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Loose Ends of Oil Pricing

This article reviews the pricing of petroleum products in the light of the reports of the parliamentary committee on petroleum and natural gas and the Rangarajan Committee on pricing and taxation of petroleum products. It provides a critical insight into the considerations that have guided pricing policies over the years, and highlights areas of concern, with suggestions as to the future course of action.

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Loose Ends of Oil Pricing

This article reviews the pricing of petroleum products in the light of the reports of the parliamentary committee on petroleum and natural gas and the Rangarajan Committee on pricing and taxation of petroleum products. It provides a critical insight into the considerations that have guided pricing policies over the years, and highlights areas of concern, with suggestions as to

the future course of action.

E A S SARMA

P
ricing of petroleum products becomes a complex and challenging exercise when the objective is to satisfy more than one stakeholder. That is indeed the case with oil pricing in India. The primary stakeholder in our case is the consumer for whom kerosene and liquefied petroleum gas (LPG) are the main domestic fuels, with petrol and diesel fuelling road transport. An upward adjustment of the oil prices would erode her/his meagre budget. For the low-income consumer, it is kerosene and, to some extent, diesel that really matter.

The government itself has a major stake in oil pricing. Oil is an important source of revenue for both the central and the state governments. In the case of most petroleum products, taxes are levied on an ad valorem basis that ensures continuing buoyancy to government revenues. Of course, in such a system, any increase in the price would have a cascading effect on the consumer. During 2004-05, customs and excise duties on all commodities in the country yielded Rs1,56,970 crore of revenue for the central government. The share of oil in this was 36 per cent. Sales tax revenues of the states during the same year added up to Rs 1,15,330 crore, in which the share of oil was 34 per cent [1]. Roughly 55 per cent of the price of petrol, 34 per cent of the price of diesel and 11 per cent of the price of LPG go into the coffers of the government to fund public expenditure. Even the consumer of kerosene, who is among the poorest of the poor, has not been spared. The government (the state governments) appropriates 4 per cent of the price of kerosene towards taxes [1]! For a government (both the central and the state governments) whose fiscal health is anything but comfortable, a reduction in the price of oil would always be an unpalatable proposition.

The third stakeholder is the oil industry itself. It comprises three distinct segments, namely, the companies that explore and produce crude oil and natural gas, the companies that refine and distill the crude into petroleum products, and the marketing companies that distribute products to the retail consumer. Some oil companies handle more than one of these activities. Over a period of time, given the high degree of monopoly, inefficiencies, both technological and managerial, have crept into each of these three segments of the domestic industry. In a free market scenario, if market forces were to have a free hand, the consumer would have benefited from imports of petroleum products at lower prices. This has not been the case, as the government has all along stood firmly behind the domestic industry, because it is the public sector that has always dominated the industry.

From an oil security point of view, support for the domestic industry is justifiable to some extent as, in times of emergency, it is always the domestic oil industry, more particularly the public sector companies that have come to the rescue of the nation. In oil pricing, therefore, the guiding principle is to ensure that the prices are so “rationalised” as to ensure that the refinery margins are not unduly compressed. No doubt, unsustainable prices would force the refinery companies to go out of business. Unfortunately, the concept of “rationalisation” has sometimes been stretched to mean the government turning a blind eye to rent seeking by some refining companies at the expense of the consumer.

For example, an across-the board price regime, that offered protection for a few old refineries that used outdated equipment and technologies, allowed the more modern, efficient refineries to earn incremental profits that are not attributable to any matching increases in their operational efficiencies. The existing differential between the customs duties on crude oil and petroleum products that allows a high effective rate of protection (EPR) is an example of how the government allows some refinery companies to earn undue profits. Indirectly, it is the consumer that is compelled to bear the burden of this largesse in pricing.

It is not always easy to balance the conflicting perspectives and interests of these three stakeholders. Compromises are usually made to appease each of these stakeholders. In the ultimate analysis, contrary to what the government may say, it is the consumer that is forced to shoulder the bulk of the burden.

Other Factors AffectingOther Factors AffectingOther Factors AffectingOther Factors AffectingOther Factors Affecting
Oil PricingOil PricingOil PricingOil PricingOil Pricing

Besides reconciling the interests of different stakeholders, three other factors have compounded the problem of oil pricing further. First, over the last few decades, the dependence of the Indian economy on oil has increased enormously and the growth in demand has outstripped production. Despite the temporary but limited relief during the 1980s [4] due to production from Bombay High, the country’s oil dependence has consistently increased over the last few decades. Today, more than 75 per cent of the oil needs of the country are met through imports [5]. At present, India is one among the larger oil consumers of the world. Without adequate emphasis on oil conservation, the country is left with no other alternative but to import oil “at any cost”. In other words, world oil market trends are becoming more and more important for pricing oil in India.

Second, the world oil prices have not only become extremely volatile but have spiralled upwards beyond the hitherto unthinkable barrier of $ 70/bbl. Should the Indian consumer be exposed to such erratic market behaviour? To what extent the domestic consumer can afford to pay such an astronomical price? If the consumer is to be insulated from these trends, should

Economic and Political Weekly July 8-15, 2006 the taxpayer be burdened? These are indeed difficult choices for the planners.

Third, instead of shedding its less important functions that could be readily handed over to non-governmental institutions and individual enterprises, the government has enlarged its presence significantly in many areas of development over the years. As a result, the expenditure incurred by the government on public services and development activities has increased enormously. The rate of increase in public expenditure has outstripped the rate of growth of government revenues. This has reduced the choices available to the central and the state governments to accommodate any major adjustment of their fiscal policies, including a reduction in oil taxes.

In this context, drawing on the Report of the Committee on Pricing and Taxation of Petroleum Products [1], it would be useful to review the historical twists and turns in oil pricing that provide an insight into the considerations that guided the pricing policies of the government from time to time.

Oil Pricing: A ReviewOil Pricing: A ReviewOil Pricing: A ReviewOil Pricing: A ReviewOil Pricing: A Review

During the 1960s, India produced meagre quantities of oil and was heavily dependent on oil imports. The country’s scarce foreign exchange resources made it difficult for the government to pay for the imports. That was the time when the Damle Committee (1961) and Shantilal Shah Committee (1969) were set up. On the basis of the recommendations of the two Committees, the government adopted “import parity” as the guiding principle for oil pricing. Accordingly, ceiling selling prices were fixed for major products on the basis of the “import parity” principle. As far as domestic crude was concerned, the government fixed the prices on the basis of the actual costs incurred by the oil producing companies.

“Import parity” implied the price in the domestic market was set as if the products were actually imported, irrespective of whether they were produced in the domestic refineries from imported or domestic crude or imported directly from external sources. The import parity price included not only the FoB (free on board) price of a product but also a horde of notional costs such as ocean freight, insurance, customs duty, ocean loss, port dues, etc. If crude oil were to be imported and refined in domestic refineries, the costs involved in handling and transport of crude to a refinery would be decidedly cheaper compared to handling and transporting individual products up to the coastal location. In other words, there is an element of cost inflation that is inherent in pricing on an import parity basis. This approach therefore attracted criticism.

The Oil Prices Committee (1974), followed by the Oil Cost Review Committee (1984) recommended a “cost plus” administered pricing. Accordingly, the government adopted the administered pricing mechanism (APM) that implied an actual audit of the costs and determination of the price on the basis of a prescribed rate of return. The APM provided a system of cross-subsidisation among the products to permit subsidies on kerosene, LPG, naphtha used in fertiliser production, etc. Through freight equalisation, the government tried to provide products to consumers at different locations at comparable prices. Through the oil pool account, the consumers were insulated to a large extent from the day to day fluctuations in the costs.

While the cost plus approach allowed the government to monitor the prices closely in line with the actual costs incurred by the oil companies, it could not fully ensure efficiency in the production and supply of products to the consumers, as average historical costs could never serve as a sound basis for fixing future prices. Moreover, when crude oil was processed in a refinery to yield different distillates, there was always the problem of allocation of the refining cost among the different products that had different specific gravities and different calorific values. Also, the supply-demand pattern for each product varied widely from region to region and season to season. Nevertheless, the APM did provide a durable, though not too efficient, basis for oil pricing till April, 2002 when the government, as a part of its overall reform effort to move towards “market determined prices”, tried to dismantle this mechanism, at least partially.

The concept of “market determined prices” was also, for the first time, adopted in the case of domestically produced crude, with several notional costs such as ocean freight, insurance, customs duty, ocean loss, port dues, etc, added to the FoB price of the respective marker crude in the international market. Meanwhile, as a result of the pressure exerted by the states, the specific rate of royalty on crude was replaced by an ad valorem rate, corresponding to 20 per cent of the well-head price of crude.

In the new set up of liberalised product pricing that came into operation at a time when the international price of oil remained fortuitously stable, the oil companies were allowed to adjust the prices of petrol and diesel in line with the market trends. In this arrangement, subsidies on LPG and kerosene were to be continued but phased out over a few years.

This was the time when the government at the centre was ruled by a political coalition that found it difficult to evolve a consensus on doing away with subsidies on domestic fuels. Consequently, every time the oil marketing companies (OMCs) tried to adjust the prices of these two products even gradually, the government forced them to defer such a step in the name of containing inflation and protecting the interests of the poorer consumers. This was despite the fact that LPG was used largely by the rich and by middle-income households. After dragging its feet for sometime, in October 2003, the government put in place a “burden sharing” arrangement in which the OMCs would bear one-third of the subsidy burden by utilising the surpluses realised from petrol and diesel, and share the rest equally with upstream companies like ONGC. This was not entirely to the liking of the oil industry.

Before the burden-sharing arrangement could make any significant headway, the world oil market started behaving in a bizarre manner and the oil price started to skyrocket. Under the heavy load of subsidies that had reached the level of Rs 26,000 crore, the burden sharing arrangement that was just put in place started to cave in. With oil prices touching new heights, the government felt that the “pass through” of price increases even in the case of petrol and diesel would no longer be politically convenient. The immediate consequence of this was that the government took over price fixation in the case of both these products, thus reverting to a system of administered prices. Effective August 2004, the only freedom allowed to the OMCs was that they could vary the prices of petrol and diesel within a narrow band of +/-10 per cent of the mean of rolling average C and F prices of the last

Table: Changes in Customs Duties onTable: Changes in Customs Duties onTable: Changes in Customs Duties onTable: Changes in Customs Duties onTable: Changes in Customs Duties on
Crude Oil and Petroleum ProductsCrude Oil and Petroleum ProductsCrude Oil and Petroleum ProductsCrude Oil and Petroleum ProductsCrude Oil and Petroleum Products

(Per cent)

Effective Crude Petrol Diesel LPG Kero-Oil sene

Prior to August

19, 2004 10 20 20 10 10 w e f August

19, 2004 10 15 15 5 5 w e f May 1, 2005 5 10 10 0 0

Source: Committee on Pricing and Taxation of Petroleum Products [1].

Economic and Political Weekly July 8-15, 2006

12 months or so. The government curtailed even this freedom, as soon as the world oil prices increased further.

The public sector oil companies demanded budgetary support from the government to sustain their operations that were hit by the heavy subsidies on kerosene and LPG and their inability to fix the prices of other products. During the first three quarters of 2005-06, even after assistance from the upstream companies to the tune of Rs 9,750 crore, the government had to provide a further support of Rs 2,000 crore to the OMCs to allow them to tide over the piquant situation.

Customs DutiesCustoms DutiesCustoms DutiesCustoms DutiesCustoms Duties

Customs and excise duties form an important element in oil pricing. In the case of customs duty, it is not merely the absolute levels at which the duty is levied but also the differential between the duty levied on crude and the duty levied on each of the products that matters, as far as the consumer is concerned. The trends in the customs duties levied on crude and some important products, viz, petrol, diesel, LPG and kerosene since August, 2004 are given in the Table.

Prior to August 19, 2004, the differential customs duty between crude and petrol/ diesel was as high as 10 per cent. In reality, this translated into a much higher effective rate of protection (ERP) for these two products.

ERP is higher than the customs duty differential, by an order of magnitude. This depends on the size of the duty differential itself and how competitive is the refinery in terms of its operational efficiency in the global context. Effective May 1, 2005, the customs duty differential has been brought down by 5 per cent. This translates into an ERP of 40 per cent for petrol and diesel. In reality, the ERP implies an adventitious gain to the refiner whose margin increases by a corresponding percentage, without any benefit to the consumer in terms of an improvement in the operational efficiency of the refinery and, therefore, any consequential cost reduction. Clearly, ERP is synonymous with huge windfall profits to the refinery company, entirely at the expense of the consumer!

Parliamentary Committee onParliamentary Committee onParliamentary Committee onParliamentary Committee onParliamentary Committee on
Petroleum and Natural GasPetroleum and Natural GasPetroleum and Natural GasPetroleum and Natural GasPetroleum and Natural Gas

The Parliamentary Standing Committee on Petroleum and Natural Gas has deliberated on oil pricing in great detail. The committee’s sixth [2] and 10th [3] Reports contain many far-reaching recommendations on the pricing of both crude oil and petroleum products. Briefly, they are as follows:

  • (1) The present method of adding notional costs such as ocean freight, insurance, customs duty, ocean loss, port dues, etc, to the FoB price of the respective marker crude in the international market in arriving at the import price of domestic crude should be done away with. The price should be pegged at the FoB price.
  • (2) The cess collected on crude should be used exclusively for the purpose for which it has been created. A price stabilisation fund should be created from it to cushion the market volatility and provide price stability for the consumer.
  • (3)The states should be persuaded to switch back from ad valorem to a specific rate of royalty on crude.

  • (4) The present basis for fixing the refinery-gate price on the basis of import parity should be done away with. Even if the import parity basis were to be retained, it should be pegged at the FoB price, without adding any notional costs such as ocean freight, insurance, etc.
  • (5) There should be a ceiling on the refinery margins earned by the refining companies.
  • (6) Excise duties should be at specific rates, not on an ad valorem basis.
  • (7) Customs duty is a levy that “was only a mechanism to ensure fruitful gains to refining companies”. There should be no duty differential between crude oil and petroleum products.
  • Committee on Pricing andCommittee on Pricing andCommittee on Pricing andCommittee on Pricing andCommittee on Pricing and
    Taxation of Petroleum ProductsTaxation of Petroleum ProductsTaxation of Petroleum ProductsTaxation of Petroleum ProductsTaxation of Petroleum Products

    It was against the above background that the government constituted the Committee on Pricing and Taxation of Petroleum Products (CPTPP) under the chairperson of C Rangarajan to “look into the various aspects of pricing and taxation of petroleum products with a view to stabilising/rationalising their prices, keeping in view the financial position of the oil companies, conserving petroleum products, and establishing a transparent mechanism for autonomous adjustment of prices by the oil companies”.

    Before reviewing the committee’s recommendations, it is necessary to understand the concept of “trade parity pricing” that has been proposed by it [6]. As already stated, the “import parity price” reflected the price in the domestic market as if the products were actually imported. This was the price that would have been applicable had there been no domestic refining capacity. In a situation in which there is adequate domestic refining capacity as it is the case now, the import parity price could be viewed as an indicative ceiling for the domestic prices in a competitive environment. When there is a protective customs duty differential for products, it implied an ERP that allowed an element of rent for the domestic refiners. “Export parity pricing” could be an alternative way to price the products. Using the same logic as for import parity, it would imply the price at which a domestic exporter would be able to export the products in a competitive market, after obtaining the same by refining imported crude in a domestic refinery. If import parity could be viewed as a ceiling, export parity could be viewed as the floor for pricing products.“Trade parity” pricing is the weighted average of import and export parity prices in the ratio of imports and exports in respect of a given product.

    Against this background, the Committee’s recommendations were briefly as follows:

  • (i) Petrol and diesel should be priced at the refinery gate as well as at the retail end on the basis of the trade parity principle. The weights adopted for import and export parity prices should be 80 and 20 respectively. These prices would beport-specific.
  • (ii) Once such a basis is adopted, the government should allow the OMCs the flexibility to fix the prices subject to these indicative ceilings. This would encourage a competitive market to the advantage of the consumers.
  • (iii) The details of the pricing methodology should be placed in the public domain for the sake of transparency.

  • (iv) The concept of freight equalisation should no longer be adopted. In the case of remote, inaccessible areas, by way of an exception, the government should devise a special approach to soften the impact of the cost of freight in an explicit manner.
  • (v) While the customs duties on crude may be retained at 5 per cent, the duty on petrol and diesel should be reduced to 7.5 per cent so as to reduce the ERP to about 20 per cent from the existing 40 per cent. Also, customs duty on industrial products other than petrol and diesel may be retained at 10 per cent “order to protect domestic producers who suffer sales tax as compared to direct importers”. However, customs duties on the industrial
  • Economic and Political Weekly July 8-15, 2006 products should also be reduced to 7.5 per cent if any additional duty is introduced to neutralise the incidence of state level taxes.

    (vi) Excise duties (inclusive of road cess) on petrol and diesel should be made specific at the current prices. Education cess would be on top of this.

    (vii) The states should be persuaded to adopt a uniform policy on sales tax on petroleum products.

    (viii) Subsidies on kerosene should be restricted to the BPL (below poverty line) families.

  • (ix) There should be a one-time upward adjustment in the price of LPG. The price should thereafter be gradually adjusted towards the market price.
  • (x) Subsidies should be funded explicitly from the budget.
  • Recommendations of CPTPPRecommendations of CPTPPRecommendations of CPTPPRecommendations of CPTPPRecommendations of CPTPP

    While the Parliamentary Committee’s recommendations were more comprehensive as they covered the pricing of both crude and products, CPTPP’s recommendations are confined only to product pricing. A comparison of the recommendations of the two committees shows that both these committees have endorsed the need to move away from the import parity principle and adopt specific rates of excise duties on products. CPTPP has recommended some reduction in the customs duty differential between crude and products. In a way this has the effect of reducing the refinery margin, a measure that is in line with what the Parliamentary Committee has also proposed, even though a total elimination of the differential would have minimised the refinery margin and made it competitive in the global context. The concept of “trade parity”, as proposed by CPTPP, is certainly an innovative approach to oil pricing in the Indian context but its implications need to be understood properly.

    As far as CPTPP’s recommendations are concerned, the government has accepted trade parity pricing in principle and reduced the customs duty differential between crude and products. The government has also accepted “in principle” the need to restrict kerosene subsidy to BPL families, though it is yet to be seen whether the government has the determination to implement it. The government has not accepted the recommendations on de-subsidisation of LPG, adoption of specific rates of excise duty on products and doing away with freight equalisation.

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    Economic and Political Weekly July 8-15, 2006

    Areas of ConcernAreas of ConcernAreas of ConcernAreas of ConcernAreas of Concern

    The major area of concern here is the reluctance on the part of both CPTPP and the government to eliminate the customs duty differential altogether, as rightly recommended by the Parliamentary Committee. By not going the whole hog on this, the ERP is still being maintained at 20 per cent, a level of protection at which the refiners are allowed to get away with huge windfall profits at the expense of the consumers. The logic put forward in defence of this recommendation by CPTPP is somewhat perplexing. It is as follows:

  • (a) Refining is a cyclic industry subject to volatile prices. The margin between the crude and product prices fluctuates. There are occasions when this became even negative.
  • (b) Providing some level of protection and thereby allowing adequate refining margins is necessary for “encouraging investment in expansion and modernisation” that are necessary for “energy security”.
  • (c) It is necessary to offset the buren on refineries of irrecoverable duties levied by the states that vary from state to state. Since ERP cannot be calibrated differently for different states, an across-the-board ERP is necessary, though at a reduced level.
  • These arguments are anything but based on sound reasoning! In a cyclic industry, the pluses and minuses even out over a period of time. That is what any commercial activity is about. To say that an element of rent is necessary for investment in expansion and modernisation for energy security appears to be a somewhat contrived argument to justify the rent. If the states have levied irrecoverable duties, there are several more rational ways to even out such under-recoveries in an explicit manner.

    The oil consumer in this country would stand to benefit only when the oil industry, especially the refinery companies, are placed in a competitive environment. Maintaining an ERP of 20 per cent on petrol and diesel and 40 per cent on other industrial products, as suggested by CPTPP, would stifle competition and provide an incentive for inefficiency.

    The impression that one gets on going through the CPTPP report is that margins in Indian refineries are under considerable pressure and they are in need of protection in the prevailing market scenario. In this context, the following observation on the Jamnagar refinery from the latest annual report[7] of Reliance Industries (RIL) would be of relevance:

    Since the commissioning of the refinery, its gross refining margin has been between US$2 to US$4 per barrel higher compared to Singapore complex refining margins. For FY 2005-06, RIL had the highest ever gross refining margin at US $ 10.3 per barrel and more importantly a spread of US $ 5.8 per barrel over the Singapore complex margin for the last quarter of the year.

    Assuming a 40 per cent ERP during 2005-06, a back-of-the-envelope calculation would show the incremental refining margin in this case to be US $ 2.9 per barrel or Rs 950 per tonne approximately. This would mean that a refinery processing one million tonnes of petrol and diesel per year would earn an incremental windfall profit of Rs 95 crore. Since the quantities of petrol and diesel manufactured in the Indian refineries add up to 70 million tonnes, on these products alone, the total incremental profits would be Rs 6,650 crore! Half of this, corresponding to 20 per cent ERP, would mean an incremental profit of Rs 3,325 crore. The windfall profits would be more in the case of the more modern refineries, as their refining costs are lower. These profits are earned at the expense of the consumer. No economic argument could defend such windfall profits being allowed to refiners, especially when the consumer is already forced to bear the brunt of the skyrocketing prices of oil in the world market.

    One could argue that some of the older refineries, those in the public sector, are in need of immediate protection, as modernising them would take sometime. The solution to this lies, not in providing them protection against competition through a customs duty differential, but by extending to them explicit assistance through loans or grants and, at the same time, expose them to global competition. A competitive environment alone would exert pressure on our oil companies to adopt efficient processes, reduce costs and deliver value to the consumer.

    SuggestionsSuggestionsSuggestionsSuggestionsSuggestions
    on Future Courseon Future Courseon Future Courseon Future Courseon Future Course
    of Actionof Actionof Actionof Actionof Action

    Elimination of the customs duty differential, coupled with pricing based on export parity, instead of trade parity, would have gone a long way in exposing our oil industry, especially the refining companies, to global competition. The hybrid arrangement of trade parity pricing would be a half-hearted and incomplete move towards a rational pricing strategy.

    The loose ends of oil pricing in India are there to see. First, the fiscal problems of the centre and the states have led to a progressive increase in their dependence on oil revenues. That is where the process of correction should begin, if the consumer were to get any relief. Second, unless the oil industry is consciously exposed to global competition, the oil companies would continue to be inefficient and be rent seeking, once again at the cost of the consumer. Subsidies need to be targeted towards the BPL families. This would imply total de-subsidisation of LPG. Finally, oil pricing should lead to demand management. India can no longer afford to be complacent in this.

    In the wake of the recent oil price increases announced by the government, as a part of government’s public relations campaign, an advertisement issued by the ministry of petroleum and natural gas appeared in the news dailies all over the country stating that only 16 per cent of the incremental burden of the recent price increase had been passed on to the oil consumers, the rest 84 per cent being borne by the government and its agencies. This advertisement hides more than it reveals. The oil consumers, most of them tax payers, know well that it is they that bear the total burden. The bane of oil pricing in our country is the opacity that surrounds it. Many benefits that the government bestows on the consumers are not readily visible. Worse, many sins committed remain equallyhidden from the eyes of the public. It is high time that the government comes clean on this!

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    Email: eassarma@gmail.com

    ReferencesReferencesReferencesReferencesReferences

    [1] Report of the Committee on Pricing and Taxation of Petroleum Products, February 2006, at http://petroleum.nic.in/Report1.pdf.

    [2] Sixth Report of the Standing Committee on Petroleum and Natural Gas, 2004-05, presented to the 14th Lok Sabha, August 2005, on ‘Pricing of Petroleum Products’ Lok Sabha Secretariat, at http://164.100.24.208/ls/ CommitteeR/Petro/6rep.pdf.

    [3] Tenth Report of the Standing Committee on Petroleum and Natural Gas, 2005-06, presented to 14th Lok Sabha, May 2006, on ‘Pricing of Petroleum Products’, Lok Sabha Secretariat, at http://164.100.24.208/ls/CommitteeR/Petro/ 10rep.pdf.

    [4] Sectoral Energy Demand in India, August 1991, Regional Energy Development Programme (RAS/86/136), United Nations Economic and Social Commission, Bangkok.

    [5] Ministry of Petroleum and Natural Gas, Petroleum Statistics, at http://petroleum.nic.in/ petstat.pdf.

    [6] Duvvuri Subbarao (2006): ‘The Logic of Trade-parity Pricing’, Financial Express, June 7.

    [7] Annual Report (2005-06): Reliance Industries.

    Economic and Political Weekly July 8-15, 2006

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