Underrecovery in the oil sector explained

You must have come across the term underrecovery (UR), while reading newspaper articles related to the oil sector. Most people erroneously think that UR amounts to loss. But this is not true.

Before we try to understand what exactly UR is, lets get few related terms clear.

Upstream Company (UC)
These are the companies which extract crude oil and supply it to the Oil Marketing Companies (OMCs). An eg. of upstream company would be ONGC.

Oil Marketing Companies ( OMCs)
They buy the crude oil from the upstream companies (or imports it) and refine to to produce diesel, petrol and other products. It has a refining arm and a marketing arm. IOCL BPCL, HPCL etc are its examples.

Crude oil to petrol
Crude oil is extracted and a process ( fractional distillation ) is carried on to produce diesel, petrol, kerosene, aircraft fuel etc from it.

The Scenario

1. Consider that the upstream compnay sells crude oil at Rs 30 to an OMC.
2. The OMC refines it into petrol, diesel and other products. The OMC incurs various costs in this process like the cost of refining, employee salary, marketing, bribery etc. Let’s suppose that all these cost it Rs 10. 3. It finally sells the petrol at Rs 45 to customers like me and you after including the profit margin (Rs 5).

As we can see the OMC is making a profit of Rs 5.

Now suppose the international price (IP) of petrol is Rs 60. Then, the government calculates the underrecovery as : International Price – domestic selling price
So, UR = Rs 60 – Rs 45 = Rs 15.

Therefore as is clear from the above scenario, that though the OMC is making a profit of RS 5, the underrecovery as the government calculates is Rs 15. Clearly this UR is in no way a loss.

The government assumes that the right price in India is actually the international market price for petrol and taking that as a benchmark, it calculates the UR. ” It’s a bit akin to assuming that a T-shirt manufacturer in Tirupur decides to price his T-shirts in India, not taking into account his own labour and other costs, but the price at which a similar piece of clothing sells for, in a Gap store in New York or London.”

Changes in UR
It is clear from the above equations that UR CAN increase if –
1. International price of petrol increases.
2. Crude oil prices decreases
3. Efficiency of the refining process increases
4. Labour costs decreases

(other factors remaining constant)

This however does not mean that losses of OMCs increase. With a decrease in a crude oil prices, reduction in labour costs and increase in efficiency of refining process, the loss if any will decrease.

Role of government

Government has both revenue and expenditure in this situation:
1. Revenues – these includes the taxes on petro products like excise duty; corporation tax from the petro companies.
2. Expenditure – this include the subsidies the government pays to companies so as to compensate them for the underrecoveries.

Government says that it pays more than it earns. Critics say otherwise. This UR system has also been slammed by many economists as there is no actual loss and still the government pays to compensate that notional loss. Blame game from both side and the usual politics goes on. These are out of scope of UPSC exams and hence are not taken up here.

(This post in based on this article in Economic Times. You can read it for further elaboration. However please note that thie article is a bit old and things have changed since then. For eg. diesel prices have also been deregulated. )
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