VZCZCXRO5945
PP RUEHAST RUEHCI RUEHLH RUEHPW
DE RUEHBI #0244/01 1501311
ZNR UUUUU ZZH
P R 291311Z MAY 08
FM AMCONSUL MUMBAI
TO RUEHC/SECSTATE WASHDC PRIORITY 6298
INFO RHMFIUU/DEPT OF ENERGY WASHINGTON DC
RUEHNE/AMEMBASSY NEW DELHI 7525
RUEHBI/AMCONSUL MUMBAI 1412
RUEHCI/AMCONSUL KOLKATA 1564
RUEHCG/AMCONSUL CHENNAI 1756
RUCNCLS/ALL SOUTH AND CENTRAL ASIA COLLECTIVE
RUEHBJ/AMEMBASSY BEIJING 0113
RUEHHK/AMCONSUL HONG KONG 0009
RUEAIIA/CIA WASHINGTON DC
RHEHAAA/NSC WASHINGTON DC
RUCPDOC/DEPT OF COMMERCE WASHINGTON DC
RUEATRS/DEPT OF TREASURY WASHINGTON DC
RULSDMK/DEPT OF TRANSPORTATION WASHINGTON DC

UNCLAS SECTION 01 OF 05 MUMBAI 000244 
 
SENSITIVE 
SIPDIS 
 
STATE FOR EEB/ESC DHENGEL, PHAYMOND, KBEL 
STATE FOR OES CHILL 
DEPT OF ENERGY FOR U/S BUD ALBRIGHT, DSCHWARTZ 
DEPT OF ENERGY IP FOR A/A/S KFREDRIKSEN, RCOOPER, GBISCONTI 
DEPT OF ENERGY IP FOR TCUTLER 
DEPT OF ENERGY FE FOR DAS JSWIFT, RLUHAR 
INR FOR AL WOOD AND RAY LESTER 
EXPORT IMPORT BANK FOR JESSICA FARMER AND ASHOK PASRICA 
STATE FOR EEB JKOPP 
 
E.O. 12958: N/A 
TAGS: EFIN EPET ECON IN
SUBJECT: STATE-OWNED OIL MARKETING COMPANIES LEFT WITH FEW CHOICES AS 
PETRO-PRODUCT RETAILING IN INDIA BECOMES INCREASINGLY UNSUSTAINABLE 
 
REF: 07 MUMBAI 0672 
 
MUMBAI 00000244  001.2 OF 005 
 
 
Summary: 
-------- 
 
¶1.  (U)  The three state-owned integrated oil refining and 
marketing companies (OMCs) have been hit by a triple whammy -- 
spiraling crude oil prices of over USD 120 a barrel, the 
depreciating rupee via-a-vis the dollar, and a higher inflation 
rate of over 7 percent.  These three factors have widened the 
discrepancy between the actual cost of petro-products and the 
"politically acceptable" sale price that is determined by the 
Indian government.  The OMCs will have to absorb USD 3.8 billion 
in losses in 2007-08, even after the government and state-owned 
upstream oil companies partially compensate them for their 
losses through the issue of oil bonds and subsidies.  The OMCs 
still have to gain the experience to participate in the 
relatively nascent commodities market to hedge against future 
crude price increases.  The federal government is considering 
several options to ease the woes of the state-owned OMCs after 
international oil prices crossed USD 130 a barrel last week, but 
it has yet to announce a price increase for the "controlled" 
petro-products.  The OMCs, left with little choice, have 
proposed curtailing their losses through "rationing" measures. 
 
¶2.  (U) Due to India's shortage of petro-products, especially 
diesel, the Government of India prevents the state-owned OMCs 
from exporting and, consequently obtaining free market prices, 
for their refined petro-products in the international market. 
The refinery expansions of Reliance Industries and Essar Oil 
will add significant refining capacity in India, and if 
Reliance's claims are to be believed, may even help ease the 
international crude oil rise which is partially linked to a 
world-wide refining capacity shortage.  Both companies said that 
they will be able to meet domestic demand as well as export 
refined petro-products once the refinery expansions are 
completed.  End Summary. 
 
Mounting Losses Force OMCs to "Ration" Supplies 
------------------------------- 
 
¶3.  (U) State-owned integrated refining and marketing companies 
-- Indian Oil Corporation, Bharat Petroleum Corporation and 
Hindustan Petroleum Corporation - claim that they lose over USD 
100 million each day by selling petrol, diesel, kerosene and 
domestic cooking gas below the actual production price. 
According to a report prepared by Enam Securities, a leading 
Mumbai-based brokerage, the Indian consumer pays around USD 49 
per barrel for these products although the Indian oil basket 
averaged USD 110 a barrel in April.  The Indian government 
believes that increasing the domestic prices of these products 
in line with the rise in international oil prices will result in 
a cascading effect on the entire economy and will bring immense 
hardship to the "aam aadmi" (common man).  The Ministry of 
Petroleum & Natural Gas has estimated the gross under-recoveries 
-- the shortfall between cost of production and the selling 
price -- of the OMCs at around USD 18 billion in 2007-08. 
ABN-Amro estimates these under-recoveries will more than double 
to USD 46 billion during 2008-09 if international crude oil 
prices remain over USD 120 per barrel. 
 
¶4.  (U) The Enam report maintains that the retail prices of 
petrol and diesel need to be raised by 44 percent and 66 
percent, respectively, and the prices of domestic cooking gas 
and kerosene supplied through the public distribution system 
have to rise by 68 percent and 300 percent, respectively, to 
pass on the full impact of the international oil price rise. 
Vinod Panjwani, Senior Manager (International Trade) for Bharat 
Petroleum Corporation (BPCL) explained that oil companies suffer 
the maximum loss on account of low diesel prices due to the 
 
MUMBAI 00000244  002.2 OF 005 
 
 
large volume of diesel consumed in the country.   Diesel 
accounts for 37 percent of petro-consumption; the Enam report 
estimates that under-recoveries would drop by USD 1.4 billion if 
diesel prices were increased by one rupee.  However, Panjwani 
noted that diesel is a mass-consumption fuel used for the 
transportation of goods and agricultural pumps and tractors and 
is more price sensitive than petrol, which is used primarily in 
private automobiles.  The government, therefore, prices diesel 
lower than petrol to avoid a diesel price-driven compounding 
impact on inflation, although both petrol and diesel cost almost 
the same to produce, he explained. 
 
¶5.  (SBU) Media reports state that the Finance Ministry has 
agreed to issue oil bonds worth USD 8.4 billion in 2007-08 to 
compensate OMCs for around 46 percent of their gross under- 
recoveries.  Of this, oil bonds worth USD 4.8 billion have 
already been issued to the OMCs in April-December 2007 according 
to the Ministry of Petroleum & Natural Gas.  An economist at 
Enam Securities told Congenoffs that the maturity of oil bonds 
is primarily 10-15 years.  The bonds are given to the OMCs, who 
then sell them to state-owned insurance companies and pension 
funds, which are the only bodies allowed legally to buy them. 
These institutions then often re-sell them to banks at a 
discount.  Since they do not qualify under the Statutory 
Liquidity Requirement (SLR), which requires banks to hold a 
certain amount of their capital in government securities, banks 
are reluctant to buy them unless at a discount, he explained. 
According to the Enam economist, these bonds are distributed to 
the OMCs in tranches in a non-transparent, ad-hoc fashion.  OMCs 
do not know when to expect the next tranche of bonds and, 
therefore, cannot gauge their future liquidity or cash flows, he 
maintained. 
 
¶6.  (SBU) Despite the non-transparent and uncertain nature of 
the bonds, the OMCs have repeatedly petitioned the Finance 
Ministry to increase the government's share to 57 percent of the 
total under-recoveries by issuing additional oil bonds.  (Note: 
Under the current burden-sharing arrangement, the government 
issues oil bonds to sustain 42.7 percent of the 
under-recoveries, oil prospecting or upstream companies bear 33 
percent of the total loss through price discounts, and the 
balance is borne by the state-owned OMCs.  End Note)  The OMCs 
will therefore have to absorb the balance of USD 3.8 billion in 
under-recoveries in 2007-08, after the issue of the remaining 
bonds and subsidies by the upstream oil companies.  However, tax 
revenue and import duties from crude oil and domestic petrol and 
diesel sales is significant, and some analysts believe this 
income is as large or larger than the losses that the OMCs incur 
for selling their products at below cost.  In 2006-07, the 
government collected around USD 17 billion of excise and customs 
duties from crude oil and petroleum products.  V. Ramamurthy, 
Head-Technical of Essar Oil, told Congenoffs that the growth of 
the service sector has resulted in a substantial increase in its 
contribution to tax revenue and, consequently, the percentage of 
tax revenue contribution by the oil sector has therefore gone 
down in relative terms.  The government is therefore no longer 
dependent on the tax revenue from the oil sector to finance its 
expenditure, he continued.  The Finance Ministry may be 
reluctant to reduce the revenue stream for fear of allowing 
India's high fiscal deficit to inflate even more, however. 
 
¶7.  (SBU) BPCL's Panjwani admitted that the cap on the retail 
prices of petroleum products wiped out all profits his company 
made by its refining operations.  He also noted that India's 
energy crunch created a significant supply-side bottleneck 
which,if corrected, would substantially increase India's growth 
rate.  Nevertheless, Panjwani pointed out that the "socialist" 
nature of the government, the upcoming state assembly elections, 
and possibility of early national elections prevented the 
 
MUMBAI 00000244  003.2 OF 005 
 
 
government from raising retail prices of petroleum products to 
"politically unbearable" levels.  Media reports state that BPCL 
plans to limit the amount of petrol and diesel supplied to its 
retail outlets to the amount sold by the outlets during the same 
period last year.  Reports claim that BPCL and the other 
state-owned OMCs also plan to "freeze" new cooking gas 
connections, fix a quota of one cooking gas cylinder per family, 
curtail the import of diesel and hold off on expanding the 
retail outlet network in the country to ride out the current oil 
price rise and to reduce their mounting under-recoveries. 
(Note: The Ministry of Petroleum & Natural Gas has publicly 
stated that it is committed to ensuring uninterrupted supplies 
of petrol and diesel and denounced any move to restrict or 
ration supplies.  However, state-owned OMCs claim that they are 
forced to "restrict" sales of petro-products due to limited 
availability.  End Note).  State-owned OMCs are also thinking of 
promoting only branded, costlier petrol and diesel, which are 
priced at a premium over the government-determined retail 
prices, hoping that customers will be willing to pay more for 
branded fuels which give greater mileage, lower emission and 
maintenance costs and cleaner engines. 
 
Private Refiners Opt out of Marketing Business but Still Hang on 
to Assets 
------------------------- 
 
¶8.  (SBU) Private-sector oil marketing companies do not receive 
oil bonds and cash discounts to compensate for the shortfall 
between the government-determined selling price and actual 
production cost, unlike state-owned OMCs.  Private-sector OMCs 
are theoretically not "bound" by the retail caps on petrol and 
diesel.  However, they have no choice but to sell their products 
at the "controlled" government prices or risk losing market 
share.  Both of the privately-owned OMCs -- Essar Oil and 
Reliance Industries -- have abandoned their oil retail expansion 
plans citing the absence of a "level-playing field" between 
private and state-owned OMCs.  However, Reliance Industries and 
Essar Oil have not yet exited the oil marketing business, as 
both believe that the situation could change in the future. 
Either the government would be forced to allow the price to rise 
or crude oil prices could fall, they opined.  Although Reliance 
Industries has closed its 1,400 oil retail outlets, it is still 
holding on to the retail assets.  Essar Oil's Sudip Rungta 
explained that Essar took a strategic decision to price petrol 
and diesel sold at their outlets at a much higher price than 
that sold at state-owned retail gas stations.  Consumers are, 
therefore, unlikely to buy from their outlets and would prefer 
to use the state-owned retail stations.  Essar Oil operates 
these 1,500 retail outlets through franchisees but Rungta 
claimed that the company compensates its franchisees to maintain 
its retail operations. 
 
Host to Asia's Largest Grassroots Refinery, India Faces Refining 
Capacity Shortage 
-------------------------- 
 
¶9.  (U) Provisional data from the Director General of Commercial 
Intelligence & Statistics under the Ministry of Commerce shows 
that India's consumption of petroleum products in 2006-07 was 
120 million tons.  Total production of petroleum products during 
the same period stood at 135 million tones, indicating a supply 
surplus of 15 million tons.  However, 32 million tones of 
petrol, oil and lubricants were exported, leaving the country 
short of 17 million tons of these products which had to be 
imported. 
 
¶10.  (SBU) The three-state owned OMCs supply exclusively to the 
domestic market.  Since India faces a shortage of refined petrol 
and diesel, privately-owned Essar Oil also currently supplies 
 
MUMBAI 00000244  004.2 OF 005 
 
 
all refined petroleum products manufactured at its 10.5 million 
ton refinery to the domestic state-owned refiners.   The company 
sells these products at the refinery-gate price or the 
import-parity price which is equivalent to the landed cost of 
imported petroleum products and includes customs and excise 
duties, freight, and transportation costs.  Essar's Ramamurthy 
explained that "hospitality" and "product-sharing arrangements" 
between all oil refining-marketing companies assured that 
state-owned OMCs would always buy Essar Oil's products at 
international-equivalent prices.  Reliance Industries -- the 
owner of Asia's largest greenfield refinery -- exports almost 
all of the petroleum products (excepting LPG) processed at its 
33 million ton refinery at Jamnagar in Gujarat.  BPCL's Panjwani 
argued that Reliance should be banned from exporting its product 
and should be "forced" to supply to the domestic market as India 
had a deficit in meeting its petroleum consumption needs.  In a 
separate discussion, Hital Meswani, Executive Director of 
Reliance Industries, claimed that state-owned refining companies 
cannot export their petro-products as they are not able to meet 
international specifications. 
 
¶11.  (U) Reliance is currently building another refinery at 
Jamnagar which would make it the largest refining complex in the 
world, with a refining capacity of around 66 million tons or 
nearly 1.2 million barrels of oil per day.  The new refinery is 
expected to be completed by December 2008.  Meswani said that 
Reliance will be able to meet domestic demand and continue 
exporting with the new capacity.  According to Meswani, the new 
refinery will be able to process all types of crude oil 
(heaviest to lightest) from anywhere in the world and can export 
the refined product to any country based on their particular 
specification, he maintained.  The refinery will help ease the 
world-wide refining capacity shortage, which Meswani claims is 
linked to the current international oil price rise. 
 
¶12.  (U) Essar Oil is also planning to expand its existing 10.5 
million ton refinery to 34 million tones in two stages at a 
total cost of USD 6 billion.  In the first stage, the refining 
capacity would increase to 16 million tons through 
debottlenecking to remove the limits on output capacity..  New 
expansion would subsequently increase refining capacity by 
another 18 million tons.  While the company can claim tax 
benefits for the first expansion phase, it would not be able to 
commence its 18-million ton expansion plan before March 31, 2009 
which is the last date for claiming the tax benefits for 
existing and new refineries.  For this reason, Ramamurthy 
explained, the company is considering setting up the new 
refinery in a special economic zone so that it can avail of 
export tax benefits.  The completion of the 34-million ton 
refinery will enable Essar Oil to export around 50-60 percent of 
refined petroleum products and to supply the rest to the 
domestic market, Ramamurthy added. 
 
Oil Futures Trading: the Answer or a Distant Dream? 
------------------------------------ 
 
¶13.  (U) The National Commodities Derivatives Exchange (NCDEX) 
and the Multi-Commodity Exchange (MCX) offer the trading of 
crude oil and furnace oil futures contracts in India.  Indian 
OMCs are not allowed to trade in foreign oil futures contracts. 
The crude oil futures contracts offered by the two commodity 
exchanges mimic the oil futures contracts on the New York 
Mercantile Exchange (NYMEX) and the Intercontinental Exchange 
(ICE), because, as Arvind Pal Singh, Assistant VP (Energy) of 
NCDEX, pointed out, India has only 2-3 percent of the world's 
crude oil reserves.  Crude oil futures contracts are used for 
risk-mitigation rather than price discovery in India, he 
continued.   NCDEX has only one indigenous contract linked to 
the domestic price of crude oil.  In contrast, furnace oil 
 
MUMBAI 00000244  005.2 OF 005 
 
 
futures contracts are designed for price-discovery.  There are 
no futures contracts for refined products like petrol and diesel 
because prices are "controlled" by the government.  There is 
zero price risk and no scope for price discovery for these 
products, he added. 
 
¶14.  (U) Refiners can hedge against their crude oil import 
exposure based on their past performance, or up to 50 percent of 
their one-year or three-year inventories.  Nevertheless, the oil 
futures market in India suffers from low penetration and 
inadequate liquidity, Pal Singh admitted.   There are only a 
handful of end-consumers for crude and furnace oil like refiners 
and proprietary power generating companies who face a price risk 
and therefore have an incentive to participate, he continued. 
Participation is low even among these limited beneficiaries, he 
continued.  BPCL's Panjwani also confirmed that the 
participation of oil companies in the futures trading market on 
both the NCDEX and MCX is negligible.  Pal Singh pointed out 
that the commodity markets are relatively new in India and 
online trading in commodity futures started only in 2003.  The 
markets still have to gain depth and liquidity and participants 
have yet to become savvy at hedging, he continued.  Moreover, 
refining companies and proprietary power generating companies 
prefer forward trading through the Over-the-Counter market, 
rather than engage in futures trading, he added. 
 
Comment: 
--------- 
 
¶15.  (SBU) The structure of the oil bonds issued to partially 
mitigate the losses of the state-owned OMCs lack transparency 
and are shrouded in secrecy.  One commodity trader and Indian 
Oil Corporation shareholder told Congenoffs that the CFO of the 
Indian Oil Corporation has declined to provide information on 
the coupon rate and maturity of the oil bonds; Enam Securities 
confirmed the opaque nature of these bonds.  State-owned 
entities (public-sector banks and pension funds) are the only 
buyers of these bonds, which raises questions about their 
overall liquidity.  In fact, the Chairman of Oil & Natural Gas 
Corporation (ONGC), a state-owned upstream company, told press 
recently that he has refused to accept oil bonds as payment for 
crude oil sales to the OMCs, but has instead offered to lend 
these companies part of its cash surplus to help ease their 
liquidity crunch.  It is, therefore, perplexing that the 
state-owned OMCs look to the bonds as their only means of 
survival and have repeatedly asked the Finance Ministry to 
increase the amount of oil bonds allotted to them.  The 
government's pro-consumer policy of preventing market-driven 
pricing of retail prices of petro-products and thereby creating 
market distortions is fiscally unviable.  The three oil 
marketing companies in India are all state-owned and must remain 
in the business even when losses mount.  Consumers and oil 
companies will continue to watch with wary eyes as and when a 
policy change is announced.  Central government policy 
approaches to this dilemma will be reported in a New Delhi 
septel. End Comment. 
KEISER