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The Deficit of Reason

The gas the Ambani brothers are fighting over can make an enormous difference to the energy security of the country

The Reliance Natural Resources (RNRL) - Reliance Industries (RIL) gas contract controversy has generated a lot of hot air which obscures the fact that it has enormous implications for the development of this key industry. The contract is sub-judice and how it is resolved will be crucial for the gas markets. One of the key points is that the original contract pricing of $2.34/BTU in 2003 is around 44 per cent less than the $4.2/BTU set by an Empowered Group of Ministers (EGoM) in 2007.

Obviously it is up to the Supreme Court to decide on the merits of the contract. However, until a decision comes through, offtake from RIL's gas fields in the Krishna-Godavari (KG) Basin will be in abeyance. Also, investments into other fields in the KG Basin, such as GSPC's discovery as well as downstream investments in pipelines and in key consumption sectors such as power, city gas and fertilisers, will be in neutral mode.

This is a great pity. India has been historically a gas-deficit economy. The finds in the KG Basin hold the promise of changing that situation and could, over the next five years make an enormous difference to the energy security of the country. But not if the Government of India (GoI) continues to treat the industry as a fiefdom.

Since the mid-1980, the GoI has always set gas prices and rationed out allocations according to its own calculations. This is part of the Administered Pricing Mechanism (APM) that is supposed to help deal with energy shortages. According to APM, so much gas is allocated to power plants, so much to fertiliser manufacturers, so much to retail (transport and cooking). Each segment of consumers pays a different price.

APM in itself is wrong-headed. It has led to under-investment and irrational investment because it distorts the impact of market forces. Power plants and fertiliser plants have been built on assumptions that gas would always be supplied at prices way below market. APM also crippled the exploration capabilities of ONGC, which was reluctant to invest in new fields.

Globally, gas is a freely-traded commodity just like petrol, coal, etc. Its price fluctuates according to the laws of supply and demand. When the New Exploration and Licensing Policy was launched in 2000, businesses entered exploration in the hopes that APM would be removed and they would be allowed to charge rates tied to global prices and to sell to anyone who would pay those rates.

The finds in the KG Basin mean that India will cease to be gas-deficit. There is enough gas to satisfy the power sector, the fertiliser sector, transport needs (where public vehicles move to CNG from diesel and petrol) and also household consumption and small scale industrial needs. There are external supplies as well with terminals at Dahej and Dabhol where LNG cargoes can be landed.

This change in market dynamics is reflected in the huge investments that have flowed into pipeline infrastructure. It has also been reflected in the enthusiastic way in which companies have bid to set up new city gas distribution networks.

All this means that there is no need to ration gas supply anymore. Nor is there a need to set prices. However, the GoI has no intention of releasing control. While GoI-controlled fields will continue to run on the old APM, it has developed new pricing and allocation formulae for the new fields, whether privately-run or run through joint ventures.

The EGoM and its elegant formulae of weightage to global gas prices and allocations to various sectors appear unnecessary. If it washed its hands of the sector and walked away, anybody who wished to buy gas could do so at market-determined prices. Businesses that use gas as fuel or feedstock would not pay more than the landed rate of overseas transporters. Nor would they buy gas at prices that made their businesses unviable.

Demand and supply would be automatically matched. Independent regulators like the relatively new PNG Regulatory Board could fulfil the role of ensuring that predatory or monopolistic practices did not prevail.

That is how markets are supposed to work. It would cause far less in the way of long-term distortions down the value chain if the new gas market was allowed to work this way. It would also make life much easier for investors either in the sector or in downstream areas where gas supply and pricing are critical inputs. Valuation models are designed to cope with the fluctuations of commodity prices, not to second-guess ministerial policy decisions.

This article appeared in the August 2009 issue of Wealth Insight