Gas Pricing Issu1

8/12/2019 Gas Pricing Issu1

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GAS PRICING ISSUE

(FIR) against Reliance Industries chairman Mukesh Ambani, Petroleum Minister M. Veerappa Moily

and sundry policymakers and against the decision to double the price of natural gas in India to $8.4

per million British thermal units (mBtu) from April 1 by kejriwal.

Implications: 1) Reliance will be a major beneficiary of the decision at a time when it is being accused

of having inflated capital costs to garner a larger share of profits (than the government) from the KG-

D6 fields leased to it and of having failed to ensure gas output levels and therefore shareable

revenues promised in the original revenue-sharing contract. 2) huge losses in the power and

fertilizer sectors and consumers having reduced access to power owing to both high prices and

supply shortfall

Decision questioned because: 1) argument that the gas industry will be starved of investment if

prices are not raised goes against the evidence, as E.A.S. Sarma, a senior and respected retired civil

servant with much expertise in the area, has argued. 2) the principles on the basis of which the newprice has been arrived at by the Rangarajan Committee are open to question 3) RIL has been charged

with wilfully not meeting the production targets agreed to in its revenue-sharing contract with the

government, and the matter is now under investigation. Many believe that RIL is hoarding gas to

reap higher profits once the prices are raised 4) other parts of the public sector, such as the power

producer NTPC, are expected to take a hit owing to cost increases and the net impact of this on the

public sector is unclear.

In 2010, the Supreme Court, while upholding the legality of increasing the price of gas,observed that the government should act as a trustee of natural resources, which belonged to

the people of the country. Two public interest litigation (PIL) petitions, filed by CommunistParty of India leader Gurudas Dasgupta and E.A.S. Sarma, on the issue are being heard by theSupreme Court.

On January 7, 2014, the Supreme Court observed that the proposed doubling of the price ofgas would be subject to the outcome of the present petitions. The final hearing of the PIL

petitions is in March.

The complaint highlights several post-contractual benefits given to RIL at the cost of the larger public

interest and points out the involvement of public servants in the same. RIL had signed a contract

with NTPC in 2004 to supply gas to its power plants at the rate of $2.34/mBtu for a period of 17

years. It also signed a similar contract with Reliance Natural Resources Limited (RNRL), an Anil

Dhirubhai Ambani Group company. The complaint states that under pressure from RIL, the

government, with Deora as the Petroleum Minister, revised the gas price in 2007 to $4.2/mBtu,

which was clearly an act of corruption. The decision of the UPA government to allow another gas

price increase, to $8.4/mbtu, will make the price of gas in India one of the highest in the world

A letter written by RIL to the Directorate General of Hydrocarbons (DGH) on May 22, 2009,giving its cost calculations, shows that the cost of production was less than $1/mBtu. NikoResources, RILs partner, has a 25-year contract with the Bangladesh government to supplygas at the rate of $2.34/mBtu.


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The complaint has also questioned the argument presented by RIL that a hike in gas pricewould bring in more investment for exploration. The complainants have alleged that there is adeliberate reduction in gas production by RIL in its KG-D6 block in order to garner larger

profits. In the production sharing contract (PSC) between the government and RIL, aparameter termed the Investment Multiple (IM) has been defined as the ratio of the total

revenue to the total investment. According to the PSC, as long as the IM is below 1.5, RIL isentitled to more than 80 per cent of the profits and the government gets 20 per cent. It is onlywhen the IM becomes more than 2.5 that the government gets 85 per cent of the profits.Therefore, RIL is said to have an incentive in keeping the IM below 2.5 by artificiallyincreasing expenditure. The CAG, in a detailed report in 2011, had found that RILexaggerated its capital expenditure for this very reason. The complaint also alleges that RILmade unjust enrichment by over-invoicing the capital costs and ensuring that it took a longertime to recover the capital costs. RIL raised its capital expenditure from the proposed $2.4

billion in 2004 to $8.8 billion in 2006. The DGH allegedly accepted this artificial increase inRILs capital cost, which it could have objected to.

In a brief dated December 28, 2011, the DGH pointed out that there was a cumulative shortfall of 76

per cent of the approved target of production until the end of 2011-12. Subsequently, a show-cause

notice was issued to RIL on July 2, 2012, by the then Petroleum Minister, S. Jaipal Reddy

A PSC has a mechanism for the progressive surrender of exploration area back to thegovernment as the contractor discovers gas for commercial production in specific pockets andas it delineates certain portions as relatively less promising. This is a mechanism to preventthe monopoly of a particular private party over natural resources without tapping them andalso to ensure higher prices for the resources through a mechanism of competitive bidding.

In the PSC with RIL, the exploration was divided into three phases. At the end of phase III,the contractor was only to hold on to that area where the operator discovered petroleumresources in commercially viable quantities and was willing to develop further for

production. The rest of the area was supposed to go back to the government. According to aCAG report in 2011, the original end date of phase III exploration was June 2007, and it wasextended to July 2008 by the government. However, RIL held on to the entire area of 7,645sq km instead of the 390 sq km from which it had begun commercially tapping reserves after

phase III. The government, in gross violation of the PSC, declared the whole of the area as adiscovery area and awarded it to RIL for future exploration.

The KG-DWN-98/3 deepwater block (also referred to as the KG-D6 block), with a contract

area of 7,645 sq km, was awarded in 2000 to a consortium of RIL, the operator, and NikoResources Limited (NIKO) through a Production Sharing Contract (PSC) for the explorationfor natural gas. RIL had signed a contract with NTPC in 2004 to supply gas for its power

plants at $2.34 per mmbtu for a period of 17 years. In 2007, the gas price was revised to $4.2per unit, under RIL pressure. Very recently, the Central government has decided to doublethe gas price from $4.2/mmbtu to $8.4/mmbtu that would take effect from April 1, 2014.

The cost of production of gas is much less than $2.34 per mmbtu. The fact that RIL hadsigned long-term agreements with NTPC and Reliance Natural Resources Ltd (RNRL) forsupplying gas at that rate for 17 years means that at the rate of $2.34 per mmbtu also, RILwas making significant profits. RILs partner NIKO has a 25-year contract with the

Bangladesh Government to supply gas at the rate of $2.34/mmbtu.


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After this price doubling to $8.4/mmbtu, the gas price in India has become one of the highestin the world. The cost of production at the well-head was never calculated by the governmentor the Rangarajan Committee appointed by the government. No attempt was made todetermine cost of production accurately and independently. According to experts, themaximum price of gas at the well-head would not be more than $1.43 and the current price of

$4.2 is already one of the highest in the world. There is also no explanation as to why, whenthe entire domestic production is consumed internally, the price was fixed in US dollars. Thisfluctuation in the dollar rate has now effectively increased the price of gas even further.

Even if the government was right that new price would bring in more investment inexploration, there is absolutely no justification for raising the price of gas from existingfields. More importantly, PSC does not permit a revision in the price of natural gas once thefield has been declared commercial, and this field was declared commercial at $4.2/mmbtu.

In much of the western hemisphere, the wholesale price (which includes the cost ofproduction at well-head and bulk transportation) is linked to the Henry Hub, based in the US.

The average wholesale price for natural gas at Henry Hub was $3.73 in the year 2013 and$2.77 in 2012; this is consistent with the expert estimation that well-head price is of the orderof $1 to $1.5 at the most, in generalRIL had in 2009 written to the DG Hydrocarbon in the

petroleum ministry that their production cost at the well-head is less than $1 per unit. There isstrong suspicion that RIL deliberately delayed recovery/production in anticipation ofincreased rate fixation by the government, going beyond the agreed terms of the PSC.

he Rangarajan formula which has faced severe criticism has pegged the price to the average

international gas price in the US, UK and Japan.

In fact, the use of Japan as one of the markets for benchmarking itself has been questioned given

that the Asian giant hardly produces any gas. But the committee justified it on the grounds that it

needed to include a market from Asia-Pacific. This average was then linked to the market price in

India, which resulted in the latest price of $8.4, effective April.

New Exploration Licensing Policy (NELP)

Under this policy, government auctioned potential oil and gas field areas to private playerssuch as Reliance, Cairn etc.These companies would take all risk of discovering the oil/gas, drilling it out and sell to tomake profit.

Conventional Mining and Royalty

if you are involved in Iron-ore mining, the Indian Bureau of Mines ( IBM) will determine itspresent market value and you have to pay 10% royalty of that, to the Government.

For example you digged 1 kilo (!) iron ore, its present market-value is Rs.100, youve to giveRs.10 as royalty


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It does not matter how much profit you make out of this, youve to pay 10% right from theday one of your mining activity.

But for the gas-exploration, the system of royality is different, it is called:

Production Sharing Contract (PSC)

But here in case of gas, first youve to do Exploration. It may happen that you drill in apotential area but still donot find any gas, and yet youve to purchase expensive drilling

instruments, vehicles, hire engineers and monthly salary to staff etc.

So there is a gestation period involved, before you actually discover the gas, start selling it,recover your costs and then see the profits.

If there is a direct royalty sharing formulas like conventional iron-ore mining, then privateplayers will not be interested in taking the risk in this gas exploration activity.

Hence government came up with a concept called Production Sharing Contract (PSC) Under this scheme, the company will have to share royalty, according to the profit made. Initially company makes low profit, government gets extremely low share, later company

discovers more and more gas fields, its production increases and costs go down, then it has

to share more profit to the government.

This is not the standard royalty model as seen in mining systems, where revenue is sharedregardless of profitability. This PSC model allows the operator (RIL) to substantially recover

his costs before the sharing of revenue.

However, once these costs are recovered, the sharing with the government is often large. But As you can understand Private contractors (RIL) have virtually no incentive to minimise

capital expenditure and a substantial incentive to increase capital expenditure (theyll buy

more and more vehicles, machines etc) to keep their operation-cost high, which would

result in low/lowest share of profit for the government of India

The crux of Reliance KG Basin controversy

It is alleged that Reliance used false accounting-methods to show huge-costs and operatingexpenses to keep the profit low so that they have to pay less money to the Government.

CAG found this out after auditing, media started reporting, right now matter in PAC (Publicaccounts committee) of parliament.

Also, RIL had to take permission of government before raising the sale price of Gas. So citing the heavy cost and low-profit, Reliance also increased the sale price of gas with

Governments permission.

And then this (expensive) gas was sold ot fertiliser companies, power plants and thus snow-balling effect: price of fertilisers, electricity also increased =inflation.

Director-general of hydrocarbons (DGH) was responsible for looking after this exploration-activity, how much gas is generated, what is the operating cost, is there any real loss etc.

(but as the common sense suggests)he might have taken suitcases to turn a blind eye to

all this.

Dateline of Reliance KG Basin Controversy

1999 Vajpayee Government introduced NELP (NEw exploration licensing policy) 2000 Reliance got the licence to explore gas in Krishna Godavari Basin


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2002 Reliance Industries discovered huge reserves of natural gasand some small reservesof crude oilin a block called D6.

2007 CAG starts auditing 2011 CAG submits audit report and media starts reporting this controversy.

War of Words

CAG

Oil Ministry and its technical arm, the Directorate General of Hydrocarbons, did not payadequate attention to protecting the governments financial interest.

Reliance Industrys response

CAG has not found any false inflation of the cost or any dishonesty in developing thenations largest gas fields.Corporate rivalry motivated a few people with vested interests to indulge in a vicious smearcampaign against usCAG neither had any expertise in hydrocarbon exploration

Ashok Chawla Committee on Pricing of Natural Resources

Production Sharing Contracts like the one Reliance Industries signed for the gas-rich KG-D6are designed to benefit private players at the governments expense.

Tapan Sen, a Rajya Sabha MP

if your production is increasing, then your expenditure per unit must come down. But, here,production cost almost quadrupled.

even if you take into account the trial and error method of digging here and there, even ifyou take into account your wasted efforts of searching gas and exploring,

your development cost cannot triple or quadruple. Reliance cant charge the country like this. Its a clear case of gold-plating the cost. It would incur the government a big loss because only after recovering the cost of

production would the government start getting a return on the national asset.

inflated cost of Reliance has national ramifications. If the cost of gas exploration is too high,then it will affect the prices.

Reliance, the company that had gold-plated the expenditure of exploration Then Reliance hiked the price from $2.34 mmBtu to $4.2 mmBtu. So, fertilisers companies,

power plants and common consumers are paying more to Reliance. This collective loss by

the nation and to 1.2 billion people should be calculated.

Whatever the money Reliance has to make, they have made. The government should have quantified the loss to the exchequer. The government should

have calculated when would Reliance recover its cost and when would the government start

sharing profits.

The same Reliance sold 30 per cent stake to British Petroleum for $7.2 billion. It wasapproved by the government.

Director General of Hydrocarbons should be prosecuted. The production-sharing contractshould be re-written and price level should be revised.


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It will make electricity cheaper, fertilisers cheaper and industries would benefit. I dont blame Reliance. If I get the opportunity to steal, am I going to leave it? It is the duty

of the government to see that nobody takes people for a ride.

PIB

The CCEA has approved the Rangarajan Committee Report recommendations. The approved

recommendations known as the Natural Gas Pricing Guidelines, 2013 will remain valid for five years.

On the one hand these guidelines will help incentivize investment in the Indian upstream sector, so

that production reaches optimum levels and all exploitable reserves are put to production

expeditiously. At the same time these guidelines will ensure that producers do not cartelize because

of the huge unmet demand. This will protect consumer interests.

The approved policy derives from global trade transactions of gas, the competitive price of gas at the

global level by combining two methods. First, the netback price of Indian LNG term imports

(excluding spot imports) at the wellhead of the exporting countries will be estimated. Such a netback

weighted average price will be interpreted as the arms length competitive price applicable for India.

The second method of searching for a competitive price for India will be to take the weighted

average of pricing prevailing at trading points of transactionstherefore, the hubs or balancing

points of the major markets of continents. For this, (a) the hub price at the Henry Hub in the US (for

North America), (b) the price at the National Balancing Point of the UK (for Europe), and (c) the

netback price at the sources of supply for Japan will be taken. Finally, the simple average of the

prices arrived at through the aforementioned two methods will be taken. Such an overall average of

global prices, derived on the basis of netback and hub/balancing point principles, will be taken as the

economically appropriate estimate of the arms length competitive prices applicable for India.

PIB

As per the Rangarajan Committee formula, the price will be fixed on the basis ofaverage of net back price of Indian gas imports and also the weighted averageof the price at international hubs. The underlying principle is that Indian

producers should get a similar price what the gas producers elsewhere aregetting.

The domestic oil and gas sector is mainly administered under New ExplorationLicensing Policy (NELP) introduced in 1997 by the United Front Governmentand the first round of bidding was announced by NDA Government in 1999.So far, nine rounds have already taken place.


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However, the performance of the NELP Blocks has been far from satisfactorydue to a variety of reasons which is evident from the fact that out of 110discoveries announced under NELP, only six are presently under production.

As per the production sharing contract signed by the Government with theselected contractors, the sale of gas is to take place at competitive arms length

price discovered by the contractor and approved by the Government.Accordingly, the present price of 4.2 $ per MMBTU was fixed in 2009 whichis applicable till March, 2014.

However, the price of 4.2 $ per MMBTU is not found to be viable forsustenance of the domestic production of gas and all the operators aredemanding increase in price. The Gujarat State Petroleum Corporation (GSPC)owned by Government of Gujarat has been demanding a price of 13 14 US$

per MMBTU for their blocks in KG basin. Similarly, Reliance IndustriesLimited (RIL) has also been asking a price in the same range. Even the PublicSector Undertakings such as ONGC and Oil India Limited have beenrepeatedly representing for increase in gas price as the production will not beviable at any price less than 7 US$.

The domestic gas production in the country has been falling drastically shortof the demand and the present deficit of 142.78 MMSCMD is expected toincrease to around 234.26 MMSCMD in 2016-17. Therefore, there will behuge dependence on the import of gas at much higher price of around 14 $ perMMBTU and above, which will simply become unaffordable for consumingsectors. Moreover, the Economy cannot afford to continue with such a hugeImport Bill which is around 160 billion US$ for the import of petroleum

products. As per a reliable estimate, the subsidy burden to meet core sectordemand through imported LNG can go up to as high as Rs 1,20,000 Crore, ifthe demand is not substantially met by domestic gas.

One of the main reasons for weak domestic gas production sector is viabilityof the production vis--vis price of the gas at which the producers are supposedto sell. The present price of 4.2 $ per MMBTU has not been found to befeasible and the Ministry is not approving the development plans for the lack ofcommercial viability. Around 3 TCF of gas reserves is waiting to be exploited.


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The investment in exploration and development has been consistently goingdown from 6 billion US$ in 2007-08 to around 1.8 billion US$ in 2011-12. Atthe same time, Indian Companies have already invested 27 billion US$ abroadand the remaining 10 billion US$ is in pipeline.

It is important to note that every 1 $ per MMBTU increase in the gas pricewould result in an additional burden of approximately 1 billion US$. However,half of it i.e. around 500 million US$ will come back to the Government in theform of royalty, profit petroleum, taxes and dividend. This additional incomecan take care of the additional subsidy burden of fertilizer and LPG, if theGovernment decides to absorb the burden.

As regards to the Power Sector, around 16000 MW Capacity is stranded forwant of gas supply. Apart from the high import price of the gas, the importinfrastructure is also insufficient to meet the requirement and therefore, ifdomestic gas supply is not restored to the Power Sector, the huge investmentmade on the gas based Power Plant will go waste.

As regard to alleged windfall gain to the private operators, more than 65% ofthe domestic gas production is by the public sector companies and theremaining 35% by the private or joint venture companies between public sectorand the private sector. As regard to RIL, presently it is producing only 10% ofthe gas production in the country. With the new price, it is expected that their

production from KG D-6 will increase with the additional investment.However, the gas flow is not likely to start before 2017-18 and therefore,allegation of any windfall gain is misconceived.

In view of the above, it can be concluded that revision of the gas price is themost economically prudent decision taken by the Government which is likely totrigger additional investment, additional production, reduction in import dependenceand therefore, better fiscal balance. Increased availability of domestic gas is alsolikely to result in affordable production by the consuming sectors such as Power andFertilizer. In any case, as indicated by the Finance Minister, the Government hasrevised the output price of the domestically produced gas and its impact on theincreased input cost for certain sectors would be looked into by the Governmentseparately


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ntroduction

Rangarajan is a noted economist, ex-Governer of RBI, ex-MP, Chairman of 12th FinanceCommission and Chairman of Economic Advisory Council to the PM.Mohan had appointed Rangarajan Committee to look into following matters

1. Production sharing contracts with oil n gas exploration companies2. Contentious issues between those companies vs Government.3. How to decide the Price of domestically produced natural gas?

Rangarajan submitted report in December, 2012. It mainly revolves around following issues

1. Production sharing contracts2. Problems faced companies3. CAG auditing4. Gas pricing mechanism

#1: Production Sharing Contract(PSCs) ?

The PSCs work in the following fashion.

This contract made between the government and a contractor (oil/gas explorationcompany).

Contracts bids for specific oil block. If he wins the bid, hell start oil exploration in that block.

Oil exploration =lot of investment and risk taking involved. This is borne by contractor. (letssay 150 million dollars were invested).

Once the oil is discovered, contractor will start commercial production and sells it. Lets say he makes profit of 1 million dollar per month. According to contract, he has the

right to first recover the investment.

So for the first 150 months, he doesnt need to share profit with Government. (because 1million x 150 = 150 million.)

Once contractor has recovered his the cost of exploration, then hell have to share part ofhis profit with the Government (as per the terms and conditions in production sharing

contract.)

Sounds well and good, right? But CAG and Rangarajan Committee found some flows in ^thisProduction sharing contract. (PSC)

1. This system encourages Contractor to inflate costs. (I would rather show cost of explorationas 2 billion dollars, even if it took me only 1 billion dollar.)

2. Difficult for Government to check the accuracy of contractors account and get the correctshare. (I may be making 1.5 million per month but I would doctor my accounts to show profit

of only 1 million.)

3. I intentionally dont run my plant on full capacity. Ill just wait till the oil prices ininternational market to sky rocket, and only during those days/ months, Ill run plant on full

capacity to make lot of profit.

For more on this, recall Reliance KG Basic articleclick me
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To solve ^these problems, Rangarajan made some recommendations. He proposed a

Royalty-tax regime

Under this system:

1. From the total profit from selling the oil, a fixed royalty is to be paid to the govt.2. After royalty is paid, the rest of revenue is shared by the govt and contractor.3. Government should allocate block to a company that offers maximum share from profit.

Advantages of the system are:

1. Encourages the contractor to reduce costs.2. In case of price rise, the contractor doesnt get windfall gains.3. Government gets more money = more money for MNREGA, food security.

#2: Problems faced by Oil/Gas exploration companies

They can be classified into three types

1. Policy Issues

1. Environment ministry cancelled the NOCs given to areas under the oilblocks.

2. Contractors have difficulty in oil-exploration in North East and Naxalaffected regions.

3. Once oil is found, contract would want to dig more wells but he wontbe allowed under the license granted.

2.Management

Issues

1. If there are merger/acquisitions of companies, the Production sharingcontract doesnt recognize them.

2. In the difficult terrain, it takes many years to complete survey,research, exploration. But production sharing contracts allow only 8

years to finish this.

3. Contractual

Issues

1. Concerns of inflation of costs. (from Governments side2. Procurement of goods and services has to be done according to the

PSC. (e.g. Government would say buy xyz machinery only fromGovernment controlled PSU, even if a foreign company is providing

better equipment at cheaper cost.)

Ranga recommends:

For Policy Related IssuesMake an Inter-Ministerial Committee to iron out the issues. To solve other issues, there is already an Empowered Committee of Secretaries(ECS). Give

them more powers to resolve these issues.

For companies exploring oil / gas in difficult terrains, should be given following extensions:


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CurrentlyRangarajan wants

Tax holiday 7 years 10 years

Timeframe for exploration8 years 10 years.

#3:CAG-Audit

Another controversial issue is : CAG auditing. Oil/ Gas exploration companies like Reliance,want following things:

1. CAG should only check our financial accounts, he should not do performance auditing.(because Production sharing contract doesnt mention performance auditing).

2. CAG should not reveal details of audit to public( not even in Parliament) because that leadsto bad publicity for our company.

3. Audit should be within 2 years. If later, then under permission of the contractor.Ranga on CAG

The CAG is bound by the constitution to share all its audit with the Parliament. Just becausesome private company doesnt want it, we cant change that!

CAG is fully empowered to carry out audits. (including performance audits) If a block has high value, then CAG himself should audit it. If the block has low value, then CAG should outsource this auditing work to others. (reputed

private audit firms selected by CAG)

#4: Gas Pricing Mechanism

India has 2 types of gas pricing mechanism

1. Administered Pricing

Mechanism (APM) 2. Non-APM

Government fixes this price for NationalOil Companies .

This is the price at which gas is providedto fertilizer, power companies, etc. (so if

National company makes losses, then

Government pay money = subsidy).

This system is already regulated underGas Utilization Policy(GUP).

This is applied to:

Imported LNG. (because Imported gascomes at a price agreed upon by the 2

countries in agreement.)

Gas obtained from National Explorationand Licensing Policy (NELP) era and pre-

NELP era gas fields. (because Pre-NELP era

licenses sell gas according to the

Production Sharing Contracts signed.)


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Not yet regulated.

Since there are ^two mechanisms, the price of gas is neither constant nor predictable inIndian market.

Ranga on GAS

Rangarajan says, first you gather two values.

Value #1price of imported liquefied natural gas

(LNG).

Value #2Weighted average price of gas in Global

markets (US, UK and Japan)

Then, take average of values #1 + #2. Thatll be the final pricing for gas in the country.

Criticism on Rangas gas pricing

1. There are two types of gases: Wet gas vs. dry gas. The wet gas contains crude oil too. Soobviously wet gas is more useful. But Committee has not considered it in in the pricing

mechanism.

2. Countries that export LNG, donot openly declare the price. Because it depends on manyvariables. (e.g. Iran may sell us gas cheap, if we support their nuclear program.) So it is hardto determine value #1 objectively.

3. While calculating Value #2 (weighted avg in global market), Rangarajan has included Japan inthe list, but Japan doesnt have its own gas production/suppliers. (counter: Japan is a big

buyer so whatever gas prices go in Japan, they reflect benchmark for Asia-Pacific region.)

4. Rangarajan says take average of Value #1 + #2. This Average logic is unheard ofinInternational markets. No country is doing this!

Ranga Defends

In free market, price of a commodity is determined by Supply demand, but Indian market isnot yet ready to introduce direct market based gas pricing. Because

1. there is huge gap in supply-demand of gas. And our sea-ports donot have sufficient capacityto handle lot of imported gas.

2. Gas is essential for fertilizer, power industries and these sectors are essential for overallperformance of economy and controlling inflation. So we cant let the gas prices to be

determined by free market.

So, use ^above pricing mechanism be used until such provision can be made.


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Rangas implication?

If Rangas pricing mechanism is implemented, we (public) will have to pay higher price forgas, just like we do for petrol right now.

On the other hand, itll reduce the subsidy burden on Government =fiscal consolidation.

Summary pointsFeature What was there earlier Recommendation of Rangarajan

1. PSC

Cost Recovery by contractor first,

then profits shared between govt

and contractor.

Move to a royalty-tax regime after which

the balance revenue is shared by govt and

contractor.

2. IssuesNorth east, naxal area, company

mergers, # of wells etc.

1. Create an Inter-Ministerial Committee

to solve policy related issues.

2. Give more powers Secretaries(ECS)

3. tax holiday, more time to explore

3. Audit

Lot of issues between the

contractor and CAG over what type

of audit can be performed.

1. CAG has the right to perform audit over

oil/gas blocks and publish report.

2. CAG to directly audit big blocks.

3. CAG to outsource auditing for small

blocks.

4. Pricing for

domestically

produced Gas

Two models: APM, Non-APMAverage of (imported LNG + wt.avg of

prices in US, UK and Japan)
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The Rangarajan formula is indeed opaque and convoluted. It wants the price in India to be anaverage of two prices: (i) the volume-weighted netback price to producers at LNG exportingcountry well head for Indian imports for the trailing 12 months, or the implicit price paid atsource for natural gas imported by India; and (ii) the volume-weighted price of gas at theHenry Hub in the United States and the National Balancing Point in the United Kingdom and

the price implicit in the Japan Customs-cleared prices of LNG for the trailing 12 months.

Adopting this formula brings, among other elements, the price of gas in Japan into thedetermination of the domestic price in India. This is problematic since prices in Japan (seechart) are among the highest in the world. On the other hand, the U.S. Henry Hub, identifiedas the most developed among global competitive gas pricing markets, has the lowest price.Further, Qatar is Indias principal source of LNG imports and Japan does not enter the

picture. So the resort to the second of the pricing components in the formula brings into thedetermination of the gas price in India prices from an irrelevant and more expensive market.In fact, the Association of Power Producers (APP) has argued that the Japanese import priceshould be removed from the domestic price computation formula as Japanese LNG-based

prices have historically been much higher than other global market prices. The resultingdistortion would, in its view, put an additional burden of Rs.7,000-8,000 crore on consumers.

As of now there are multiple pricing regimes prevailing in Indias gas market. The ones thatmatter the most are the prices charged by the principal producers, consisting of the publicsector Oil and Natural Gas Corporation Limited (ONGC) and Oil India Limited (OIL) and the

private sector Reliance Industries Limited (RIL). They, together, account for more than 85per cent of the domestically extracted and delivered natural gas.

The prices charged by ONGC and OIL for much of the gas they sell are based on anadministered pricing mechanism (APM), wherein prices are ostensibly calculated on a cost-

plus basis. The price charged by RIL (of $4.2 per million metric British thermal units, ormmBtu), on the other hand, is an arms length price linked to the price of oil and arrived at

in consultation with the government as per the terms of the New Exploration and LicensingPolicy (NELP). Currently, the price of APM gas varies from $2.52 to $4.2, while the price ofnon-APM gas varies from $4.2 to $5.25 per mmBtu.

Raising the price

In December 2012, one more of the many official committees headed by C. Rangarajan,Chairman of the Prime Ministers Economic Advisory Council, recommended that Indiashould shift over time to a single gas pricing formula for all forms of gas and all consumingsectors with domestic gas prices being determined on an arms length basis. On the basis ofthat recommendation and a version of the pricing formula suggested by the committee, the

Petroleum and Natural Gas Ministry reportedly moved a Cabinet note recently,recommending that the price of domestically produced gas be fixed at $6.7 per mmBtu,


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which amounts to a 60 per cent increase in the currently most prevalent non-APM price. Thiswould benefit the public sector oil companies immediately and Reliance Industries fromApril 2014.

COUNTERCURRENTS

While everyone recognises the significance of petroleum industry for an economy like India,the real happenings and intricacies of the sector do not often make the news. At best thesedays one hears a lot about the high and ever increasing prices of the petroleum products. It isonly recently due to the commotion created by the leading lights of anti-corruption movementthat the gas business of the Reliance corporation (henceforth RIL) has come for some publicattention though earlier also it generated some interest when the two Ambani brothers weresparring about it. And yet in the mainstream media one hardly finds any meaningful analysison the issue. At best there are news reports about the ongoing standoff between thecorporation and the government and even such reports are lost on lay people due to thetechnicalities and the specificities of the petroleum business. An attempt is being made hereto bring out the key issues involved that a citizen ought to be concerned about, given that it isall about claims on the precious energy resources of the country.

Before we get into the issues involved some background details of the Reliance KG gasbusiness will be in order. Though the hydrocarbon reserves belong to the people of thecountry and state is supposed to be their custodian, in 1999 the government came up with the

New Exploration Licensing Policy (NELP) allowing private players to enter the fray. Right inthe first round, at that time, undivided RIL (i.e., before RIL was divided between the two

brothers) bagged the contract for exploring deep water D6 block of the Krishna Godavaririver basin in Andhra Pradesh constituting an area of 7645 square kilometres. A productionsharing contract (PSC) was signed in April 2000 between the government and RIL and itsminor (10 percent) partner, NIKO Resources Ltd (a Canadian corporation), for explorationand production of gas/oil. The KG Basin is considered to be the largest natural gas basin inIndia. A total of 19 discoveries have been made in the block during 2002-08, 18 of gas andone of oil; in two of them a declaration of commercial discovery was made in 2003-04 in anarea of 340 square kilometres as those were substantial gas reserves; later commercial oildiscovery was made in MA oil fields in an area of 50 square kilometres.[2] It is Ministry ofPetroleum and Natural Gas (MoPNG) which is supposed to take care of the exploration and

production of natural resources while an office of Directorate General of Hydrocarbons

(DGH) was created in 1993 as the key regulator for the petroleum business in the country.[3]

In 2011 the Comptroller and Auditor General (CAG) of India came up with a report onPerformance Audit of Hydrocarbon Production Sharing Contracts in which the Reliance D6gas business was taken up for a detailed scrutiny. The report offers significant insights aboutall the three aspects of the business: its exploration, investments involved, as well as pricingof the gas produced; we will take up these issues both on the basis of the CAG report [4] aswell as the available media accounts.

II. Exploration at KG Basin D6 Block

The production sharing contract [5] has a built-in mechanism for progressive surrender ofexploration area back to the government as the contractor discovers gas for commercial


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production in specific pockets and as it delineates certain portions as relatively lesspromising. The idea goes into the very heart of NELP: that the state lacks capital for rapidexpansion in exploration and production of petroleum resources of the nation; hence the

private parties are being invited for a time bound exploration and then forfeit the rest of thearea back to the government. The objective is further twofold: one, to prevent hoarding of

natural resources by the private parties without tapping them, like we have seen both in caseof coal and spectrum in recent times; and two, to get a better price for the resources: as oiland gas are discovered in the basin, the neighbouring areas are likely to fetch better prices inthe next round of auctions for further exploration, like what happens with land prices.

Thus in the contract the exploration was divided into three phases and at the end of each ofthe first two phases the contractor was supposed to relinquish 25% of the area and finallyafter the phase III, it was to hold on to only that area where the operator discovered the

petroleum resources in commercially viable quantities after drilling wells and was committedto develop further for production, rest all area was supposed to go back to the government.According to CAG, phase I of preliminary exploration got over in June 2004 and RIL gave

notice of beginning phase III in 2005, but without relinquishing any part of the original areaof basin allocated to them in 2000. For phase III exploration the original end date was June2007 and was extended to July 2008 by MoPNG, but the end result is that RIL has held on tothe entire 7600 square kilometre basin for exploration till today instead of 390 squarekilometres from which it had begun commercially tapping petroleum reserves after the phaseIII. Though Reliance had not drilled any wells in most of the area yet the ministry in a volteface of its earlier stance in February 2009 decided to declare the whole of it as discoveryarea and thus practicallyawarding it to Reliance for future exploration in gross violation ofthe contract, according to CAG.

The Ever-expanding Discovery Area

As per the contract, discovery area is only that area, where based on discovery and resultsobtained from wells drilled the contractor is of the opinion that petroleum is likely to

be produced in commercial quantities. Thus the concept of discovery area is inextricablylinked to drilled wells and findings of petroleum deposits that are recoverable. In this case thecontractor till 2010 had drilled wells only in one specific area in the North West of the total

block allocated to them. To begin with DGH did not agree to RILs insistence of notrelinquishing any area before moving to phase II in May 2004, but according to CAG, itcapitulated within an year! It was now willing to let the exploration continue based onseismic data, which, as per the contract, was clearly a part of phase I which had to be finished

before moving to phase II of drilling exploratory wells. Now DGH found it prudent forReliance to analyse the seismic data on a fast track basis and that would also allow them tomark the area of relinquishment in a proper manner, DGH argued. One of the thingsReliance said in its defence was that it lacked ultra deep-water rigs for exploratory drillingin the deeper Southeast parts of the block underlining the point that seismic data by itself isinadequate for discovery.

In July 2006, DGH permitted RIL to enter phase III without surrendering any area, since thedata showed continuity of discovery in the whole block, of course based on Reliancesseismic data. According to the contractor the hydrocarbon bearing channels were continuingthroughout the block and had the potentiality to produce gas in commercial quantities.

Interestingly even the seismic surveys covered only a part of the block. CAG has documentedthat MoPNG resisted this idea in 2006-2007, but had also come round to the view of DGH


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(and Reliance) by 2008 and approved the Reliance proposal of declaring the entire area to bediscovery by February 2009. CAG asserts that the idea of relinquishing of undiscoveredarea of the D6 block was lost in a sea of correspondence between RIL and DGH (laterDGH and MoPNG) and the contractor kept insisting that the petroleum was likely to existand hence the whole area should be declared discovery area. The only little problem with

the plea is that this is not what is meant by discovery as per the contract signed by RIL andwhich they preferred to conveniently ignore and DGH and MoPNG were willing to comply.As CAG concluded:

The contractors opinion that petroleum was likely to exist in the entire contract area andcould be produced after an exhaustive exploratory/ appraisal programme is not inconsonance with the PSC definition of discovery area which is centred on existence of

petroleum, based on wells drilled in that part (p. 39).

III. Reliance Investments in KG D6 Block

The contract is supposed to be based on the idea that the contractor takes the risk forexploration in terms of initial investments, but in turn is rewarded with adequate returnsalong with a mechanism for profit sharing with the government. Thus the contract has built ina concept of an investment multiplier (IM),that is, the ratio of cumulative net income tocumulative capital investment in the project. As the investment multiplier goes progressivelyup (because the initial investment stagnates while revenues keep adding up) and thecontractor has received adequate returns, the government share in the profits will go upincreasingly. Thus the contract bid actually seeks the profit sharing plan of the prospectiveoperator at specific points of IM and obviously the attractiveness of a bid will depend uponthe kind of profit sharing that a bidder is willing to commit to the government. Here the KGD6 contract turns quite interesting. The profit sharing plan in the PSC reads as follows: forIM less than 1.5 [6] it is 10%, IM between 1.5 and 2 it is 16%, till 2.5 it is 28% and when IMis expected to go above 2.5, most interestingly, the government share in profits promised bythe contractor jump to 85%!

Now in order to understand the implications of this curious looking profit sharing plan weneed to get into the actual details of investments in the Reliance KG basin gas business.Initially, D6 was expected to produce 40 mmscmd (million metric standard cubic meters perday) of gas, which was subsequently revised to 80 mmscmd. The initial development costwas envisaged tobe $2.4 billion in May 2004, which was revised through an addendum in2006 to $5.2 billion in the first phase and $3.6 billion in the second phase. So while the

contractor claimed that the gas output would double, at the same time the required investmentalmost quadrupled![7] If we connect it with the profit sharing schedule where the governmentshare jumps from 28% to 85% when the IM crosses 2.5, it could be well anticipated that theoperator will do everything possible to keep it below 2.5, and one obvious way to do that is tokeep increasing the denominator by adding up the investment required. In fact CAGcommented, The private contractors have inadequate incentives to reduce capitalexpenditureand substantial incentive to increase capital expenditure or front end capitalexpenditure, so as to retain the IM in lower slabs (p. xvi) The CAG has also observed thatthe $3.6 billion development cost for the second phase has the possibility of being hiked up infuture in the same way as the first phase.

Thus as per the CAG report there is every reason to believe that these investment costs havebeen doctored and in fact it also identifies several such mechanisms: award on single party


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bids, post hoc revision in scope, specifications, and amount of bids, substantial changes inorders, etc. CAG has specially mentioned serious deficiencies in the award of $1.1 billionorder for a floating production, storage and offloading (FPSO) vessel (for oil production)from Aker Floating Production. In fact CAG points out that many of the single bid contractswere handed out to the Aker group companies amounting to more than $2 billion and that

Aker had no prior experience of an FPSO. Based on an analysis of the CAG report,Purkayastha observes [8],

Reliance therefore can make a double killingby over invoicing the capital costs, it canskim money from the top. In addition, by ensuring that the capital costs take a longer time torecover, it takes out its major share of the profit right in the beginning. Not only did theDirectorate General of Hydrocarbons accept this increase in capital cost, which under thecontract it need not have accepted, it did so in unseemly hasteit took a scant 53 days to gothrough cost increase of nearly $ 6.3 billion! Some wizardry indeed.

IV. Pricing of Reliance KG D6 Gas

Another aspect worth noting that has been part of the ongoing drama about Reliance gas hasbeen its pricing. Till Reliance came into the fray when only the public sector was involved ingas business, it was the government that would administer the gas prices. It needs to be notedthat the gas prices have serious implications for two of the critical industries, fertilizer and

power, where it is a vital input; for instance 10% of electricity in the country is beingproduced through gas. Thus before 2009 Oil and Natural Gas Corporation (ONGC, a PSU)gas was being sold at the rate of $1.83 per unit. In 2004, RIL bid a price of $2.34 per unit to

National Thermal Power Corporation (NTPC, a PSU) against international competitivebidding. The gas was meant for its 2600 MW Kawas and Gandhar power projects and theoffer was for 17 years. NTPC accepted the offer and issued a Letter of Intent, which in turnwas accepted and confirmed by RIL. But then RIL had second thoughts about its bid andrefused to sign a Gas Sale and Purchase Agreement forcing NTPC to file a suit against RIL inBombay High Court in December 2005; the case is still sub judice.[9]

Meanwhile the two Ambani brothers, who between them literally ran RIL like their personalfief in spite of all the facade of it being a publicly held corporation, began fighting for thecrown jewel of KG gas as the RIL empire was being split between them after the death oftheir father. The entity which executed the contract with the government in 2000 was splitinto two companiesRIL and RNRL (Reliance Natural Resources Ltd). As RIL wassupposed to supply gas to RNRL (later merged with Reliance Power, part of the younger

brothers stable), price of the gas became part of the dispute. In June 2005, the two brothershad a private settlement which included issues regarding utilisation and pricing of the gasbetween them, as if it was a personal property of the family, completely oblivious to the factthat the gas belonged to the nation and RIL had signed a contract with the government onlyfor exploration and production.

In 2007 matter of KG D6 gas price was referred to an Empowered group of ministers(EGoM) led by the then finance minister, Pranab Mukherjee, who approved a rate of $4.2 perunit for five years. This undermined the ongoing NTPC plea for $2.34 price in the court asthen the government itself was fixing the higher gas price for RIL! It might be noted that till2008 ONGC was being paid only $1.83 per unit of gas. The $4.2 price was supposedly done

on the basis of RILs price discovery. Reliances so called price discovery was to ask aselected set of bidders (from the user industries) to quote a gas price according to a formulae


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which fixed the price within a narrow range of $4.54 to $4.75. With this as the basis,Reliance declared the discovered price to be $4.59/ unit which was later revised to $4.3.The Government then magnanimously decided that the right price was $4.2 and claimed thatit was arrived at through a discovery mechanism.[10] It is also worth emphasising that theEGoM decided this price going completely against the recommendations of a committee

headed by the cabinet secretary which had strongly objected to the Reliance proposal. Formerprincipal advisor (energy) to the Planning Commission, Surya Sethi sums up this confusionwell:

The fact of the matter is $4.2 valid price for natural gas is the highest price that anybodyhas received for natural gas anywhere. And while you say cost of production you knowvarious figures came out: somebody has said one dollar but nobody has claimed cost of

production more than 1.43 or some such number but there are numbers to show probably it is99 cents also Why under that situation we are paying 4.2 dollars is completely beyond meat least. As I said, this was discussed, this was demonstrated (that) this is not the way to pricenatural gas but yet the EGoM decided to go with that price.[11]

Now in October 2012, Reliance has sought an import parity price of $14.2 for KG D6 gas,straightaway more than three time increase, even before the period of present fixed price getsover in Aril 2014 and a committee headed by the chairman of the PMs economic advisorycouncil has been formed to look into it.[12] While RIL had in its submission to the SupremeCourt in the gas supply row with RNRL stated that it was merely a contractor who is bound

by government decision on price and sale of gas in national interest (thus arguing for $4.2price from RNRL as determined by EGoM and not the $2.34 that the younger brother wasclaiming as per their family contract), the company in January this year wrote to the

petroleum ministry seeking revision of discriminatory and sub-market price. Thus, whilein its dispute with the younger brother RIL conveniently wanted to follow the governmentdetermined price in 2008 since that was almost double than what the younger brother waswilling to offer, it now wants to go with the international prices (because apparently it issignificantly higher) and is ready to contest the same government determined price!

It might be argued that the Government also stands to gain out of high gas prices. But this isonly partly true. As gas is the major feedstock for fertiliser production and also a fuel for

power, this gain has to be offset against the resulting higher fertiliser and power prices. If thecost of fertiliser and power goes up, so does the government subsidy. So while the RIL would

pocket the benefit of the higher cost of gas, the government would have to pay out a muchhigher subsidy which more than counteracts the gains from the increased gas prices. In fact

the committee headed by the cabinet secretary had pointed out that higher gas prices wouldresult in prohibitive fertiliser and power subsidies in its input to the EGoM [13] in 2007. Thisshould be compounded with the overall deleterious effect on the economy of rising powerand fertiliser costs.

In a still evolving suspense (or horror?) story, the gas production from D6 came down to 31million standard cubic metres per day in 2012 from 61 mmscmd in 2010, while the

production was supposed to reach 80 mmscmd by 2012-13.[14] Reliance took the stand thatthere were technical snags, while government kept pleading for hike in production. Theyhave also revised the estimates of gas reserves in the basin to 20% of their earlier estimates.Such precipitous decline in production has to be analysed in light of Reliances persistent

demand for threefold hike in gas prices. Most likely the snags will magically disappear oncethe government gives in to the demand for price hike! In August 2012 Andhra Chief Minister


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voiced the concern to the Prime Minister that Reliance was deliberately reducing theproduction.[15] In fact part of the ongoing dispute between the ministry and RIL has beenwhether, with such low level of production, the latter has the right to charge the massivecapital investment (made for 2.5 times the present production) as cost and thus deny thegovernment its share of profits (see Section III). Last year the solicitor general advised the

ministry that, the costs/expenditure incurred in constructing production/ processing facilitiesand pipelines that are currently underutilized/ have excess capacity cannot be recoveredagainst the value of petroleum and according to media reports [16] close to $2 billion should

be disallowed and recovered from the contractor. As of last year, RIL has already recovered$5.26 billion out of an investment of $5.69 billion. According to a senior MoPNG officialquoted in The Hindu, [17]

Every 1 mmscmd drop in production of gas means a loss of 210 MW of power capacity.Power plants in various parts of the country to the capacity of nearly 20,000 MW with bankguarantees of around Rs. 30,000 crore are lying idle without gas. Fertilizer was beingimported more than anticipated due to the fall in gas output from the KG basin. This is a huge

loss to the nation, and who knows if gas production was being suppressed for want of revisedprice.

V. Conclusion

Let us summarise the evolving state of affairs of the Reliance KG basin gas business in thelast 12 years:

Once the corporation bagged the contract in 2000 for exploration and production, RILbegan with asserting that the whole basin is full of gas through continuity of hydrocarbonbearing channels and convinced the government to declare all of the 7600 square kilometresas discovery area in 2009 after a protracted battle based on thin seismic evidence at best andagainst both the word and spirit of the contract that they had signed with the government;according to the CAG the discovery area as per the contract was mere 5% of this area, therest should have been surrendered back to the government in three stages.

Then they jacked up the investments involved by quadrupling it, at least on paper, whiledoubling the capacity of commercial production, thus quickly skimming off their investmentswhile drastically reducing/ delaying the profit sharing with the government. Most likely, asCAG stresses, it has cooked up the books to earn handsome returns out of this investment aswell.

At the same time, they have refused to honour their commitment to NTPC to sell the gas at$2.34 and instead have been able to force the government to grant them a price of $4.2, allthe while when ONGC was being allowed a price of $1.83.

And the latest is that RIL is seeking an import parity price of $14.2 while the productionfrom the fields has come down to 31 mmscmd (from 61) when it was actually supposed to goup to 80, apparently due to technical snags and lack of gas!

In the meantime, in spite of lack of gas and production, Reliance has managed to offload a30% stake in 23 hydrocarbon blocks, including D6, to British Petroleum for $7.2 billion in

2011 and the deal was cleared by none other than a cabinet committee headed by the Prime


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Minister. Never mind that Reliance was supposed to be only the contractor and the assetsbelonged to the people of the country!

en during the Nehru era, now commonly dismissed as the heyday of the licence-permit raj, it was

clear that policy implementation favoured big business, which was able to garner a disproportionate

share of licences, leading to increased industrial concentration and the strengthening of a few

industrial houses that competed with each other but kept out all new entrants

certain differences between what was observed at that time and what has been witnessed overthe past three decades. First, most often, the strength of the traditional business groups did notcome largely from a relationship with the state that involved a quid pro quo. Rather, it came

because of the ability of these groups to circumvent and/or subvert state policy and the failureof the state to discipline Indian capital, even in areas like tax evasion or avoidance. Thedominant problem was state failure rather than state capture.

Business power in post-Independence India was not the result of cronyism but the result ofthe ability of the private sector to stand up to the state and the failure of the state to penaliseerrant business behaviour. A striking example of this was the ability of the leading groups to

pre-empt a large share of the licences issued, even when they did not plan to implement them,and keep out new entrants. Second, while the traditional business groups were benefited bystate policies such as protection, regulation of foreign investors (who would, otherwise, haveswamped Indian business) and investment support from the development finance institutions,

they did not get support in the form of state-provided access to near-free land, mineral andother resources and large tax concessions, all of which became routine once economic reformbegan and it was declared that the role of the state was not to regulate private capital andbuild a strong public sector but to facilitate and promote private investment.

a feature of the neoliberal era in India, as elsewhere in the world, is the role played by the state in

redistributing assets and incomes in favour of a small elite, including specially chosen business

groups. There are many other ways in which this redistribution has been engineered. One obvious

example is disinvestment. Not only has the government divested equity in some of its most

profitable enterprises, but it has done so at prices that have been found (as in cases such as BALCO

sold to Vedanta, IPCL sold to Reliance or Centaur Hotel, Mumbai, sold to Batra Hospitality and then

Sahara)

nder the policy of strategic disinvestment, business groups that acquired a minority stake of 26 per

cent or more were handed over complete control of the company. In the case of Videsh Sanchar

Nigam Ltd (VSNL), this allowed the Tata group to access the large cash reserves that were available

with the company to facilitate its own expansion

the role of public banks in the case of Kingfisher Airlines is telling. Not only was the airline favoured

with huge loans of around Rs.7,500 crore, but when it became clear that it was not in a position to

meet its debt service commitments, the debt was restructured with lengthened maturity, better

terms, additional financial support and the conversion of loans into equity.


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Revenues foregone through various concessions and tax preferences have become a significant part

of fiscal policy. Although the Kelkar Committee Report on Direct Taxes (2003) recommended

reducing or eliminating such concessions while reducing tax rates, this has not happened. Indeed,

while the tax rates have been reduced progressively since then, various concessions were also

continued and then even expanded, especially in the wake of the global crisis in Budget 2009-10.

tax preferences include a range of measures, such as special tax rates, exemptions, rebates,

deductions, deferrals and credits, provided in accordance with certain policy priorities of the

government, which obviously affect both the level and the distribution of tax revenues.

Documents

Gas Pricing Issu1