For quite some time, media has been agog with strident criticism about Modi government’s alleged inability to come up with big bang reforms. One area where it has been targeted the most for alleged delay pertains to pricing of gas. To put things in perspective, a few words on the background are in order.
In 2007, based on recommendation of a group of ministers (GoM), then UPA government had approved a price of US$ 4.2 per million British thermal unit (mBtu) – on net calorific value (NCV) basis – for gas supplies from Reliance Industries Limited (RIL’s) KG-D6 fields [awarded in first NELP (new exploration and licensing policy) round 1999] chargeable for 5 years from commencement of production. This price was also made applicable to supplies from ONGC/OIL – mainly to fertilizers and power sectors – under administered price mechanism (APM) that had been in vogue since 1987.
Dr Rangarajan Committee Pricing Formula
In April, 2009, production from KG-D6 fields commenced. Therefore, as per GoM decision (2007), next price revision was due from April 2014. Demonstrating extreme urgency – rarely seen in annals of policy making in India – in early 2012, government set up a committee under Dr C Rangarajan, chairman, prime minister’s economic advisory council (PMEAC) to recommend a formula.
The committee submitted its report in December, 2012 and in June, 2013, the cabinet committee on economic affairs (CCEA) approved a new structure of gas pricing based on Rangarajan formula to be effective from April 1, 2014.
The formula takes average prices of global benchmark at Henry Hub (USA) and NBP (national balancing point), UK on one hand and producers net-back from supplies of liquefied natural gas (LNG) to India and Japan in preceding 6 months on the other. On this basis, the price worked out to US$ 8.4 per million mBtu. The committee was silent on whether the price would be NCV basis on gross calorific value (GCV) as is the international practice.
Approved by erstwhile UPA regime
CCEA approved Rangarajan formula despite strong opposition from fertilizer and power ministries who pointed out the serious implications for production cost and in turn, increase in subsidy. The cabinet got over the resistance on the basis of a commitment that government would work out a special dispensation to address concerns of these sectors which account for about 75% of domestic gas consumption.
In August, 2013, Parliament’s Standing Committee (PSC) protested against the formula and asked government to re-consider its decision keeping in mind cost of production from domestic fields. This was in line with the production cost approach followed all along for determining producer price in respect of domestic supplies from ONGC/OIL till 2007 as per Kelkar formula.
Rangarajan formula based price is also out of sync with prevailing prices in other countries viz., US$ 2.6 per mBtu in Russia; US$ 3.3 per mBtu in USA and US$ 1.5 per mBtu in UAE.
On January 10, 2014, UPA government approved the new structure of gas pricing based on Rangarajan methodology. While giving the green signal, it not only ignored PSC recommendation, but also showed complete disregard to concerns of fertilizers and power (promised special dispensation was also quietly buried). However, notification of new pricing regime was held back on directions of Election Commission till election results rolled out.
Rangarajan formula ‘Modified’ by Modi
Immediately after swearing-in on May 26, 2014, Modi set in motion ‘brainstorming’ sessions with key ministers viz., finance and oil & gas etc to come to grip with the contentious issue and understand its nuances. Considering its widespread ramifications for economy, on June 25, 2014, CCEA deferred decision for 3 months to allow time for consultations with all stakeholders viz., exploration and production (E&P) companies and users such as fertilizers, power, CNG (compressed natural gas), PNG (piped natural gas) etc.
Meanwhile, in August, 2014, government set up an inter-ministerial committee of secretaries (CoS) under chairmanship of secretary, petroleum & gas which included secretaries from fertilizers, power and expenditure. The committee held discussions with industry representatives & other stakeholders and submitted its recommendations on September 16, 2014.
Based on the recommendations of CoS, on October 18, 2014, CCEA approved a price of US$ 5.05 per million Btu on GCV basis using a ‘modified’ Rangarajan formula. The modification involves dropping of LNG price of gas supplied to Japan and price of LNG imports by India and substituting these by Alberta Gas Reference (AGR) price for consumption in Canada and actual price in Russia weighed by consumption in Russia.
On NCV basis, the price works out to US$ 5.61 per mBtu and is applicable for the period November 1, 2014 to March 31, 2015. Thereafter, the price will be revised bi-annually (once in 6 months) and will be computed by taking weighted average prices of relevant indexes viz., Henry Hub (USA), NBP (UK), AGR (Canada) and Russian price for a full year three months prior to the effective date for next revision. Thus, for price effective from April 1, 2015, the reference period will be January–December, 2014.
The price computed as above will be applicable to gas supplied from ‘nomination’ blocks of ONGC & OIL; supplies from blocks given under NELP; blocks under pre-NELP where production sharing contract (PSC) provides for price approval by government and coal bed methane gas (CBM).
Pricing arrangement for supplies from KG-D6
For gas supplies from D1 & D3 blocks of KG-D6 fields, even as consumers pay revised price US$ 5.61 per mBtu, RIL will only get existing price US$ 4.2 mBtu and the differential amount will be deposited in a gas pool account (GPA) to be maintained by Gas Authority of India (GAIL). The arrangement will continue till such time RIL fully makes up for the cumulative shortfall in gas supplies during the past 4 years (1.9 trillion cubic ft) vis-a-vis commitment under PSC.
The disposition of differential amount will be decided based on the outcome of pending arbitration proceedings in the case (proceedings were initiated by RIL in November, 2011 against government’s decision to impose penalty for former’s failure to meet production targets as envisaged under PSC). Thus, if it turns out that RIL deliberately suppressed production, the amount will be appropriated by government. On the other hand, if decline in production is found to be the result of geological or other technical reasons therefore beyond its control, the amount will be released to RIL.
Premium for deep/ultra-deep water blocks
For deep water blocks, ultra-deep water blocks and blocks with gas at high temperature and pressure which present challenging geological and physical environments entailing higher capital cost in exploration and production, government will consider giving a ‘premium’ price. This price will be determined in a transparent manner based on a clearly laid down criteria. To prepare for this, consultation with stakeholders has been initiated and the exercise is expected to be completed in early 2015.
A critical evaluation of ‘Modified’ R-formula
Delivered in record time
True to its commitment to deliver results on a fast trajectory and despite other pressing national and international commitments – requiring urgent attention – Modi government has delivered on new gas pricing policy within record time of less than 5 months from the day it took charge. Considering complexities of the issue and the many pulls and pressures, this is an exemplary achievement.
Brings lingering uncertainty to end
The policy puts an end to the uncertainty of the policy environment and provides a viable and sustainable basis for attracting investment in exploration and production besides ensuring optimum utilization of already discovered fields for maximizing production.
Respects market-based principle
The formula based pricing of gas is consistent with the underlying spirit of PSC which requires price to be determined on market principle. The indexes in formula are picked up from countries viz., USA, Russia, Canada etc where markets for gas are well developed and prices are determined in a competitive manner. This serves as a good proxy for a country like India where gas market is in a nascent stage and producers cannot be left free to charge any price of their asking as that is bound to be exploitative – given huge shortfall in domestic supply vis-a-vis demand.
Critics allege that the formula has been modified with a deliberate intent to suppress the price and the price arrived in this manner does not reflect the true opportunity cost of gas or replacement value of fuels such as naphtha or fuel oil that it seeks to replace. Both the allegations are baseless and totally out of context.
Removes ‘aberrations’ in R-formula
The reality is that it was none other than the Rangarajan formula that was orchestrated with an intent to artificially jack up the price to confer an un-warranted bonanza to E&P companies. This is amply demonstrated by the committee deciding to include the price of LNG imported by Japan and India. Japan is neither a producer nor an international trading hub for gas. Taking advantage of tight global demand supply balance, the price on supplies to Japan is artificially inflated and contains hidden margins. This also holds for LNG supplies to India.
The price of gas in exporting countries is a ‘fraction’ of what importing countries such as India or Japan pay. In Oman, the ammonia/urea joint venture of OOC (Oman Oil Company) with Iffco/Kribhco gets gas at no more than $3 per mBtu. The price even at Henry Hub (USA) is $3-4 per mBtu. Yet, on reaching India, it shoots to $12-14 (or even higher) due to liquefaction, transportation, re-gasification, etc. These add-ons are not relevant in the context of pricing domestic gas.
It may be argued that the aforementioned components are removed and only net-back prices are included in Rangarajan formula. Once on principle, it is accepted that these are irrelevant then, why in the very first place, look at landed cost in importing country and then work backwards? This can lead to lot of subjectivity and hidden margins creeping in; indeed this is precisely the reason behind the formula leading to ‘exceptionally’ high price.
In view of above, the ‘modified’ formula based on CoS recommendation has very rightly deleted LNG import by India and Japan from calculations and substituted by gas prices in Russia and Canada even while retaining HH (USA) and NBP (UK). This results in a drastic drop in price from US$ 9.3 per mBtu on NCV basis (corresponding to US$ 8.4 per mBtu on GCV) under R-formula to US$ 5.6 per mBtu under ‘modified’ R-formula.
Clearly, the price as per modified formula approved by the government is a competitively determined price and reflects the true opportunity cost of gas that should yield to producers of gas in India returns comparable to those obtaining in other countries.
Looking at gas as a replacement for other fuels like naphtha, fuel oil etc – as suggested by critiques – is also not tenable. This is because globally gas is the most preferred feedstock/fuel in major user industries such as fertilizers and power. In India too, this is the predominant feed used in fertilizer production (nearly 80% of capacity is already on gas and rest is in process of being switched over). Therefore, gas pricing has to be on its own and linkage with alternate fuels is totally un-warranted.
Gives ‘incentive’ for investment
The ‘modified’ R-formula yields a price that will provide an opportunity to E&P companies to make a reasonable return on their investment. As per an assessment by ministry of petroleum & natural gas (MPNG), at a price of US$ 5.61 per mBtu, investment in new discoveries like Gujarat State Petroleum Corporation (GSPC) in Deendayal bloc in Bay of Bengal, RIL in Cauvery (CY-D5), KG-D6, (R-Series) and ONGC, Mahanadi (NEC-25) block will be viable.
Moreover, since the price is adjustable every 6 months based on the movement in indexes encapsulated in the formula, this can move upwards as well giving ample opportunity to investors to further improve upon the returns. The other big advantage is every thing under the new dispensation is ‘open’ and ‘transparent’ thereby giving a stable policy environment and ensure that companies can do their calculations with precision and certainty. In other words, unlike previous regimes, no surprises will haunt them!
Here it may be worth citing a statement by finance minister, Arun Jaitely who stated ‘new gas pricing regime is profit centric and will encourage companies to invest in exploration and production’. At the same time, he went on to add ‘it won’t guarantee above normal profit’. Surely, this may have disappointed those who were gunning for a price of US$ 9.3 per mBtu or even higher.
The attractiveness of new pricing structure is also corroborated by a statement of ONGC chairman that at US$ 5.61 per mBtu, investment in the KG-DWN-2 fields (adjacent to RIL’s KG-D6) in the Krishna-Godavari basin will be viable. He exuded confidence especially taking in to account the longer recovery period of capital expenses over 20-25 years or so.
Double-speak by private E&P companies
Representatives of private gas companies have come up with a strange argument in support of their inflated ambitions. Thus, they say that price prevailing in USA, Canada and Russia cannot be used for determining price in India as exploring gas fields in former is much easier entailing lesser investment (much of that is ‘associated’ gas oozing out along with oil) as against latter where geological conditions are challenging leading to higher investment.
By using this line of argument, are they now suggesting that government should go for cost of production approach? Having advocated market based pricing all along, how can they now do a turn around? The irony is that even on production cost methodology, they are not in a position to justify higher price. Let us look at some facts pertaining to KG-D6 which is a deep water field.
In 2004, DGH had approved an initial development plan (IDP) of US$ 2.47 billion for recoverable resource at 3.81 trillion cubic feet (Tcf) and corresponding production 40 mmscmd with first gas coming in August 2006. However, in October 2006, RIL submitted vide an addendum to IDP increases in capital expenditure requirement to US$ 8.8 billion and recoverable reserves to 12.04 Tcf.
In December 2006, a management committee (MC), comprising representatives of DGH, oil ministry and the operator, approved revised plan for US$ 8.8 billion putting recoverable reserves at 10.03 Tcf and doubling of output to 80mmscmd. The cost was subsequently revised to US$ 5.6 billion.
With production @ 80 mmscmd even at existing price of US$ 4.2 per mBtu, RIL would be able to recuperate the entire investment of US$ 5.6 billion in just about 15 months. During the last 4 years, it produced much less than the committed quantity and yet has already recovered the entire capital expenses. Clearly, on production cost approach, there is absolutely no case for any increase in price even over existing level.
Optimizing production – key to viability of investment
A key factor in determining the viability of investment – hitherto ignored by E&P companies – relates to the dire need for maintaining production from discovered fields at committed level. While, a few percentage variation is normal in any business, in case shortfall is substantial (as happened KG-D6 where production has fallen to less than 10 mmscmd recently as against committed 80 mmscmd) then, any price level howsoever high will be inadequate to ensure the viability. Therefore, companies need to give requisite attention to this over-arching factor.
A supportive ‘regulatory’ architecture
On its part, government is helping them by removing procedural hurdles. In this regard, production sharing contract (PSC) is being amended to provide for flexibilities in various milestones viz., (i) extra time for submission of declaration of commerciality (DoC) and field development program (FDP); (ii) reduction in minimum work program (MWP) in blocks overlapping with SEZ, reserve forest, navy/space/defence/ armed forces danger zone; (iii) swapping of 2D and 3D seismic MWP; (iv) entry in to subsequent phase, once cost of unfinished work is paid for; (v) condoning delays in submission of notice for entering in to next phase; (vi) drilling of appraisal wells after submission of DoC and (vii) probing additional reservoirs during appraisal program.
Director General of Hydrocarbons (DGH) and Management Committee (MC) (MC includes besides DGH representatives of E&P companies and ministry of petroleum and natural gas) have been empowered to grant the aforementioned flexibilities. Under the erstwhile dispensation, all such cases were required to be approved by the cabinet leading to huge delays in development of the fields.
More leeway can be provided to companies by granting exploration and production rights for oil & gas fields over their entire economic life. Under extant regulations, the tenure of lease rights is for a lesser period though it is extendable by 10 years for gas/oil & gas fields and 5 years in case of oil fields. This is a major deterrent to operator who gets restrained from undertaking long-term investment commitment. A case in point is Cairns India fields in Barmer district of Rajasthan where current lease expires in 2019 whereas it has the potential of yielding oil for another 10 years. This anomaly will be taken care if rights are granted for entire economic life of the field as recommended by Dr Kelkar committee.
‘Balances’ interests of users with producers
While, formulating the new pricing policy, Modi government has kept to the forefront dire need to protect the interest of user industries especially fertilizers and power which together account for about 75% of total gas consumption. These are also the industries whose end products are used by millions of poor farmers and consumers where, the government is also required to give subsidy to maintain food security and serve welfare objective by ensuring access to power at affordable rates to the poor.
Adoption of Rangarajan methodology as such would have produced a debilitating effect on these sectors through a steep increase in price from existing US$ 4.2 per mBtu to US$ 9.3 per mBtu or by US$ 5.1 per mBtu. Instead, approval of ‘modified’ R-formula has restricted the increase to US$ 5.6 per mBtu or an increase of only US$ 1.4 per mBtu. To that extent, unlike the erstwhile UPA dispensation which showed scant regard for user industries, present government has performed a fine balancing act. While, giving incentive to E&P companies, it has also addressed concerns of gas consumers.
Nevertheless, some impact on these sectors cannot be wished away. The increase in gas price by US$ 1.4 per mBtu will increase urea production cost by US$ 34 per ton [24 mBtu (needed for a ton)x1.4] or Rs 2040 per ton. On 17 million ton gas-based urea, additional burden on fertilizer industry will be about Rs 3500 crores in a full year though during remaining 5 months of current year, this would be limited to about Rs 1450 crores. Since, maximum retail price (MRP) (controlled at a low level) remains unchanged, there will be corresponding increase in subsidy payments. For gas based generation plants, cost of power will increase by 60-65 paise per unit.
Offers a stable policy environment – for India’s energy needs
To sum up, the new structure of gas pricing is based on sound principles, strikes a judicious balance between the interests of producers and consumers and most importantly, provides a long-term and stable policy environment. Together with a sound regulatory architecture with necessary flexibilities in production sharing contract (PSC), this will provide a sound basis for development of a robust and healthy gas sector to meet ever expanding energy needs of the economy.
However, success of the policy will be tested by responses of the exploration and production companies who need to extend full cooperation through commensurate investment in new fields as also by optimum utilization of already discovered fields. They need to focus on maximizing domestic production so that dependence on high cost imported LNG can be reduced and critical user industries like fertilizers and power can get access to gas at affordable rates.
On its part, the government will need to bring about long-awaited reforms in both these sectors to give them required resilience to get adjusted to fluctuation in gas prices which henceforth will be market-linked. It needs to replicate the diesel story – an initial phase of calibrated increase in price followed by eventual decontrol – in both fertilizers and power. The policy makers must take this road-map sooner than later to give the benefits of competition to users by lowering prices/tariffs.
As regards, protecting the poor, assistance should be given to them directly in to their bank account for which a robust financial architecture is being put in place, thanks to Prime Minister Jan Dhan Yojna (PMJDY).