An Inquiry into the debate on Petroleum & Privatization

For businessman minister Mahesh Lal Pradhan, who holds the portfolio of Industry, Commerce and Supplies, it must have been a very much embarrassing situation to sign the decision allowing the state monopoly Nepal oil Corporation (NOC) to hike the prices of two petroleum products – motor spirit (petrol) and LP gas. The embarrassment was perhaps compounded by the fact that the decision had to be signed within days of the announcement by the government of a relief package for the people adversely affected by the ongoing economic crisis. Moreover, the hike came just after a news report appeared in the press quoting the authorities that the government had returned the NOC demand for the permission to hike the prices of petroleum products.

For the general people it was enough to conclude that the new government was not going to be any better than its predecessors. The tradition of ‘governance by lies’ was not going to be changed.

While approving the price hike only in two products and rejecting the proposal to hike the price in diesel and kerosene, Minister Pradhan followed the logic that while price hike in diesel would very severely hamper the industries and raise the transport costs, thus increasing the prices in all the daily necessities, the hike in kerosene price was not justified as it was the only source of light for the poor in remote areas and only cooking fuel for the poor in urban areas.

Despite such care of the minister, there were however sharp public reactions denouncing the decision of the government. While the government and NOC clarified that the hike was necessary to cover up the losses that NOC was incurring, the consumer activists (such as the Consumer Protection Forum) demanded that if the leakages and irregularities within NOC are checked, there will be no need to increase the prices. Another standard official argument in favour of price hike in petroleum in Nepal is the need to keep the prices along the Nepal-India border at par so that there would be no incentive for smuggling in petroleum. The critics would say that if the government cannot stop smuggling, it forfeits the authority to govern. They simply overlook the reality of the economic incentive to smuggling.

More important point of the other critics is that the idea of keeping the kerosene price low has no plausible economic logic. While kerosene and petrol are said to cost almost the same in every country of the world because the production cost for both is almost the same, in Nepal kerosene is quite cheap, thanks to the subsidy on it on the basis of the logic that kerosene is an item for the consumption of the poor. But the subsidy on kerosene has rather benefited the rich more than the poor. For example, while the total amount of subsidy enjoyed by a poor is Rs. 7 only per month (if one litre of kerosene is enough for a year for the poor  who use it only for lighting purpose), the rich are enjoying a subsidy of worth several hundred times of what the poor does use it for room heating purpose. Though the consumer activists are demanding dual pricing – a cheaper one (less than the actual cost) for the poor and expensive one (more than the cost price) for the rich, by adopting the ration card system that India has been using, the experts do not see this idea as practical. A similar effort as using ration card system for kerosene made in Nepal a couple of years ago failed miserably. Moreover, as such a system has proved to a breeding ground for corruption in India, the economists and other experts in this field are strongly against this idea.

Whenever the government faces a difficult situation, the easy way out has been to set up a committee and ask the people to wait till the committee gives its report. The government did exactly the same also this time. The high level committee headed by a retired judge of the Supreme Court is asked to study how the leakages and irregularities occur in petroleum business in general and in NOC in particular and to suggest measures to stop these irregularities so that a smooth supply of cheap petroleum could be ensured. The tenure of the committee was 15 days and, as was expected it asked for an extension of another 15 days. Though it has already submitted its report to the government, the contents were not made pubic by the time this magazine went to the press. However, experts in this field say that the issues that the committee was asked to investigate are trivial. “There is no disagreement that irregularities and leakages must be checked, but the role of the irregularities in the determination of the price of the petroleum in Nepal is insignificant – as low as may be only 1%”, says Amrit Nakarmi, a former CEO of NOC. In his opinion, the most important factor in determining the petroleum price in Nepal is the international price and the high volatility in it. Giving idea about the volatility in the international price in petroleum, he estimates that the standard deviation in the prices is as high as 40%. “State owned companies simply cannot keep pace with the volatility in the international prices. The result is long backlog in price adjustment. Ultimately, the government raises the price in a single go and there is huge public outcry against the decision”.  The latest price rise (or the proposal for the same) has come nearly two years after similar price rise in Nepal.

For this reason this latest episode of petroleum price rise has given rise to a renewed demand for privatization of petroleum business and NOC. Talking at different forums after the latest price hike decision, Minister Pradhan himself repeatedly spoke of his preference to break the NOC monopoly. “I don’t like to see this single-horse race continued”, has been his refrain.

Privatization

It may be noted that the idea of privatizing petroleum business is not new for Nepal. Neither is it an easy proposal to implement. The import of petroleum had long been under Open General License (OGL) system (OGL is the list of items for which the import licenses are put on auction by the government so that any private party can import it). The government had also made a provision to allow the private sector importer to use the storage facility of NOC. But the private sector could not participate in this business, because, as one expert puts it, “it was like the soup served for the stork on a flat dish”. The private sector was not entitled the government facilities available to NOC, according one of the two private sector parties that had tried to utilize the opportunity. Though Sher Bahadur Pandey, a former Chairman of NOC, gives a different reason for the private sector’s lack of willingness to enter this business in the past, the fact remains that the incentive for private sector involvement in it was not there.

However, the situation  now is substantially different. Though the petroleum prices in Nepal are still totally dependent on the prices in India (they are kept nearly equal to what they are in India so as to avoid the chances of smuggling), they are not so stable in India as in the past. Since the prices in India used to remain fairly stable for a quite long period of time, it was possible for Nepal to follow the Indian price pattern. But now the petroleum business is being deregulated in India and they are currently following the method of fortnightly price adjustments. Therefore, the prices in India change very frequently. As a result, it has become very much difficult for NOC and the Nepali government machinery to respond so quickly to the change in prices in India.

In the international market, the price changes are much more frequent. While the international price for the crude oil (spot delivery) was around US $ 29 per barrel in October 2002, it went down to around US $ 26  in early December 2002.  Though this shows the need to reduce prices in Nepal, NOC gives another figure (as presented in the table in this page), thus indicating a need to increase prices.

That warrants privatization of the petroleum business in Nepal, because the required flexibility cannot be expected in NOC as it is a government enterprise and any pricing adjustment it has to make needs the government department’s approval.

Thus there seems to be a consensus among the experts of this field to privatize the petroleum business, and as Pandey says, since the government has already decided to privatize all the PEs, privatization of NOC is only a question of how and when. But there are some differences of opinion regarding the modality of privatization. While some experts would say it will be better than the present situation even if NOC is simply disbanded and the private sector is made free to import petroleum and sell in the market at whatever prices the market is ready to pay, others warn that such outright disbandment will create chaos in the market (see interviews and articles in this section). In order to ensure smooth transition from the present system to a privatized market system, the experts suggest some short-term and long-term strategies.

Short-term Strategies

Amrit Nakarmi, former General Manager of NOC, suggests that given the practical difficulties to do it otherwise, Nepal should follow the path followed by India in privatizing its petroleum sector. However, since Nepali petroleum business is only in the downstream areas (i.e. in storage and distribution not in exploration and refining) the policies here should concentrate only on the downstream aspects of the business.

Accordingly, Nepal’s petroleum prices should be pegged to the Indian prices along the Nepali border for the time being, so that the risk of petroleum smuggling across to India is avoided, says Nakarmi. This should be accompanied by handing over the pricing authority from the government to NOC. But NOC should be allowed to make only a specified profit, say of around 12% of its net assets (which includes the petroleum stock). The figure of 12% is suggested because it is the figure accepted in India, though in African countries it is 17% and in some other countries it is as high as 30%. Nakarmi says, if it so happens that the profits are higher than the permitted 12% when the prices set are equal to or above the level prevailing in the border towns of India, the excess should be deposited in a special fund – called “Price Stabilization Fund” – to be maintained within the Ministry of Supplies. This fund can be used to absorb the shocks of any possible abrupt price hike in the international market. He has also analyzed whether it would be practical to follow the Chilean model of petroleum price fixation (see his article later in this section).

LPG Experience

But whenever the question of privatizing NOC is raised, the NOC officials and other opponents of the proposal come up with the example of what is happening in the LPG marketing and say that the private sector in Nepal is not capable of taking up the petroleum business. Though the LPG business is still administered through NOC, the import and sales are made entirely by the private sector. NOC is simply issuing the delivery order to the LPG supply depots of Indian Oil Corporation. But there are frequent shortages caused in the LPG because the private sector companies have not created sufficient storage capacity.

Similarly, the retailing part of petroleum is already with the private sector. But the private sector is frequently accused of adulteration and creating artificial shortage. This means the private sector is still to convince the policy makers, the independent experts and the general public that it is now willing and capable to be really professional in the business if given the opportunity.

Meanwhile, as the experts suggest, the preparations for ultimate privatization has to start and as the same time some cost-cutting measures should be started in NOC. Some examples of areas where cost-cutting should concentrate are as follow:

Demurrage

One reason for the high cost of petroleum in Nepal is the high demurrage that NOC has been paying to the port authorities in India for delayed use of the port in transferring to Indian Oil Corporation (IOC) the oil that NOC brings from overseas. The provision in the agreement with IOC allows that such oil can be transferred to IOC in the high sea itself, but this provision is never used, say the sources near NOC. Since the demurrage cost is estimated experts at 3.5% of the import cost, which comes out to be nearly Rs. 500 million every year, this will help reduce the petroleum prices, hopes Nakarmi.

Interest

Under the present arrangement with IOC, around Rs. 800 million of NOC are estimated to be always lying with IOC without yielding any interest.

Conversion system

Another way NOC can reduce its costs is by reviewing with IOC the basis of conversion of petroleum quantity, as explained by Prof. Pyakuryal (see his interview).

Petroleum Sales in Nepal

Source: NOC

Import prices of NOC (US $ per barrel)

Source: NOC

Petroleum Pricing in Nepal

Source: NOC  

"Set up a regulator body first"

How was your experience as the CEO of the NOC?

I was quite surprised to know the lack of corporate planning at NOC. Even the top management was unaware of the demand growth of petroleum products and forecasting techniques, which are so essential in an energy company like NOC. I tried to develop medium term and long-term projections for demand growth in petroleum products. Based on these forecasts, a long-term plan was developed for the expansion of storage facilities. I hear that these plans are still in use.

How changed do you see NOC now as compared to when you were its CEO?

With the growth of 12/13 percent per annum in the consumption of petroleum products, the business has grown from Rs. 1,000 million to Rs. 2,500 million per annum within a span of eight years. But the storage facilities, human resources, the pricing mechanism, and the corporate policies could not keep up pace accordingly.

Do you see the possibility to run NOC as an efficient state enterprise?

There are so many studies conducted by the World Bank and the International Monetary Fund (IMF) that have established beyond doubt that public enterprises cannot run as efficiently as private enterprises. Most of the state controlled oil businesses have been deregulated and state oil companies privatized in the developing and transition countries. Constant political interference and government meddling in the operations can not be ruled out in a state enterprise. These will not make NOC an efficient enterprise.

What should be done to run NOC as an efficient state enterprise?

If you can ensure that political and government interferences will not be there and if its management is entrusted to the professionals, it may run better than at present. But in the long run, state monopolies are after all monopolies, and hence, they will not be able to provide the goods and services as efficiently as the private sector does in a competitive market.

How practical is the proposition outright and complete privatization of petroleum business in Nepal given the ground realities?

Outright and complete deregulation of the business which is a monopoly right now will lead to a chaotic situation which may not be beneficial either to the government or to the consumers.

An outright privatization creates a private monopoly in-place of the state-owned one. There are high possibilities that consumers will be exploited both in terms of quality of goods and services.

How should the government go about in privatizing the NOC?

There are various models developed for privatization of state controlled energy monopolies. But in my opinion, first, a regulatory body has to be set up. Second, a proper pricing mechanism has to be developed, so that the domestic petroleum prices reflect the total economic costs incurred. Third, all the NOC’s depots at various locations have to be valuated at fair-market  prices and auctioned off to separate strategic private investors, keeping some golden shares with the government. The private investors have to develop enough storage facilities to ensure oil supply security. The regulatory body has to monitor the quality of goods and services of these fragmented oil companies, their pricing, and other policy matters. The petroleum market should be allowed to mature before full deregulation.

What would be the good or bad repercussions if NOC is simply disbanded and the private sector is left free to import and sell without any control?

There will be chaotic situation. Because oil is an essential commodity and we cannot simply let it be freely traded without any monitoring. Consumers may be exploited and frequent supply crises may be envisaged. We have to ensure oil supply security, because out of the total Nepal’s energy needs, petroleum products meet 9%, whereas electricity meets only 1.5%. Especially in a developing country like ours, a regulatory body has to monitor the oil supply business.

People say that petroleum prices are being fixed by taking into the political consideration rather than the economic considerations. To what extent is this true in your opinion on the basis of your experience in this field?

Petroleum prices have both the political and economic impacts, as petroleum products are essential commodities. In the industrialized countries, petroleum prices are fixed mostly on the basis of economic considerations, but we cannot do so in the case of developing countries. We have to develop a pricing mechanism, whereby maximum economic considerations are taken into account with minimum political implications.

Multifaceted Issue of Petroleum Pricing

by Sher Bahadur Pandey

In the context of petroleum pricing, I am referring to petrol, diesel, kerosene and LP gas as the "petroleum products". The price of these products is fixed by the government, and the Nepal Oil Corporation (NOC) has been given the sole right to import these products. These products are consumed by the general people, and therefore these have direct relations with the public life. The private sector is allowed to import and fix the price of the other petroleum products.

If we give a look at the consumption pattern of these products we see three characteristics: First, the ratio of the consumption of petrol, diesel and kerosene is 1:5:6. Secondly, it costs almost the same amount of money to refine both kerosene and petrol. Thirdly, there is no significant difference between the prices of petrol and kerosene in many countries. Rather, in some countries petrol is cheaper than kerosene. However, in the context of our country we need to think more carefully when the price of kerosene is fixed because it is commonly used as fuel by large population.

There is a vast difference on import duty on kerosene, diesel and petrol. Likewise, the pricing mechanism too is different for these three products. Kerosene is priced lower than its cost whereas other products are priced higher than their cost. The price of petroleum products is fixed as per the cross subsidy mechanism in which an attempt is made to recover the loss in one product by the profit in the other so that the government does not have to finance the loss of NOC. When it fails to recover the loss, NOC suffers a loss in its income account and when the loss is recovered, NOC may earn a profit.

When the government fixes the price of kerosene, it always considers the socio-political impact. The price of diesel is also fixed in the same way but in this case less consideration is given to socio-political impact than in the case of kerosene.

The consumption pattern shows that the loss incurred in kerosene and diesel cannot be recovered by increasing the price of petrol alone. It may be noted that the import tax on petrol is much higher than on kerosene and diesel.

NOC and the private sector

NOC imports these products from India and stores it in its storage tanks. Then it supplies these products- kerosene, diesel, petrol to dealers all over Nepal. LP gas is brought directly by the gas companies (through NOC) and stored in their tanks. The sale and distribution of petroleum products is being done through the private sector.

In 2052 B.S. (i.e. seven years ago) the government decided to allow the private sector to import petroleum products. It also made an arrangement to make available the storage tanks of NOC for the private sector importers to store their merchandise, if needed. Despite these facilities no importer ventured into this business. They did not import petroleum products even when the international price went down much considerably.

There is an agreement between NOC and Indian Oil Corporation (IOC), the largest oil company of India. NOC has been importing petroleum products from IOC under this agreement. Petroleum products used to be under Administered Price Mechanism in India till March 2002 and the Indian government used to provide subsidy to Indian oil companies. Because of this system, petroleum products were sold at subsidized prices in India. Export of petroleum products was canalized through IOC in India. But as the Indian government brought out a new provision effective from April 1, 2002 under which it allowed all the Indian petroleum companies to import and export petroleum products, the private sector of Nepal began to show interest in importing petroleum products.

I have not much idea about the background of the government’s decision taken in 2052 B.S. However, the consumption pattern and pricing mechanism in those days were also the same as they are today. As the private sector of Nepal is now interested in importing petroleum products, we must find answers to some crucial questions regarding the situation after the private sector is allowed into this: what will happen to the import pattern? Will the ratio of 1:5:6 be maintained? What will be the result if the private importers import only those products which they find profitable? How to monitor the import of petroleum products? To find solution to these questions, the Ministry of Industry, Commerce and Supplies did set up a committee to conduct a study and make recommendations.

However, the present situation is such that the 2052 decision was reverted and the government has imposed restriction on import of petroleum products by the private sector for six months from April 1, 2002. Now the restriction has been extended for another six months.

Pricing

IOC used to fix the price of petroleum products in every six months irrespective of frequent price changes in the international market price. In the year 2001-2002, IOC fixed the price every three months. The Indian government made a new provision effective from April 1, 2002 and allowed the Indian companies to fix the price of petroleum products by themselves. As per this new provision, the Indian companies now fix the price every 15 days and NOC has to pay accordingly for the petroleum products it imports from India.

Considerable change has taken place in the price pattern in international oil market but in Nepal the government has been following the same old and outdated pattern. Its impact is going to be visible only in the future.

Our practice has been such that the price of petroleum products has remained fixed for one or two years or even more. Therefore, when the price goes down in the world market, it is not reflected in the local market, but when the price goes up, the prices are increased in the local market. Thus, it has left a negative impression among the consumers. In some cases, the government has tried to adjust the effect created by the decrease in the international price by increasing the taxes.

Smooth supply

NOC has developed its storage capacity to ensure smooth supply of petroleum products. More than Rs. 750 million has been ploughed back from NOC profits and it is invested in developing the storage capacity. Now NOC has capacity to store petroleum products enough for a month. And currently, NOC has a stock of petroleum products worth about one and half billion rupees. So, the supply of petroleum products is going on smoothly in the market. In my opinion, NOC needs to increase its storage capacity further so that it will be able to maintain a stock enough to meet the requirement for at least two months. It needs a big investment. Similarly, a big amount of money is required to import petroleum products to maintain the stock for such a long period.

Reasonable price

Generally, we see that the ocean and stock losses and NOCs' administrative expenses combined make about 2% of the total expenses of these products. The rest includes the purchasing price of the merchandise, tax, and other distribution cost etc. When we talk about supplying petroleum products at a reasonable price, it implies that the market price should go down when purchasing cost decreases. In order to put it into practice, the government should review the purchase cost of the product regularly and fix prices accordingly. Now, it must review the cost and price every 15 days. The whole mechanism must be scientific, and transparent. I think there may not be any suitable alternative to this.

Capability of the private sector

The private sector is already involved in the sale and distribution of petroleum products. If the private sector is to involve also in import of petroleum products, they should be allowed to do so on the condition of their contribution towards creating petroleum stock, fulfilling the long-term objectives and maintaining the product ratio in import. If they have capability to fulfil all these requirements, it will be all right to allow them to import petroleum products.

The private sector has started showing interest to enter this business only after a new provision was introduced in India on April 1, 2002 and all the Indian companies are now allowed to fix the price of petroleum products by themselves. This has created a favourable situation for the private sector of Nepal as well.

Adulteration

It is not right to blame NOC alone for adulteration because the sale and distribution of petroleum products is solely in the hand of the private sector. NOC can be blamed only for the adulteration that takes place at its depots. The surveillance team consisting of different bodies of the government is responsible to prevent adulteration and take action against the culprit. At the same time, NOC too should keep its dealers under strict surveillance.

Disbanding NOC

It will be an absolutely wrong step to disband NOC, which has already created such a huge storage capacity and acquired so much experience and developed skills to deal in this. Why should NOC disband? It is supplying petroleum products smoothly. It is true that its management is not satisfactory. But I doubt if it will be reasonable to disband the institution only on this ground.

NOC to improve management

Better performance cannot be expected from any business organization unless it functions in a professional way. To run an organization in a professional way, its Board and top management must be manned by professionals, who can devise a system to make the employees realize their responsibilities towards the organization. This will automatically remove many of the things which we term as "irregularities". For this, a favourable environment should be created by increasing salaries and benefits of the employees and delegating authority to the employees commensurate with their responsibilities. The board and the top management of the institution must be free from unnecessary interference and control. But this is hardly possible in government-owned institutions. That is why the concept of privatization has become extremely important. 

Privatization Modality
While privatizing NOC, the following points need to be taken into consideration:

NOC has a lot of assets, which need to be increased further. NOC should increase its storage capacity for which it has to make big investment. That means, its equity base should be increased. Arrangement should be made to maintain a proper debt-equity ratio.

One important decision in connection with NOC privatization will be regarding whether to allow foreign investment or not.

Institutional participation in NOC should be encouraged. Financial institutions, the Employee’s Provident Fund, Citizen Investment Trust, business houses and other institutions should be invited to participate in NOC by way of share investment. Employees also should be given some shares. In this process, if so happens that the government still ends up holding majority shares. I think it  need not to worry. The government should give up its control over the institution in order to make it scientific and modern. The government may send its representative to the Board only for the supervision of its investment. I am confident that the directors appointed by the institutional investors will be competent professionals, who will promote professionalism. When professionalism is introduced into an institution, no staff will have to be dismissed because they will try to improve their efficiency by themselves. In the long run the institution will show better performance and business transparency will be maintained. Once the institution starts operating well and making profit then the government may dilute its share to the general public.

So far as the question of privatization of NOC is concerned, it is worth noting that the government has already decided to privatize all the government-owned corporations. So, privatization of NOC is only a matter of time. The way in which NOC is going to be privatized is the most important aspect that we have to think about carefully.

(Pandey is a former Chairman of Nepal Oil Corporation)

CA’s Views on NOC Privatization

by T.R. Upadhyay

There cannot be two opinions that NOC needs privatization.  However, this must not be done in a hurry as it requires careful planning and well thought out approach and strategy.  Adequate storage facility, efficient distribution channel, reliable supply and economic pricing are vital considerations for privatization of NOC. Over the years NOC has been able to expand and build considerable storage facilities.  A private sector firm independent of NOC may not be able to make required investment in the short run on infrastructure to build up the required storage capacities.

NOC’s distribution network is extensive though the quality of service provided is questionable.  The possible impact on existing distribution network after the trade is open to private sector needs to be assessed as private investment is significant in this area.  The private sector would take some time in developing the network of dealers and agents.  The investment in developing such a network is colossal.

NOC has been operating in a protectionist environment as it enjoys a monopoly over import and storage of petroleum products.  The situation has been further complicated by administered price regime.  Although it is claimed that the changes in prices are reflective of volatility in oil prices in international market, in reality it is politically manoeuvred. Case in point is the price of petrol prevailing in Nepal which is extremely high due to cross subsidization policy whereas in international market there is no significant difference between the price of diesel and petrol.  Further, the price of kerosene is kept artificially low which is not only encouraging adulteration but a significant quantity is smuggled back to India as the price difference for this product between the two countries is considerable.  In effect, Indian consumers are enjoying the benefit of Nepali subsidy on diesel and kerosene.  This unaccounted Nepali subsidy to Indian market is colossal.  NOC and the politicians need to be blamed for such stupidity.

The operation of NOC is not transparent as it has never made public its procurement and price fixation mechanism.  Consumer has a right to know the standard mark up of NOC on CIF value of petroleum products.  Its dependence on Indian Oil Corporation for processing and initial storage of crude imported from abroad  are other grey areas where consumers have no knowledge.

The political interference in the appointment of top level management is one of the root cause of corruption that is said to be deep rooted in NOC operation.  This has prevented NOC from developing a core team of professional managers.  Since high ups in management hierarchy are politically blessed, they remain indifferent to implementing new and scientific management techniques.  It is a shame to the state that NOC accounts have remained unaudited for past several years, and the latest audit report available has pointed out serious persisting irregularities.

Numerous arguments could be put forward in favour of NOC privatization but the state should learn lessons from the errors made in past privatizations.   Major objective of privatization is to bring in private capital and efficient management to ensure sustained growth of privatized entity.  The past privatization efforts grossly failed to attain either of the said objectives.

In this context the prudent course of action could be as follows:

1.     Update NOC accounts and complete up-to-date audit and ascertain its net worth.  It is believed that it has accumulated huge operating losses.

2.     Off-set the liability and operating losses to the extent covered by the assets. Any further losses remaining unrecouped must be realized by maneuvering the price of petroleum products.

3.     SWOT analysis of NOC be performed by internationally reputed consultants.  Measures be implemented for mitigating the weaknesses and developing NOC into an efficient and economically viable entity.

4.     This viable entity then be put up for sale to international bidders.  The eligibility of bidders must be precisely defined.  Among others, it should be financially sound, committed to make investment in developing infrastructure, dealing in oil should be its core business, it should have investment in oil fields and refineries in multiple countries and possess demonstrated capabilities in managing oil companies.

5.     The desired investor may put forward its own conditions that could be negotiated.  This is emphasized because NOC’s operation is much smaller and may not be lucrative enough to attract the attention of oil majors. One way of ensuring their participation may be by extending monopoly for the gestation period. But in such a case, mechanism for ensuring fairness to consumers has to be thought out.

6.     Until NOC is not successfully sold out, import and storage of petroleum products should not be permitted to the private sector as competition between public and private sector is not fair.  It is universally accepted fact that such competition is always disadvantageous to the state.

7.     The government should publicly announce its long term oil policy. The policy should clearly stipulate the time frame when dealing in petroleum products will be completely liberalized and the prices shall be determined by the market forces without government intervention.  The policy should also clearly spell out the nature of competition envisaged, role of various players, anti-dumping regulation, consumer grievance handling mechanism, permitted margins, conditions for government intervention etc.

(Upadhyay is a reputed Chartered Accountant of Nepal and his firm TR Upadhyay & Co. is a correspondent firm of KPMG International)

Petroleum Pricing: Learning from Chile

by Amrit Nakarmi

There was a big uproar from the public at a recent price hike of some petroleum products by His Majesty’s Government of Nepal (HMG/N). Nepal Oil Corporation Ltd. (NOC), which is the state monopoly for the imports and distribution of petroleum products in Nepal, is still clamoring that it is losing almost Rs. 300 million every month, almost 10% of the government’s revenue. As was done before, HMG/N has formed a committee to look into the anomalies in NOC and to suggest the necessary steps.

Considering the volatilities of international oil market, it is quite surprising to note that HMG/N has effected domestic price adjustment only after two years (the last one was at the end of 2000). And the latest price adjustment is not adequate, as diesel and kerosene prices are left untouched. And these are the most consumed petroleum products. It is apparent that HMG/N has not been able to do the price adjustment due to political reasons. The minister concerned has promised to develop a proper system for the petroleum pricing.

In this context, it will be very pertinent to highlight some of the findings of a working paper published by the International Monetary Fund (IMF) in May 2001. Many developing countries are significantly exposed to oil prices at a macroeconomic level. For a sample of 45 developing countries surveyed (that were net oil importers), most countries’ exposure to oil price changes in 1999 was in the range of 1-4 percent of the GDP. In Nepal’s case, it comes almost 4 percent of the GDP. This implies that the adjustment of domestic prices with international oil prices is an important economic and political issue in many developing countries.

If adjustment is complete (full pass-through, i.e. changes in international prices directly reflected in domestic prices) the government is relatively insulated from a fiscal point of view, and the private sector and the general public bear the volatility in real income. If the adjustment is incomplete, the government bears the maximum volatility.

From a survey of these developing and transition countries, it was found that

• A significant majority of the countries surveyed regulate petroleum prices (partial pass-through mechanism)

• Only a minority of countries have an automatic pricing mechanism (full pass-through mechanism)

• Approximate one-quarter of the countries which regulate prices run specific stabilizing funds to manage smoothening process

A full pass-through rule in the context of petroleum price regulation has a number of appealing institutional properties, such as transparency and fiscal insulation properties. It minimizes both the government’s exposure to fiscal risk due to oil volatility and the risk of political interference in the price determination process. A full pas-through rule based on spot prices is politically difficult in many developing countries as seen from the case of the recent hike in petroleum prices in Nepal.

Alternatively, partial pass-through rule may prove to be more sustainable than full pass-through of spot price changes, and may, therefore, deserves consideration on “political economy” grounds, even if they may be the second-best to full pass-through mechanism in terms of economic efficiency.

Partial Pass-through Rules

Governments can implement three types of partial pass-through rules to allow for domestic price smoothening:

• Moving average rules, which base retail prices on a moving average of spot prices

• Trigger rules, by which prices are updated only if spot prices change by more than a pre-determined trigger amount, and

• Max-min rules, which place a ceiling and a floor on the level of retail petroleum prices

Under a moving average rule, current retail prices are set on a moving average of past spot prices, starting from the current month and moving backwards. The petroleum prices that NOC is getting fortnightly from the Indian Oil Corporation Ltd. (IOC) is based on this rule. The longer the time horizon of the moving average, the more price smoothening this rule achieves.

Under the trigger rule, a price band is initially determined (e.g., plus or minus 10 percent of the current spot prices), and retail prices are updated to reflect the current spot price only when spot prices reach a level which is outside the band. The effect of this pricing rule is to avoid minor fluctuation in retail prices, but pass-through relatively large changes in international prices.

Max-min rules specify a price band around a central price, which defines the maximum and minimum level retail prices can reach. If the cost-plus level of retail price is above the band’s ceiling, the government or the state-owned oil company absorbs the difference between two prices by paying out a subsidy from the Price Stabilizing Fund (PSF). If the cost-plus retail price is below the minimum price set by the band, the government taxes away the difference or assimilate it in its PSF, and sets retail prices at the minimum. This price rule achieves directly the aim of complementing consumers’ risk-coping activities, shielding them from large price shocks, but passing through small shocks which they can accommodate.

Chilean Model

Max-min pricing rule does not automatically pass-through large price changes if these price changes are persistent and long-term in nature, and, therefore, require adjustment. For this to occur, and to avoid excessive fiscal risk to the government or to the national oil company, a max-min rule needs to be complemented by a mechanism which updates the position of the max-min band or which scales down the additional subsidy (tax) determined by the rule if the cumulative loss (gain) exceeds a given level. Chile has recently adopted this kind of rule for its domestic petroleum price adjustments.

Chile has operated a domestic petroleum price stabilization mechanism since January 1991, and has recently reformed it. The original mechanism was based on a max-min rule with a Stabilization Fund (FEPP) of $200 million. Under this rule, maximum and minimum prices for each petroleum product was set at +/- 12.5 percent of a reference price set by the energy regulator (CNE) on a discretionary basis, to reflect medium and long-term market trends. If the import price was above the ceiling of the band, the fund will pay out a subsidy equal to the difference between two prices from the stabilization fund. If the import price was below the floor of the band, the difference in the two prices would be taxed away, and deposited into the fund.

According to the reformed mechanism, the reference prices which determine the position of the band for each petroleum product are updated weekly, on the basis of a formula, which includes historical prices (a weighted average of prices from the past 2 years), short-term forecasts, and long-term forecasts. This rule makes the band itself move up and down. The prices can rise (fall) above (below) the ceiling (floor) of the band to prevent excessive depletion (accumulation) of the resources of the fund. The domestic price will be adjusted within the band, thus the consumers are protected against sharp increases in the international petroleum prices.

As per the IMF, this model of pricing mechanism is quite robust compared to other rules. Many developing countries, which are net oil importers, should adopt this kind of model in adjusting their domestic prices.

Nepal’s Context

In Nepal’s context, neither HMG/N nor NOC has adopted any kind of mechanism for petroleum pricing. Because of this, both the government and NOC have not been able to manage the domestic petroleum prices, incurring sometimes making huge profit and sometimes huge losses. Both the government and NOC have failed to protect consumers from the risk of price changes in the international oil market.

Nepal should adopt a petroleum pricing mechanism at the earliest, and the best suitable mechanism will be the one that is based on the Chilean model.

•       It has to establish a Price Stabilization Fund (PSF) equivalent to around two months’ import amount of NOC (e.g. around Rs. 1600 million). If the current reserves of NOC are not depleted, they can be sufficient enough.

•       A max-min rule is to be developed for each petroleum product taking NOC’s cost plus prices as the reference prices. A band is to be created with +/- 12.5 percent around this reference price for each petroleum product. The reference prices have to be developed so that they are not only based on IOC’s fortnightly prices but also based on a fixed return on NOC’s assets (12% after tax return on net fixed assets and the petroleum inventory of NOC).

•       If there are changes in the NOC’s cost plus prices within the band, then domestic prices have to be adjusted accordingly. If the prices go outside the ceiling of the band, a subsidy equivalent to the difference has to be provided from the PSF. If the prices go below the floor of the band, the difference between the price and the floor will be taxed away and deposited into the fund.

•       One vital factor has to be considered that we have open border with India, and the transportation costs are higher for imports to Nepal. Hence, our domestic petroleum prices should keep parity with the prices across the border in India. Otherwise, petroleum products can flow through the porous border to India.

If HMG/N and NOC undertake such a time-tested pricing model and adjust the domestic prices accordingly, then the pricing decisions will be politically as well as economically efficient. As a consequence, there will be hardly any uproar in the streets. The government will not have to bother all the time when NOC adjusts the domestic petroleum prices. NOC will also have a fixed return on its net assets, so that it can invest in the storage expansion to keep up with the burgeoning growth of petroleum consumption in Nepal, which is growing at the highest rate in the whole of South Asia.

(Nakarmi is currently the CEO of Nepal Lube Oil Ltd. and was the CEO of NOC from 1991 to 1995)