government defer the liberalization of the other more sensitive activities and transactions such as retailing of transportation fuels; market pricing for petrol and diesel; reduction of subsidies on LPG and kerosene; as well as financial and managerial autonomy for the PSEs from the second year onwards and thereafter. Its end objective was total deregulation by the end of the fourth year.

  These recommendations were approved by the Gujral government in November 1997 and subsequently by the Vajpayee government. A gazette notification was accordingly issued on 1 April 1998 that the petroleum industry would be fully deregulated by 1 April 2002.

  The second initiative followed close on the heels of the approval of the R Group report. This was the decision to disinvest the government’s shareholding in the refining and marketing companies HPCL (Hindustan Petroleum Corporation Limited) and IBP (Indo-Burmah Petroleum).

  As already noted, the private marketing companies Exxon, Burmah Shell and Caltex had been nationalized in the mid ’70s. The assets of Burmah Shell were transferred to Bharat Petroleum (BPCL) and that of Exxon and Caltex to HPCL. These two companies had grown significantly since and by the mid-1990s, they controlled approximately 45 per cent of the refining and marketing market. The balance 55 per cent was controlled by IOC (45 per cent) and IBP, formerly a British JV with approximately 1000 retail outlets predominantly in the Northeast. The government’s decision to disinvest its majority stake in HPCL and IBP and to consequently relax its control over these companies therefore heralded a major structural change in the market and a radical departure from past practice. It also signalled the government’s intent to create a transparent, market-oriented and competitive ecosystem.

  The third initiative was to lay out the conditions for private-sector eligibility for market transportation fuels under the company’s brand. This initiative was a logical fallout of the R Group report and the decision to disinvest. It was also a reflection of the government’s concern regarding the rising opportunity cost of India’s inadequate logistical and distribution infrastructure. Two examples brought this cost into sharp relief. One, the severe shortage of LPG and the consequential growth of a black market for the product. A part of the reason for this shortage was that India had only two LPG import terminals in the country, in Mumbai and Visakhapatnam. It could not therefore import sufficient quantities to satisfy the latent demand. Two, the rising costs of demurrage. It was estimated that IOC spent over $100 million annually on demurrage because of the inadequacy of deep-water ports for crude oil tankers.

  To contain these avoidable losses, the government leveraged the appeal of India’s large market to attract private-sector investment into production and infrastructure activities. It issued a directive that only those companies that had invested Rs 2000 core in one or more of the following businesses would be eligible for a marketing licence to retail petrol, diesel, kerosene and LPG, viz. exploration and production of oil and gas; refining; LNG regasification terminals; and pipelines and petroleum storage facilities. Such companies would be allowed to operate unencumbered; they would be free to set prices and brand their outlets. And most importantly, they would operate on the same level field as the incumbent public-sector marketing companies.

  These three initiatives triggered considerable activity. A number of companies dusted off their India investment plans. Three companies—Essar, Reliance and Shell—met the Rs 2000-crore condition and received a marketing licence. Caltex and SHV built LPG import terminals. Total Oil invested with HPCL in an LPG storage cavern. And BP and Shell expressed interest in the deep-water prospects offshore of the Krishna–Godavari basin.

  Deregulation Dilemmas

  One concern, however, overhung the deregulation process. The strength of the political commitment. How strong was this commitment? Would the politicians abort the process in the face of altered market and political circumstances? There were good reasons for this concern. For, petroleum-related issues sit at the nub of every politician’s deepest dilemmas. They have to reconcile efficiency with equity. Efficiency requires the creation of competitive and market-oriented systems. Equity demands that the public be protected against high prices through regulatory checks. They have to balance industrial growth with environmental protection. Petroleum products are the engine of industrial development, but they are also major contributors to air pollution and global warming. They have to crack the conundrum of the relationship between the State and the Market. The former are the custodians of public interest. The latter drives efficiency and innovation.

  Industry was cognizant of this political reality. They knew that in the context of India with its legacy of forty years of Fabian socialism, the residual ideological antipathy to
wards the market, the pressures of incumbent vested interests and the state of the macroeconomy, politicians would have to show huge resolve to stave off the pressures to ‘roll back’ deregulation. In the end, their concern was justified. Politicians did not show such resolve and slowly but inexorably they stalled and then reversed the deregulation process.

  Deregulation Unravelled

  The first casualty of populist politics was the disinvestment of IBP and HPCL. Both these companies had been listed for disinvestment. The government had announced that it would sell down their shareholding—totally in the case of IBP and partially for HPCL—but they did no such thing.

  The IBP disinvestment was rolled back subtly and behind closed doors. This was because the process had already begun and the government did not want to draw undue attention to its change of heart, especially since it had received praise for the clarity and transparency of its approach. Every company had received full data; they had been given sufficient time to carry out due diligence, and to all intents and purposes, the bidders, whether Indian or foreign, private or state-owned, were being given an equal and fair chance to acquire the company. What prompted the ‘change of heart’ is not known as the bid process was completed and the company was acquired by the highest bidder, IOC. The fact that there was a change of heart is however clear given that IOC bid an irrationally high price. It was more than twice the offer made by the second-highest bidder and it made no economic or commercial sense. The only explanation for such a bid had to be the government’s determination to keep IBP within the public sector fold. Rumours did, of course, abound to explain the bid. The explanation accepted by most people was that politicians were concerned they would be criticized for allowing a formerly British-owned company to fall back into the hands of an MNC. There was also concern at the security implications given that the bulk of IBP’s retail outlets were located in the Northeast. Whatever the truth, all that the process achieved was that the IBP lost its independent standing and came under the control of IOC. It remained however firmly within the fold of the public sector.

  The HPCL disinvestment did not require any subterfuge. The government aborted the process before the companies started their due diligence. They pegged this decision on the legal argument that HPCL had been created by an Act of Parliament and as such, its ownership could only be altered through a superseding new Act. Here again, the government did not provide more than a legal explanation for its decision. But the general view was that the politicians were concerned that disinvestment would trigger labor unrest and that this could lead to fuel shortages in the run-up to the 2004 General Elections.

  The second casualty was the R Group report.

  As already noted, the government had through the gazette notification of 1 April 1998, deregulated the petroleum sector on 1 April 2002. As a consequence, the public sector companies were designated ‘Maharatnas’ and given broad-based operational and financial autonomy. Over the next two years between April 2002 and July 2004, they exercised this autonomy to alter the price of diesel and petrol twenty-three times (fifteen times upwards and eight times downwards). Further, Reliance and Essar invested in refineries and in time these two companies created in Jamnagar one of the largest refinery hubs in the world. Finally, the private sector entered main fuels retailing. Reliance, Essar and Shell acquired permission to set up over 5000 retail outlets and although everyone knew that it would be years before they posed a threat to the monopoly of the public sector, the writing of private sector competition was now firmly on the wall.

  Much of this movement towards a free and competitive market went into reverse gear in 2004 following the election to power of the UPA coalition led by the Congress. This was a fragile coalition and as regards petroleum-sector deregulation many of the constituent members thought market economics would not make for good politics. Their views were reinforced by the tightening of the international oil market. The price of crude oil in April 2002 when the gazette notification was issued was around $26 per barrel. A few months into the new government in 2004, the price had risen to $40 for a barrel.

  The decision to reimpose price controls over the PSEs in July 2004 did not therefore come as a surprise. It was in keeping with the rhetoric and the ideological leanings of the senior members of the UPA Cabinet. The gazette notification of April 2002 was not revoked and the de jure status of deregulation was not altered. Instead, the government used its administrative and ownership clout to ‘revoke’ the operational and commercial autonomy of the PSEs. Pricing decisions were brought back de facto into the hands of the Ministry of Petroleum.

  The reimposition of administrative pricing had broad-based negative consequences.

  First, it pushed the marketing PSEs (IOC, BPCL, HPCL) off the financial edge. This was because these companies were now compelled to retail LPG, kerosene and diesel below the cost of production. The consequent loss was huge. It is estimated that IOC, BPCL and HPCL lost (‘under-recovered’) approximately Rs 3,00,000 crore over the five-year period of 2005–2009. In FY 2011–12, they ‘under-recovered’ an additional Rs 1,33,000 crore. These losses were ‘nominally’ covered through long-dated IOUs issued by the government but there was a cash drain. These triple A-rated companies consequently ended up with amongst the most leveraged balance sheets of any PSE (for example, approximately Rs 1,40,000 crore in 2009). The upstream company ONGC was also badly impacted. For, it was required to assign almost 50 per cent of its earnings to keep the downstream companies financially afloat. As a result, it was compelled to cut back its exploration expenditure and reduce its R & D budget.

  Second, it killed market competition. The private-sector marketing companies could not compete against the administrative price structure of the PSEs and had to effectively close down their marketing operations. Essar and Reliance shut their retail outlets; Shell kept them open but lost the bulk of its diesel volumes. The private sector was also pushed out of the LPG market. Shell sold its LPG import terminal in Pipavav and exited the business; SHV and Caltex stopped operations.

  Third, it called into question India’s commitment to creating a competitive, fair and open operating environment. Many petroleum companies took India off their agenda and there was a general downgrade of interest in investing in India even amongst the non-energy–related MNCs.

  Conclusion

  With the benefit of hindsight, one wonders whether the government would have been better equipped to balance ‘good economics’ with ‘good politics’ had they imposed deregulation through one surgical strike and not followed the prescription of the R Group to deregulate in phases and incrementally. One should also ask whether the government should not have made a greater effort to harness the ‘soft power’ of public opinion before embarking on the politically sensitive subject of petroleum sector deregulation.

  In my view, the government did well to look for a ‘soft landing’ rather than go for a surgically swift implementation of deregulation. First, the political system does not allow for radical overhaul. The antibodies to such a shift are much too powerful. Second, incrementalism provides the time and space for the multiple stakeholders to align behind each step in the process. Third, once the first step is taken, it is easier to move forward with larger subsequent steps. Four prime ministers (Gujral, Vajpayee, Rao and Modi) supported petroleum deregulation. They were able to do so because they followed the footsteps already taken by their predecessors. And finally, incrementalism changes the discourse of deregulation. Whatever the short-term twists and turns on deregulation, there is no gainsaying the fact that the R Group report led to the inclusion of the subject of petroleum deregulation in the government’s vocabulary. It is because of this fact that when the market conditions changed in 2014, the Modi government was able to bring deregulation back on to its policy agenda. Today, with relatively low oil prices and a strong central government, deregulation has been almost fully effected. The prices of all petroleum products are determined by the market; the subsidy on kerosene and LPG has
been reduced and the private sector is looking once again to invest.

  As regards the ‘soft power’ of public opinion, this has often been deployed by countries to help strike the right balance between the Market and the State and to manage the political dilemmas. This is because in an electoral democracy, public opinion is the politician’s lodestar. When that shifts, the politicians move in synch. Many countries have used this power to effect change. Malaysia, for instance, expended much effort to explain to its public the benefits of a market-driven pricing structure. They explained that subsidies took away funds from essential infrastructural investments to the longer term detriment of public welfare. Their efforts paid off and they were successful in effecting their deregulation programme. The Indian government should have made a similar effort to educate the public on the costs and consequences of subsidies and regulation on the macroeconomy and social (education, health) and physical (roads, ports, housing, water) infrastructure investment. They should have tested the assumption that consumers are loath to give up the benefits of subsidies even though the bulk of subsidies are sequestered by the middle man and the corrupt, and does not reach the intended beneficiary. They should have researched the question: ‘Might the consumer prefer a small and phased increase in the price of essential fuels in return for the assurance of secure, affordable and quality fuel supplies?’ In the absence of such an effort to ascertain the views of the public, the government went with the conventional wisdom that consumers will not accept short-term pain in return for possible long-term gain. In the absence of effort to secure public support for ‘good economics’, they followed blithely the path laid out by what they believed was ‘good politics’ and brought the deregulation process to a standstill.