STATE-OWNED OIL MARKETING COMPANIES LEFT WITH FEW CHOICES AS

UNCLAS SECTION 01 OF 05 MUMBAI 000244

SENSITIVE
SIPDIS

STATE FOR EEB/ESC DHENGEL, PHAYMOND, KBEL
STATE FOR OES CHILL
DEPT OF ENERGY FOR U/S BUD ALBRIGHT, DSCHWARTZ
DEPT OF ENERGY IP FOR A/A/S KFREDRIKSEN, RCOOPER, GBISCONTI
DEPT OF ENERGY IP FOR TCUTLER
DEPT OF ENERGY FE FOR DAS JSWIFT, RLUHAR
INR FOR AL WOOD AND RAY LESTER
EXPORT IMPORT BANK FOR JESSICA FARMER AND ASHOK PASRICA
STATE FOR EEB JKOPP

E.O. 12958: N/A
TAGS: EFIN EPET ECON IN
SUBJECT: STATE-OWNED OIL MARKETING COMPANIES LEFT WITH FEW CHOICES AS
PETRO-PRODUCT RETAILING IN INDIA BECOMES INCREASINGLY UNSUSTAINABLE

REF: 07 MUMBAI 0672

MUMBAI 00000244 001.2 OF 005


Summary:
--------------


1. (U) The three state-owned integrated oil refining and
marketing companies (OMCs) have been hit by a triple whammy --
spiraling crude oil prices of over USD 120 a barrel, the
depreciating rupee via-a-vis the dollar, and a higher inflation
rate of over 7 percent. These three factors have widened the
discrepancy between the actual cost of petro-products and the
"politically acceptable" sale price that is determined by the
Indian government. The OMCs will have to absorb USD 3.8 billion
in losses in 2007-08, even after the government and state-owned
upstream oil companies partially compensate them for their
losses through the issue of oil bonds and subsidies. The OMCs
still have to gain the experience to participate in the
relatively nascent commodities market to hedge against future
crude price increases. The federal government is considering
several options to ease the woes of the state-owned OMCs after
international oil prices crossed USD 130 a barrel last week, but
it has yet to announce a price increase for the "controlled"
petro-products. The OMCs, left with little choice, have
proposed curtailing their losses through "rationing" measures.


2. (U) Due to India's shortage of petro-products, especially
diesel, the Government of India prevents the state-owned OMCs
from exporting and, consequently obtaining free market prices,
for their refined petro-products in the international market.
The refinery expansions of Reliance Industries and Essar Oil
will add significant refining capacity in India, and if
Reliance's claims are to be believed, may even help ease the
international crude oil rise which is partially linked to a
world-wide refining capacity shortage. Both companies said that
they will be able to meet domestic demand as well as export
refined petro-products once the refinery expansions are
completed. End Summary.

Mounting Losses Force OMCs to "Ration" Supplies
--------------


3. (U) State-owned integrated refining and marketing companies
-- Indian Oil Corporation, Bharat Petroleum Corporation and
Hindustan Petroleum Corporation - claim that they lose over USD
100 million each day by selling petrol, diesel, kerosene and
domestic cooking gas below the actual production price.
According to a report prepared by Enam Securities, a leading
Mumbai-based brokerage, the Indian consumer pays around USD 49
per barrel for these products although the Indian oil basket
averaged USD 110 a barrel in April. The Indian government
believes that increasing the domestic prices of these products
in line with the rise in international oil prices will result in
a cascading effect on the entire economy and will bring immense
hardship to the "aam aadmi" (common man). The Ministry of
Petroleum & Natural Gas has estimated the gross under-recoveries
-- the shortfall between cost of production and the selling
price -- of the OMCs at around USD 18 billion in 2007-08.
ABN-Amro estimates these under-recoveries will more than double
to USD 46 billion during 2008-09 if international crude oil
prices remain over USD 120 per barrel.


4. (U) The Enam report maintains that the retail prices of
petrol and diesel need to be raised by 44 percent and 66
percent, respectively, and the prices of domestic cooking gas
and kerosene supplied through the public distribution system
have to rise by 68 percent and 300 percent, respectively, to
pass on the full impact of the international oil price rise.
Vinod Panjwani, Senior Manager (International Trade) for Bharat
Petroleum Corporation (BPCL) explained that oil companies suffer
the maximum loss on account of low diesel prices due to the

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large volume of diesel consumed in the country. Diesel
accounts for 37 percent of petro-consumption; the Enam report
estimates that under-recoveries would drop by USD 1.4 billion if
diesel prices were increased by one rupee. However, Panjwani
noted that diesel is a mass-consumption fuel used for the
transportation of goods and agricultural pumps and tractors and
is more price sensitive than petrol, which is used primarily in
private automobiles. The government, therefore, prices diesel
lower than petrol to avoid a diesel price-driven compounding
impact on inflation, although both petrol and diesel cost almost
the same to produce, he explained.


5. (SBU) Media reports state that the Finance Ministry has
agreed to issue oil bonds worth USD 8.4 billion in 2007-08 to
compensate OMCs for around 46 percent of their gross under-
recoveries. Of this, oil bonds worth USD 4.8 billion have
already been issued to the OMCs in April-December 2007 according
to the Ministry of Petroleum & Natural Gas. An economist at
Enam Securities told Congenoffs that the maturity of oil bonds
is primarily 10-15 years. The bonds are given to the OMCs, who
then sell them to state-owned insurance companies and pension
funds, which are the only bodies allowed legally to buy them.
These institutions then often re-sell them to banks at a
discount. Since they do not qualify under the Statutory
Liquidity Requirement (SLR),which requires banks to hold a
certain amount of their capital in government securities, banks
are reluctant to buy them unless at a discount, he explained.
According to the Enam economist, these bonds are distributed to
the OMCs in tranches in a non-transparent, ad-hoc fashion. OMCs
do not know when to expect the next tranche of bonds and,
therefore, cannot gauge their future liquidity or cash flows, he
maintained.


6. (SBU) Despite the non-transparent and uncertain nature of
the bonds, the OMCs have repeatedly petitioned the Finance
Ministry to increase the government's share to 57 percent of the
total under-recoveries by issuing additional oil bonds. (Note:
Under the current burden-sharing arrangement, the government
issues oil bonds to sustain 42.7 percent of the
under-recoveries, oil prospecting or upstream companies bear 33
percent of the total loss through price discounts, and the
balance is borne by the state-owned OMCs. End Note) The OMCs
will therefore have to absorb the balance of USD 3.8 billion in
under-recoveries in 2007-08, after the issue of the remaining
bonds and subsidies by the upstream oil companies. However, tax
revenue and import duties from crude oil and domestic petrol and
diesel sales is significant, and some analysts believe this
income is as large or larger than the losses that the OMCs incur
for selling their products at below cost. In 2006-07, the
government collected around USD 17 billion of excise and customs
duties from crude oil and petroleum products. V. Ramamurthy,
Head-Technical of Essar Oil, told Congenoffs that the growth of
the service sector has resulted in a substantial increase in its
contribution to tax revenue and, consequently, the percentage of
tax revenue contribution by the oil sector has therefore gone
down in relative terms. The government is therefore no longer
dependent on the tax revenue from the oil sector to finance its
expenditure, he continued. The Finance Ministry may be
reluctant to reduce the revenue stream for fear of allowing
India's high fiscal deficit to inflate even more, however.


7. (SBU) BPCL's Panjwani admitted that the cap on the retail
prices of petroleum products wiped out all profits his company
made by its refining operations. He also noted that India's
energy crunch created a significant supply-side bottleneck
which,if corrected, would substantially increase India's growth
rate. Nevertheless, Panjwani pointed out that the "socialist"
nature of the government, the upcoming state assembly elections,
and possibility of early national elections prevented the

MUMBAI 00000244 003.2 OF 005


government from raising retail prices of petroleum products to
"politically unbearable" levels. Media reports state that BPCL
plans to limit the amount of petrol and diesel supplied to its
retail outlets to the amount sold by the outlets during the same
period last year. Reports claim that BPCL and the other
state-owned OMCs also plan to "freeze" new cooking gas
connections, fix a quota of one cooking gas cylinder per family,
curtail the import of diesel and hold off on expanding the
retail outlet network in the country to ride out the current oil
price rise and to reduce their mounting under-recoveries.
(Note: The Ministry of Petroleum & Natural Gas has publicly
stated that it is committed to ensuring uninterrupted supplies
of petrol and diesel and denounced any move to restrict or
ration supplies. However, state-owned OMCs claim that they are
forced to "restrict" sales of petro-products due to limited
availability. End Note). State-owned OMCs are also thinking of
promoting only branded, costlier petrol and diesel, which are
priced at a premium over the government-determined retail
prices, hoping that customers will be willing to pay more for
branded fuels which give greater mileage, lower emission and
maintenance costs and cleaner engines.

Private Refiners Opt out of Marketing Business but Still Hang on
to Assets
--------------


8. (SBU) Private-sector oil marketing companies do not receive
oil bonds and cash discounts to compensate for the shortfall
between the government-determined selling price and actual
production cost, unlike state-owned OMCs. Private-sector OMCs
are theoretically not "bound" by the retail caps on petrol and
diesel. However, they have no choice but to sell their products
at the "controlled" government prices or risk losing market
share. Both of the privately-owned OMCs -- Essar Oil and
Reliance Industries -- have abandoned their oil retail expansion
plans citing the absence of a "level-playing field" between
private and state-owned OMCs. However, Reliance Industries and
Essar Oil have not yet exited the oil marketing business, as
both believe that the situation could change in the future.
Either the government would be forced to allow the price to rise
or crude oil prices could fall, they opined. Although Reliance
Industries has closed its 1,400 oil retail outlets, it is still
holding on to the retail assets. Essar Oil's Sudip Rungta
explained that Essar took a strategic decision to price petrol
and diesel sold at their outlets at a much higher price than
that sold at state-owned retail gas stations. Consumers are,
therefore, unlikely to buy from their outlets and would prefer
to use the state-owned retail stations. Essar Oil operates
these 1,500 retail outlets through franchisees but Rungta
claimed that the company compensates its franchisees to maintain
its retail operations.

Host to Asia's Largest Grassroots Refinery, India Faces Refining
Capacity Shortage
--------------


9. (U) Provisional data from the Director General of Commercial
Intelligence & Statistics under the Ministry of Commerce shows
that India's consumption of petroleum products in 2006-07 was
120 million tons. Total production of petroleum products during
the same period stood at 135 million tones, indicating a supply
surplus of 15 million tons. However, 32 million tones of
petrol, oil and lubricants were exported, leaving the country
short of 17 million tons of these products which had to be
imported.


10. (SBU) The three-state owned OMCs supply exclusively to the
domestic market. Since India faces a shortage of refined petrol
and diesel, privately-owned Essar Oil also currently supplies

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all refined petroleum products manufactured at its 10.5 million
ton refinery to the domestic state-owned refiners. The company
sells these products at the refinery-gate price or the
import-parity price which is equivalent to the landed cost of
imported petroleum products and includes customs and excise
duties, freight, and transportation costs. Essar's Ramamurthy
explained that "hospitality" and "product-sharing arrangements"
between all oil refining-marketing companies assured that
state-owned OMCs would always buy Essar Oil's products at
international-equivalent prices. Reliance Industries -- the
owner of Asia's largest greenfield refinery -- exports almost
all of the petroleum products (excepting LPG) processed at its
33 million ton refinery at Jamnagar in Gujarat. BPCL's Panjwani
argued that Reliance should be banned from exporting its product
and should be "forced" to supply to the domestic market as India
had a deficit in meeting its petroleum consumption needs. In a
separate discussion, Hital Meswani, Executive Director of
Reliance Industries, claimed that state-owned refining companies
cannot export their petro-products as they are not able to meet
international specifications.


11. (U) Reliance is currently building another refinery at
Jamnagar which would make it the largest refining complex in the
world, with a refining capacity of around 66 million tons or
nearly 1.2 million barrels of oil per day. The new refinery is
expected to be completed by December 2008. Meswani said that
Reliance will be able to meet domestic demand and continue
exporting with the new capacity. According to Meswani, the new
refinery will be able to process all types of crude oil
(heaviest to lightest) from anywhere in the world and can export
the refined product to any country based on their particular
specification, he maintained. The refinery will help ease the
world-wide refining capacity shortage, which Meswani claims is
linked to the current international oil price rise.


12. (U) Essar Oil is also planning to expand its existing 10.5
million ton refinery to 34 million tones in two stages at a
total cost of USD 6 billion. In the first stage, the refining
capacity would increase to 16 million tons through
debottlenecking to remove the limits on output capacity.. New
expansion would subsequently increase refining capacity by
another 18 million tons. While the company can claim tax
benefits for the first expansion phase, it would not be able to
commence its 18-million ton expansion plan before March 31, 2009
which is the last date for claiming the tax benefits for
existing and new refineries. For this reason, Ramamurthy
explained, the company is considering setting up the new
refinery in a special economic zone so that it can avail of
export tax benefits. The completion of the 34-million ton
refinery will enable Essar Oil to export around 50-60 percent of
refined petroleum products and to supply the rest to the
domestic market, Ramamurthy added.

Oil Futures Trading: the Answer or a Distant Dream?
--------------


13. (U) The National Commodities Derivatives Exchange (NCDEX)
and the Multi-Commodity Exchange (MCX) offer the trading of
crude oil and furnace oil futures contracts in India. Indian
OMCs are not allowed to trade in foreign oil futures contracts.
The crude oil futures contracts offered by the two commodity
exchanges mimic the oil futures contracts on the New York
Mercantile Exchange (NYMEX) and the Intercontinental Exchange
(ICE),because, as Arvind Pal Singh, Assistant VP (Energy) of
NCDEX, pointed out, India has only 2-3 percent of the world's
crude oil reserves. Crude oil futures contracts are used for
risk-mitigation rather than price discovery in India, he
continued. NCDEX has only one indigenous contract linked to
the domestic price of crude oil. In contrast, furnace oil

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futures contracts are designed for price-discovery. There are
no futures contracts for refined products like petrol and diesel
because prices are "controlled" by the government. There is
zero price risk and no scope for price discovery for these
products, he added.


14. (U) Refiners can hedge against their crude oil import
exposure based on their past performance, or up to 50 percent of
their one-year or three-year inventories. Nevertheless, the oil
futures market in India suffers from low penetration and
inadequate liquidity, Pal Singh admitted. There are only a
handful of end-consumers for crude and furnace oil like refiners
and proprietary power generating companies who face a price risk
and therefore have an incentive to participate, he continued.
Participation is low even among these limited beneficiaries, he
continued. BPCL's Panjwani also confirmed that the
participation of oil companies in the futures trading market on
both the NCDEX and MCX is negligible. Pal Singh pointed out
that the commodity markets are relatively new in India and
online trading in commodity futures started only in 2003. The
markets still have to gain depth and liquidity and participants
have yet to become savvy at hedging, he continued. Moreover,
refining companies and proprietary power generating companies
prefer forward trading through the Over-the-Counter market,
rather than engage in futures trading, he added.

Comment:
--------------


15. (SBU) The structure of the oil bonds issued to partially
mitigate the losses of the state-owned OMCs lack transparency
and are shrouded in secrecy. One commodity trader and Indian
Oil Corporation shareholder told Congenoffs that the CFO of the
Indian Oil Corporation has declined to provide information on
the coupon rate and maturity of the oil bonds; Enam Securities
confirmed the opaque nature of these bonds. State-owned
entities (public-sector banks and pension funds) are the only
buyers of these bonds, which raises questions about their
overall liquidity. In fact, the Chairman of Oil & Natural Gas
Corporation (ONGC),a state-owned upstream company, told press
recently that he has refused to accept oil bonds as payment for
crude oil sales to the OMCs, but has instead offered to lend
these companies part of its cash surplus to help ease their
liquidity crunch. It is, therefore, perplexing that the
state-owned OMCs look to the bonds as their only means of
survival and have repeatedly asked the Finance Ministry to
increase the amount of oil bonds allotted to them. The
government's pro-consumer policy of preventing market-driven
pricing of retail prices of petro-products and thereby creating
market distortions is fiscally unviable. The three oil
marketing companies in India are all state-owned and must remain
in the business even when losses mount. Consumers and oil
companies will continue to watch with wary eyes as and when a
policy change is announced. Central government policy
approaches to this dilemma will be reported in a New Delhi
septel. End Comment.
KEISER