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Growth Hinges on Energy

The government needs to revive its gas policy & offer clarity on prices to decrease dependency on imports

The mess at Reliance Industries’ KGD6 offshore block is a good example of what can go wrong with regulation. When the strike was originally made, it was hailed as transformational for the domestic gas industry. By 2009-10, KGD6 was producing around 60 mmscmd (million standard cubic metres per day) of gas — over 40 per cent of domestic production at the time.

Based on that strike, and on other big strikes like Gujarat State Petronet’s Deen Dayal Field, it seemed that domestic gas demand could be met without recourse to imports. Downstream investments were made in pipelines and in city gas distribution (CGD) networks. Analysts projected that there would be an accelerated switch to gas for transport and cooking. Power plants and fertiliser plants breathed a sigh of relief in the knowledge of assured fuel and feedstock supplies. Two years later, the scenario has changed dramatically for the worse. KGD6 is producing only about 30 mmscmd and the output is projected to fall further. Downstream investments are stuck. Excess demand is being met by expensive LNG imports.

The cause of the dip in output at KGD6 isn’t clear. RIL claims it’s due to technical difficulties with sand and water entering the wells. RIL also claims that it needs to spend large sums in tandem with its technical partner, British Petroleum, to revive production at KGD6. The reserves estimates for the block have been downgraded. Obviously, there is a large problem. RIL has undergone several quarters worth of lower profits and revenues and eventually, suffered downgrades.

At the same time, there is a huge dispute between the Government of India and RIL which is likely to retard attempts to revive KGD6. RIL wants a considerably higher price for the gas it is evacuating. Originally, it had asked for the administered pricing mechamisn (APM) price of $4.2/mmbtu (million British thermal units) to be hiked to above $14 in this fiscal. Then it changed its stance and offered a formula for a price hike to about $12 when the current contract runs out in April 2014.

The price isn’t the only issue. The Ministry of Petroleum and Natural Gas (MoPNG) is only prepared to allow a certain percentage of what RIL says it has spent developing KGD6 to be written off. The MoPNG says that RIL hasn’t fulfilled the terms of the production sharing contract (PSC) by drilling the agreed number of wells. It is demanding that RIL opens its books to a CAG audit before it considers writing off a large chunk of expenses incurred in the past three fiscals. RIL on its part says the PSC doesn’t specify that a certain level of output must be hit before expenses can be written off. Whatever the truth, the PSC needs to be ironed out so that future exploration and production (E&P) activity isn’t hampered by ambiguous legal clauses. The government also needs to take a look at gas pricing in general. A poor gas policy could end up causing almost as much damage to the macro-economy as a poor petro-fuel policy has. India has estimated gas reserves of around 1,200 billion cubic metres (bcm), which would last around 26 years at the current rate of domestic output. The reserves estimate is a best guess made by experts on the basis of geological indicators. Most of the working fields are mature (Bombay High is over 30 years old).

New strikes need to be made and quickly developed if import dependency is to be eased. That will only happen if there’s sensible E&P policy with cast-iron PSCs, clarity on pricing, and perhaps, other incentives. Nine rounds of the New Exploration Licensing Policy (NELP) bidding have made a beginning and the government has stated its intention of opening things up with a more open acreage licensing policy. But global exploration majors have stayed away from the NELP and they will continue to stay away unless there’s clarity on the contractual front. Meanwhile, the government has to decide what it will do about shale gas and coal bed methane (CBM). There isn’t policy clarity on either of these fronts and these natural resources are not going to be developed until there is clear policy.

In North America, shale gas extraction has transformed the natural gas market in the past three years, albeit with huge environmental consequences. India also has big CBM resources, which remain untouched. Sooner or later, it will have to make policy decisions on shale and CBM. It needs to learn from the US experience to ensure that these resources are extracted in environmentally sustainable fashion.

Pricing gas is complex. There are huge regional price differences due to transport costs. Asian gas is generally linked to Japanese LNG rates. Those are trending above $16/mmbtu. Roughly 20 per cent of Indian gas comes from LNG imports. Some of that is imported on long-term contracts at $7/mmbtu and some imported at spot rates of $16 or more. For a long time, India has been negotiating for a Turkenistan-Afghanistan-Pakistan-India pipeline. If this comes through, and there are obvious geopolitical reasons why it may never fructify, it would mean a useful external supply. The price would be around $12/mmbtu.

India’s APM price is artificially low and more to point, arbitrary. There are times when spot LPG rates have been lower than the APM. The power and fertiliser sector largely benefit from this APM because they get priority allotment of domestic output. Cooking gas and CNG is also sold at low controlled prices but these segments are under increasing pressure because imports are required to meet the domestic demand-supply gap. CGD has been stalled because of supply constraints. Without CGD, the economy will remain stuck in a loop of using diesel and kerosene in circumstances where gas would be cleaner and cheaper, net of subsidy.

Suppose the government learns nothing from the KGD6 situation. Things will get stuck in a long dispute with litigation, exploration will remain stalled, CGD networks will remain stalled and pipelines will remain stalled. Pricing policy will presumably not be reviewed. But demand will grow anyhow. Gas usage is likely to double at the minimum in the next 10 years — it could triple if constraints are removed. India’s current energy mix has about 10 per cent contribution from gas. The global average is closer to 30 per cent. As kerosene is replaced as a cooking fuel (and a source of lighting) and as diesel is replaced as a transport fuel in public transport, gas usage will rise. If the bottlenecks are not cleared, that will mean a larger import burden and potential problems in gas similar to the financial problems in the crude value chain. Gas is politically sensitive. If the government subsidises the domestic price while buying in hard currency at higher prices, it will run into the same problems it has with crude. In that case, count on a bigger trade gap and larger fiscal deficit.

Let’s say the government learns from the KGD6 situation. It reviews and rewrites the PSCs and in the next round of bidding for exploration blocks, it gets a better response. Let’s say it also works out a better market-linked formula for gas pricing. Or it gives bulk consumers the option to buy where they will at market rates, and sell at what rates they can get. Either way, the market will develop faster. There will be less import dependency because there will be an incentive to develop domestic resources. Downstream investments in pipelines, CGD, power plants will come up and these businesses will all be established assuming realistic input prices. Hence, these businesses will be sustainable. No economy can grow without secure sources of energy. India is deficient in crude, it is deficient in gas. The domestic coal industry is badly run and despite ample reserves, India has to import coal. The power sector has huge accumulated losses and it cannot even meet current demand. Solar, wind, biogas and other renewable resorces could take decades to be really meaningful.

All the grandiose plans and projections of an 8 per cent GDP growth will stand and fall on the foundations of sustainable development of the energy sector. So far, successive governments have failed to put energy security on a firm footing. Gas is, relatively speaking, in better shape than crude or power. KGD6 could be a tipping point for this fuel and its value chain.