Administered Price Mechanism

From 1970s to 2002, there was an Administered Price Mechanism (APM) system in place in oil sector. Under this system, the oil and gas sector was controlled at four stages viz. production, refining, distribution and marketing. The supply of raw material to the refineries at point of refining was done at a predetermined price called ‘delivered cost of crude’. The finished products were also made available at predetermined priced called ‘ex-refinery prices’. The overall regime was based on the principle of compensating normative cost and allowing a pre-determined return on investments to the oil companies. For example ONGC and OIL were compensated for their operating expenses and allowed a 15% post-tax return on the capital employed. Both ONGC and OIL sold crude to refineries at $7-8 per barrel when the prevailing oil price was $17-19. Government regulated sourcing and import of crude, its refining as well as its sale till it reached the end consumer.

This system worked till 1980s when there was an upward swing in the oil prices. The escalating demand made the PSU’s overburdened and this started the series of additional imports of crude oil at very high costs. So the need was felt for deregulation and decontrol. There were some other reasons also that led to dismantling of the APM in late 1990s. Firstly, the the idea of providing returns on cost-plus formula was not encouraging to encourage efficiency in prduction because it was not at all profit motivated. Secondly, oil sector had started getting gradually decontrolled in late 1980s and part by part foreign, private investment was made opened in most activities of this sector. So long only PSUs were players, government was able to effectively control the investments and costs. But as the entry of the private sector happened; the inflated costs posed a risk to the PSUs. Thirdly, since any government decision could affect the profitability; the oil sector did not see any substantial investments.

After the new Industrial Policy of 1991, the government first opened refinery sector for private participation. This led to emergence of one of the largest players – Reliance Refinery. The decision to move from a the industry to a market driven petroleum sector was the most important decision which resulted in the dismantling of the Administered Price mechanism in April 2002.

Under the new regime, Oil Marketing Companies (OMCs) were made free to set retail product prices based on a so called import parity pricing formula. The domestic refining and retail sector was also opened to private-sector firms, leading to the emergence of a small private-sector retailing presence in India consisting of firms such as RIL. Because of the importance of LPG and kerosene, per unit subsidies funded from the government’s budget were maintained on LPG and on a fixed proportion of supplied kerosene.

This system continued till mid-2004, when it was effectively abandoned, with the Central Government once again centrally controlling upward price revisions. The government used to increase / decrease the price of petrol and diesel, and the prices of LPG and kerosene prices have remained effectively fixed due to heavy subsidy upon them.

• The prices of petrol and diesel were protected because of the importance of these products as transport fuels (especially as they are widely used in public transport, food freight, etc).
• Diesel in particular is important, as it makes up over one-third of India’s petroleum product consumption, and has uses outside transport, e.g., as an input into agricultural production.

The abolishment of APM led to the private-sector to rapidly set up retail operations and all of a sudden we saw rise of many new petrol pumps belonging to RIL, Shell and Essar. But when the prices again come under de facto control of the government, these three private firms which had retail license in India were forced to close their retail outlets across India, because of uneconomical business of retail trading of petrol and diesel.

Till recently, India maintained price controls on four “sensitive” petroleum products – petrol, diesel, liquefied petroleum gas (LPG), and kerosene. India’s government-owned Oil Marketing Companies (OMCs) were tasked by the Government of India (GoI) to sell these products in retail markets at a centrally determined sales price. Upward revisions to prices in response to higher global crude prices were rare. The upwards revisions were subject to all kinds of political implications as well.

The objective of these controls was to insulate consumers against high global crude oil prices.  But due to frequent ups and downs in the oil prices, the Oil Marketing Companies started recording significant “under-recoveries” on the sale of sensitive petroleum products. Under recoveries is a measurement that represents more or less the difference between the refinery-gate cost of refined product paid by OMCs and their managed sale price.

Under-recoveries are calculated as the difference between the cost price and the regulated price at which petroleum products are finally sold by the OMCs to the retailers after accounting for the subsidy paid by the government.

A large part of these under-recoveries is compensated for by additional cash assistance from the government (over and above the fiscal subsidy). Some part is also compensated by the upstream companies while remaining portion remains uncompensated to the OMCs. In 2008, the highest prices of crude oil in the international market led the OMCs under-recoveries to be around USD 25 billion. The Government had to issue hundreds of billions of Indian rupees to OMCs to counteract mass under-recoveries since 2005 in order to maintain the solvency of these key companies. Most of this funding was done using the debt securities called Oil Bonds. The drag on fiscal condition of the country was very acute.