Gas after coal? Why government's decision on gas pricing and Reliance will be crucial

The Supreme Court's verdict on the coal block allocation scam has sent jitters across the corporate world, with the court declaring that all blocks allocated since 1993 have been illegal. The Supreme Court has made it clear that the government needs to follow a more fair, transparent and competitive route to distribute natural resources of the country.

Taking a page from this book, it will be interesting to see what the new NDA government decides on the gas pricing issue for Reliance Industries (RIL). The government has been in a tussle with RIL for a long time, and the new government has said it will take the decision by the end of September. 

This piece is not a passionate debate or an opinion to add to the plethora of writings already available on the controversy. Rather we try to simply explain why Reliance is at loggerheads with the government. A detailed look at the tussle is essential to understand the significance of the government's decision slated to come soon.

Latest developments

Reliance Industries has made it clear that it will not withdraw an arbitration notice that it had sent to the government, as it says it would be wrong for the government to assume that it could set the price of the gas itself. Even if it means a direct collision with the government, the company will not back out. After the Supreme Court judgment on the coal block allocation, where the court has taken a strong stand on natural resource allocation, the government's decision on gas pricing will be worth looking forward to.

Reliance Industries has been in the news in recent times after the new NDA government imposed a fine of $579 million (Rs 3,474 crore at an exchange rate of Rs 60) for not meeting the production target at the D6 block of the Krishna-Godavari basin, otherwise called the KGD6 block. This is the fourth time the company has been fined in the last four years. The first three fines were imposed by the UPA government, while the final one is being imposed by petroleum minister Dharmendra Pradhan. The total fine amount now goes up to almost Rs 14,200 crore in the four financial years (beginning April 2010). Now, the new government has appointed Supreme Court judge GS Singhvi as the arbiter of the gas dispute between the company and the government. Singhvi, who was the judge for the 2G spectrum case and the Article 377 case, said he would do his best to protect the interests of the people in the country. What is the dispute about?

The beginning

The KGD6 basin located in Andhra Pradesh is the largest natural gas basin in India. After the government opened the natural gas sector for private companies in 1991, Reliance bagged the rights to explore this basin in 1999 through the New Exploration and Licensing Policy.

Natural Resources : To whom do they belong?

The natural resources of the country belong to the people of the country. However, the government retains the right to explore and exploit these resources either by it or via contractors. It also retains the right to oversee these explorations and share the profits, that goes back to the exchequer. Be it spectrum or coal, oil or gas, the Government of India has entered into a number of agreements to ensure the best allocation of resources, at least on paper.

The government and the company enters into a production sharing contract (PSC) which constitutes of the responsibilities and gains of both the parties from the exploration: it sets the terms and conditions of the public-private partnership. In the KGD6 case, the Directorate General of Hydrocarbon oversees the contract that was signed between an undivided Reliance and the government.

The Reliance Split

Ironically, the first complaints against the exploration was brought in by Anil Ambani, the younger brother of Mukesh Ambani, after the split of Reliance into RIL and the ADAG group. Anil Ambani asked Mukesh Ambani to honour a contract that bound Reliance Industries to supply gas at a rate of $2.34 per million metric British thermal units (mmbtu) for 17 years to Reliance Natural Resources Ltd (RNRL) for its Dadri power plant. The price was based on what Reliance had agreed to supply gas at to NTPC as well. But the PSC for KGD6 made it mandatory that the government would agree to the price at which RIL was selling. Here the government opposed, saying it would make huge losses. Anil Ambani alleged that Mukesh Ambani had the right friends in place because the clause of the government approval came in 2006 while the RIL-RNRL contract was signed in 2004.

In August 2009, Anil Ambani's company put out advertisements in newspapers critiquing the government's approval to increase the project cost of KGD6 from Rs 12,000 crore to Rs 45,000 crore. Since the PSC said that the higher the capital expenditure, the lower the profit share for the government would be, this would mean huge losses to the exchequer. In May 2010, the Supreme Court ruled in favour of Mukesh Ambani, saying it is the government that would decide the selling price, and the contract between the two companies was voided.

What are the issues with the PSC?  

• RIL was supposed to produce 40 million MMSCD (Million Cubic meters per day), which was subsequently revised to 80 MMSCD.
• The initial cost stood at $2.4 billion which was revised in 2006 to $5.2 billion in the first phase and $3.3 billion in the second phase. The cost of this second phase could also go up, said the Comptroller and Auditor General (CAG).
• Now the profit sharing between Reliance and the government is made through what is termed an “investment multiplier” which mandates that the higher the capex, the lower will be the government's share in profit. Till the costs are recovered, 90% of the money from gas sold will be taken as “cost” recovery and 10% as profit. The share of this profit will also tilt towards the company till most of the cost is recovered. While the capex has gone up by four times, production has gone up twice.
• The ability to raise costs without raising production in similar proportions means the bidding rates on the basis of which contracts are meted out by the government change

​Gas pricing: The issues

In 2007 a group of Empowered Ministers (led by Pranab Mukherjee) declared the price at which Reliance could sell the gas was $4.2 per MBTU. The price discovery mechanism was not clear as ONGC was getting a price of $1.8 MBTU at the same time. The implication for the government was huge. It would definitely gain from higher gas prices, but would have to shell out much more for subsidising fertiliser and power, both of which would now get costlier. Surya P Sethi, Principal Advisor, Power and Energy to the government of India, gave it to the EgoM in writing that the cost of production could not be above $1.43 per MBTU and thus the price decided by the EGoM looked exorbitant.

CAG Report, 2011: Why is this important?

The CAG in 2011 criticised the government for letting RIL retain the whole of the KGD6 block. It said there was no proper appraisal of how much reserves could be found. Since one was not sure of the estimates of reserves, it would be baseless to say for sure that Reliance was hoarding gas, as often alleged. On the other hand, it was questionable if Reliance had the right to retain the whole area, including the one where discoveries were not made.

The Rangarajan formula

Rangarajan, the former head of the Prime Minister's Economic Advisory Council, came out with a formula to peg the gas prices to international prices, unlike how most other countries price their gas. There are two PILs filed by Communist Party of India leader Gurudas Dasgupta and another by NGO Common Cause questioning this pricing formula. The Supreme Court also asked why one had to go to such a complex formula when something simpler could have been done. The cabinet had approved the formula which would spike the prices to almost double of the $4.2 per MBTU price right now. The UPA government, however, passed the buck to the next government by deferring its actual implementation. The Modi government has to take its own stand on this now. The new government said it will take a decision by October 1.

Why is the government imposing a penalty on Reliance?

The debate around the fines being imposed has been polarised. On the one hand we have the critics who argue that the people of India have lost out and the treasury has suffered because of contracts that had been partial since the beginning. The whole controversy around gas pricing has been termed as an example of “predatory capitalism” by Paranjoy Guha Thakurta, who has brought out a book on the gas pricing war in India. This theory has found support in a report by CAG in 2012, which has questioned the government on approval of the gas prices being offered to Reliance. It said the government had not been able to oversee the process and had lost out on its own share of profits.

Reliance has called the government's move to fine it time and again illegal. The Mukesh Ambani-led company insists that the production sharing contract with the government had not set a target that was binding on the company, but was only an indicator of the expected production of gas. It said in a press release in 2011 that RIL had in fact begun production within six years of the discovery against a global average of 9-10 years. And the production had allowed the government to bring down its subsidies on fertiliser and augmented energy security of the country.

Reliance is producing just a tenth of what the PSC promised: 80 million metric standard cubic metre per day (mmscmd). In June this year, the production came down to 8 mmscmd. The government alleges that Reliance has not drilled enough wells, and not generated enough gas. Therefore, Reliance would have to pay a penalty. The government would realise the penalty by not paying Reliance for its own share of the capex. The oil ministry has directed Reliance's customers GAIL India and Chennai Petroleum Corp (CPCL) to deposit their next payment for purchase of crude oil and natural gas from the KGD6 basin to the government accounts instead of remitting it to the company in an attempt to recover the government's profit share due from the Mumbai-based company.

The deal is that Reliance gets to recover much of its costs before it shares any profit with the government. By way of penalties, the government does not allow the company to recover its costs, and also increases the share of profits for Reliance. However, both the companies have expressed their inability to follow the government's orders since no amount was pending against crude oil and gas that they have purchased from Reliance.