INDIA’S ENERGY SECURITY: OIL AND GAS SECTOR

India's energy security is a critical issue and its economy and even foreign relations are substantially affected by its dependence upon imported crude oil. Oil requirement in future will be significantly higher, because of growth in economy and in turn growing consumption of households and industry. It is also pre- requisite for success of recent initiatives such as 'Make in India'. India's oil reserves are insufficient for its growing energy needs and situation is made worse by policy paralysis which increases the gestation period of the projects. New Exploration Licensing Policy was adopted in year 1997 and since then India's exploration and refining capacities have increased manifold. Off late its is being realized that, we need to diversify our energy basket through alternate fuels such as Coal Bed Methane, Hydrogen, Shale Gas or effective Ethanol blended fuel etc. , to ensure energy security. At the same time growing impetus is being given in improvement of infrastructure which shall result in efficient extraction, minimization of transportation and distribution losses, costs and time by building pipeline networks, storage facilities etc. Despite of significant expected increase in non-conventional energy, oil demand will only grow in future.

 

Oil & gas industry is divided in Upstream, Midstream and Downstream sector, based on the value chain which starts from crude oil and ends at products such as Petroleum, High speed diesel, LPG, Polypropylene, Synthetic Rubber reaching the customers. Actually this is common in almost every industry that raw material is extracted, processed, transported and converted into finished consumable item. But huge investments and technicality at every stage, particularly in this sector, makes these distinctions desirable. There are very few companies in the world which take up all three sectors simultaneously.

 

Upstream Sector

It involves oil exploration, prospection and extraction/production from oil wells. There are about 40000 oil well across the world. It is quite common that oil is found, but it is not commercially exploitable i.e. costs of extraction are significantly higher than realizable value of oil. This makes this business quite risky and only few companies operate in this area. Some of the leader companies are Chevron, ExonMobil , Shell. In India ONGC, Oil India ltd, Reliance Industries and Cairn Energy are involved in exploration.

 

New Exploration Licensing Policy, 1997

This aimed to facilitate exploration sector by providing level playing field to private players against public enterprises. This was result of dismal performance of state enterprises in the past. In last 15 years, sedimentary basin area under exploration increased from 11% to around 58% and number of companies operating in this field is nearly 70.

Under this policy oil blocks are allotted and 'Production Sharing Contracts' are signed with oil explorers through competitive bidding. So far there have been 9 rounds of auctions and 254 oil blocks awarded and out of these 166 are active, rest were relinquished( because of unviability). NELP-X auctions are due this year.

 

Production Sharing Contracts – Since oil is national resource revenues is to be shared with government. Hence, it is a method to share revenue, where explorer is allowed to recover its investment before sharing revenue with government.

 

Sedimentary Basins - These are the regions of earth which are subsided from long and are later filled by sediments. This results in gradual thinning of crust by sedimentary, tectonic or volcanic loading. These basins are rich in Organic material (detritus)or fossils, which over time under pressure gets converted in fuel. Generally speaking, oil and gas are formed from the organic remains of marine organisms which become entrained within sea-floor sediments. Coal, by contrast, is typically formed in non-marine settings from the remains of land vegetation.

 

India has about 3.1 million sq. Km. of sedimentary area, which comprises of 26 basins and out of these 18 basins are presently under exploration. Of this 57 % area is in deep water and remaining 43% area is in on land and shallow offshore.

Most reserves are in western basin, in Gujrat and Rajasthan. Assam Arkan basin is also important reserve and holds 23% reserves and 12% production.

Open Acreage Licensing Policy (OALP)

There are demands to replace NELP with OALP under which oil blocks will be available throughout for sale. It allows ample time for explorer to study the fields and bid for block of his choice. It is said that 'National Data Repository' is prerequisite for functioning of OALP. Its contract has been awarded recently. It will be a 'hydrocarbon data center' which facilitate prospection of resources.

 

Revenue Sharing Contracts as an alternative to Production Sharing Contracts (PSC)

Under revenue sharing model, government gets share in revenue from the exploration from very beginning. In contrast PSC, allows government to have revenue share only when costs are recovered by explorer.

There is demand from civil society and within government, to shift to revenue sharing model, this is because -

1. It is felt that explorers are trying to inflate investment by classifying revenue expenditure as capital expenditure. PSC allows company to recover investments, but routine expenditure such as maintenance, Salaries of staff, material etc. Ought to be deducted from current income. This will result in lower current income (which is supposed to be shared with government). On other hand, if classified as capital expenditure, total costs which company is allowed to recover alone (under PSC) will be more. This way government will lose revenue.
   Say expenditure in question is Rs. 100000
   If classified as capital expenditure - company will be entitled to recover this alone
   Otherwise (classified as revenue), it will reduce profit by Rs. 100000, and if government's share is 20 % , company in effect will be benefited only by Rs. 80000
   
   
2. It delays revenue to the government - Since capital outlays are huge, it may take decades to recover the costs.

Kelkar committee have recommended that –

Deep sea offshore Blocks – Production Sharing Contracts should be adopted

Onshore and Shallow blocks – Revenue Sharing Model

Natural Gas – It is by product of crude oil and is considered as clean fuel. India imports 25% of its natural gas requirement, mainly from Qatar. India has significant natural gas reserves in offshore block. This gas is replacing coal for production of Power, fertilizers and steel.

It is originally in gaseous form and is stored in liquefied forms in LNG tankers at ultra-cool temperature. Transportation by ships is also done by using these tanks, but by pipelines it is transported in gaseous and compressed form. 

 

Recently Reliance Ltd stopped Natural Gas production from Krishna-Godavari basin block claiming unviability of operations. In order to make this sector lucrative for investors Rangarajan Committee was appointed which suggested linking gas price to price of imported gas and gas prices prevailing in exchanges of USA, UK and Japan (weighted average) so as to bring it at parity with international prices. This would result in increase of price from $ 4.2 mmbtu to$ 8.4 mmbtu, this formulae was approved by UPA Government, but was not implemented.

Government now raised prices to $5.61 mmbtu, which will be applicable from 1 November. But, Reliance will continue to get old price unless they make good shortfall in production because of suspended operation. Prices will be revised every 6 months.

This increase is expected to result in hike of prices of Fertilizers, Power and steel significantly.

OPEC – Organization of Petroleum Exporting Countries

Formed in 1960 by 5 countries Iran, Iraq, Kuwait, Saudi Arabia and Venezuela, and letter joined by Qatar, Indonesia, UAE, Libya, Algeria, Nigeria, Gabon and Angola. These 12 member forms a supplier cartel for group bargaining with international Oil Companies. They tend to control production and supply of crude to keep it below international demand. From long, fuel prices are spiraling upwards due to this grouping.

It is only recently that Crude oil's prices have crashed, it is down about 25 % from historical high, whether it is short term phenomena and prices will bounce back when International Economy picks up, remains to be seen. However, present scenario indicates OPEC is set to lose its hegemony over pricing soon due to and at same time supply will exceed demand due to –

1. Growing shift to clean energy worldwide.
2. Shale gas revolution in USA , which can be used as portable fuel for vehicles.
3. Chinese manufacturing industry slowdown.
4. Worldwide efforts for adoption of Efficient technology and growing ethanol blending ( Brazil 25% and Indian government policy – 10% )
5. Differences among member countries. For eg. Venezuela wanted other members to reduce supply as Oil below $80/ barrel doesn't fulfill its domestic budgetary requirements, but at same time IRAN and Saudi Arabia were not interested and they even increased production.

China, USA, Japan and India (sequence) are biggest importers of crude oil, as matter of strategic interest they should form a buyer's cartel/ Group, by this they can turn seller dominated oil market into buyer dominated one. This will improve their trade balance considerably.

ONGC Videsh Ltd. (OVL)

It is subsidiary of ONGC, tasked with prospection, exploration, production of oil in blocks acquired overseas. Currently involved in 33 projects out which 13 are in production. These are in Russia (Sakhalin), Vietnam, Sudan, South Sudan, Brazil, Venezuela, Azerbaijan and Myanmar. It contributes about 14.5 % and 8% in India's Oil production.

OVL, in recent past got involved in intense competition with cash rich Chinese counterparts over acquisitions, which almost always outcompeted OVL.

Reasons was –

1. Chinese have huge current account surplus and they are in foreign asset acquisition spree from quite some time and energy security is their one of the core interest. In contrast, India incurs current account deficit and OVL is most of the time cash starved.
2. Further, it has better access to Central Asian reserves. Geographical barriers to India make it exceptionally expensive and unviable for India.
3. Lastly, in last few years crude oil prices were at historical high. This high price usually gets reflected in price demanded or discovered in auction process. As these are long term decisions , with production spread over coming decades, future turbulence in crude prices matters a lot. For eg if OVL acquired a block when crude oil was $120/ barrel , it will end up investing approx.20% more than that at $100/ barrel rate. We can say that OVL acquired whole expected production in future at that price. As now price $ 80 / barrel in would have incurred substantial losses. By this analogy buying crude from open market is much better option when crude prices are at historically high rather than investing in new oil block.

Midstream sector

This sector involves transportation of oil and gas from blocks to refineries and from refineries to distribution centers. It also includes storage infrastructure. Most cost effective way is through pipeline, in comparison to road and railways which higher economic and environmental costs.

Current pipeline infrastructure is skewed in favor of North and West India, which accounts for 60% of gas pipelines and 80 % of gas consumptions. To remedy this, central government has proposed to set up National Gas Grid under which additional 15000 km of pipelines will be laid down. This is expected to cost Rs 75000 Crore. It will be executed under PPP model and will be eligible for 'Viability Gap Funding'.

Further, City Gas Distribution network is there only in few cities. In most of cities gas is transferred through bottling plants and distribution agency. This result in wastage by leakages and theft, otherwise too this whole process is quite expensive to operate.

Viability Gap Funding – In some PPP projects in India Central and state governments undertake to provide support funding to successful bidders. Bids are made as to requirement for funding from government and one whose requirement for state funding is least is awarded the project.

Indian Oil Corporation and Gas Authority of India are two PSUs involved in this sector. GAIL have largest network of pipelines (15000 km.)

Storage

Government is building underground storage capacity of 15 million metric tons for petroleum and related products. In first phase construction is going on in Vishakhapatnam, Mangalore and Padur. Storage facilities are essential for safeguard against shortages or supply disruptions.

Apart from this, International Gas transit pipelines are important part of Indian diplomacy. Currently India imports gas through LNG terminals which get imported gas in liquefied form in tankers and then they regasify it by heat and compression. This again is expensive process and gas from central Asia this way will be even more expensive. For this there is constant negotiations going on for Turkmenistan – Afghanistan – Pakistan – India (TAPI), Iran- Pakistan- India pipeline, Myanmar – Bangladesh -India. Indian Government joined the TAPI project in the year 2012 and recently signed the 'Gas Sales and Purchase agreement' along with other participating countries.

China has dominant access to central Asian reserves because of better geographical access. Recently a new gas pipeline agreement was signed between Russia and China. Russian President also invited India to join the project.

In October, 2014 India Pakistan entered in Gas supply agreement under which India will supply LNG to Pakistan and GAIL will lay pipeline from Jalandhar to Wagha border (110 km).

Downstream sector

This sector involves refining, processing and marketing of products and byproducts of crude oil

India's refining sector is quit efficient, government adopted policy to make India a refining hub and currently, India is net exporter of petroleum products. Some special economic zones were notified for this purpose (Jamnagar is SEZ). There are 22 refineries, 17 PSUs owned, 3 privately owned and 2 are in joint venture.

Reliance Ltd. owns two refineries in Jamnagar which are renowned worldwide for their capacity to refine sour and heavy crude oil. Reliance Ltd. is largest refiner with market share of 32 %.Other private refinery is owned by Essar Oil. Under joint venture one is HPCL-Mittal Energy ltd. and other is Bharat Oman Refineries Ltd.(BPCL + Oman oil)

Other most of the refineries are owned by 3 Oil Marketing Companies (OMCs), they all are among 20 biggest Indian companies and Fortune 500 or world's biggest 500 companies in terms of Capital –

Indian Oil Corporation Ltd – It is largest company in India by sales and second largest refiner.( 31% share)

Bharat Petroleum Corporation Ltd

Hindustan Petroleum Corporation Ltd

These companies are also involved in oil exploration in India and overseas.

OMCs also act as medium through which government provides subsidized products to customers, as they hold last selling point in the value chain. Further, private refiners due to controlled prices of diesel (now decontrolled), LPG and Kerosene were unable to compete with OMCs, couldn't establish themselves in Retail sector. So they sell their products to OMCs, who then sell products at subsidized price.

OMCs for their under recoveries are compensated by government by issuing them 'Oil Bonds'. Bonds are instruments by which government acknowledges their liability in favor of OMCs. But this doesn't solve problem as these have maturity period of 5,7,10 or even 20 years. This means OMC will get cash against these bonds only after expiry of maturity period. At same time OMC can use them by pledging/depositing them with lender and raise loan or these (bonds) may themselves be used as money, if it is acceptable to buyer.

It works in following manner –

OC makes loss selling petroleum products due to govt. restrictions on pricing. The govt. of India compensates this loss by issuing special oil bonds.
Say IOC shows these bonds as income on its P&L 10000 crores, This means that without paying a penny for these bonds, IOC has invested in these GOI bonds (by way of selling products cheaper by 10000 crore, and that deficit made good by government) If you think about it, the real investment is the losses IOC incurred to oblige the GOI.
Now, if IOC just sits on these bonds, it will get a cash flow (around 7% - 8%) from GOI by way of interest payment on these bonds. Also upon maturity, the GOI will have to redeem these bonds from IOC i.e. upon maturity the GOI has to cough up cash compensation for the losses IOC has incurred in this year
Instead, what IOC does is, it sells these bonds in the secondary bond market to mutual funds, insurance companies and other such financial institutions.

Thus, the bonds are converted into hard cash. This is how IOC gets hard cash to compensate for its losses immediately. (Of course, upon maturity the GOI has to still pay cash to whoever holds these bonds at that time).

(Further RBI has allowed banks to keep exposure against Oil Bonds to the extent of 25 %. It means banks can lend to the extent of 25% of the amount of Oil Bonds it hold. But oil bonds doesn't have SLR status, if they had this status, then demand from banks will make them readily liquid)

Now these subsidies have been matter of much debate. Petrol was deregulated few years back and High Speed Diesel is deregulated by government recently.

Committee was set up under Kirith Parekh to advice on Pricing Methodology for Diesel, Domestic LPG and PDS Kerosene  which last year in its report recommended - abolish subsidy on Diesel and increase price of diesel, Reduce subsidized cylinder from 9 to 6 ( but soon it was increased to 12), subsidy on kerosene be given by direct cash transfers.

Soon govt adopted policy of increasing diesel price by 50 paisa monthly. Since this is political issue new government seized opportunity provided by low global crude oil prices.

For the moment it will address Inflation but in long run, it remedies Fiscal deficit worries. Also, it will result in coming back Private refiners in retail business, hence increasing competition.

Regulatory environment of sector

Sector remains highly regulated and largely state controlled.

Policy Formulation – Planning Commission (Until now) and Ministry of Finance

Regulation – Ministry of Petroleum and Natural Gas, Director of hydrocarbons, Petroleum and Natural Gas Regulatory board

Director General of Hydrocarbons (as per website) –

The Directorate General of Hydrocarbons (DGH) was established in 1993 under the administrative control of Ministry of Petroleum & Natural Gas through Government of India Resolution. Objectives of DGH are to promote sound management of the oil and natural gas resources having a balanced regard for environment, safety, technological and economic aspects of the petroleum activity. 

DGH has been entrusted with several responsibilities like implementation of New Exploration Licensing Policy (NELP), matters concerning the Production Sharing Contracts for discovered fields and exploration blocks, promotion of investment in E&P Sector and monitoring of E&P activities including review of reservoir performance of producing fields. In addition, DGH is also engaged in opening up of new unexplored areas for future exploration and development of non-conventional hydrocarbon energy sources like Coal Bed Methane (CBM) as also futuristic hydrocarbon energy resources like Gas Hydrates and Oil Shale.

Petroleum and Natural Gas Regulatory Board –The Petroleum and Natural Gas Regulatory Board (PNGRB) was established in 2007 as the downstream sector regulator, tasked with regulating the refining, processing, storage, transportation, distribution, marketing and sales of petroleum products and natural gas. It does not, however, authorize refinery infrastructure construction, which is controlled by MPNG, and has no role in market pricing, or pricing policy. The key practical function of the Board relates to

(a) Its role as court of arbitration in disputes within the downstream sector; and

(b) Its powers to release tenders for, and grant of authorization to lay, build, operate and expand cities natural gas distribution networks.

FDI – 100 % FDI allowed in upstream, downstream, midstream sectors

If you have read this article make sure you attempt some questions –

1. What are the roadblocks to India's energy security and what policies/actions government adopted to overcome these? How successful were those efforts? (200 words)
2. Analyze New Economic License Policy's shortcomings and suggest alternatives or improvements. (200 words)
3. What are the reasons for recent crash in Oil prices and tell its implications to India and how India can capitalize on this opportunity. (200 words)