Finally there is recognition that the public sector oil companies need to merge to allow them the size to be able to hold out against larger companies. All kinds of red herrings are being put forward and it is important that we do not get this wrong. We have already wasted much time forcibly keeping the oil companies from making their own decisions. When oil was around 10 dollars a barrel and companies like Indian Oil wanted to buy excellent oil fields abroad at low prices, the government could not understand enough to allow them. The Chinese oil companies including CNOOC and its much bigger domestic rivals PetroChina and Sinopec meanwhile had been furiously increasing their reserves through overseas acquisitions, and continue to do so.  Belatedly, it is becoming clear to decision makers that there is no better use for India’s foreign exchange reserves than to “put” them in reserves of oil and gas abroad.  Hopefully, the moves to recast Indian companies to be able to compete reflect a deeper understanding of the sources of the advantage of oil companies. Firstly, one ought to be talking of energy companies and not oil alone, since oil companies are important players in the gas markets and the two markets are increasingly influencing each other. Furthermore, the retailing of gas in India starting with CNG is bound to grow rapidly and oil companies would naturally like to have a share of the business. The key driving force that has kept a large part of the oil business integrated and has driven other companies (the so- called independents) to integration is the aspect of vertical integration economies. It is not that smaller companies do not exist. They have their own niches, and through agreements and specialized activities like services provision, equipment and technology provision, or through control over small but well situated resources as in the US are able to survive.  Vertical integration economies especially render stand-alone refinery companies less profitable than companies that do refining along with distribution and/or production. The principal diseconomy for stand alone refining arises because of the high variation (not entirely correlated) in product and crude prices that makes the margins vary even more, so that the capital markets value such businesses as being too risky. This is another way of saying that the markets for crude and products are very far from “perfect”; and options would when available be for short periods and that too only at very high cost so that there is no realistic option but to straddle a larger part of the value chain, or to go in for long term enforceable contracts. Since the rents in crude production are large, the ability of holders of cheap reserves to reduce prices is of significance in recessionary conditions and adds to the problem. This would seem remote today when oil is upwards of S45 a barrel and all crude producers are flush with profits and rents, but is real enough when prices fall.

 

Size in itself is important but so is the right constitution of the future energy companies out of the existing PSUs and Reliance. It would stand to reason that two rather than one company, centered around ONGC and Indian Oil would be the obvious choice with the distribution might of IOC-IBP being balanced by its take over of GAIL and OIL. And the ONGC being aligned with HP and BP; and both combines being allowed to buy up fields abroad without outbidding each other. The domestic economy would need at least two companies to keep the business about as competitive as it can and needs to be. But is there realization that without managerial freedom there is little that these companies, whether two or one can do to hold out against oil giants if one were to decide to enter the country? Or for that matter make the right decisions with regard to overseas acquisitions? There is too much of ill-analysed ‘political’ and security considerations coming from the government that could negate potentially good acquisitions.

 

From the companies’ and the country’s long term interest it is necessary to keep global players out of the Indian market. The barrier to entry is the distribution chain and that too only to the extent that retailers cannot shift out to new tie-ups. The pipeline segment is another barrier but again only to the extent that as user-owners they can resist open-access in a limited way. Together they are not large enough to deter a global player, which is deeply bullish about the future of the Indian market.  So reform of the sector – movement to (uniform) value added tax with pricing freedom to oil companies and direct subsidization of poor kerosene users (which are immediately required from the need to remove the vast hurtful distortions on the Indian citizens and industry) need to precede if the oil companies are correctly grouped. It is important to achieve this exit from the current “arbitrary price mechanism” and give the restructured oil companies time, say three years, to learn to manage price volatility through the distribution chain before allowing foreign players into the local distribution business.  India’s certain dependence on imported energy in the foreseeable future is an ‘advantage’ that can be leveraged in the global market and it is important that these are exploited by Indian companies. Oil and energy are sectors where a large country like India cannot but have its own strong domestic players. Not just security alone but the economy demands its own players. It would be sad to today lose the legacy of the great KD Malviya to the imperialists of the past, just because the government could not act correctly. And the best action is to let the companies involved including Reliance be the principal decision makers in the process, with the government coming in only to keep the global players out for a while.

 

The government has been parasitically squeezing the oil companies for dividends and privatization money; and that pressure for ‘revenues’ can only grow. Therefore it would be futile to expect the government to enhance the equity base of oil companies to allow them to become ‘global’ players - all the more reason that they go to the equity market for resources and large expansion. That would mean getting rid of all the policy and tax distortions on the sector, and a commitment to not interfere in their management – in turn best communicated by announcing a desire to go down to small minority stakes. That would enable the companies to go to markets with high valuations. And government would be the principal gainer.