Pricing Domestic Natural Gas Some Improvement, But Flaws Remain

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The new formula for the pricing of natural gas produced in the country is an improvement on the Rangarajan formula because it corrects many of the computational flaws of the much-criticised approach of the previous government. However, there remain faults and there are conceptual flaws as well in the new formula, which if corrected should take the well-head price of gas to no more than   $4.20 per million British thermal unit, rather than the price of $5.05 that has now been notified. There also continues to be a problem with this intervention in fixing prices since the production-

sharing contracts do not provide for a direct role for the government in setting the price of natural gas at the well-head.

Surya Sethi (spsethi09@yahoo.com) is Former Principal Advisor Power and Energy, Government of India. 
On 18 October 2014, the Narendra Modi government finally announced a new methodology for determining the well-head price for domestic gas produced in India.  Within 10 days of announcing the new gas pricing formula, the government notified a price of $5.05/million British thermal units (MMBTU), on a gross calorific value (GCV) basis, effective for the six-month period commencing 1 November 2014.  
On a like-to-like comparison, based on the net calorific value (NCV), the new price would translate to about $5.55/MMBTU when compared to the prevailing well-head price of $4.20/MMBTU for most of the gas now produced in the country which for a few fields is also priced at $5.25/MMBTU.  At the very outset, I would request the government to put the detailed working of the new price in the public domain to foster informed and research-based analysis and debate.
The government has discarded the Rangarajan formula that had been accepted by the United Progresive Alliance government which I had vehemently objected to in a number of op-ed articles[i].  This should have, under normal circumstances, given me reason to rejoice.  After all, the new formula proposes to correct many of the seven cardinal sins of the Rangarajan formula that I pointed out in a letter dated 10 August 2014, addressed to Prime Minister Narendra Modi.  But the Modi Government has not exactly scored a home run with its proposed formula for determining the well-head price of domestic natural gas.  Simply stated, we are not there yet.
Conceptually Flawed Formula
At the very core of my conceptual problem with the Rangarajan formula was the fact that there is no international price for natural gas.  Unlike crude oil, the global gas market is fragmented and not fully fungible.  Even the more tradable liquefied natural gas (LNG) does not have an international benchmark price like crude oil, and LNG procured from the same source for different markets could vary in price by a factor of two or more.  Hence Rangarajan’s attempt to establish a well-head price for natural gas produced in India by imputing a volume-weighted global well-head price, based on gas prices prevailing in different markets fed by disparate gas sources in different forms in varying proportions, without appropriate and defensible adjustments, was simply wrong.  It was akin to establishing the price of carrots through some imputed prices of apples, bananas and oranges.  This fatal conceptual flaw still remains in the new formula announced on 18 October 2014 even though the computational missteps of the Rangarajan formula have been moderated to a significant extent.
It is noted that when a natural gas resource is owned by a sovereign, the considerations that apply for pricing domestic sales of natural gas and those that apply for the sale of the same natural gas via pipeline or liquefaction to another country are very different.  One should not mix these very differently driven prices.  Both the Rangarajan formula and the formula of the Narendra Modi government are guilty of doing so albeit to different degrees.
Importantly, since gas markets are not fungible, India (or for that matter most gas producing countries in the world) cannot set the domestic well-head price of natural gas based on the well-head prices prevailing elsewhere in the world — even if we somehow succeed in accurately estimating such global well-head prices.  Most countries that produce natural gas regulate well-head prices based on purely domestic considerations.  Such considerations typically encompass available energy alternatives and their demand and supply balance, the impact on other sectors of the economy, the size and the nature of domestic energy reserves, domestic costs of extraction, domestic infrastructure limitations, and options available or challenges faced in importing and using imported energy.
North America is the only region wherein gas-on-gas competition among natural gas producers primarily determines the market price for natural gas.  This was not always the case even in North America.  However, as North American energy markets became fully fungible with multiple suppliers, and the necessary energy transportation, distribution and storage infrastructure (essential to a functioning market) was created, a competitive market and a market-determined natural gas price emerged in the continent.  Reserves that cannot be commercially exploited at this market-determined price remain untapped in North America.
Computational Improvements
The Rangarajan and the new formulae both seek to determine the Indian well-head price for natural gas by estimating the volume-weighted global well-head price for natural gas.  Beyond this common conceptual flaw, it is noted that the formula coined by the Modi government demonstrates far greater computational integrity in comparison to the Rangarajan formula.  The specific improvements include:
(i) High LNG-linked prices of Japanese and Indian gas imports that were given almost a 60% weightage for determining the well-head price of natural gas in India by the Rangarajan formula have been rightly dropped altogether in the new formula.  This computational flaw contributed the most to the high price delivered by the Rangarajan formula.  It is noted that LNG accounts for just 0.6% of Indian gas consumption and 9.75% of gas consumption worldwide;
(ii) The new formula recognises that the hub-based price indices must be adjusted downwards to account for gas transportation and treatment charges.  One can comment on the appropriateness of the adjustment actually made under the new formula only when the details become publicly available.  However, it is noted that the Rangarajan formula proposed no such adjustment;
(iii) The well-head price for natural gas consumed in Russia will now be rightly derived from domestic Russian prices for natural gas instead of the United Kingdom-based National Balancing Point (NBP) price index that was used in the Rangarajan formula without any adjustment as a proxy for Russian well-head prices.  The Rangarajan formula ignored the fact that the Russian well-head prices are less than a third of the NBP price index.  Again, it is stressed that the integrity of the Russian well-head prices used in the new formula can only be established after the details become available ; and
(iv) The well-head price of the gas consumed in Canada will now be rightly determined on the basis of the Alberta Hub price index under the new formula instead of using the US-based Henry Hub (HH) price index proposed by the Rangarajan formula.  The Alberta Hub price index has been at least 20% below the HH price index in recent years.
In addition, the proposed formula shifts to the international norm of GCV-based pricing.  This is a welcome move that I fully support.
Need for Further Correction/Clarification
The press release announcing the new formula does not address some important questions in respect of its approach to calculating the global volume-weighted well-head price for natural gas.  The most important of such unanswered questions are detailed below:
(a) Like the Rangarajan formula, the proposed formula also uses the NBP price index as a proxy for well-head prices of gas consumed in Europe and the former Soviet Union (FSU) republics.  First, for reasons detailed below, using the NBP price index for the FSU republics is incorrect.  But more importantly, it is unclear what adjustment, if any, is proposed in the NBP price index to account for the fact that this price index reflects Europe’s dependence to the extent of around 60% on much costlier LNG imports and piped imports of Russian natural gas.  This is the key reason why in recent years the NBP price index has been roughly three times the US HH price index that primarily mirrors the well-head prices of natural gas produced in the US.  Similarly, the Alberta Hub price index also primarily mirrors the well-head prices in Canada.  The HH price index (or the Alberta Hub price index for that matter) and the NBP price index value two very different products because the underlying constituents of the price index are very different.  To correctly assess the well-head price for gas consumed in Europe and for consistency among the price indices used in the proposed formula, the NBP price index must be adjusted for (i) the high-priced LNG component; and (ii) the high-priced Russian natural gas component that includes the high cost of pipeline transportation and geo-political premiums paid by some importers.  The press release of 18 October 2014 offers no indication of whether the proposed formula will adjust the NBP index and how it will do so to make it compatible with the other hub indices used in the proposed formula.  It is noted that the Rangarajan formula saw nothing wrong in using the NBP price index without making the required adjustments;
(b) Like the Rangarajan formula, the new formula continues to use the NBP price index for the block of countries referred to as FSU.  Not only is this incorrect, it is also inconsistent with the approach the new formula adopts for estimating the well-head prices for Russian and Canadian gas consumption.  Well-head prices in some of the FSU republics  are even below those prevailing in Russia and Canada;
(c) The new and revised formula excludes, as did the Rangarajan formula, from its estimate of the global volume weighted well-head price of natural gas, the consumption of natural gas in Central and South America, Africa, Middle East (stet), Asia, and Australia, which together account for about 35% of global consumption.
(d) It remains unclear what adjustments to well-head prices, if any, are proposed under the new formula to account for the presence of natural gas liquids.  Both the old and new Indian formulae fail to specify that what is being sought is the price of dry (stet) natural gas at the well-head that has been duly adjusted for recoveries from the extractable high-value natural gas liquids.  The Rangarajan formula did not recommend any adjustment for natural gas liquids in estimating the global volume-weighted well-head price of natural gas; and
(e) It would be in order to specifically state that associated gas is excluded from the ambit of the new formula.  Indian Production Sharing Contracts provide for this but a specific mention of such a policy would be useful.  The Rangarajan formula also chose to remain silent on this matter.
The first four of the five issues detailed above were also raised in my letter of 10 August 2014 that highlighted the computational infirmities of the Rangarajan formula to the Narendra Modi government.
Importantly, if the unaddressed concerns and those addressed by the Modi  government are correctly handled; the new formula would yield a global volume-weighted well-head price of natural gas that is very close to the current price of $4.20 being paid for most of the natural gas producers in India.  Thus no change or only a marginal change may be warranted for Indian well-head prices for dry natural gas!
Additional Complexities
The Indian bureaucracy is not known for simplifying rules and regulations.  Every move towards rationalization is accompanied by an opposing move that introduces ambiguity and discretion.  In keeping with this tradition, the 18 October press release states: “For all discoveries after this decision, in Ultra Deep Water Areas, Deep Water Areas and High Pressure-High Temperature areas, a premium would be given on the gas price to be determined as per the prescribed procedure”.
While one awaits the “prescribed procedure” by which future discoveries will benefit from the above decision of the government, it is pointed out that this would require changes to the way the Production Sharing Contracts (PSCs) are currently structured.  The PSCs allow for not only the recovery of full production costs but also the recovery of a multiple of the approved exploration and development outlays to assure return on capital invested.  The PSCs thus ensure that the higher costs and risks associated with difficult horizons including deep and ultra-deep horizons and high pressure or high temperature horizons are duly compensated.  Are we proposing an additional bonus over and above this?  Do we have a mechanism in mind whereby the proposed premiums would be determined transparently?  Remember that the CAG report on the KG Basin revealed that we do not even have a fool-proof mechanism in place to approve/reject claimed outlays and/or critically evaluate field development plans.  Introducing new and complex concepts that are, in addition, redundant is totally uncalled for.
Given that serious concerns have been identified in administering of the PSCs, this new policy pronouncement, quite honestly, comes as a total surprise and deserves its fair share of skepticism.
Violating the PSCs
Like the price setting mechanism established by the Rangarajan Committee, the new pricing mechanism also violates the provisions of the PSCs.  While this matter is before the Supreme Court, suffice it to say that under the PSCs, a universal price for all gas produced in India is simply not tenable.  The PSCs rightly allow for each field to have a unique well-head price based on the nature of the reserve and the field characteristic.
Equally contentious is the role of the government in setting this price.  The PSCs do not provide for a direct role for the government in setting the price of natural gas at the well-head.  The genesis of this problem goes back to the Supreme Court overturning the Mumbai High Court verdict in the dispute between the Ambani brothers on the sale of KG basin gas.  The Supreme Court decision was based on a highly debatable affidavit filed by the Government of India under the stewardship of former Petroleum Minister Murli Deora.  If one goes by the more recent decisions of the Supreme Court on allocation of spectrum and coal blocks, the current petition before the Supreme Court on gas pricing may end up rewriting the basis on which India’s natural resources should be priced and the sanctity of a sovereign undertaking such as the one on pricing contained in the PSCs.  Under the current PSCs, the government can merely approve or reject an “arms-length” pricing mechanism proposed by the operator, and subject the proposed pricing mechanism to independent regulatory oversight, assuming such a regulatory mechanism exists.
Role of Director-General Hydrocarbons
The Director-General Hydrocarbons (DGH) has not exactly covered itself with glory in administering the PSCs, critically evaluating the investment proposals of the operators, or in providing evidence-based research and analysis on the quantity and nature of hydrocarbon reserves declared by operators.  These failures have an impact on pricing of domestic hydrocarbon resources.  The numerous violations of the PSC covering the KG Basin are well documented.  The UPA Government even drafted a cabinet note just before the 2014 general election to seek approval for regularizing all such violations relating to extension of time lines, non-relinquishment of concession areas, delineation of discovery area etc.  Luckily this attempt failed.  Going forward, the Modi government has proposed changes that will help strengthen contract administration by the DGH but much remains to be done in this regard to reach global standards.
What is immediately relevant to the proposed gas pricing formula though is that, reportedly, in response to an enquiry from the Prime Minister’s Office the DGH recently provided the cost of producing gas in the KG Basin based on the originally claimed reserves and the reduced level of reserves that is now claimed.  These cost estimates include the full recovery of the capital invested without any return on capital.  As always, the DGH has provided debatable numbers that err on the side of overstating the cost of producing gas in the KG basin.  I shall refrain from digressing and leave the reasoning behind this stand of mine to another article.  Nevertheless, I categorically reiterate that the numbers provided by DGH overestimate the cost of producing gas in the KG basin inclusive of full recovery of the capital outlay.
However, it is important to note that even these high estimates establish the cost of KG basin gas at only $2.19/MMBTU based on the original estimate of the reserves claimed by Reliance Industries Limited (RIL), and only $3/MMBTU based on the revised lower estimate of reserves declared by RIL.  Even if we overlook the fact that under the PSCs, the risk of exploration, development and operation falls squarely on the contractor and the rise in cost due to a lowering of the reserves must be borne by the contractor, the inconvenient truth is that the current price of $4.20/MMBTU for the KG Basin gas is high enough to deliver decent returns despite the increase in cost.
The icing on the cake, as already emphasized, is that if all the computational errors of the Rangarajan formula highlighted are correctly addressed, the new, and definitely improved, formula coined by the Modi government will not yield a well-head price much different from the $4.20 currently being paid for most of the gas produced in India.
The talk of upstream public sector companies (PSCs) getting 80% of the benefit of any price increase is pure hogwash without a solemn undertaking from the Government of India that it would not ask the upstream public sector companies to pay for the government’s burden of under-recoveries.  The upstream public sector companies coughed up Rs. 60,000 crores last year from their revenue to improve the government’s fiscal situation!  In comparison, the price increase now announced under the new formula is estimated to raise only an additional Rs 3,800 crores as per the October 18, 2014 press release.
All is Not Well With Energy Sector
The pronouncements, thus far, for the energy sector are far from convincing.  The various initiatives of the Modi Government covering coal, power, renewable, nuclear and the oil and gas sector – all need much more serious research-based inputs for the dreams to become a reality.  I am hopeful that this will happen sooner than later.  It is still early days but, as the saying goes, well begun is half done.
Notes
[i] See for instance among many articles  Sethi, Surya (2014) “Seven Deadly Sins of Pricing Formula”, Business World, 23 August.
[ii]“ Another Scam in the Making (,23 December 2013, Business Standard), and Of Reliance, by Reliance, for Reliance(1 July 2013, The Hindu).
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