Mr Kejriwal, Grow Up. Your open letter to Modi is all gas, no economics

Subject: Mr Kejriwal, Grow Up. Your open letter to Modi is all gas, no economics
From: An Indian citizen
Date: 19 May 2015

Dear Mr Kejriwal
I understand that you have sent an open letter to Narendra Modi on questions that are bothering you. I like your inquisitiveness and eagerness to know such details, but it should be obvious to everyone that the basic purpose of sending "open" letters is usually self-publicity. As a politician you are entitled to self-promote, and I certainly don't grudge you that.
You have asked three basic questions of Mr Modi: whether he will go ahead with the UPA government's decision to raise gas prices to $8 per mmBtu; what his relationship with Mukesh Ambani is; and how much his election campaign is costing.
I obviously cannot answer questions two or three. If you have any information that the relationship between Mr Ambani and Mr Modi is not proper, or that excessive amounts are being spent in the Modi election campaign, all you have to do is go to the police or complain to the Election Commission. Since you have already filed an FIR accusing everybody and the dog-at-the-lamp-post of colluding to raise gas prices, you should get an answer to this question from the courts. A PIL on gas pricing is already filed in the Supreme Court. That obviously has not stopped you from milking this issue for what it is worth with open letters.
However, if you a really want serious answers to the main question you have asked on gas pricing, you won't find them with Mr Modi - who is no expert on gas pricing - but with real experts. From your recent track record, I find that you shoot first and ask questions later. Sometimes you ask questions first, but don't wait for answers - which is not unlike some of our TV anchors. In Delhi, you ordered a CAG audit of your discoms, but announced a subsidy without waiting for its report. You offered free water even though you know most homes in Delhi are not metered. Which means only a minuscule number of people will benefit - probably those who can afford to pay.
However, we shall let that pass. This letter is an attempt to educate you a bit on the basics of business economics, something which P Chidambaram called Economics 101 in an NDTV interview the other day on your bogus gas pricing theories. After you filed the FIRs, I started reading a bit more about gas, the production contracts signed by various offshore exploration companies, and pricing. I don't pretend to understand all the gory details - it's too technical - but I believe I do understand the basics. You should make an effort too.
Before we begin, a small disclosure: Firstpost and Firstbiz are owned by Network 18, whose promoters have been partly funded by Mr Ambani's company. You could presume that as an employee of Network 18 this writer is an interested party. You can choose to take this stand, but whatever you choose to conclude about my alleged bias, you could still consider the facts as separate from them. Even assuming bias, facts and economic reasoning can stand on their own.
Your question to Mr Modi, on whether he is going to stick to the UPA government's decision to raise gas prices from 1 April to $8 per mmBtu, is actually irrelevant: the question is not whether this is the right price or the wrong one, but whether this is the right way to price gas at all. You should know that hydrocarbon resources are scarce, and India is not well-endowed with huge untapped hydrocarbon potential. We import 80 percent of our crude oil, and around 40-50 percent of our gas. The oil and gas imports are the main reason why our current account deficit is damaging the rupee and our economy.
If you are short of a key energy resource, should you price it low or high? We can address the issue of whether Mr Ambani is walking away with all the profits a bit later. But you should answer this question first.
My own answer is clear: we should free gas prices to find their own level and must simultaneously incentivise fresh exploration and bring in greater competition in gas exploration and supply so that over time gas prices become reasonable. US natural gas prices at the Henry Hub hit $10 in the middle of the last decade, before falling to just over $4 now following high shale gas production. The US will soon become a net energy exporter because it does not interfere with pricing. This itself should warn you about trying to fix gas prices. If Reliance had been operating in the US, its gas prices would not be any higher than what it is now being given under government decree. But it is also costlier to produce gas offshore. By artificially pegging gas and pump prices of oil low in India, we have become more dependent on imported oil and gas.
Anyone who prices gas cheap is thus acting against the national interest. He is making us dependent on the oil sheikhs of the Saudi peninsula. I am sure, Mr Kejriwal, you do not consider yourself a pal of Saudi and Qatari gas interests.
Arvind Kejriwal's assumptions on how gas should be priced are retrograde and are a mockery of the idea of "honest politics." Crony capitalism cannot be eliminated by the state fixing prices of gas. PTIArvind Kejriwal's assumptions on how gas should be priced are retrograde and are a mockery of the idea of "honest politics."
This shows how little you understand about pricing any commodity, leave alone a complex commodity like gas extracted from ultra-deep mid-sea gas wells. The profit margin on any commodity cannot be calculated on the marginal cost of a commodity - the cost of raw materials plus some profit margin - but its entire cost, including overheads, financing costs, and marketing costs.
Also remember, it's not as if Reliance was handed a well where it could just put a pump and sell the oil coming out. It had to explore, lose money, invest, create the infrastructure, and then get the gas out. It has taken all of nine years so far.
The $1-1.5 per mmBtu cost of gas that you take as Reliance's cost of production is a piece of fiction. I don't know where you got that price from, but it would have been some kind of well-head price which is derived on the basis of total estimated reserves still underground, and would probably exclude the costs of oil exploration, and all the related investments in production platforms, undersea installations, pipelines - the works. Once you include these things in the price, the cost will not be anywhere near $1-1.5. I don't know what the real costs would be, but I can bet it won't be less than $3-4 per mmBtu.
If you have any pals in the oil ministry - unlikely, I know, since you have now FIR-red them - they will tell you a bit about what these overhead costs are. Companies who received offshore blocks to explore for oil or gas get nothing if a well they dig turns out to be a dud or does not have commercially extractable quantities. That cost has to be written off by the company - and nothing gets paid. Only if a well is shown to be commercially viable can a company start earning some returns - but not before making billions of dollars in investment.
But even a commercially viable block like KG-D6 - Reliance's gas gusher - does not yield huge returns till the sunk costs are recovered. Under the contract, no profits are shared with the government till basic investments are recovered, but after this, 10 percent of earnings have to be shared with government, rising on a sliding scale to 85 percent once a level of 2.5 times of invested costs are recovered.
Put another way, once costs are recovered, 85 percent of the profits earned go to the government - and this is over and above the royalties paid. This is hardly a one-sided contract. So, the higher the price fixed for Reliance gas, the quicker the profit turnaround where the government itself starts getting 85 percent of its profit oil.
The proposed doubling of gas prices is, as many others have pointed out, not really about Reliance. ONGC, which produces five times as much gas as Reliance does currently, will be the biggest beneficiary. In fact, the real reason why the government is doing this is because ONGC is unable to invest much in oil and gas exploration - and handing over additional profits to ONGC is vital for revitalising this company.
The other fact is that ONGC, Oil India and Gail have borne the brunt of the diesel, LPG and kerosene subsidies amounting to Rs 8,00,000 crore over the UPA's 10-year term. The gas price hike may be intended to put some more money in ONGC's hands after debauching it financially with subsidies.
The deliberate and heavy subsidisation of hydrocarbon fuel prices has thus encouraged overconsumption and wastage, causing a fiscal and current account crisis which has pushed the rupee down and made fuel and fertiliser even more costlier than they ought to be. Consistently wrong energy pricing is the single most important reason for the UPA government's fiscal bankruptcy - and the resultant two-year slowdown that shows no signs of reversing.
No government, whether headed by Modi or even you, Mr Kejriwal, can improve India's investment climate without fixing energy pricing. And this is not about raising gas prices by government fiat - which you are right to object to - but allowing the markets to decide.
On another occasion, you said this: "The (Reliance) wells belong to us. If Reliance and Mukesh are not producing gas in order to create an artificial scarcity, then the government should look at giving these wells to the (state-run exploration company) ONGC and some other entity which can operate them and produce gas."
Well, Mr Kejriwal, I have news for you. Nobody will spend billions of dollars prospecting for oil and gas in India if this is your offer to them: "Take 10-15 percent margins over costs and go." Investors can earn that kind of money without risk merely by investing in government bonds or fixed deposits or corporate debentures. Even tax-free government bonds today yield over 9 percent - which is 12 percent pre-tax. So who will take so much risk to invest in your "10-15 percent" offer. It's a nice way to close down any business.
In case you haven't noticed, after bidding and getting over 40-45 oil/gas blocks for exploration over the last decade or more, Reliance has returned most of them and is now down to a handful of blocks. And most of the company's fresh investments in oil and gas are in the US and Venezuela, not India. The company is investing more in the US - where presumably there is less of crony capitalism, which, you believe, is the reason for fixing gas prices at $8. Landed costs of gas in India are nearly twice that level, and by saying that $8 is too high, you are forcing importers to pay even more.
Mr Kejriwal, I hold no brief for Reliance or anyone else. If there is any evidence to prove wrongdoing by anyone, they will surely get their just desserts. But we can do without your shrill holier-than-thou antics.
I understand your concerns about crony capitalism, but crony capitalism is the product of socialism - where the state decides who should make what kind of profits. Your insistence that gas should remain priced at $4 per mmBtu is exactly the kind of socialist/populist posturing that will encourage crony capitalism.
At a recent address to the CII, you said you are not anti-business, and that you are fighting for "honest politics." I am all for that. But should "honest politics" not mean "honest economics" and an honest introspection of your own publicity-seeking "open" letters to top politicians? You decide.
An Indian citizen
PS: There has been much debate - especially over twitter - over an average cost of under $1 quoted in a court case involving the Reliance gas business after this article was published. The real issue is this: marginal, average and other costs are incredibly hard to calculate in the case of an oil or gas well, because it is not just the cost of pumping the stuff out that is important.It is all costs, most of them variable and violently variable, over time.
For example:
1) In theory, gas in a well is essentially free - and the direct costs involved in pumping it out may be low. But calculating average costs for something that is a finite resource, and whose extraction costs may rise as extraction proceeds, is incredibly tough. So average costs in 2007 can be markedly different what is calculated in 2012.
2) The costs so calculated have to have some connection with the expected life of the well. If a well, say, has 100 mmBtu of gas today, and if tomorrow the estimate of reserves fall to a third of that level, and/or the geological complexity of the well has been underestimated initially, then all cost estimates change. An average cost of less than $1 in 2007 could become an average cost of $2-3 or even $4 if reserves fall. You can dispute Reliance's claims that its reserves are underestimated, but this can be easily established - or proved wrong - by neutral technical experts who have no stake in the Reliance-government dispute.
3) We are also underestimating the costs involved in discovering oil or gas. You can't charge the costs of drilling a dud oil block to the costs of a gushing block, according to the terms of the production contracts signed by the government of India. From a contractual point of view this is the reality, but from a business point of view, sunk costs from dud blocks have to be recovered from the gushing wells at some point.
4) Real costs include not only the drilling costs and production infrastructure at the well sites, but the whole undersea infrastructure of pipelines, the onshore installations, the financing costs of the whole project, etc. Since it takes 7-10 years from initial prospecting to production time, at 12 percent interest, financing costs alone would double overall costs from start to production time. So cost disputes are going to be endemic - and it may not be appropriate for a CAG, which is basically an accountant, to estimate how costs may have changed during the 7-10 years from initial prospecting to final production, when geological issues and estimates of reserves may have changed. Costs of everything, from hiring of drillrigs, to the final production and transport installations would have changed over a decade. So quoting a under $1 average cost makes no sense at all today.
5) The most important point I failed to discuss yesterday is this: at the time of bidding for the oil and gas blocks, the government promised market-based pricing for all winning bidders. This promise has still not been fulfilled as we have gotten into administered pricing.
The bottomline is this: offshore gas in tough undersea conditions is not an easy business to succeed in, but levelling allegations of fraud are easy since estimates change all the time. Only neutral experts of the oil industry should be relied on, but even they can go wrong 50 percent of the time.