With rising oil prices, time to reduce LPG subsidy

When oil prices collapsed, there was some expectation that the NDA government may take some hard decisions to reduce oil sector subsidies especially selling of LPG which help mostly the middle class and the rich. Unfortunately, the Narendra Modi government has so far not shown any signs of taking such a bold step. Ever since the introduction of LPG for residential use in 1980s, it has always been subsidised. Earlier, there was a need to popularise it. Now, it has become a political hot potato especially after the stunning success of AAP in Delhi’s election.

Very few had predicted the fall in oil prices to the current low level in 2014. After reaching a high of $110 per barrel in June, 2014, Brent fell to a low level of $45 in January of this year. Since then, oil price has recovered to above $60, an increase of 38 per cent. Will oil prices fall or increase or remain around the current level? This is a million dollar question for which there is no definite answer. Forecasting oil prices is still an art than science because of many unpredictable factors.

Still, oil experts from investment banks, private consulting companies, government agencies, etc., attempt to predict, if not a precise price. Having burnt their fingers in the past, economists from oil companies are not so brave today to take such a risk.

For example, in a note published by Citibank in February, analysts found the possibility of crude oil falling to $20. On the other hand, JP Morgan analysts are predicting that oil prices might have bottomed out and are likely to rise. Similar predictions are made by International Energy Agency (IEA) and Energy Information Administration (EIA) of the US. There are some who even predict oil prices falling to $10 which is highly unlikely based on marginal cost of oil production to meet the demand. The EIA predicts an average price of $58 for 2015 and $67 for the fourth quarter.

In recent months, oil price volatility has increased more than three times based on the analysis of oil future prices. Implied oil price range for December 2015 according to EIA is between $32 and $108. Reasons for such uncertainty are as follows.

Though oil prices have fallen by more than 50 per cent, it is not clear how supplies will respond. A recent study by Wood Mackenzie, an energy research organisation showed that only 1.6 per cent of 2,200 oil fields surveyed by them will have negative cash flow even at $40. Marginal cost of shale oil production in Permian Basin in the US is only about $20. With such low marginal cost, oil supplies might not have responded as expected by Saudi Arabia when they decided to maintain their market share and allow the market to set the prices.

Still, it cannot be ruled out that some of the oil exporting countries including Saudi Arabia may decide to control production not being able to manage with low oil prices. The greatest uncertainty is the possible disruption in oil supplies in politically unstable countries like Iraq, Iran, Libya, Nigeria, and Venezuela. There is also some probability, depending upon how normalcy may come to the first three countries, that oil production in those countries can easily add three million barrels per day (mmbd).

However, it is more than likely that the OPEC decision to maintain market share has an impact on medium term oil supplies. Just about every oil company has reduced exploration and production budget which is bound to reduce non-OPEC production in the medium term.

Supply, demand uncertainties
However, on demand side, there will be positive results as a result of fall in oil prices. OPEC is forecasting oil consumption to increase by 1.2 mmbd to reach 92.3 mmbd in 2015. The current production spare capacity according to IEA is around 3.4 mmbd. With all the uncertainties of supply and demand, and relatively small spare capacity, oil market can easily turn around should there be any oil disruption which we cannot foresee today.

It is quite likely that when oil prices start increasing again (which is more than likely in the next few years), it may easily go above $100. Some even suggest as high a price as $200. At that time, if India continues to subsidise residential LPG like today, the subsidy burden may exceed Rs 1,00,000 crore per year.

If the NDA government is interested in helping the poor by improving education, providing other welfare measures like subsidised quality power, water supply and health facilities, then it needs all the funds it can save by limiting subsidy to the middle class and poor. LPG sector subsidy is one such to tap into provided there is political will.

The best time to eliminate subsidy for any commodity is when consumers do not suffer much when that commodity is liberalised. LPG subsidy per cylinder has fallen from a high of around Rs 480 per cylinder to the current low level of Rs 113. Instead of eliminating the subsidy in one step, it can be done over a period of six or 12 months, as they did in the case of diesel, to minimise the hardships on the consumers. Of course, the poor can continue to be assisted through direct subsidy through Aadhaar system to prevent any leakage.

If the NDA government waits long and oil prices increase, which is more than likely, then it would have lost a golden opportunity of helping the poor by eliminating LPG subsidy.