CHAPTER V

DEMAND-SUPPLY IMBALANCE - HISTORICAL OUTLINE

Trends in the consumption of petroleum products were examined in the

previous chapter. An important feature of consumption pattern that emerges is the

increasing share of middle distillates in the overall demand. Pricing policy decisions

have direct repercussions on the demand-supply imbalance which has manifested itself

in the disproportionate use of middle distillates. The present chapter analyses the

genesis of the so-called 'middle distillate problem' in the Indian oil industry and its

consequences.

In the early years of free India, while the demand increased steeply,

there was no increase in the supply because of the shortage of oil in the world market.

The country was completely at the mercy of the majors for the supply of oil. They used

to indicate to the Government the quantity of products available for each quarter of

a year, and the Government had no option but to resort to a rigorous rationing system.

The initial spurt in MS consumption came to a standstill during the

period 195 1-61. MS consumption grew after 1961 due to an increase in military activity

as a result of conflicts with China and hkistan. On the other hand, consumption of

diesel grew unabated as a result of dieselization of vehicles, which was encouraged by

the Government by maintaining a differentla1 tax system in favour of diesel against

MS. This Govenunent policy was a reaction to the wartime and post-war shortage of

MS supply. But very soon the technical advantages of using HSD particularly in

vehicles with a capacity of more than five tons became clear to the consumers of

motor fuel and despite the increase in diesel taxes in later years the proportion of

diesel driven vehicles kept on increasing rapidly. The rate of growth in consumption

of HSD during the period 1953 to 1965 averaged above 18 per cent. Dieselization of

locomotives, use of diesel for power generation and in inigation pumps also

contributed to the growing demand.

The product imbalance was also a creation of the policy to establish

domestic refineries. Technical limitations require that every refinery should produce

a certain product mix, irrespective of the demand pattern. It then becomes necessary

to find a market for some of the products which are likely to be in surplus.

Correspondingly, there would be deficits in some other products which would have to

be imported. Biplab Dasgupta describes the scenario that existed:

Upto 1957 when f.o.b.US Gulf product prices were adopted for the Eastern hemisphere markets the relative price structure for oil products net of taxes in the latter was not different from that in the former region. This provided a strong incentive for the refiners of the eastern hemisphere markets to try to adopt output patterns comparable to those in USA and out of line with those on demand in the Fatern hemisphere. Whereas the proportion of consumption of light distillates in the Eastern Hemisphere was relatively lower than that for the middle distillates the refineries in that region produced more of the former because relative prices favoured the production of light distillates. The changes introduced after 1957 in the system of pricing oil products made the new f.0.b. Persian Gulf prices comparable to the pattern of demand in Western Europe but failed to meet fully the problems of individual countries like India whose pattern of consumption diverged from that of the markets of Western Europe.

It was because of the price of motor spirit f.o.b.Persian Gulf was higher than that of kerosene when the three refineries owned by the majors were constructed in India that these were so designed as to yield a relatively larger proportion of MS. Since each of these refineries formed part of an international group it was perfectly rational on their part to continue producing MS in excess of its level of consumption in India at parity prices if these prices are high enough to offset the wst of exporting the surplus as naphtha at lower prices. The fact that these refineries reduced the proportion of light distillates between 1955 and 1960 was due, firstly, to the decline in the relative price of MS in those years, and secondly, to the appreciation of the fact that export opportunities were diminishmg in the world."

Another factor that helped change the situation was the growth of

petrochemical and fertilizer industries in India which provided a good market for the

surplus naphtha.

Demand estimates of the other middle distillate, kerosene oil, also went

wayward. I t was thought that with increased availability of electricity, the consumption

of kerosene would fall. Thus, when the refineries were built during the 1950s, they

were designed to produce, with the aid of catalytic cracker units about 22 per cent MS

and only 33 per cent middle distillates. But the actual consumption pattern of oil

products did not conform to the expected pattern as can be seen from Table 5.1.

Table 5.1 presents the percentage shares of major petroleum products in

POL consumption from 1950 to 1995. The proportion of light distillates in the total

oil consumption declined from over 21 per cent in 1950-51 to less than 12 per cent in

I9 Dasgupta; Op.cit., pp. 166- 167,

Table 5.1

Percentage Share of Maior Petroleum Products in POL Consumption: 1950-1995

Light Distillates Middle Distillates Heavy Year LPG MS Total SKO HSD Total Ends

Note: Totals do not tally as they include other products. Source : Indian Petroleum & Natural Gas Statistics (Latest 1994-95)

62

the 1990s, owing to increased demand for LPG and naphtha for fertilizer production.

On the other hand, the share of middle distillates exceeded 50 per cent in the early

1950s and continued to grow in spite of a reduced demand for kerosene. Diesel now

accounts for nearly 44 per cent of total oil product consumption.

The technical specifications of the refineries built in Barauni and

Guwahati during the 1960s attempted to cure this imbalance, but because of the lighter

nature of the domestic crude which these refineries used, the proportion of light

distillates could not be reduced below 19 per cent. The private sector refineries

reduced the proportion of MS, with Burmah Shell reducing it from 22 per cent to 14.9

per cent between 1955 and 1960. The Govenunent also took the step of amending the

specifications of HSD, by lowering the required initial boiling point from 150oF to

1310F, which increased the proportion of diesels at the cost of naphtha. But the overall

effect of this change was negligible. In 1962, the proportion of light, middle and heavy

fractions in the total oil output for the whole country were 18, 46 and 36 per cent

whereas their respective percentage share in consimption were 12, 52 and 36

respectively. ' It was predicted that, given the policy of maintaining self-sufficiency in

refined oil products, there would be a 1.6 mmt surplus of light distillates, with an

accompanying 1 mmt deficit of kerosene by 1966."

Ibid, pp. 125-126

I, Estimates Committee: Twenfy Eighth Report to the n i r d Lok Sabha, 1962-63 on Indian Oil Cornpony.

63

The adjustments made by the report of the Oil Price Enquiry Committee,

1961 (Damle Committee) in the relative prices of products only aggravated the

problem of product imbalance. Due to higher discounts for HSD, although the f.0.b.

posted price for HSD was higher than that of MS in the Persian Gulf, MS had a higher

computed f.0.b. price than HSD in India. These discounts also reduced the relative

f.0.b. price advantage of kerosene. From the point of view of the refiner, therefore,

MS trade was more attractive in India than selling HSD and the kerosene trade was

relatively not so profitable as it would have been otherwise without this schedule of

discriminatory discount rates highly favourable to MS trade.*

An underlying principle of pricing policy has been the premise that petrol

is mostly used by richer sections of society and, therefore, it could and should be taxed

for augmenting government revenue. HSD is considered the common man's transport

fuel and kerosene his heating and lighting hel . Therefore, the rate of taxation of HSD

is kept low and that of kerosene still lower. Although th~s tax policy may not affect the

economics of the refineries, it changes the pattern of relative prices for the consumer.

In the long run the high price of MS encourages dieselization of vehicles. All these

factors led to a consumption patterr! which was out of line with the pattern anywhere

else. The international oil industry perceived this as a problem peculiar India and had

no incentive to promote research for solving India's problem of imbalance in refining.

The existing state of technological knowledge did not permit the refiners to change the

product mix to conform to India's consumption pattern

7.2 Dasgupta; 0p.ci t . . p. 167

64

After the public sector refineries were built, the Government considered

the possibility of exporting at least a part of the surplus products. Since the

Govenunent had no marketing apparatus of its own in other countries, this surplus

could be sold only through trade agreements with other countries, or through

international oil companies. The Government decided to accord priority to products

of the public sector refineries in the lndian market in order to force the international

majors to export a larger share of their surplus. The foreign collaborators of CRL and

MRL were also asked to assume the responsibility for exporting their surpluses. The

10C itself also undertook to export to neighbouring countries a part of the surplus. The

closure of Suez Canal in June 1967 helped IOC in exporting larger quantities of light

distillates to Burma, Thailand, Ceylon and Japan. *

The Ministry of Petroleuni and Chemicals had been holding Supply Plan

Meetings (SPM) with the oil companies once in a month to discuss and finalise the

production pattern of individual refineries. This was being done to ensure availability

of various products according to their current demand. The refinery agreements gave

the foreign companies considerable freedom to determine the relative portion of the

products manufactured by their refineries, provided they maintained the output of

kerosene not too far below the designed capacity. Since kerosene was a profitable

item, the companies used to produce this item often in excess of the designed capacity.

But when they reduced the production o f fuel oil following the closure of the Suez

65

Canal, the Government was not in a position to exercise any control on the companies.

Fortunately, the IOC and the CRL helped the Government to overcome the shortage

of fuel oil by increasing their own supply. Still, the Government did not use the

provisions of the Essential Commodities Act to direct the private companies to avoid

such manoeuvres.

The volume of crude to be imported was determined mainly by the

requirements of the middle distillates. In spite of fluidized catalytic cracking (FCC),

this resulted in the surplus of naphtha and fuel oil (FO) which had to be disposed of

at a discount to induce their use as inputs in the fertilizer industry and as fuel for a

number of industries respectively. If, instead of this, hydrocracking facilities for the

secondary processing of the heavy stock were expanded it would have been possible

to meet the demand for the middle distillates with a reduced volume of crude. The glut

in naphtha was a world-wide phenomenon in the mid-60s. The market price of naphtha

was low at international level as well. This encouraged a complacent view about the

cost of development of the naphtha-based fertilizer industry in the country. Not only

that plans for fertilizer industry were worked out for utilization of the current surplus

of naphtha available within the country but long-term plans for expansion of capacities

of fertilizer industry and of refineries were also based on the expectation of import of

cheap naphtha in future. This approach deprived the country of the opportunity of

development of the indigenous coal as an alternative base for the fertilizer industry

and kept the country tied to the vagaries of international market forces in respect of

a series of vital industries. K.K.Chakravorty shows how the choice of naphtha-based

66

fertilizer plants, 20 in number, led to the decision to expand refinery capacities to

supply feedstock for their requirement. This in turn called for import of crude to feed

these refineries. It was thought to be an economic way of reducing our dependence for

import of naphtha. One wrong decision was sought to be undone by another.

The first oil crisis of 1973 provided an ideal setting for shifting the

emphasis from oil to coal. The Fuel Policy Committee recommended in 1974 that nc

fertilizer projects should be designed to make use of coal as the feedstock. Even if

fertilizer units are set up based on oil on account of expediency, the Committee

suggested that they should have adequate provision to switch over to the use of coal

at a later date.= However, as soon as the Bombay High potential was revealed, the

focus shifted back to oil.

Between 1955 and 1970, the change over to diesel trucks and buses

reduced the number of petrol-using large vehicles from 154,000'to 130,000, while the

number of scooters, motor cycles and rickshaws rose 15 times from 41,000to 609,000

and the number of cars, taxis and jeeps three-fold from 203,000 to 670,000. Between

1973 and 1975 the retail price of petrol increased by 124 per cent. Ashok Desai points

out that this had a three-fold effect. First, the rapid increase in the number of

U Quoted by Deb Kumar Bose, "Towards a Policy for Exploration of Oil in India" Urja, Oct 28, 1978.

Report of the Fuel Poliq Cbmmifree, 1974, Paras 8.41,8.42.

67

scooters and similar vehicles continued; their number reached about 1.4 million in

1976. In 1970 there were only about as many scooters as there were cars: by 1976 there

were almost twice as many scooters as cars. Second, there was a shift from cars and

taxis to minibuses and charter buses, resulting in a reduction in petrol consumption per

traveller. Third, the sales of cars and jeeps fell sharply from 55,000 in 1973 to 31,000

in 1975.% This also led to increased dieseliiation of cars and jeeps. Given the relative

price of petrol and diesel, a private taxi operator may find it economic to incur

additional expenditure to retrofit a diesel engine, but for the national economy which

is subsidising diesel, this may not be beneficial. Ramesh Bhatia has shown that the

social cost of running a car with petrol would be lower than that of running a diesel-

retrofitted car." Since diesel demand cannot be met without imports, the social cost

is not likely to favour diesel in future too.

The misuse of kerosene for adulterating HSD has been a contentious

issue for a long time. The Estimates Committee of the Fourth Lok Sabha which went

into this issue had recommended that the Government should use chemical markers

to avoid adulteration of HSD with kerosene." From 1957 till the end of 1973 kerosene

was priced substantially below HSD. with which it was therefore clandestinely mixed.

After November 1973, when the price of HSD was matched with that of kerosene,

x Ashok V. Desai, "Indian Policy Response To oil Crisis", Commerce Pamphlet-135, 1979

n Karnesh Bhatia in Thukral and Pachauri (Eds.); Op.cit., pp.143-144.

28 1:stirnates Committee; 0p.cit.. 1968.

68

there was no incentive to mix kerosene with diesel, but kerosene used to be mixed with

petrol, in lesser proportions than was common with HSD since kerosene and petrol are

less close substitutes.

According to A.K.N.Reddy, the transport sector consumed about 35 per

cent of the total oil used in the country in 1987-88. But, unlike the industrialized

countries where petrol is the main transport fuel, India's transport runs mainly on

diesel which, in 1987-88, accounted for 70 per cent of the oil used in the transport

sector, in comparison with petrol which was only 15 per cent. The corresponding

percentages for lJSA are 15 and 69 in 1988. In 1986-87, trucks consumed 42 per cent

of the &esel in India and hauled 48 per cent of the country's freight in comparison

with 31 per cent carried by diesel locomotives which consumed only 5 per cent diesel.

Despite the obvious energy efficiency of railway haulage, the share of total freight

transported by trucks has increased enormously since independence. In 1950-51, trucks

carried only 6 per cent of the total freight of 105 billion tonne kilometres; in 1989-90,

the percentage had risen to 52 per cent of 433 billion tonne kilometres. The reasons

quoted were inefficiency of the publicly owned railways, shortage of wagons, delays,

pilferage of goods, inconvenience because of the lack of door-to-door service, lack of

reliability etc.lY

29 Reddy, "Sustainable Development in India Through Reduction of Oil Dependence", International Programme for Petroleum Management and Administrnrion Seminar Proceedings, pp. 152- 154.

69

Truck costs are lower than rail costs for short hauls, but rise rapidly with

distance and exceed rail costs at large distances. The break even distances below which

trucks are economical decrease as the diesel price increases. On the basis of 1984-85

prices of diesel, the break-even distances are between 200 and 400 lans depending on

the commodity. Trucks are able to move freight over &stances exceeding the break-

even distances because truck operators are not paying the social price of diesel.)'

The relative position of diesel and petrol underwent some change in the

1980s due to an increasing emphasis on personal vehicles. The share of MS in total oil

consumption increased by 31 per cent during the decade, from 4.93per cent in 1980-81

to 6.44 per cent in 1990-91, while the share of HSD increased only by 14 per cent, i.e

from 33.48per cent in 1980-81 to 39.81 per cent in 1990-91. (See Table 5.1).

Kerosene is a very inefficient illuminant. Still, being the poor man's fuel, it had

to be subsidized. Large scale electrification of houses and easy availability of LPG in

rural areas are the only solutions to this highly uneconomical pricing system. When

kerosene becomes redundant as an illuminant, the subsidy on kerosene and

consequently on diesel can be removed. It would then be possible to bring the price

of diesel closer to that of petrol which costs almost the same to produce. This is more

or less the position in many industrialized countries.

Table 5.2

Average Retail Prices of SK. HSD and MS Selected Countries (Price in RupeeS)

Country Year SK HSD MS MSlHSD

India Argentina Australia Canada France Germany Italy Japan Malaysia Mexico Myanmar New Zealand Pakistan Philippines Russia South Korea Switzerland UK USA Taiwan Thailand Venezuela Vietnam

2.55 9.46

N.A. N.A. N.A. N.A. N.A. 16.87 5.97 N.A. 18.59 12.45 6.00 8.92 N.A. 10.18 N.A. N.A. N.A. 15.00 10.59 N.A. 8.07

N.A. = not available Sources: 1. Indian Petroleun & Natural Gas Statistics, 1992-93, 1994-95

2. IEA Statistics, Energy Prices & Taxes, Second Quarter 1996

7 1

Table 5.2 lists the average retail prices of major petroleum products in

certain selected countries in 199311995, While in most countries of which data was

available, kerosene prices were higher than those of diesel, in India, the diesel prices

in 1995 were three times the kerosene prices. Similarly, as revealed in the last column,

the price ratio of MS to HSD in India was 2.46,exceeded only by Argentina and South

Korea. In most countries, the ratio hovered around 1.5.

Reddy suggests that the funds used for implicit subsidies on kerosene and

diesel which are of the order of Rs.20,000 crores per year can be diverted for

improvement of the railway's freight operations and for rural electrification. Steps

should also he taken to discourage long distance haulage of freight by trucks and to

link truck facilities with railway freight operations to provide door-to-door freight

movement.

Tyner" observed that since 1974, the drastic price increases and supply

constraints on petroleum products have caused disruptions in transport and industrial

activity. Inadequate energy supplies can result in lower industrial and agricultural

production and reduce the rate of economic growth. In addition, uncertainty regarding

future adequacy of energy supplies could be a deterrent to both private and public

investment in the current period. Expectations of abundant energy supplies at

reasonable costs could provide a stimulus to investment. Energy supply policy should

" Tyner: Fhergy Resource und Economic Development in India, 1978.

72

be an important consideration for development planners since adequate supplies of

energy are an important component, if not pre-requisite, of sustained economic growth.

Drawing a parallel from A.O.Hirschman's unbalanced growth

framework ", Tyner argues that in a country like India accustomed to vicious circles of

shortages, a shortage of any form of energy could simply decrease the level of Directly

Productive Activities (DPAs) using that form of energy, rather than compell'mg public

authorities to remove such shortage. On the other hand, abundant supply of any form

of energy can induce investment in DPAs using that form of energy.

Geeta Gauri" did a time series analysis on the consumption pattern of

major petroleum products product-wise and sector-wise and supplemented it with an

econometric analysis of the market structure. Multiple regressions were run for each

of the 4 broad sectors, viz. household, agriculture, transport and industry. All sectors

displayed certain common features in regression results. The first major observation

was the low price effect on consumption prevalent in all the sectors. This reflected the

price inelasticity as well as the growing proportion of petroleum product consumption

in all the groups. The second feature displayed by all the sectors is the high level of

inter-fuel substitution, not only among different cuts of the same distillate but even

" Ibid., quoting Albert 0.Hirschman: The Strategy of Economic Development, Yale University Press, 1958, pp.62-97.

33 Geeta Gauri; Pricing for Welfare; Petroleum Producls in India, 1988.

73

between different sources of energy, such as coal and fuel oil, electricity and diesel,

etc. The third feature was the predominance of income effect in the demand equations.

Finally, all the regressions suffered from multi-collinearity.

In the household sector, the demand for LPG was found to be directly

related to its own price and inversely to the price of kerosene. This is thus, in a broad

sense, a Giffen paradox. Population growth and per capita income asserted greater

influence on demand for kerosene than either the price of kerosene or the price of

LPG. The low values of the coefficient of per capita income raises doubts about the

claims of the Government that kerosene is consumed by low income groups.

In the agriculture sector which consumes HSD and light diesel oil (LDO),

the demand was found to be price inelastic and inter-fuel substitution was evident. In

the industry sector, consumption of fuel oil is largely determined by the relative price

of FO and coal and inter-fuel substitution is important in industry. In the transport

sector, the demand for diesel displayed a high level of inter-fuel substitution with

kerosene. The bame is not observed for MS, which is difficult to substitute. Both

products were price inelastic.

1~he inefficacy of administered prices to control demand in a segmented

market is implicit from the above analysis. If the Government policy is to regulate

demand, then under the prevailing market conditions, administered prices have to be

combined with rationing. Reliance on differential pricing for individual products

74

between consumers will also fail, as long as the boundaries between sub-markets

cannot be assured.

Geeta Gauri explains the price inelasticity of demand as a natural

manifestation in a regime of administered prices. Two categories of price inelasticities

can be discerned. First, price inelasticity of products which satisfy merit wants such as

kerosene consumption of small consumers. Each consumer consumes relatively small

quantities, and since the product is an absolute necessity, consumption cannot be

curtailed unless effective substitutes are found. The second category of inelasticity is

the ratchet effect prevalent in economic systems which have developed on a petroleum

base. For example, many industries use FO as a basic source of power. A shift to other

forms of energy may require additional investment on capital equipment. Second,

despite the rise in price of MS and HSD, it is not feasible to utilise cheaper modes of

transport. These elements of price inelasticities are strengthened when administered

prices are kept low. Demand responds to price only at much higher levels.

I t is estimated that the demand-supply imbalance will continue to grow

in spite oi the increased refining capacity envisaged by the planners. The Sub-group

on refining for the Eighth Plan estimated that at the end of the Plan, there would be

a deficit oi 4.79 mmt of light distillates, 11.14 mmt of middle distillates and 3.40 mmt

of heavy ends. The corresponding figures for the year 2001-02 could be 10.80.20.18

and 5.15 respectively. If all the proposed grass root refineries and capacity expansion

projects of existing refineries are completed, the indigenous availability of products

75

would not be more than 25.85 mmt light distillates, 64.71 mmt middle distillates and

24.39mmt heavy ends by 2001-02. This may wipe out the deficit by that year, but soon

the demand would outgrow supply, as estimated by the Oil Industry Planning Group

under the chairmanship of U.Sundararajan, Chairman and Managing Director, BPCL.

This would lead to a deficit of 3.24 mmt of light distillates and 9.06 mmt of middle

distillates and a surplus of 3.2 mmt of heavy ends by 2006-07.