Petroleum Product Pricing Mechanism

Oil and gas have many characteristics that distinguish them from
other commodities, such as:

 the high uncertainty linked to resource development and the

high specificity of investment all along the energy chain from
production to consumption,
 the character of a natural resource,
 the finiteness of the resource, exacerbated by the high
concentration of reserves in about a dozen countries,
 the involvement of two decision makers on the production side:
producing company and resource owner,
 the often highly inelastic demand for energy and its interaction
with concentration and capacity restrictions on the supply side,
and
 market imperfections such as unavoidable externalities.
History of Oil Pricing

Until the beginning of the 1970s, energy and oil market

development was described by the ascending branch with
accelerated growth of Hubbert’s curve.

Production growth was based on the discovery of major new

low-cost oil fields primarily in the Middle East. The international
market was closed to any outsiders, first split between the
Seven Sisters under the 1928 Achnacarry Agreement, and

By the end of the 1960s, increasingly dominated by OPEC,

especially after re-nationalisation of their resources in the mid-
1970’s following the end of colonialism in the 1960s.
However, the embargo in 1973/1974 and the oil price increases in
1973/1974 and 1979/1980 triggered investment in oil outside of
OPEC, the development of new technologies, oil substitution by
other energies especially in power generation, more efficient
energy use, and substitution of energy by other productive
resources, firstly by capital.

This finally led to the decrease of absolute volumes of world oil

consumption in the early 1980s and to the oil price collapse in
1985/1986, to more competitive structures and finally to a liquid oil
market.
Price Formula

Prior to 1979-80, long-term contracts accounted for most international

trade. In the 1970s, crude was sold at official selling prices, which were
set according to differentials to Arabian Light.

The differentials were based on physical properties of the grades and

distances to the markets.

However, the official price system, which was the basis for most long-
term contracts then, was no longer working in the mid-1980s under the
decreasing call for OPEC oil due to increased non-OPEC production and
diminishing oil demand in the early 1980s.

Saudi Arabia, which played the role of swing producer within the OPEC
quota system, established the netback pricing system in late 1985 to
defend its market share, and abandoned the official prices. The netback
pricing system tied the value of crude oil to the spot market prices of
refined products
The netback pricing system was followed by a brief, unsuccessful
return to the fixed official price system. In late 1987, however,
geographically specified pricing formulas were introduced.

This system is still in place today. It has a direct reference to the

global crude markets. It also permits sellers to target specific
areas and customers by modifying formulas and other aspects of
the contracts to meet individual needs.

These adjustments have resulted in highly individualised

contracts and price formulas. Although the use of tailor-made
formula reduces transparency of prices, pricing formula has
proved to be an effective, durable and flexible tool.
The netback pricing formula was:

Crude oil price (FOB) = GPW in the spot market – fixed refining margin
– transportation costs (from the terminal in the oil-exporting country
to the refinery in the oil-importing country)

Netback pricing was also attractive to the buyers (refiners), which

otherwise were suffering from unstable, low margins. However, the
success of netback pricing and the increase in Saudi Arabia’s production
led to a huge drop in oil prices in 1986, plunging below 10 $/bbl.

This is sometimes called ‘the counter oil crisis’ as opposed to the two
previous oil crises. Netback pricing was blamed for the price crash. After
a brief period of netback pricing dominance, the fixed official selling
prices returned briefly in late 1987. Producing countries stopped posting
the prices in 1988
Refining Margins

Refining margins represent monetary gains or losses associated with

crude oil processing operation.

To make comparisons possible by crude grade, refinery operation or

region calculations normally assume standardised refinery configurations.
The margin calculation takes into account wages, construction and other
associated costs incurred in refinery operation, together with variable
costs including buying and processing crude oil. Although margin
calculations are more reflective of economics of processing a marginal
barrel rather than returns from base-load operation, refining margins can
suggest indications of financial returns to a refinery.

Refining margin = GPW - crude costs - transport costs and applicable

fees and duties - Financial costs – variable costs – fixed costs
India has persistently been depending on imported crude oil (primarily
from the oil and petroleum exporting countries in the Middle East) to
meet the lion’s share of its requirement.
The import dependence for crude and the consequent vulnerability of
the country to oil price shocks has exacerbated over the recent past
owing to rapid growth of the Indian economy post-1991 that has fuelled
a rapid growth in oil consumption.
Petroleum Pricing Mechanism in India

The pricing of crude and petroleum products in the country has been
influenced by a multiplicity of politico-economic factors and (oft-
contradictory) interests of various actors and interest groups involved in
the matrix, such as the consumers, particularly the vulnerable sections;
the producers; refiners; marketing companies; and the government.

Till1997-98 the domestic petroleum sector in India was operating under

administered Pricing Mechanism (APM) for refined petroleum
products. The pricing mechanism was based on the concept of
retention price, by which refiners were allowed to retain out of their
sale proceeds - cost of crude, refining cost and a reasonable return on
investment. The same mechanism was extended to marketing and
distribution companies, which were compensated for operating costs
along with an assured return.
In addition to these, the price at which the finished products were
finally sold was set by the Government and was totally delinked from
returns of oil companies. The APM played a significant role in
insulating oil producers, refiners and marking companies from global
oil price fluctuations and fulfilled the socio-economic objectives of
the government considerably but in the process failed to generate
adequate incentives for investment in the sector and thus failed
miserably to create a vibrant and globally competitive oil industry.
Objectives of APM

The primary objectives of the APM were as follows:

• To optimize the utilization of refining and marketing infrastructure by treating the

facilities of all the oil companies as common industry infrastructure, the access of
which would be available to all the oil companies by hospitality arrangements, thus
eliminating wasteful duplication of investment.
• To make available all products at uniform ex-refinery prices so as to minimize cross-
haulage of products and associated energy costs.
• To ensure continuous availability of crude to refiners by recognizing import needs
wherever there are deficits in indigenous production.
• To ensure that the returns to oil companies are reasonable and in line with
operational efficiencies and to see that sufficient resources are generated to enable
industry to setup facilities to meet the growing needs.
• To ensure stable prices by insulating domestic market from the volatility of crude and
product prices by making products available at subsidized rates for weaker sections
of the society and priority sectors in the industry through cross-subsidization.
Transition to Market Determined Pricing Mechanism

The Government in November 1994 had set up an industry study group

under the chairmanship of Mr. U. Sundararajan, the then Chairman and
Managing Director, BPCL (Bharat Petroleum Corporation Limited) to
prepare the blueprint of the deregulation and tariff reform that was
required in the oil sector and provide a framework for the development
of Market Determined Pricing Mechanism (MDPM).
The Committee, while expressing its concern for a possible burgeoning
increase in consumption of petroleum products in future and limited
existing indigenous production and refining capacity to meet that
expected increase, came out with some broad recommendations
which are as follows:

• Recovery of oil from existing fields should be enhanced; exploration

efforts should be accelerated to find new fields and acquire equity
capital abroad.
• Additional refining capacities and marketing infrastructure should be
created
• Port facilities and pipeline capacities should be augmented
• Foreign and domestic investments should be promoted in the
hydrocarbon sector
• Efficient use of oil should be promoted
To achieve these broad objectives, the Committee suggested that the
entire oil sector (upstream, downstream and marketing) should be
completely opened up through the following steps;

• Introduction of market determined pricing mechanism (MDPM)

• Removing all restrictions on imports and exports
• Removing restrictions on sourcing and type of crude and product
pattern
• Allowing oil companies to decide on development of infrastructure,
mode of transportation, the selection of marketing areas,
appointment of dealers/distributors, the amount of commission
payable to intermediaries and the sales volume, purely on
commercial considerations
Ensuring fair competition by setting up a regulatory body to control the
market in a transparent manner. Pipelines that are natural monopolies
should be treated as utilities and the common energy carrier principle
should be adopted

Setting up of an oil commodity exchange to provide an institutional

market for exchange of crude and petroleum products at market related
prices

The hydrocarbon sector should be totally de-regulated at one go

¾ by evolving suitable tariff structure to promote investment in the

sector without diluting the revenues of the government
¾ by removing subsidies; wherever products need to be subsidized,
Central and State Governments should directly disburse subsidies and
oil companies should be permitted to sell all products at market related
rates
Post-APM Scenario

Crude Pricing

The import parity price of crude oil produced by ONGC, the largest crude oil
producer in India, consists of the following components:-
1. FOB prices of the respective marker crudes adjusted for Gross Product
Worth (in US $/ barrel)
2. Ocean Freight (Average Freight Rate Assessment for VLCCs)
3. Insurance
4. Customs Duty
5. Ocean Loss
6. National Calamity Contingent Duty (NCCD)
7. Port dues
8. Octroi
Petroleum Products Pricing

The various notional components of the import parity price of the

petroleum products are:
• FOB price as quoted in Arab Gulf Market and as reported in Platts
and Argus
• Premium / discount as published in Platts or Argus
• Ocean freight from mid-port in the Arab Gulf to Indian ports
• Insurance
• Exchange rate
• Custom Duty
• Ocean Loss
• Wharfage and Port Charges
Import Parity Pricing
The oil marketing companies have two sources for obtaining petroleum
products, viz. imports and/or procurement from domestic refineries.
Import-parity price of the petroleum products basically means the price
that the actual importer would pay for the imported product. The
pricing of petroleum products on ‘import parity’ basis at refinery gate is
basically aimed at bringing parity in the cost of product procurement
from various sources.
 Petrol & Diesel Prices in New Delhi - (3rd February 2018)
Fuel Type Petrol Price Diesel Price

International Price of Crude Oil with Ocean Freight (as on 3rd February 2018) 65.5 $ or Rs 4200 per Barrel 65.5 $ or Rs 4200 per Barrel

1 Barrel of Crude Oil 159 Litre 159 Litre

Crude Oil - Cost per Litre Rs 26.42 per Litre Rs 26.42 per Litre

Basic OMC Cost Calculation

Entry Tax, Refinery Processing, Landing Cost & Other Operational Costs along with Margins Rs 4.75 per Litre Rs 7.5 per Litre

OMC Margin, Transportation, Freight cost Rs 3.31 per Litre Rs 2.87 per Litre

Basic Cost of Fuel after Refining Cost Rs 34.48 per Litre Rs 36.79 per Litre

Additional: Excise Duty + Road Cess as Charged by Central Government Rs 19.48 / Litre on Petrol Rs 15.33 / Lit on Diesel

Pricing Charged to Dealers before VAT Rs 53.96 per Litre Rs 52.12 per Litre

Calculating Dealer Retail Price - Base Location Delhi

Commission to Petrol Pump Dealers Rs 3.59 per Litre Rs 2.51 per Litre

Fuel Cost Before VAT (rounded off for approximation) Rs 57.55 per Litre Rs 54.63 per Litre

Additional:VAT (Varies from State to State - 27% on Petrol & 16.75% on Diesel + 25p as Pollution Cess with
Rs 15.54 / Lit on Petrol Rs 9.44 / Litre on Diesel
Surcharge)

Final Retail Price as on 3rd February 2018 -(calculation) Rs 73.09 per Litre Rs 64.07 per Litre