A Kelkar Committee model could be the best option for oil and gas pricing

Media analyses of the Kelkar Committee on reducing import dependency in oil and gas have focused on the committee’s suggestions on gas pricing. But it has also proposed new models for exploration and production contracts to reduce disputes and corruption, while improving bidders’ interest in new exploration blocks.

For decades, India has signed production-sharing contracts (PSCs), which are common globally. If successful bidders find any oil or gas, they first get enough ‘cost oil’ to recover their costs, then they get ‘profit oil’ that is a multiple of costs, and then ‘residual oil’.

Contracts are won by bidders offering the government the highest shares in these three phases: cost oil, profit oil and residual oil.

Waiting for Windfall

But controversies over Reliance’s Krishna-Godavari (KG) field have led to accusations that PSCs have been manipulated to artificially inflate costs, increasing the operator’s share of cost oil and profit oil.

Critics pooh-pooh Reliance’s claim that technical problems have caused a catastrophic fall in gas production from the KG basin, alleging that the company is simply slashing production at today’s low process in order to jack up production once the government decrees an overdue price increase.

Reliance has also submitted plans to invest billions to raise production again. Critics suspect this is another way of inflating costs and, thus, Reliance’s share of gas. The petroleum ministry has been paralysed by the swirl of accusations.

Meanwhile, foreigners have lost interest in bidding for Indian fields — the political risks and uncertainties are unacceptable.

Simple vs Complex Model

The Narendra Modi government has invited public comments on a new model contract. This is quite complex, based on revenue-sharing linked to production. Companies will have to specify the amounts to be shared with the government at different stages and different prices, with different rules for different drilling conditions.

This is a complex variation of the revenue-sharing model proposed by the Rangarajan Committee. That provided bidding for a flat share of production, without getting into calculations about true costs and true multiples for calculating profit oil. This aimed to eliminate complex calculations and disputes.

However, very few countries go for flat revenue-sharing contracts, because if fields turn out to be smaller than expected, or costs higher than expected, production will become uneconomic. Flat revenue-sharing contracts might attract decent bids in blocks with excellent geological prospects (as in Saudi Arabia), but Indian geological conditions are poor by global standards.

The one field that promised a lot, the KG basin, has proved a disappointment. So, revenue-sharing contracts may discourage all but very low-share bids. These may provoke accusations that fields have been given away too cheaply, so an approach aimed at ending controversies could create fresh ones. The Kelkar Committee proposes two alternatives.

The first model just tweaks the existing PSC. In this model the managing committee and directorate general of hydrocarbons focus only on standards and best practices, without assessing costs. Oversight will be left to the tax authorities, who already oversee other forms of government share such as royalties and taxes.

Kelkar’s second model is a supernormal tax model. This gives the government no share of oil or gas at all. Instead, the government gets just royalties and taxes when profits are limited. When profitability crosses a certain threshold, a supernormal tax kicks in, providing a much higher government take.

Supernormally Simple

This model eliminates the need for detailed calculations and disputes on true costs and profit oil shares. It is by far the simplest and cleanest model. The committee says the threshold for levying a supernormal tax could be two to three times the yield on 10-year gilts.

The threshold rate could also be a biddable item, with the highest bidder winning. I favour simplicity and speed. The government’s new proposal looks a bit complex, inviting disputes and litigation. Kelkar’s first model will not do either: it is too close to the existing one.

The Rangarajan model of revenue-sharing is better, but could inhibit bids for areas with small fields. Kelkar’s supernormal profits model looks best. It promises to be simple, fast and dispute-free. It will encourage bids for blocks with modest prospects, combined with a big government share if an unexpected bonanza turns up.

Some politicians will feel comfortable only if they have a physical share of oil or gas, to be allotted according to political priorities. Very well, let’s modify the supernormal tax model to mandate a flat 10 per cent government share of all oil and gas found. That will not inhibit bids for small fields, and still remain simple and dispute free.

The Kelkar Committee strongly opposes retrospective changes after a contract has been signed. It also wants contracts to be extended to the full lifetime of fields where hydrocarbons are found. This will incentivise explorers to follow judicious techniques that maximise total oil recovery.

Limited contract timelines (as proposed by the government) will encourage flogging a field for quick gains, even if this seriously damages total recovery. Contracts should stand automatically cancelled if there is no production for five years.

What do you think?