The oil pricing formula

Source: http://www.dawn.com/2008/08/03/ed.htm#5


By Asad Sayeed and Vikash Ahuja


AFTER yet another price hike in petroleum products, people reeling under the burden of a constant and seemingly endless inflationary spiral are legitimately asking the question whether such sharp increases in petroleum prices are necessary?

An increasingly vigilant media having dissected the different components of the retail price of petroleum products has challenged the government’s decision to keep taxing petroleum products and for allowing the refineries, the oil marketing companies (OMCs) and dealers to rake in huge profits at the cost of the consumer by linking their returns to international oil prices.

A number of these concerns are valid. However a focused analysis of the different components of pricing is necessary to understand who gets what and at whose cost. It is also necessary to understand the compulsions of the government in light of the external and internal imbalances it is confronted with.

There are essentially four elements that constitute the price that the consumer pays on petroleum products. The import parity price is the first element. This comprises the import price, adjusted for government subsidies and duties. To this cost is added the Inland Freight Equalisation Margin (IFEM) that is charged by the OMCs to sell petroleum products at a uniform price across the country. To these two elements is added a 3.5 per cent margin for the OMCs, and four per cent for dealers, of the combined cost of the two elements described above. The sum total of the above three is then subjected to 16 per cent general sales tax by the government.

The frequent lament in the media is that a large chunk of the retail price is the sales tax. The magnitude of taxation in the prevailing price of petroleum and high speed diesel comes to Rs11.95 and Rs8.92 per litre respectively. Moreover, an increase in the international oil price automatically increases the revenue yield of the government.

For the government to forsake revenue through the sales tax in given conditions will be a folly for two reasons. Firstly, once we factor in the subsidy the government provides, the relevant figure to look out for is net taxation (sales tax minus subsidy) rather than sales tax per se. For instance, in the fiscal year 2007-08, the subsidy on petroleum products was Rs175bn, whereas revenue from sales tax was Rs118.2bn. Net taxation in the outgoing fiscal year was, therefore, Rs56.8bn. If the government had reduced or removed the sales tax, the amount of subsidy would have been proportionate to the foregone revenue.

It is important to emphasise that subsidies are not a free lunch. State subsidies are generally financed either through bank borrowing (in other words by printing money) or by borrowing from international or domestic capital markets. If the subsidy is financed through printing money — as the Musharraf government did in the outgoing fiscal year — it creates an inflationary spiral in the economy and wipes out the benefit provided through the subsidy.

Alternatively, if the subsidy is financed through borrowing from capital markets, it creates a future liability on the taxpayer in the form of debt servicing. Now if there are good tidings expected in the future — in the form of a more favourable international environment and high GDP growth domestically — then it may be worthwhile providing a generalised subsidy. But if the future is uncertain, as it certainly is presently, then this becomes a risky proposition.

Second, for a revenue-starved state (remember Pakistan’s tax-GDP ratio at 10 per cent is one of the lowest in the developing world) the petroleum sector is a source of least resistance for tax collection. Until the state broadens its tax base to devise a truly progressive taxation structure and reallocates its expenditure away from territorial to human security, removing the sales tax on petroleum products will only amount to enhancing the fiscal deficit which will have to be paid by present or future taxpayers, perhaps at even more onerous rates. In the present milieu, it only makes sense to provide targeted subsidies to the most vulnerable sections of society rather than subsidise everyone.

The margins of OMCs and dealers, however, have rightly come under fire and in the recent price increase their margins have been frozen. But this is not enough. The formula of linking margins to a proportion of the import parity price and the freight equalisation margin is fundamentally unjust and irrational. It is irrational because distribution or dealership has no link whatsoever with fluctuations in international oil prices.

It is unjust because this formula enables the OMCs and dealerships to rake in profits on the basis of exogenous developments (international oil prices) at the cost of both the state and the consumer. If there was ever an example of blatant profiteering — devised by the Musharraf government, small wonder — as a consequence of collusion between self-appointed policymakers and the corporate sector, this was it. Rather than arbitrarily freezing the margin as has been done now, the formula needs to be altered and margins should be determined on the basis of actual costs and ‘reasonable’ profits to the companies and dealerships.

Rent-seeking by the OMCs, however, is not limited to margins only. The freight equalisation margin is another source of dubious profiteering by these entities. The IFEM is used to equate the prices of POL products across Pakistan and covers primary transport costs incurred by OMCs to transport petroleum products. IFEMs are recommended by the Oil Companies Advisory Committee (OCAC) and are subject to adjustment on the basis of actual monthly freight computations. Since IFEMs are added to IPPs to calculate OMCs’ and dealers’ margins, it creates incentives for OCAC to set IFEMs at higher than actual levels, which not only increases their actual reimbursement but their margins as well.

To illustrate the extent of rent-seeking on the pretext of freight equalisation consider the fact that between Sept 1, 2007 and July 1, 2008 freight margins were increased by 348 per cent for motor spirit, 319.5 per cent for HOBC, 304.2 per cent for kerosene, 81.4 per cent for light diesel and 82 per cent for high speed diesel. This increase in freight charges is nothing short of daylight robbery on the part of the OMCs. Thus, where the government is rightly moving in on curbing the margins on distribution and dealerships, a serious review of the policy on freight equalisation margins is also required.

Another element in the pricing formula that adds to the windfalls of the refineries is the deemed duty benefit that they receive in the import parity price, primarily for diesel but also for other products. In 2001, it was decided to allow the refineries to retain the duty that was charged on local finished products for one year to upgrade their capacity. While some products have been taken off the list, seven years later the refineries are still charging this amount on diesel which constitutes the bulk of the volume consumed in the market. There is no justification, therefore, in allowing this pilferage on the part of refineries to continue.

While the fact remains that the bulk of the price increase in domestic prices is driven by surging world oil prices, some relief can be provided if the pricing formula adopted by the Musharraf-Aziz combine to benefit big business at the expense of the consumer is altered. Lately the OMCs and the refineries have adopted a threatening tone with regard to reduction in their illegitimate profiteering. It is high time their bluff is called and for the sake of the consumer, this relic of the past is undone as soon as possible.