Ambit Capital Pvt Ltd.

Ambit Capital Pvt Ltd.

SECTOR UPDATE
Oil Sector Deregulation
No deregulation without tax reform
Backed by the Kirit Parikh committee report, released 3rd Feb, 2010, noises are
getting stronger for auto-fuel deregulation, especially petrol. We however believe,
while a price hike cannot be ruled out, deregulation would be difficult to achieve
in the absence of tax reforms. Tax rationalisation, a key element ignored by the
report, in our view would be essential to determine a path for deregulation. We
hence focus on this aspect and argue that price deregulation in auto-fuels (read
petrol) would be hard to achieve without reform in taxation.

Tax component of fuel price amongst the highest in India

Our analysis suggests that the tax component in the fuel pricing in India is
amongst the highest in the world on an absolute level; and when we view it in
the perspective of per capita income or purchasing power of Indian consumers,
the scenario appears all the more inequitable. For instance the tax component
on gasoline in India is ~49% which is on a par with that of Japan, but the per
capita income of India (GDP per capita) is at a dismal US$1,070 compared with
US$38,210 of Japan! The point to note is that though the discretionary spending
power of the Indian consumer on fuel is considerably lower in comparison with
that in developed countries, the Indian consumer is being asked to cough up an
equivalent amount (read global equivalent) of tax! Besides, the idea of levying
tax is to rationalise the use of fuel, which in the case of India is anyway getting
rationalised to a large extent by the limited spending power compared to other
developed/ developing nations.
Exhibit 1: Auto fuel prices Exhibit 2: Tax as a % of retail price

2.5 70% 59000

60% 49000
2.0
50%
39000

($/Capita)
1.5 40%
US$/ltr

29000
30%
1.0 19000
20%
0.5 10% 9000

0.0 0% -1000
Germany

Canada

Thailand
USA

Mexico
France

Italy

China
Spain

India
UK
Japan
Germany

Indonesia
Canada

Thailand
USA

Mexico
France

Italy

China
India
UK
Spain

Japan

Petrol Tax% Diesel Tax% Per-Capita Income

Gasoline Diesel

Source: Industry, Ambit Capital research Source: Industry, Ambit Capital research

Government's dilemma!
The government is well aware of the sticky situation that prevails with regard to
taxation. On the one hand, auto fuel taxes are an easy and efficient source of
revenue for both the centre and state, on the other hand, the high rate could
Analyst
Saeed Jaffery serve as a bane for the consumer in a deregulated price regime. It is a catch 22
Tel.: +91-22-3043 3203
saeedjaffery@ambitcapital.com situation - the government cannot deregulate the price without lowering taxes;
and they cannot reduce the taxes due to the obvious revenue impact. The Kirit
Nitin Tiwari
Tel.: +91-22-3043 3252 Parikh committee has also conveniently skirted the issue, focussing purely on
nitintiwari@ambitcapital.com

OIL & GAS UPDATE 16 FEBRUARY 2010 1

Ambit Capital Pvt Ltd.

economics. Hence we do not foresee price deregulation in auto fuels without a

reform in taxation. Possibly a way forward for the government could be a flexible
tax mechanism wherein taxes adjust with increase/ decrease in fuel prices to
protect the consumer from excessive burden. But this inherently would mean
government intervention in pricing, defeating in principle the very purpose of
deregulation.

Current tax structure does not merit deregulation

Although taxing fuel makes tremendous sense from an environmental perspective,
the existing tax levels do not merit price deregulation. In India, fuel is taxed at
both the federal and state levels, leading to non-uniform pricing and state
governments taking advantage of the industry/consumer for revenue as per
their discretion. Earlier a case of high fuel taxes was justified because the direct
tax collection by government was not effective and there was considerable tax
evasion, therefore auto-fuels became an effective means of indirect tax collection.
Now as we can see, FY08 onward, direct tax collections have not only increased
but surpassed indirect tax collection, which validates a case for revision in fuel
tax structure.
Exhibit 3: Tax collection by GoI Exhibit 4: Excise duty collection

3500 250

3000
200
2500
150
2000
Rs Bn

Rs Bn

1500 100
1000
50
500
0 0
FY91

FY99

FY00

FY01

FY02

FY03

FY04

FY05

FY06

FY07

FY08

FY09
FY96
FY97
FY98
FY99
FY00
FY01
FY02
FY04
FY05
FY06
FY07
FY08
FY09

Gasoline Diesel
Direct Indirect

Source: MoF, GoI, Ambit Capital research Source: MoPNG, Ambit Capital research

Often a case for price deregulation is made when crude oil prices are low and
the argument cited being that 'if prices are deregulated now, common man won't
feel the impact' but what about when prices shoot up again? In that case, with
the current level of taxes, a common consumer would be reeling under heavy
fuel expenses. With auto fuels being kept out of the purview of GST, we do not
see the scenario changing.

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Ambit Capital Pvt Ltd.

Another oft-quoted argument, in support of petrol price hike is that it is a fuel for
the urban and well off classes. We believe this a misnomer, the very fact that it is
a fuel for two-wheelers (we have diesel cars and SUVs, but not two-wheelers!),
being used by the middle, lower-middle and poor and rural households, explains
the impact of a high petrol price in a deregulated price scenario.

Exhibit 5: Car sales v/s two wheeler sales

9000
8000
7000
6000
000s

5000
4000
3000
2000
1000
0
FY03 FY04 FY05 FY06 FY07 FY08 FY09
Passenger Vehicles Two Wheelers

Source: Industry, Ambit Capital research

Exhibit 6: Impact of gasoline price deregulation on common consumer

Percapita Income USD per annum 1070
Income spent on fuel @6% of gross 64.2
Distance Travelled daily (Km) 15
Distance travelled in a year (Km) 4680
Litres of petrol considering avg of 40km/ltr 117

Increase in Fuel expenditure USD % Increase

for a Rs5/ltr increase in fuel 13.0 20%
for a Rs22/ltr increase in fuel* 57.2 89%
*In accordance with the highs of July 08
Source: Ambit Capital research

A scenario analysis (exhibit 6) explains the impact of a hike in petrol prices on

the wallet of an average Indian. An increase of Rs5/ltr, which is the current
under-recovery on petrol would increase the annual auto-fuel expenditure by
~20%. In a worse case (not improbable) scenario, the auto-fuel expense would
go up by ~90% should fuel prices again test the highs of July 2008. The impact
of diesel price hike could be much worse because of the ripple effect it could
cause for other goods.

What's cooking with the cooking fuels?

As identified by the committee itself, kerosene is mostly used by the rural poor for
lighting purposes, its use and related subsidy burden, we believe, would die a
natural death as electrification of rural areas spreads in the coming years. Though
as a short term measure to control the under-recovery, a 'stepped' price increase
if not a one-shot increase of Rs6/ltr, we believe is warranted and implementable.

LPG though is a different story and the use of LPG is increasing annually at the
rate of 5~6% and so is the associated under-recovery. LPG has historically been
a negative margin product for a refiner, which if further processed can be used

OIL & GAS UPDATE 16 FEBRUARY 2010 3

Ambit Capital Pvt Ltd.

as feedstock for a higher value product. By virtue of the fact that OMCs are not
processing LPG as feedstock for petrochemicals and are distributing it as fuel for
social benefit, there is a strong case for compensation being provided to them.
The compensation method as suggested by the committee, we believe is apt:

 LPG price needs to be raised, at least to the extent income has increased, to
manage the subsidy burden,

 Since LPG is an urban fuel, the growth in total GDP should be used to
determine the appropriate price for LPG

 Weeding out of multiple connections

 The group recommends a Rs100 per cylinder increase in LPG prices

 Raising LPG price by Rs100/cylinder will reduce the under-recovery by

Rs75.8bn.

Bottomline: Uncertainty to persist

While the ministry currently deliberates on the scope of implementation of the
committee's recommendations, we believe that partial execution would be a
challenge as well. This would imply that the uncertainties that plague the sector
would continue going forward. Hence we maintain our cautious stance on oil
PSUs (IOC/HPCL/BPCL). Having said that, implementation of the committee's
recommendation would be most beneficial to GAIL, given that it has been excluded
from subsidy sharing. We note that GAIL's FY11E EPS would increase by ~50% in
the event of the latter event panning out.

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Ambit Capital Pvt Ltd.

Appendix
Exhibit 7: Retail selling price of Diesel in 174 countries (as of Nov 2008)

Source: www.gtz.de

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Ambit Capital Pvt Ltd.

Exhibit 8: Retail selling price of Gasoline in 174 countries (as of Nov 2008)

Source: www.gtz.de

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Ambit Capital Pvt Ltd.
Explanation of Investment Rating

Investment Rating Expected return

(over 12-Month period from date of initial rating )
Buy >15%
Hold 5% to 15%
Sell <5%

OIL & GAS UPDATE 16 FEBRUARY 2010 7

Ambit Capital Pvt Ltd.
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