Mumbai: Higher global oil prices coupled with increasing demand in India have led to the current oil subsidies becoming unsustainable as the government has been reluctant to pass on a share of the highr prices to consumers.

In a report titled, Indian Oil Sector Subsidies: Need for a Serious Re-think, rating agency Firch says this has leading to an increasing burden being borne by the downstream public sector companies and the central government.

"The changed market scenario requires a serious re-think from a policy perspective, keeping in mind the broader issues of liquidity and financial health of the oil companies, the fiscal position of the government, energy efficiency and energy security," said Abhinav Goel, director, Fitch Ratings India.

"Furthermore, the policy of shifting the burden of today's subsidy to future generations should not continue unabated. Even if oil prices decline in the short term, it will not obviate the need for a more far-sighted energy pricing and subsidy policy," Goel adds.

The oil subsidy policy, which is aimed at insulating domestic consumers from crude oil price volatility, has led to far greater implications for the oil industry and the government due to the unanticipated run in oil prices. This not only affects the liquidity position and financial health of the downstream public sector oil companies, it also impacts the fiscal position of the government itself, which is likely to deteriorate if off-budget subsidies are accounted for on-budget, the study cautions.

The current fiscal stance puts at risk much of the fiscal improvement that has taken place over the last few years. According to Fitch estimates, if all off-budget subsidies were accounted for on-budget, the general government deficit would approach 9.0 per cent of GDP in 2008-2009 (FY2009). Unfortunately, this comes at a time when elections for the central government are due next year, making tough measures from the government unlikely in the near term.

Moreover, the current subsidy policy does not take into account longer-term issues such as the fair price for energy consumption to ensure efficient utilisation of scarce resources, and the financial capability of the downstream public sector oil companies to undertake capital projects to create refining assets in line with the growing domestic consumption.

It further undermines the plans of these companies to make any meaningful progress in their attempt to acquire interest in upstream assets. "Subsidy-sharing by the upstream public sector oil companies means that they are at a relatively disadvantageous position vis-a-vis international upstream companies which are reaping the huge windfall of the price of crude oil. For Indian upstream PSCs, this represents an opportunity lost to create higher cash reserves to internally finance their international upstream plans in a larger way," Goel added.

Since FY06, the government has, from time to time, announced an ad hoc support mechanism under which the subsidies are shared by upstream public sector oil companies through discounts on domestic crude oil supplied to public sector refiners - by the state, through oil bonds; and the balance by the downstream PSCs. Some of the crude price increase has been covered by product price increases and tax cuts.

"Though the reluctance of the government to fully pass on crude oil price increases - and the discretionary nature of the subsidy-sharing - was always a concern in the ratings of downstream PSCs, the problem has been accentuated in FY09 due to the significant increase in crude oil prices," Goel adds.

The sheer size and timeliness of oil bond issuance and its liquidation is creating huge spikes in the borrowings of the downstream PSCs, and stressing their liquidity. The liquidity strain can be gauged from the fact that as of September 2008, no oil bonds for FY09 have been issued; moreover, part of the oil bonds for FY08 are yet to be issued.

Pending issuance of oil bonds and their subsequent liquidation, all these entities are resorting to higher borrowings, most of which are short-term. Moreover, all these entities have planned several capital projects in the medium- to long-term, which will require increased borrowings. Debt will rise even further if under-recoveries continue at current levels.