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BW Businessworld

Seven Deadly Sins Of Pricing Formula

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Having questioned the Rangarajan Committee’s gas pricing formula and the UPA’s stand on the issue through five op-eds in leading dailies, I am encouraged by the NDA government’s decision to review the matter.  It is unlikely that the high-calibre panel did not comprehend the conceptual and arithmetical errors in the basis it recommended for pricing dry natural gas at Indian well heads. Is it possible that it planted these anomalies in the methodology to deliver a desired price level?

Let me begin by disabusing the readers, Rangarajan and his expert panel of all notions of a global market price for natural gas in any form. Even liquefied natural gas (LNG) does not have a global market price and export prices may vary by a factor of two, even from the same source. The world gas markets are fragmented and not linked to a common global benchmark. Natural gas can only be traded as compressed piped gas or LNG. These are two separate commodities governed by distinct and fragmented pricing mechanisms that often include geo-political and non-price considerations. Making global markets fully fungible requires massive domestic and cross-border investments. Only a functioning market can deliver a “market price”.  The Rangarajan formula simply delivers another administered price.

Only North America can claim to have a largely fungible market with multiple producers and hubs, and the required storage, transportation and distribution infrastructure that allows determination of a competitive market price. However, benchmarking Indian gas prices to this market would lower prices being realised currently by Indian producers.

At the broad conceptual level, the panel concluded that the average spot price indices of two chosen international gas hubs and the adjusted net-back prices of LNG imports by Japan (as calculated under the panel’s methodology) for the trailing 12 months, weighted by the respective volumes of gas consumed in these three regions during this period, will deliver what it calls the ‘Weighted Average Price to Producers in the Global Markets’. This is wrong on several conceptual counts. Also, the formula makes glaring arithmetical errors. Given the sensitivity of gas pricing in the Indian context, such negligence is shocking.

First, the National Balancing Point (NBP) Spot Price Index, which has been about three times the Henry Hub Spot Price Index in recent years, grossly overestimates the well head price realised by natural gas producers feeding the EU. This is so because the EU is dependent, to the extent of 60 per cent, on costlier imported LNG and Russian natural gas loaded with high pipeline tariffs and arbitrary geopolitical premiums. Thus, the two indices used by the Rangarajan panel price two very different products and hence, are internally incompatible. The NBP index should, at the least, be adjusted to net out the extra costs associated with LNG and Russian piped gas imports. The panel saw nothing wrong in using the extremely high unadjusted NBP index as proxy for the average well head price of producers feeding the EU.

The Rangarajan formula erroneously prices the consumption of natural gas in Russia, other former Soviet Union republics and Eurasia  (many of whom are major producers) at the NBP index, even though the prices in these nations, on average, are well below half that level.

Thirdly, the panel overlooks the fact that the average US producer price for dry natural gas is at least 10 per cent below the Henry Hub index due to transportation costs. The price at Canada’s Alberta hub is 20 per cent below the Henry Hub price. Canadian producers could be realising 25 per cent less than the Henry Hub price for dry gas at their well heads.

In dealing with Japanese LNG, the Rangarajan formula commits its fourth sin. It prescribes a net-back methodology that estimates the producer price of natural gas in LNG exporting countries by subtracting standard costs of local transportation, liquefaction, ocean transportation and insurance from the insurance and freight import costs. This merely establishes the effective free on board realisation of an LNG exporter for its natural gas and not the well head producer price for dry natural gas in the exporting country.

Qatar, the world’s largest LNG exporter, is the biggest supplier to Japan, EU and US. Applying the methodology to LNG imports by these three regions yields a Qatari producer price anywhere between $4/mmbtu and $10/mmbtu. Can the panel tell us the right Qatari producer price in this range?

The truth is that average well head producer price for dry natural gas in Qatar is well below $4/mmbtu. As already noted, the Rangarajan formula forgets to apply a similar net-back methodology to the NBP Spot Price Index.

The fifth sin is the exclusion of about 35 per cent of global natural gas consumption from the formula for estimating the global well head producer price of dry natural gas. Consumption in the Middle East, South and Central America, Africa, Australasia and Asia (except Japan) is excluded. Prices in many countries in these regions are well below the two indices used by the formula. Sixth, the Rangarajan formula makes no correction for high value natural gas liquids typically present in natural gas and LNG traded across borders. The six sins combine to deliver an erroneously high and indefensible ‘Weighted Average Price to Producers in the Global Markets’. The knockout punch is the seventh deadly sin whereby the second half of Rangarajan’s formula abandons all conceptual and intellectual integrity and adopts a simple average (as opposed to the volume-weighted concept of the first half) to determine the producer price of dry gas at Indian well heads.

This shift to a simple average of the weighted global producer price estimated in the first half of the formula and the net-back price of India’s LNG imports effectively gives an additional 50 per cent weight to high LNG-linked prices for determining India’s well head price for dry natural gas.

Inclusive of the overstated Japanese (net-backed) and EU’s (unadjusted) LNG, the Rangarajan formula gives a weight of about 60 per cent to the high LNG-linked prices for determining India’s well head price of dry natural gas. This is inexcusable because Indian LNG consumption accounts for only 0.6 per cent of global gas consumption and LNG’s share in the global gas basket is only 9.75 per cent.

In reviewing gas pricing and indeed the state of the entire energy sector, the new NDA government will do well to not rely on convenient energy experts patronised by the previous UPA government. 

The author is former principal advisor, power and energy, Government of India

(This story was published in BW | Businessworld Issue Dated 08-09-2014)