Knowledge Series 5

Thirsty India
While the sustained economic growth of recent years has brought several wideranging and mostly positive changes to India, it has also resulted in a burgeoning appetite for energy to sustain that growth. DhanBank PRU looks at the broad contours of the energy industry in the country.

Topic
1. A crude run down a) Types of crude oil b) Spread between heavy and light crude c) Benchmark crude oil prices d) Factors affecting crude oil prices 2. Industry structure 3. Domestic scenario a) New exploration licensing policy b) Consumption of petro-products c) Demand drivers of crude oil in India 4. Regulatory framework 5. Current scenario a) Opec to improve spare capacity ratio b) Petroleum product pricing 6. Financial performance 7. SWOT analysis

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A Crude Run Down

rude oil (or petroleum) and natural gas are a major source of primary energy used world over. Crude remains one of the worlds most widely traded sources of energy.

Most of the worlds oil and gas resources are concentrated in the west Asian region. Saudi Arabia is the largest producer of crude oil in the world and USA the largest consumer. For a long period, the developed world was the dominant oil consumer. However, in recent years developing economies, including China and India, have been reporting robust growth in consumption, backed by sustained economic growth. The largest natural gas reserves almost a quarter of the worlds total -- are with the Russian Federation. Natural gas can either be used as a primary source of energy as is by fertiliser units or can be broken down into various hydrocarbons such as ethane and its derivatives.

Types Of Crude Oil

In simple terms, crude oil comes in various varieties defined according to its density and sulphur content. While all varieties of crude yield all types of fuels, the ratio of higher and lower value fuels differs from crude to crude. Broadly there are two main types of crude light and heavy. Also, along the process of refining, any variety of crude oil generally yields three main kinds of distillates lower, middle and heavy or residuum. Lower distillates include aviation turbine fuel (ATF), liquefied petroleum gas (LPG), petrol (gasoline) and naphtha. Middle distillates involve fuels like kerosene and diesel. Heavy distillates or residuum comprise lubes, heavy fuel oil and asphalt.

Lower distillates (or alternatively higher value products) are more easily produced through a simpler distillation of lighter crudes. The denser (heavier) crudes produce a greater share of heavy distillates through simple distillation and require additional processing to produce the lower distillates.

Spread Between Heavy And Light Crude Oil

Crude varieties with light and sweet properties are easier to distil into high value, high quality products. Hence, they are sold at a premium compared to the heavy and sour varieties. The spread between the prices of heavy and light crude varieties reflect the demand scenario. Increasingly, production of light crude is rising faster than that of the heavy variety, affecting the proportion of light and heavy varieties in global oil market mix. Earlier, refiners were not able to process heavy crude because of its higher wax content which coagulates the refining system, resulting in a larger spread in prices. However, the incremental refining capacity being added has the capability to refine heavy oil as well.

Benchmark Crude Oil Prices

Of the various crude oil varieties, three are commonly traded on exchanges and used as benchmarks -- Brent (benchmark in European region), West Texas Intermediary (US) and Dubai (Gulf). Mostly because of a severe demand-supply mismatch, crude prices surged to $140 a barrel in 2008. With the advent of the global financial crisis, slowdown in major economies and subsequent fall in demand for crude and its derivates, prices nosedived to $40 per barrel in December 2008. There has been some pick-up in prices subsequently as demand started showing some signs of revival thanks to

the various government stimulus programmes taking hold across the globe. Crude prices even touched $80 a few months ago.

Factors Affecting Crude Oil Prices

Demand and supply. Political situation in oil rich countries and production policies of Opec countries. Stock positions of large consumers such as the US. Weather conditions -- severe winter or summer pushes up demand for petroleum products. Speculative trading while demand-supply conditions are the basis for movement in prices, speculation about higher/lower demand also has an important role to play.

Oil stocking by various countries as part of energy security strategy.

Industry Structure

he Indian petroleum industry is mainly divided into upstream and downstream companies. While the upstream segment includes exploration of oil and gas, downstream companies are involved in refining and marketing of the products. Refineries distil crude oil and process it into fuel and lubricating products, the important among these being petrol, diesel, LPG, kerosene, ATF and lubricating oil. The upstream companies in India include ONGC, Oil India, Essar Oil, Hindustan Oil Exploration, Selan Exploration Technology and Cairn Energy. The downstream segment involves refining of crude oil (distillation, conversion and treating) into final products and marketing of these products. Those entities involved only in refining and not marketing are known as standalone refineries. Chennai Petroleum, Bongaigaon Refinery and Numaligarh Refinery are examples of this category. Companies which both refine and market are known as integrated refineries -- IndianOil Corporation, Hindustan Petroleum, Bharat Petroleum, Mangalore Refinery and Kochi Refinery. Reliance Industries could be broadly put in a third category, as the company is present along all points of the value chain from oil exploration to polyester [the main textile derivative of petroleum] to fabrics. There are standalone marketing companies too such as Indo Burma Petroleum Company. Some companies are also involved in production and marketing of lubricants, petroleum coke, paraffin wax, bitumen and asphalt. For instance, Castrol India, Bharat Shell and Goa Carbon among others. In the past few years the Indian petroleum refining industry has witnessed consolidation, with oil marketers taking over standalone refineries. ONGC bought out the total share of the initial promoters, A V Birla Group, in Mangalore Refineries (MRPL) and infused further equity capital, in the process making MRPL its subsidiary. IBP Co also got merged with its parent company -- IndianOil Corporation. Also, Kochi Refinery was merged into its parent Bharat Petroleum.

The Legend of Digboi Dig-boy,dig, shouted the British engineer, W L Lake, at his men as they watched elephants emerging out of the dense forest with oil stains on their feet. This is possibly the most distilled though fanciful version of the legend explaining the siting and naming of Digboi the small town in Tinsukia, Assam, which houses Indias and Asias first and one of the worlds oldest oil wells. Crude oil was struck here in 1882 by the Assam Railways and Trading Company. According to the legend, officials noticed quite by accident that the slush sticking to the feet of elephants, which were being used to lay railroad tracks, smelt of oil. Retracing the trail of footprints, they found oil seeping to the surface. Lake being an oil enthusiast, persuaded the company to drill a well. The first well was started in Digboi in September 1889. This historic site continues to produce oil, though production is not too high.

Wikipedia

Once the sector was opened after the commencement of economic reforms in 1991, the industry witnessed the entry of private players such as RIL. Cairn and Essar followed suit.

Domestic Scenario
ndia produces just over 26% of its total crude consumption. Government-run ONGC is the countrys largest oil producer, contributing about 78% to the total production. The other state-run player involved in exploration and crude production is Oil India.

New Exploration Licensing Policy

To explore and develop Indias oil and gas reserves, the government devised the New Exploration Licensing Policy (NELP). The scheme was brought into effect in 1997-98, providing equal opportunities to all interested parties in the award of oil and gas exploration blocks. Under NELP, the successful bidder is required to enter into a production sharing contract with the government.

RIL, Essar Oil and Cairn India are the major private sector participants in Indias oil production business. While ONGC has accounted for nearly 75% of the oil and gas output in India till recently, its share has been declining, with private sector participants eating into its pie. After the government opened up the refining sector in 1991, private participants like RIL and Essar Oil set up refineries. As on April 1, 2010, there were 21 refineries in India with a combined refining capacity of 18.44 crore tonnes (184 million tones, see table 1).

Table 1: Installed Refining Capacity As On 1 April 2010 (in million tonnes) IndianOil Corporation Hindustan Petroleum Corporation Bharat Petroleum Corporation Chennai Petroleum Corporation Numaligarh Refinery ONGC Mangalore Refinery & Petrochemicals Total PSU Reliance Industries Reliance Petroleum (recently merged into parent co RIL) 51,200 13,800 21,500 10,500 3,000 78 11,820 1,11,900 33,000 29,000 10,500

Consumption Of Petro-Products

Petroleum products form an important Total Joint Venture & PVT Companies 72,500 energy source in India, accounting for a GRAND TOTAL 1,84,400 third of the requirement and second only to coal. Consumption of petro-products grew at a compounded annual rate of 4.4% during the five years ended March 2010 (see table 2, page 4).

Essar Oil

Table 2: Consumption Pattern Of Petro-Products In India % YoY Growth 2007-08 High Speed Diesel LPG Motor Spirit / Petrol Furnace Oil /LSHS Naphtha Superior Kerosene Pet Coke Bitumen Aviation Turbine Fuel Others TOTAL 11.1 12.1 11.3 0.8 -4.3 -1.5 9.4 17.6 14.1 -0.6 6.8 2008-09 8.5 1.5 9 -1 4.6 -0.7 3.6 5.3 -2.6 -15 3.6 2009-10 (Prov.) 8.9 6.3 13.9 -7.9 -26.4 0 9.5 3.6 4.6 19 3.4 2007-08 37 9.4 8 9.9 10.3 7.3 4.6 3.5 3.5 6.5 100 % Share In Total 2008-09 38.7 9.2 8.4 9.4 10.4 7 4.6 3.6 3.3 5.4 100 2009-10 (Prov.) 40.8 9.5 9.3 8.4 7.4 6.7 4.9 3.6 3.3 6.2 100

High speed diesel (HSD) is the highest consumed product. It is widely used as a fuel for transport sector, including trucks (which consume 37% of total diesel), buses (12%) and passenger cars (15%). HSD is also used for agricultural and power generation purposes. LPG and kerosene are broadly classified as cooking fuels. While the share of superior kerosene is declining, that of LPG is rising, consequent to increased urbanisation and rising living standards. Demand for ATF had been rising rapidly until the global recession hit the aviation industry.

Naphtha and furnace oil are used as feedstock fuel for the fertiliser units, power plants and the petrochemical industry.

Even though two-third of the crude oil consumed in India is imported, with the commissioning of RILs Jamnagar refinery, India has become a net exporter of petroleum products. RIL has commissioned another refinery in Jamnagar as an export-oriented unit.

Demand Drivers Of Crude Oil In India

Since India has expanded its refining capacity rapidly in the past few years, crude oil imports have also surged. So, higher crude imports are not only an indication of higher domestic demand for petroleum products, but are also indicative of an increase in exports of petroleum products from India.

Regulatory Framework
he oil sector was strictly under government control till recently. Under administered pricing mechanism (APM), prices of crude oil and petroleum products were fixed in such a manner so as to ensure fixed returns to companies.

Prices were decontrolled from April 1, 2002, by the NDA government, wherein oil marketing companies were free to price petrol and diesel in line with import parity prices. However, LPG for domestic use and kerosene sold under the public distribution system continued to be subsidised, which would also later be dismantled. However, with surging crude prices, the government decided to review the tariff structure on petrol and diesel on a quarterly basis, taking into account factors such as global oil prices and domestic retail prices. Since then, the government has been controlling the prices of all essential products, including petrol, diesel, LPG (for domestic use) and kerosene (under PDS). Recently, the empowered group of ministers (EGoM) finally freed fuel prices from the APM amid huge political opposition. The panel of ministers said petrol prices will henceforth be market driven, while diesel prices were only partially freed. Kerosene and cooking gas prices were raised and are expected to be freed at a later date. It is, however, unclear as to how under-recoveries in FY11 will be shared and by whom, thereby dampening the enthusiasm of companies and investors.

Bombay High
Supplying 14% of Indias oil requirements and accounting for about 38% of domestic production, Bombay High is perhaps the most important fuel asset the country has got within its territorial limits. Bombay High is an offshore oilfield 160 km off the coast of Mumbai. The oil operations are run by ONGC. Bombay High field was discovered by a Russian and Indian oil exploration team operating from the seismic exploration vessel Academic Arkhangelsky during mapping of the Gulf of Khambat (earlier Cambay) in 1964-67. It was a curious combination of reasons that gave the field its name. For one, it got the name Bombay because the team that conducted a geological survey in 1965, functioned out of Rashmi Building at Cumballa Hill in Mumbai, then called Bombay. Also, since the deposit was found in an anticlinal fold trap (upward convex, in the form of a hill), that gave birth to the High bit in the name. The field was thus called Bombay High. The first offshore well was sunk in 1974.

Wikipedia

Current Scenario
he financial crisis that engulfed the developed world, particularly the US, hit the demand for crude. However, developing economies such as India and China keep demand buoyant, though its still below the past demand levels displayed by the US or Europe.

Production from ONGCs oil fields is constrained by the declining potential of many traditional fields. The situation is expected to improve with more investments being made in oil recovery schemes. Oil is expected to flow from discoveries by new private sector entrants like RIL, Cairn India and Essar Oil.

Opec To Improve Spare Capacity Position

A major factor that influences the global crude oil market is Opecs spare capacity, which is the amount of crude available to meet global demand in case of disasters such as hurricanes and wars. This spare capacity and crude prices have an inverse relationship. In the past few years, besides the demand-supply mismatch, rising exploration and production costs too have been pushing up prices. Demand for oil rigs -- onshore and offshore -- rise with increase in investment in oil exploration.

Petroleum Product Pricing

The government is actively involved in determining retail fuel prices in India. Being administered, retail prices are kept lower than the prevailing market prices, which leads to under-recoveries for the public sector oil marketing companies. In June 2010, the EGoM freed petrol prices from the shackles of the administered price mechanism regime. Details are covered under Regulatory Framework.

Financial Performance
erformance of the crude oil and natural gas sector (only upstream companies) in India is mainly determined by the performance of ONGC -- the largest oil exploration company. The major cost components of this industry include royalty and cess paid by companies to the government (see table 3).

While rising prices have augured well for the explorers, the subsidy burden borne by public sector companies, including ONGC and Oil India, dent the profitability of the industry. These companies share with the oil marketing companies the under-recoveries arising out of retail sales below market prices. On account of lower margins and high subsidy burden, the financial performance of oil refiners and marketers has been poor. The petroleum oil & products industry (upstream & downstream) accounts for a large chunk of the revenues of corporate India. Lower prices of petroleum products, including regulated ones like petrol and diesel as well as non -regulated ones, pulled down overall sales by 4.4% in FY10. Also, 2009-10 was a slow year for overall demand, with demand for petro-products picking up pace from the December 2009 quarter. Crude oil prices recorded a YoY rise from the December 2009 quarter onwards, resulting in a 3.1% fall in raw material cost. The industry registered an 8.1% growth in employee cost. A fall in interest charges and other expenses, together with lower raw material expenses, enabled it to record a 29.1% rise in net profits.

Table 3: Financial Performance Of Petroleum, Petro-Products & Natural Gas Cos Rs crore % y-o-y growth Mar-08 Mar-09 Mar-10 Mar-09 Mar-10 Net sales Other income Raw materials, stores, spares & purchase of finished goods Salaries and wages Other expenses Interest expenses Depreciation Total tax provision Net profit 714,210 9,911 587,376 9,473 40,777 4,557 20,443 19,254 46,120 890,178 14,605 724,881 13,656 63,332 12,324 25,898 16,611 40,424 850,778 15,755 697,514 14,758 55,679 7,450 34,236 21,037 52,183 24.6% 47.4% 23.4% 44.1% 55.3% 170.4% 26.7% -13.7% -12.3% -4.4% 7.9% -3.8% 8.1% -12.1% -39.6% 32.2% 26.6% 29.1%

Note: Sample includes only 21 oil and gas companies with financial data available for all three years, for ease of comparability.

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SWOT Analysis
Strengths
Demand for petroleum products increases with economic growth. Expectation of healthy economic growth could bolster consumption of petroleum products, and hence sales of oil companies. India has the potential of becoming a petroleum products hub, with many countries looking to source refined products from relatively low-cost countries.

Weakness
High dependence on imported crude oil accounting for over 80% of the consumption could pose an energy threat to the country anytime in the future. In this sense, such high dependence could amount to a strategic disadvantage. The sector is partially government-administered that is, in LPG (domestic) and kerosene (under PDS) -denting profitability of upstream and downstream companies. Lack of crude storage makes the country and by, extension, the oil companies vulnerable to oil shocks.

Opportunities
The recent petrol price deregulation augurs well, especially for private players. Backward and forward integration in the petroleum value chain portends a bright future. Natural gas has the potential to be the fuel of the future with demand outpacing supply.

Threats
Deregulation of prices will boost competition for existing refining and marketing majors, with a possibility of shrinkage in their market shares and, consequently, margins. Continuation of government interference can hamper profits.

Note: All data used in the charts, graphs and tables in the previous pages have been sourced from the Ministry of Oil and Natural Gas, Govt of India.

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