The gas price debate - a problem of information asymmetry?

I can't get a proper handle on the controversy surrounding the government's recent decision to increase the regulated price of natural gas. In this I share Anantha Nageswaran's ambiguity.

For the record, the government has accepted the recommendations of the Rangarajan Committee, which has been variously estimated to virtually double the domestic price of natural gas to about $8.4 per million BTu by 1 April 2014. The Business Standard has a nice summary of its implications, especially on fertilizer and power prices. The Rangarajan Committee had proposed a pricing mechanism that took a simple average of US's Henry Hub, UK's National Balancing Point, Japan's JCC, and the 12-month average of imported LNG prices. It also suggested that the prices be revised every quarter and this arrangement itself be reviewed after five years.

The government has also decided to do away with the earlier practice of revenue-sharing (with government) after cost of exploitation is fully recovered (by the field developer) in the production sharing contracts. Under the earlier arrangement, the government would get a share of the profits only after the developer recovers all its capital investments. In this case, there are strong reasons, as the CAG has pointed out, to believe that Reliance Industries (RIL) has gold-plated its capital investments, so as to defer the sharing of revenues with government.

The government's decision has apparently been motivated by two considerations. The first being that the gas price was, in any case, up for review on 1 April, 2014. The second, more substantive reason, being that it was thought necessary to encourage upstream investments, especially by foreign investors, which is necessary to raise oil and gas output and thereby ensure energy security as well as balance our current account.

It is clear that  RIL is going to be the biggest private beneficiary of this decision. It is also probable that RIL played hardball with the government, by "reducing" production from nearly 70 million metric standards cubic metres per day (mmscmpd) in 2010 to just 15 mmscmpd today. So the accusations of crony capitalism are inevitable.

But there are several areas where clarity is at a premium. In the circumstances, a more meaningful debate is possible only with more information. What is the realizable output from the field? What is the cost of realization? What is the capital investment made by the firm? What are the problems that hinder exploitation of the field? What are the additional investments required? A best estimate for each of these questions is necessary to clear the air and ensure fairness in pricing decisions.

In other words, oil and gas exploration sector suffers from the problems associated with information asymmetry. The exploration firm has the best answer to all the aforementioned questions. The regulator, whose responsibility is it to determine price based on the cost of exploitation, has access only to secondary information, which too comes mainly from the explorer firm. Fair price discovery is virtually impossible in these circumstances. It is also an invitation to cronyism and corruption. In the circumstances, any reform should push for an immediate institutionalization of a system of periodic technical performance audit of all oil and gas fields which have been leased out by the government.

There is also a need for greater debate on the best possible pricing model for gas producers. Is marginal cost pricing, at import prices, desirable? Given our scarce readily exploitable oil and gas reserves, what is the opportunity cost of inviting investments by foreign private developers? Does this, atleast partially, explain the reason why the large foreign firms have stayed out of Indian market? Needless to say, even this debate depends on answers to the questions raised earlier.

Unfortunately, a lot of the mainstream criticisms of the government's decision - here, here, here, and here - do not address any of these relevant issues. These critiques are focused on its impact on downstream fertilizer and power consumers, increased subsidy burden if government decides to absorb this impact, and most often, the inevitable availability bias that a corruption tainted government (and equally corruption-scarred RIL) engenders. In fact, it also highlights the difficulty of taking such decisions in an environment that has been vitiated by populist rhetoric of political parties and lazy analysis of mainstream opinion makers.

The most compelling critique of the government's decision comes from Surya Sethi. While his first two reasons are more rhetorical and speculative, the argument against raising prices for an "existing field" appears compelling,

What is the justification for raising the price of gas from existing fields? We can always pay a higher price for more difficult horizons provided the duly approved and audited costs of exploration and production warrant that. The current production was realized with no prospect of getting $8.4/MMBtu.

Here too it needs to be borne in mind that the agreement with RIL (and I am not fully aware of its details) does talk about periodic price revisions, as can be construed from the fact that the price was up for revision from April 2014. This article in Hindu does raise this issue and indicates that the production sharing agreements signed by the Government of India mandates arms-length market based pricing. So while an increase in prices may have been perfectly legal, though the magnitude of increase would be a matter of debate. But this too appears to have missed the radar of informed opinion makers.

In fact, even accepting Mr Sethi's very logical argument about revisions being applicable only for newer fields and cost-plus pricing of gas, we also appear to have missed an opportunity to debate the fundamental issue of pricing dry natural gas at the well-head. What are the different approaches to gas pricing across the world? Which of them, or their variants, is relevant for India and why? Is the Rangarajan Committee's recommendations the most appropriate pricing model for India? Should India adopt the marginal pricing (at well-head import prices) or pricing indexed to global petroleum prices or a cost-plus pricing model based on the cost of recovery from respective gas fields? Here too Mr Sethi has important points to make, none of which get carried forward into mainstream debates about reforming gas pricing.

What complicates matters is that natural gas markets are fragmented and prices vary widely and are volatile. In fact, current prices vary from 75 cents per thousand cubic feet in Saudi Arabia, $3-$4 in the US, around $12 in Europe, and as high as $16-$17 in Japan. The inherent difficulties associated with transporting natural gas has been a major contributor to the market fragmentation. In addition, the implicit US natural gas export curbs (by limiting the development of off-shore LNG terminals), have acted as a major deterrent to convergence in global prices.

I am inclined to agree with Mr Sethi that marginal pricing, based on import prices, may not be an appropriate price signal at a time when natural gas markets are extremely fragmented and prices vary widely across the world, being dictated by local factors than any objective market considerations. But this does not mean that cost-plus pricing is the natural alternative. We need to bear in mind that while this is the present state of global natural gas market, these arbitrage opportunities are too large and strategically sensitive to persist for too long. Therefore a pricing mechanism which overlooks global prices, while likely to be appropriate for now, may not be so in the future. Regulators and policy makers will need to respond dynamically to emergent scenarios.

In any case, three things, not substantively related to the particular issue, stand out from this. One, decision making on important issues with high stakes has become a treacherous activity, with politicians and opinion makers trying to outbid each other with populist rhetoric. Two, related to the first, with the media debates on important issues being disappointingly sub-standard, a critical forum to debate and contribute to the design of important reforms and build public support for them appears to have become superfluous. Three, one cannot but get the distinct feeling that the gas-price decision itself appears to be in keeping with the practice of re-negotiations that have become a feature of private participation in India's infrastructure sector.