Sunil Jain: Gas in pricing remains

RATIONAL EXPECTATIONS

The government made much of the fact that the Group of Ministers (GoM) had capped the prices of natural gas to be sold by Reliance Industries Limited from its Krishna-Godavari Basin fields at $4.2 per million metric British thermal units (mmbtu) "" while this was only marginally lower than the $4.33 price submitted by Reliance, the big achievement touted was the GoM capping the crude oil price at $60 in the Reliance gas pricing formula. In addition, the GoM was supposed to have removed a biddable component ("c") in the formula, again something that would lower prices.

Later, enterprising journalists of the newly-launched Mint found this wasn't quite true, "c" had not been removed, but had merely been assigned a value of zero for the current lot of bids Reliance had received "" the company would be free to get bids on this for other lots of gas. Mint made much of this, and rightly so, since it showed the government was being economical with the truth. But the truth is that neither the crude price cap nor the biddable component makes much of a difference. 

'GAS' WHAT? Reliance gas price hardly changes even when crude prices do
Crude Price in $	Selling price of gas* ($ per mmbtu)
	Without biddable "c"	With biddable "c"
105	4.43	4.68
85	4.35	4.6
65	4.24	4.49
45	4.07	4.32
25	2.5	2.75
*Selling price ($/mmbtu)=2.5+(Crude Price-25)0.15 + "c" Note:  1) "c" is assumed to be zero, except in last column, where it is assumed at 0.25 cents;    2) Exchange Rate assumed at Rs 40=$1

Sure, if the cap is removed (and crude prices surge) or if the bids for "c" are high, gas prices will rise. But the real cream for Reliance lies in the manner in which it invited the bids, and in the pricing formula it fixed, and in the fact that the GoM just tweaked this a bit "" this, despite the Prime Minister's Economic Advisory Council (EAC) quite clearly saying major changes were required in both the formula as well as the manner of bidding. Indeed, if the same method that has been sanctified for Reliance (inviting just a few firms to bid and based on a formula chosen by the supplier) is to be used by others, including ONGC, which has also found huge gas reserves in the same KG Basin, gas prices in the country are going to rise in a big way "" interestingly, the production-sharing contract specifically prohibits "restricted" sales, though neither the EAC nor the GoM thought it relevant.

To understand this, let's just go back to how the bid was conducted. In April, Reliance chose 10 buyers and gave them a formula on which they had to bid "" this had a fixed component, another related to the prevailing price of crude oil, and one biddable component "c". Given that gas is a sellers' market, who the bidders are is critical "" if firms whose plants are closed due to lack of gas are invited to bid, the bid prices will obviously be higher. So, an unrestricted bidding process is critical. Here's what the EAC had to say: "Since there appear to be some doubt about the transparency of the bidding process adopted by M/s RIL, especially relating to placing restrictions on who was invited to bid, and the volume of total gas on offer, it may be appropriate to (i) Take immediate action to invite fresh bids in a transparent and well-publicised manner from all parties in a position to lift gas so as to discover the true arms length competitive price for the gas." The GoM ignored this advice from a body that it itself recognised to comprise technical experts.

What of the formula on which the bids were to be invited? The formula, as the EAC observed, was in keeping with international practice of using "a rather opaque mix of constants, exponents and competing fuel benchmarks". So, it was in line with industry practice but it was opaque! If you see the table, Reliance has virtually no downside "" if crude oil prices rise to $105, it gets $4.43 per mmbtu, but if crude prices fall to even $45 (that is, by more than half), it still gets $4.07 (a fall of just 9 per cent)! So, the capping of crude prices at $60 in the formula is only of academic interest.

What of "c"? While, as we now know, this was never removed, as the table shows, its importance is overstated. In the bids that Reliance got, the highest bid it got for "c" was Rs 10 (0.25 cents). Plug this into the pricing, and you'll see it just raises prices by 5-6 per cent, not something to scoff at, but the real cream lies in the rest of the formula. What does the EAC say on this? After pointing out that the government has not prescribed any guidelines or thumb rule for arriving at an acceptable formula, it says "any guidelines on use of formulae in the price discovery process, including the currency in which it should be denominated, should be quickly put in place".

The GoM had a golden chance to put the country's gas pricing on track, but it just blew it.