Under recovey

Monday, October 20, 2014

4:57 AM

Under- recovery - It is the gap between the local price of fuel and what
would have been the price if the fuel were imported.

Is under-recovery the same as loss?

It is a notional loss in revenue to the extent the international price of the
fuel is higher. It may or may not be a loss-making proposition to produce
the fuel when there is an under-recovery.
Under-recovery is not the same as a loss
under-recovery is a notional concept and does not necessarily mean a
loss.
The only exception when it could include a loss is where global crude oil
prices surge to abnormal levels and the retail price of fuels remains
unchanged

The idea of under-recoveries is actually pretty straightforward. Let's

assume that it costs a refiner-cum-marketer like Indian Oil $2 to produce a
unit of diesel from crude. This includes all costs the cost of the crude
itself (which forms the bulk of costs), as well as the costs of refining,
manpower and even financing costs. But due to price controls in the
Indian market, IOC is forced to sell that diesel to you and me at $1. Thus,
the loss to IOC, as you and I would understand it, from selling diesel at a
subsidised price below its costs, is $1 ($2-$1).
But suppose the global market price for diesel, and the cost at which India
can import it, is $4. While the 'loss' to IOC is $1, the under-recovery as the
government calculates it, is $3 ($4-$1).
Under recovery assumption - people should pay the cost equal to the cost
of importing diesel from the international market

Are Under Recovery and Loss are similar

terms?
OMCs are selling Diesel at Rs. 10/L loss. They get
the same amount back, partly through Govt.
subsidies and partly through discounts from oil
suppliers (ONGC and OIL).
Notionally, OMCs dont incur any losses but the
delay in repayment of subsidies by Govt. means
OMCs have to borrow money from the market and
that entails a heavy Interest cost.

Under recovery = market price - selling price

Loss = CP - SP

Under-recoveries the difference between the oil companies

desired price of a fuel, say diesel, and its
prevailing retail price in the domestic market.

This desired price is calculated on trade-parity

basis that takes into account the landed cost of
imported fuel and the price at which it is
exported by domestic refineries.
Presently, the ratio is 80:20 in favour of
landed cost.

LossIn case of kerosene, oil companies suffer an under-recovery as well as a

loss because the local retail price is much lower than the cost of crude oil.
But sale of a product like petrol can still be very profitable at times, even
if oil companies are reporting under-recovery of a few rupees a litre.
Can oil companies be at a disadvantage by linking prices to underrecovery?
Yes. This may happen next year. In 2010, very little new refining capacity
was added in Asia, while demand was strong. Next year, China and the
Middle East will add about 1 million barrels per day of refining capacity.
This is expected to increase supply of products and deflate refining
margins. As a result under-recovery is expected to fall.

India imports crude, refines it into diesel, and sells it to the end consumer.
What India doesn't do is import diesel and sell it to the end-consumer (at
least not on a large scale).
That key distinction between importing crude oil and importing diesel,
is what makes all the difference.

As a report by a committee on fuel pricing headed by C Rangarajan

pointed out a few years back: "The under-recoveries are different from the
actual profits and losses of the oil companies as per their published results.
The latter take into account other income streams like dividend income,
pipeline income, inventory charges, and profits from freely priced
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when a producer is forced to sell his product below

cost.

pipeline income, inventory charges, and profits from freely priced

products and refining margins in the case of integrated companies." In
short, no.

Before 1998, the government compensated oil companies on a 'cost-plus'

system essentially allowing them to charge a price(subsidised to the
end-consumer) which accounted for costs as well as a 12% profit margin.
This gave little incentive to oil companies to undertake crucial investments
or even exercise cost control, since they were guaranteed a minimum
return.
The switch to the current system of pricing, which is benchmarked to the
international market was completed in 2002. Since then, claims the
government, refinery capacity in the country has risen to 213 millions
from 114 million tons, with about 40% of capacity in the private sector.

The government on Saturday deregulated diesel prices. In simple terms,

the government will no longer decide the selling price of diesel in the
country. That decision will now be taken by oil retailers such as Indian Oil
Corp, BPCL and HPCL.
1. The cut in diesel prices today will lead to a further cool off in inflation.
That's because diesel is the most used fuel product in the agriculture
sector and the transportation industry, both of which have a direct
bearing on food prices. Lower inflation will improve purchasing
capacity of common people.
2. A further fall in inflation - Reserve Bank to cut rates- boost demand in
the economy.
3. The government's subsidy bill will come down
4. Lower subsidy means the government may be able to meet its fiscal
deficit target of 4.1 per cent of GDP. This will be a big positive for the
Indian economy.
5. Lower fiscal deficit will reduce government borrowing and increase
spending on asset creation, which will add to economic productivity.
6. India imports over 75 per cent of its domestic oil requirements. Oil is
the biggest component of the import bill. Falling crude prices will lead
to a reduction in import bill and will have a positive impact on rupee.
7. Diesel sales account for about 55 per cent of overall sales of oil
marketing companies. Till now, these companies had to pay part of the
subsidy on selling diesel at below-market price to the government.
Saturday's move will ensure that these companies will not have to shell
out money for diesel subsidy. Their profitability will go up and so
expect shares in IOC, BPCL and HPCL as well as upstream oil
companies such as ONGC to jump on Monday.

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