PETROLEUM PRODUCT PRICING MECHANISM
By Feroze J. Cawasji
July 15 - 21, 2002
In the last few weeks, various articles have appeared in newspapers criticizing the increase in the prices of petroleum products, particularly the prices of diesel. Most of the writeups do not reflect the factual position, which therefore tends to mislead the reader and create doubts in their minds about the pricing mechanism for petroleum products. In order to remove these doubts, it is therefore essential to explain the mechanism that is in place since the last one-year and which has been strictly followed by the Oil Companies Advisory Committee (OCAC). It also needs to be mentioned that the pricing mechanism followed by OCAC has been approved by the Government and is a step towards deregulating the petroleum sector.
At the outset, it is necessary to point out that most of the writeups written link the international crude oil prices with the trend of petroleum product prices in Pakistan. Indeed this is a reasonable indicator but often tends to distort results. The correct indicator is to analyze the trend of product prices in the international market. Product prices fluctuate based on the demand and supply situation that is prevalent at any given point in time. The differential between the FOB price of crude oil and product prices represents the refiners/traders margin. The region in which a country is situated is also an important factor. Most analysts tend to compare trends in the price of Brent crude oil with the consumer prices in Pakistan. This is not a reasonable indicator. Pakistan is situated in close proximity to the Middle East region and therefore any analysis that is done should relate to the Arab Gulf region.
In order to analyze the trend, given below is the data pertaining to the FOB price per barrel of Arab Light crude with the FOB price of diesel in the region for the last three months:
Arab Light $/barrel
It can be seen from the above table that there is a gap between the price of a particular product and that of crude oil. Although the crude oil price fell on average during June 2002 by $ 0.68 per barrel a drop of 2.7%, the price of diesel increased marginally but the gap between the price of crude oil and diesel increased by $ 0.73 per berrel. The FOB price of diesel gets reflected in the working of consuxner prices. Based on newspaper reports and articles that crude oil prices have declined, the public perception is that product prices will also show a decline. When the consumer price does not follow the same trend, as that of crude oil as seen in the chart above, there is general criticism regarding the whole pricing mechanism.
Freight is another fmpo:rtant factor that should not be forgotten. Grude oil is transported in tankers usually called "dirty tankers," while finished products are transported in tankers called "clean tankers". The freight for products is therefore substantially higher than that of crude oil.
Consumer prices in Pakistan are made up of the following elements:
Government levies (excise duty and petroleum development levy)
Distributor and dealer margins
The ex-refinery price of a product, which is paid to local refineries, equates to the landed cost of the product. In other words it relates to the import parity price of the product if the same were to be imported. The base price relates to the relevant products FOB price averaged for the fortnight as quoted in the Arab Gulf region to which are added other elements like freight, L/c and bank charges, wharfage etc to arrive at the refinery price.
Government levies are the prerogative of the Government and are fixed in accordance with the needs of the Government. Petroleum products are an important source of any Government's revenue and Pakistan is no exception. The currcut Government levies on petrol are Rs. 12.87/litre representing excise duty and petroleum development levy, while on diesel it is Rs. 2.76/litre representing petroleum development levy only.
Inland freight is used to equate the prices of the products all across Pakistan. In order to do this, 29 core depot locations have been identified and prices are kept constant over these locations. The product wise cost of product transportation from refineries or imports to these 29 locations is allocated to the respective product and is called primary transport cost. This element represents actual cost and does not include any profit element for the marketing companies. The cost of transporting product from these aforementioned core 29 depot locations to the respective retail outlet is called secondary transport cost and varies in accordance with the distance of the retail outlet from the nearest depot. This cost is over and above the fixed sale price determined by OCAC for the 29 core depot locations. Cartage rates for the transporters are revised on a quarterly basis to reflect both the upward/downward movement in the prices of diesel.
The Government fixes the distributor and dealer margins, which represent the profit element for the oil marketing company and their dealers. These margins are represented as a percentage of the fixed sale price. Till February 2002, the margins were 2% and 3% respectively for the OMC's and dealers when they were revised to 3% and 3.5% respectively. From July 2002, these have been fixed at 3.5% for OMCs and 4% for dealers.
Sales tax is the last element in the consumer pricing and is calculated at 15% of the price before sales tax. This varies in accordance with the movement in the price of various products based on the FOB value and the Rupee/Dollar parity rate.
It is hoped that the above article will help in removing the misgivings in the minds of analysts about the pricing mechanism of petroleum products and will also create a better understanding of the whole process in the minds of the general public.