(EnergyAsia, July 28 2010, Wednesday) — By Vivek Shankar Mathur, Associate, Energy Security Analysis Inc (ESAI).

Summary: The end of price controls on gasoline and diesel (in phases) in India marks a clear break from previous attempts at price deregulation and indicates a renewed emphasis on domestic energy sector reform. In the short-term, this move will benefit private refiners Reliance and Essar, who now have the incentive to supply fuels in India’s domestic market.

In the longer term, this policy should encourage foreign participation in India’s refining and fuel retail sector and may well signal the first true step towards a liberalised and transparent oil market in the country.

Winds of change

In 2009, India’s oil demand ranked just behind the US, China and Japan. Demand for oil products grew at a robust 6% on average in the last five years. At the same time, India continues to import well over 70% of its demand for crude oil. Although India’s energy requirements certainly reflect the needs of a growing economy, its domestic oil demand has also been encouraged by an inefficient system of fuel subsidies.

This system may well be a thing of the past if the Indian government sticks to its recent commitment to end price controls on gasoline and diesel. The policy effectively permits India’s state refiners the freedom to set retail prices. The price of diesel will also be market-determined, but on a slower reform path.

Isn’t this the same old song?

Indisputably, India’s track record of fuel price deregulation has been poor. There have been instances of oil product decontrol in the past, notably in 2002, when state-owned refiners were permitted to set retail prices twice a month. However, that policy ended in 2003 after a controversial decision by the then Bharatiya Janata Party (BJP) led-government to stop the fortnightly revision of auto fuel prices before the May 2004 elections. Since then (as well as in 2002) all retail price revisions of auto fuels have been determined by oil marketing companies under advice from incumbent governments. The announced plans certainly signal a strong break from the past.

There is also a greater degree of political commitment towards energy reform. India’s policy makers are much more serious about tackling India’s yawning fiscal deficit (now estimated to be over 5.5% of India’s GDP), and Prime Minister Manmohan Singh’s coalition government (the UPA) has been slowly taking important steps towards energy price reform in India:

In May 2010, for example, the Cabinet issued a price hike for the natural gas produced by ONGC and OIL and brought it to par with the prevailing private market rate of the gas produced and marketed from Reliance’s offshore KG-D6 fields in east India. This was a much needed reform for the public sector’s upstream companies whose marketed gas prices had not been revised since 2002.

The momentum for reform also stems from the current coalition government’s increased confidence in its political mandate – it won a second five-year term in office last year, and more recently survived a no-confidence vote (over a proposed increase in fuel prices in this year’s Budget) in Parliament in April 2010. In a worst-case scenario, if there is a roll-back, ESAI believes it will be delayed until 2014—after the next general elections.

The need for diesel price deregulation

The impact on India’s oil demand at this point in time is limited. Gasoline remains the rich man’s fuel in India, and a moderate price hike will not reduce demand for the product significantly. For oil demand to fall, it is more important to deregulate diesel prices fully—as diesel constitutes the largest piece (almost 40% or 1 million b/d) of India’s oil demand. In contrast, gasoline demand accounts for only 10% (300,000 b/d).

India’s diesel demand growth has averaged a healthy 6.6% (60,000 b/d) in the last five years, led by rising demand in transport, agriculture and off-grid power generation. India’s diesel demand is currently forecast to rise to almost 1.5 million b/d by 2015. At these rates of growth, India’s policy makers have certainly taken an important step to move away from subsidising diesel.

While diesel price deregulation will remain a more politically sensitive issue than gasoline, we do expect the pace of diesel price deregulation to quicken by the middle of 2011—after some of the UPA government’s coalition allies will have undergone regional and state elections.

If diesel prices are fully deregulated, higher prices could make India’s subsidised consumers take efforts at conserving fuel use. Diesel consumption may also be managed more efficiently: a policy currently being discussed is how to divert diesel use more in the rail freight sector than in trucking, for example. 

Reliance and Essar and the domestic market

The immediate impact of this deregulation of gasoline (and eventually diesel) prices will be an increased focus on India’s domestic oil market by private refiners Reliance and Essar. Both refiners have until now focused on external markets because they were not part of the government’s subsidy-sharing mechanism, making it uneconomical for them to sell in the domestic market while state-owned refiners sold subsidised fuels.

A more competitive domestic retail market provides both Reliance and Essar the incentive to expand their retail presence and supply gasoline and diesel in India.

A nation-wide fuel spec switch to Euro-3 gasoline and diesel (Euro-4 in select cities) this year also means these refiners have an outlet for their clean fuels in the high-growth Indian domestic market. As the phased policy of diesel deregulation becomes clearer, ESAI believes it is likely that these private refiners will export lower volumes of gasoline (and subsequently, diesel) in the coming months—some much needed bullish support for Singapore refining margins.

The enhanced presence of Reliance and Essar in the domestic market will also pressure state-owned refiners in the fuel retail sector. They may not necessarily lower refinery utilisations, however. They will utilise their advantage of being more geographically dispersed in the country, and an already-present system of distribution and retail networks. They are also likely to increase fuel sales outside metropolitan areas as well.

Investment in the downstream sector

In the long-term, ESAI also expects this move to make India’s downstream oil sector more attractive to foreign partners. India’s past attempts at wooing foreign investment in the downstream sector has met with failure–both Kuwait and Saudi Arabia have either pulled out, or have been disinterested in taking stakes in various refinery projects recently. A deregulated market with fuel retailing rights could provide these companies the incentive to access India’s rapidly growing domestic oil market whilst providing additional funding, and secure crude supplies for various downstream projects to their Indian partners.

In sum, while India’s road to complete deregulation of auto-fuels is fraught with challenges, the new policy is a clear break from the past. If India’s policy makers remain true to their commitments, ESAI believes this policy could mark the first true step towards a liberalised and transparent domestic oil product market in India.   

The author is an analyst with Energy Security Analysis (ESAI). He can be contacted at +1781-245-2036 x 27.