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Crude Connections

If PSUs can export surpluses, the valuations should rise because financials improve sharply

Japan is famous for its high-quality steel manufacturing despite being an iron-deficit nation. It imports iron and exports value-added items like ships and cars to create huge trade surpluses.

India could develop a similar situation with respect to another key commodity — crude. India imports about 75 per cent of its crude and currently has around 12-15 per cent surplus refining capacity, which is exported in the form of petrol, diesel, aviation fuel, etc.

Most of India's refiners are undertaking major capacity expansions and although crude imports will rise, domestic refining capacity will ascend much faster. By 2012-13, India could generate huge forex surpluses on the petroleum front. This has very interesting implications.

Some rough numbers. India imported 128 million tonnes of crude last year - about 75 per cent of total consumption - for a cost of $76 billion ($67 bn in 2007-08). Over 160 mt of crude was processed by Indian refineries (Reliance's new 29 mtpa facility came onstream only in mid-December 2008).

About 135 mt of throughput was consumed domestically. Products from about 25 mtpa of throughput was exported for revenues of $30 billion, up from $7 billion in 2004-05. Petro-exports contributed 17 per cent of all merchandise exports.

Domestic consumption will rise at 7-8 per cent compounded annual growth rate (CAGR) over the next five years. Domestic crude production will also rise. Once Cairn's new Rajasthan fields and Reliance's offshore KG assets are in full production. India will produce 55 mtpa, up from the current 45 mtpa. (About 1 lakh barrels per day = 5 mtpa). By 2012, Indian refining capacity should be 260-270 mtpa, up from a current 175 mtpa. Domestic demand  will reach around 160 mtpa by then. About 100-110 mtpa of products could be exported.

Assocham did a study that suggested that by 2012-13 India's petro-product exports would fetch a surplus of about $70 bn over the import bill. The crude-product equation will clearly change to forex-surplus even if the estimates are optimistic.

What is the impact on refining and retail? Right now, Reliance and Essar Oil are the only exporters. But the public sector undertakings (PSUs) will contribute about 70 mtpa of the new capacity (some via joint ventures) and thus be able to export after meeting their domestic commitments. This improves their bottomlines and forex generation ability.

The logic for subsidies will change. The government has an administered pricing mechanism (APM) setting retail prices of diesel, kerosene, aviation turbine fuel (ATF) and petrol. (ATF and kerosene are the same substance, but priced differently for household consumption and for aviation).

When crude prices are high, PSUs in retail-refining such as IOL, HPCL and BPCL, etc, lose money. Private refiners find retail unprofitable due to APM. Reliance, Essar, Shell, ONGC, etc, have all set up retail pump networks and then shut down operations.

PSUs are partially compensated through oil-bonds that are redeemable many years later at low interest rates. Last year's losses due to APM were over Rs 100,000 crore and around Rs 22,000 crore of bonds were issued. Accounting jugglery makes PSUs technically profitable. The bonds are booked at full value though they can only be redeemed at deep discounts in practice. The Reserve Bank of India (RBI) takes special measures to enable bond sales and offer forex loans.

Not surprisingly, oil PSUs are traded at low valuations. Now, if PSUs can export surpluses, the valuations should rise because financials improve sharply. Also, if the dynamics of the industry change in this fashion, so does the rationale for APM. The political imperatives can be met through targeted subsidies to consumers rather than by artificially holding retail prices down.

Will this happen, and if so, how soon? There is one signal that changes are expected. Reliance is now, along with IOL, the largest refiner in India with a throughput of about 62 MTPA. It has withdrawn Export-Oriented Unit status on its earlier 33 mtpa facility. The new 29 mtpa facility will be an export-oriented unit (EOU). Reliance is also reported to be reopening its network of 1,400 retail outlets.

This means RIL expects to sell 33 mtpa in domestic retail. It cannot safely do so under the current APM because it could incur huge losses. To my mind, the implication is that there will be strong lobbying to induce a review of APM and the subsidy mechanism. Any policy changes that occur will benefit Reliance more than the PSUs, but it will have a positive fallout on PSUs as well.