LPG: IS DEREGULATION BENEFICIAL?

SYED AKHTAR ALI
(feedback@pgeconomist.com)

Mar 14 - 20, 2011

There is a lot of protestations against the increase in LPG prices which have been termed unjustified by the consumers and other stake-holders. LPG is retailed in some places at a rate of Rs135 per kg, against its normal price of Rs80 per kg.

There appears to be a lot of confusion in LPG policies. Apparently , the sector is unregulated, yet OGRA is prescribing LPG producer prices of local and imported production.

Perhaps these are recommended prices and do not carry the weight and support of law. The air is full of controversy. Minister of petroleum and others in government have spoken against LPG price increases and profiteering of the LPG sector. A parliamentary committee is investigating some questionable deals in LPG sector while OGRA keeps threatening the marketing companies with action and dire consequences. Let us examine the issue and the nature of the problem in some detail and the possible options and approaches that may be available to resolve these. Some perspective is essential.

Only 20 per cent of households in Pakistan have access to natural gas. Gas supply to consumers is dictated by the availability and expansion of the gas distribution network. Some 68-83 per cent of households rely on wood and biomass. Bulk of the natural gas goes to the non-domestic sector, 33 per cent to power, 28 per cent to industries, and 16 per cent to the fertilizer production. Only 16 per cent of gas goes to the domestic sector.

For small residential consumer, the gas tariff has been kept really low at 1.5 USD per unit as compared to the average rate of 6 USD per unit. In contrast, average tariff is USD12 per unit, while in most of Europe it is twice the US gas tariff. I am recounting this data for giving the reader a perspective, and am not building an argument for increasing domestic gas tariff.

Most of the cheap domestic fuel (natural gas) is available to the urban areas. Most people in rural areas either burn woody biomass and some consume LPG. Half (50 per cent) of LPG consumption goes to the transport sector, mostly in taxis which cannot afford the initial cost of CNG installation or operate in non-CNG areas. 30 per cent of LPG goes to residential and commercial sector. Also, roadside cafes and tea-stalls use LPG for a variety of reasons of supplies related issues. Other commercial and industrial users consume the remaining 20 per cent.

LPG has unique characteristics, some of which make it a preferred fuel, especially its relatively easy transportation as compared to the natural gas which has to be distributed through pipeline and also cannot be stored conveniently. Despite this LPG consumption in Pakistan is very low; 2.6 Kg per capita, as opposed to 7.3 kg in India, 12 kg in Philippines. LPG consumption peaked in the year 2006-7 at a level of 649,000 tons, and came down in the last few years to 500,000 tons, perhaps due to the price increases and unstable pricing regime that we would discuss in the following.

This amounts to some 25 billion Cft as opposed to 204 billion cft (12 per cent) of natural gas consumption in domestic sector, and 1275 Bcft (2 per cent) of total yearly gas consumption of the country. LPG market should be able to be quadrupled to 2 million tons in a matter of a few years.

We live in the gas surplus region or adjacent to it. Iran and Qatar together house 33 per cent of world natural gas resources. In LPG sector also, there is a surplus, which is exported. Middle East has a surplus of more than three million tons, half of which is in Iran. Iran is facing problems in its exports due to the frequent trade embargoes of all kind. Also there is exportable surplus in Turkmenistan, which goes as far as Indonesia. Pakistan has not been able to fully exploit the potential of LPG imports from the region. Only 8 per cent of the demand is met through imports, which are really negligible.

There is a scope for expanding LPG imports and supplies by establishing a stable and dynamic LPG market based on imports, while there are obvious limitations on domestic production. LPG imports from Iran can provide for a very significant domestic demand, if adequate transportation infrastructure is brought about and facilitated. All of this can be provided by the private sector. Ideally, rail transportation is the most economical, but is subject to many issues. For all practical purposes, road transport may have to be employed. GOP lifted price controls in a hope that it would expand supplies and attract investments in imports, storage, transportation, and distribution.

Nothing appreciable seems to have happened. This is despite, that there is no restriction on imports. Anybody can import. In fact, the sector suffers from monopolistic conduct and structure. Competition Commission of Pakistan (CCP) has levied fines and penalties on two major LPG companies, which is reportedly sub-judice.

Competition does not seem to work in Pakistan. We have witnessed this in case of sugar and cement and other areas where there are a far more number of suppliers than they are in LPG. In LPG sector, there are only 10 producers. Neither has price gone down, nor have supplies and investments increased despite significant scope and opportunities of imports from Iran.

Only some smuggling takes place, and is undertaken possibly by small parties who do not have the wherewithal of dealing with the practical barriers that may be involved in official imports despite an ostensibly open import regime.

As mentioned earlier, LPG can play a significant role in filling the demand supply gap, especially in cooking fuel sector, domestic and commercial. Pressure on gas supplies is increasing. Due to the lack of availability of a suitable alternative, rural population is resorting to felling of trees, reducing the much needed forestry cover. Recent floods have been aggravated due to massive deforestation in the northern areas. For the 80 per cent uncovered population, LPG seems to be the only short-term option, especially when the domestic natural gas resources are running out.

LPG has economic characteristics in between oil, a traded commodity deserving international market price regime, and gas, which is often priced at local production cost. Currently, Saudi contract prices are taken as a benchmark for prescribing upper limits for the producer prices. Following are some other pricing options that could be examined:

a) Imported LPG be priced at landed cost plus taxes and duty, taking Saudi contract Price as a benchmark.

b) Forward prices in the value chain to be fixed by allowing gross margins/mark-ups for marketing companies and distributor. If such margins are fixed in case of gasoline and diesel, why can't it be done in case of LPG?

c) The retail price basket of selected stations in the U.S. or EIA retail average price could be taken as a benchmark. Other prices in the value chain are worked out as per fixed margin allowed to every stage. Current retail price of LPG in the US averages around 1.25 USD per kg. In Europe, it is about 1 euro per liter before tax. In the U.S., however, the marketing and distribution margin appears to be quite high, almost 100 per cent, as one would readily see from the table provided. LPG is marginally taxed in Europe, while petrol attracts heavy taxation of 100 per cent. It can be safely concluded that the classically, LPG/LNG are priced at 75 per cent of oil/gasoline prices per unit of calorific value.

One is intrigued by the kind of controversy that prevails around LPG sector. It is alleged that the powerful local producers are inhibiting competition by keeping the prices low and discouraging competition. On the other hand, there are charges of excessive monopoly profiteering and that the actual profits are made at retail level, as most producers have profit linkages down the line. One would require undertaking a detailed cost of production and marketing study, to get to the bottom. It appears rather strange that some quarters demand higher producer prices, so that they can import LPG and make profits. This would naturally make the prices still higher, while people are protesting against high LPG prices already.

Imports are normally allowed to keep the local prices in check and not otherwise. In fact, a case could be made the other way round for decreasing the producer prices. As we have discussed earlier, LPG has trade and pricing characteristics midway between oil and gas. LPG is also extracted from gas, while gas prices in Pakistan have been lower comparatively. Taking the US LPG price regime as benchmark at 1 USD per kg of retail for residential customers, a retail price of Rs 100 per liter seems to be competitive and a producer price of Rs55000 per ton seem to be appropriate.

The idea of providing subsidies to LPG to targeted sectors such as domestic consumers in FATA and NWFP deserves serious attention as well. These subsidies could be shared under a trilateral programme wherein GOP, GoKP and U.S aid could share the cost. The programme should be administered under some kind of a fuel ration card system to restrict the subsidies to the intended target group. Apart from welfare and political consequences, the subsidized cooking fuel rationing would help reducing deforestation. There is a public demand of doing away with the GST on LPG; one would be inclined to support it for residential use of poor customers, especially in KP and FATA.

Also, the proposal of mandatory imports by the local producer to the tune of 25 per cent of their annual production is worthy of consideration. LPG supplies are often found restricted, especially in winters when the demand in the northern region is high. It has been alleged that imports of LPG are discouraged by the dominant local producers and some key players. Mandatory quotas of imports are expected to improve supplies

GOP and the Ministry of Petroleum (MPNR) would be advised to come out with an explicit policy for the LPG sector. If unregulated sector has not given the desired dividend, regulation and controls may be tried. Regulated sector often provides the stability, confidence, and reassurance our business sector needs. It is perhaps not strong and confident enough to benefit from an open sector that works without assurances of return. Regulatory status has not prevented power sector to attract IPPs. In fact, it is doubtful that IPPs investment would have come about without a regulated policy frame-work. Same may be true for LPG.

NATURAL GAS PRICING

It has been reported recently that natural gas prices would be rationalized. Some ADB wise man seems to have suggested it, as a precondition to some loan agreement. It is through these lending arrangements that little thought through ideas and policies are imposed on us.

Admittedly gas prices in Pakistan are low, but so are the production cost and the incomes of the people. In a utopian world of these economists, all prices everywhere would converge to be the same, but after a lot of adjustments in the world where most of the people of the world would be populated in the hereto under populated developed countries. This kind of adjustment is certainly not acceptable. They would suggest every other type of adjustment, sacrifice, and even cruelty on the poor. Their counterpart rich people, of course, do not suffer, as a consequence of the proposed adjustments.

The ostensible logic may be that the gas is under priced and thus sends wrong signals resulting in sub-optimal consumption and waste and that price should represent scarcity value leading to allocative efficiency ultimately. And, those higher prices would enhance producer profits and would thus attract investment in exploration and production, increase supply and stabilize prices but at a higher level. We have seen how capitalism and competition has been thwarted by the powerful monopolists and the stake. Take the case of sugar, but that is a separate subject, which we would not enter into here due to space constraints.

Let us test this logic against the real world data. Today, in the US gas prices are one of the lowest in history, having hovered around 6-8 USD per MMBtu (call it unit for simplicity) for most part of the last ten years. This is a yearly average; otherwise, there is significant seasonal variation. In gas producer countries, gas prices have never been linked to oil prices; reason very simple and oft-practiced. Natural gas is not tradable, except for LNG, which represents an insignificant proportion in trade and production. Oil is tradeable, and hence priced as per international trade prices plus some tariff and taxes. It is only in non-producer countries of Europe, Japan, and South Korea that gas prices are linked to oil. In these countries, natural gas prices have hovered around 75 per cent of the oil prices. In the case of Japan and South Korea, it is the LNG factor that operates in pricing. In throughout gas producing countries of Asia e.g. China, Malaysia, Indonesia, natural gas is priced low even as compared to the low prices of USA. Chinese economy and exports would nearly collapse if higher energy prices and higher exchange rate are forced on them.

Currently, there is no major rationale to this kind of linkage in Pakistan as gas trade in the form of either LNG or expensive natural gas from Iran is still a few years away and even then, its contribution in overall consumption is projected to be low. As the costly imports increase there would be an automatic reflection of it and no such policies would be necessary. We have already increased gas prices over the recent years, especially the gas prices coming from Balochistan. The recent currency devaluation and its expected slide downwards would keep the prices high and increasing. No special tools should be moved in to achieve this.

Power sector is the major consumer of gas with a share of 33.7 per cent, followed by general industries 28 per cent, domestic 16 per cent and fertilizers another 15-16 per cent. CNG/transport consumption has been increasing at a very fast pace until recently. Higher gas prices for power sector would enhance electricity tariff, which is slated to increase under various pressures and sources including rental power. Something, however, may have to be done with respect to the gas prices in fertilizer sector, where gas goes literally free, at one-tenth of the average tariff. But, increasing those would increase crop prices. This is the kind of hidden subsidy that we provide to agriculture. This is indeed a very difficult situation. People outside the power corridor think that it is all a free flowing stream and if they get a chance they would be setting it right.

Pakistan's energy woes is hydel power and Thar coal. Both suffer from various set of political and administrative problems. Leadership would have to be shown towards creating consensus and removing the other bottlenecks that are there. Nothing was free and would be free. Hydel power would not be as cheap as it is now (less than a Rupee per unit) due to older investments in Tarbela and other dams. New investments would result in hydro electricity costs of 5-6 rupees per unit. The royalty demands of KP alone would be more than the current total unit production cost, on which a reasonable settlement is long over due. The government would be well advised to thoroughly consider the impact of these proposals, which enter into the national policy apparatus through lending requirements of the often-unfeasible projects, which the vested interest keeps pushing on government functionaries. The funny situation is that consumer and trade bodies start shouting at the very end at the level of distribution companies tariff, be it gas or electricity and enter into useless and destructive litigations, when the die has already been cast. Expensive projects are approved with considerable padding by some of their brother project promoters and investors.