Tuesday, September 16, 2014

Observations on the Reliance gas pricing issue

Swaminathan Aiyar proposes that the government allow Reliance to sell the gas produced from KG Basin at the market price, which is the marginal price of gas supplied or the prevailing import price.

Supporters of a market-based pricing model argue that it encourages investments in natural gas exploration, thereby curtailing India's growing gas imports. Aside from the numerous controversies surrounding the Reliance project, I have two concerns with this argument.

1. The United States which apart from being one of the largest gas producers is also a large importer does not appear to have embraced this principle in aligning incentives. In 2013, its LNG import prices varied from $6-15 per mmBTU, whereas benchmark Henry Hub natural gas prices (which is not regulated and is market-determined) averaged $3.73 per mmBTU. In other words, the market-determined domestic price for natural gas in the US was far lower than the marginal price as represented in the import price. And it continues in 2014.

This emergent general equilibrium pricing of domestically produced natural gas, which is less than half the price of the imported LNG, questions the logic that production incentives are optimized when producers in India are able to sell their produce at the import price. The far lower price in the US market has not in any way deterred massive exploration in shale gas (whose exploration cost is incidentally more than that of conventional natural gas).

In fact, while the domestic prices in the US are in the $3-4 per mmBTU range, the LNG export prices have nevertheless been in the range of $12-15 per mmBTU. Given than the combined cost of liquefaction, transportation, and re-gasification is no more than $2.5 per mmBTU, this wide differential is itself a pointer to the inefficiencies in the global natural gas markets.

2. This brings me to the objective of any gas pricing policy. Econ 101 teaches us that an efficient market price is one which while encouraging exploration and production also incentivizes investments that generate demand for the gas. In other words, the price should reflect both reasonable profit for the producer and an acceptable cost for the consumer.

This trade-off maximizes the total producer and consumer surpluses and not just the producer surplus. Therefore, instead of just "encouraging domestic natural gas exploration by maximizing profit incentives", the objective should be to "encourage domestic natural gas exploration consistent with optimal development of economic activities that use natural gas". The logic that Reliance or any other natural gas producer should get a price comparable to LNG import price so as to incentivize India's gas fields development therefore appears to be flawed. 

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