It is a moot point if the government's decision to hike fuel prices was well-timed or ill-timed, but what's not in debate is its inevitability. With global crude prices soaring, but Indian oil marketers being forced to hold on to retail prices, taking money out of consumers' pocket was the only way the government could have protected its own finances and kept the public sector oil companies from drowning in a sea of red ink. The question now is, will corporate earnings and the economy suffer? We'll come to the corporate question in a bit, as for the economy, some experts already expect a 0.35 percentage point increase in the rate of inflation in the short term, followed later by a higher 0.80 percentage points.

No prizes for guessing what higher inflation and higher interest rates (the Reserve Bank of India recently announced an unscheduled 25 basis point hike in repo rates in a bid to curb inflation) will mean for an economy that hopes to grow at 8 per cent this year. Softer consumer demand and more expensive borrowings will give companies the perfect reason not to invest and, thus, starve economy of growth capital. Although the RBI says that it intends to keep the rate of inflation between 5 and 5.5 per cent, it will be a delicate balancing act. The good news: "The recent hike in petrol and diesel prices is likely to have only a marginal impact on prices given the competitive pressures," says D.K. Pant, Fellow, NCAER.

India's Oil Conundrum

"The next price hike will not occur for the next decade," declared Union Petroleum Minister Murli Deora soon after announcing a four-rupee hike in price of petrol and two-rupee for diesel. Of course, he didn't mean a word of it. And that's just not because he and his government may not be around that long. Rather, it is because the measures to insulate the consumer from price shocks have proved notoriously difficult to implement. One of the major reasons for it is that despite repeatedly knocking on the Finance Minister's doors, the Petroleum Minister has not been able to significantly divert revenues realised from the petroleum sector back into the sector. Had he been able to do so, prices would have been dropping by half, thus protecting mass consumption products-petrol, diesel, LPG and kerosene-from price hikes even if crude oil soared past the $100 (Rs 4,500) per barrel mark.

Scrubbing away at petro-taxes is a hard task, since (at Rs 3,65,875 crore last year) they account for almost a third of the government's total tax collections. Not only is the government cash-strapped, but it is pursuing an increasing number of social programmes. This year's list alone adds up to over Rs 50,000 crore. Adding to that is the subsidy bill, which is another Rs 45,000 crore. By the way, this does not include the estimated burden of Rs 42,500 crore that public sector oil companies will have to bear notwithstanding the price hikes, cut in taxes and issuance of oil bonds worth Rs 28,300 crore.

Is there something the petroleum ministry can do despite the constraints? A part of the answer lies in addressing the disease and not the symptom. The problem began around early 2002, when crude prices started moving north. Since we import around 70 per cent of our oil needs, exposure to the vagaries of global oil market was inevitable. However, equally much, the prospectivity of oil and gas in the country has gone up by leaps and bounds, beginning with Reliance Industries' find in 2002 off the coast of Andhra Pradesh. However, the 'rent' received by the government on oil and gas produced in the country (the asset belongs to the state and only leased to the operator) is around a modest Rs 10,000 crore. What holds back a higher rent is the prevailing production-sharing contract regime, where the oil field operators are allowed recovery of costs involved in successful exploration ventures.

Well, it's plastic: Companies like LG have uped prices

Furthermore, the government gets 'profit petroleum', which is only a part of the discovered oil or gas, in the form of money. Profit petroleum is a key aspect in the bidding of oil and gas blocks. However, this 'soft' system is designed to attract global players in areas where prospectivity remains to be established and the risk in the exploration business is significantly high. While the exploration risk has reduced in certain zones of the country like the Krishna Godavari basin, no modifications have been made to improve the government's take. Perhaps a cue can be taken from our neighbour Pakistan, which follows a hybrid model that links the 'comfort' of the contract regime to the risk in the exploration business. Operators of exploration blocks located on land get paid for the volume of the crude oil lifted and their remuneration is not linked to the price of oil (it's called a concession agreement). However, in the offshore deep waters, where the risk is higher, the contract allows for profit sharing, linked to the global price of crude oil.

Given the resistance to price hikes, Petroleum Minister Deora has skilfully negotiated a 'concession' from the government-allow oil companies to raise prices if crude crosses $73 (Rs 3,285) per barrel as well as introduce trade parity pricing. While the first measure is meaningful if implemented, the second measure is not without its share of issues. Trade parity is aimed at curbing the protection to domestic refiners, who, according to the government-appointed Rangarajan Committee, enjoy an effective rate of protection of around 40 per cent. And so arises a case for pruning returns to the refiner. However, there is a debate on the extent of protection-there shouldn't be, since it is an arithmetic formulation. The public sector companies argue that several factors have been omitted-products like kerosene and LPG attract negative protection, and states charge taxes that are not recovered from the consumer.

Then, there are issues relating to export of petro products (oil companies want to, government won't let them). Evidently, the Petroleum Minister has a lot of balancing acts to do. Hopefully, his skills at the game of bridge will come handy.

The Corporate Impact

The effect of oil price hikes will be felt across the board in corporate India due to three factors: higher transportation costs, hike in fuel-related input costs, and dearer raw materials such as plastics. Not all sectors will feel the pinch immediately (see The Cycle Of Hurt), but by the end of this year, almost all will feel the heat. "On an average, there is a 3 per cent increase in cost for India Inc.," says Gurunath Mudlapur, Managing Director, Atherstone Institute of Research.

Business Today spoke with analysts to find out which sectors will be the worst hit by the increase in fuel prices. They gave us a list of four sectors, comprising cement, automotive, metal and power. Here's a quick look at how each of these sectors and the top companies within them will be affected:

Worst hit: High freight costs will impact cement firms

Cement: It's a double-whammy for cement. Not only is the sector energy-intensive, it is heavily dependent on transportation. Analysts are concerned that with the monsoons approaching and the government trying to curb cement prices, it will be difficult for cement firms to pass on the added costs to consumers. Among the top manufacturers, acc is expected to fare better since its dependence is on domestic coal, but Gujarat Ambuja and Ultratech Cement could be hit by higher fuel costs. While the former uses furnace oil and imported coal, the latter consumes naphtha and imported coal.

Automobiles: "The rise in diesel prices will have a negative impact as sales volumes may come down," says Avinash Gorakshakar, Head (Research-PCG), Emkay Shares and Stockbrokers. Although fuel and power costs account for not more than 3 per cent of total expenditure for auto makers, commercial vehicles (think Tata Motors and Ashok Leyland) and cars (Maruti Udyog) will probably be the most impacted, since some buyers may put off their purchase plans. On the contrary, the rise in fuel prices may spur the fortunes of the more economical two-wheelers.

Power: The hike in fuel prices will be a mixed bag for power majors. Reliance Energy (REL) will be least impacted, thanks to its use of domestic coal (85 per cent of all coal consumed), but Tata Power may continue to take a hit on its books. Reason? The Maharashtra Electricity Regulatory Commission (MERC) has capped fuel adjustment charges, which means the company can only partly pass on the rise in fuel prices to the consumer. "Following MERC decision, there is a deficit in cash flows of the company, which is expected to continue even this year," says an analyst. In 2005-06, Tata Power's cash flow deficit was at Rs 350 crore.

Metals: In general, the metals industry, including steel and aluminium, is extremely energy hungry. Tata Steel, for example, spent 5 per cent of its revenues on power and fuel last year. Throw in freight costs, the figure jumps to 12 per cent. However, aluminium maker Hindalco will be worse hit than Tata Steel. Its power and fuel costs are even higher at 16.5 per cent of its revenues (the figure is for 2004-05; last year's is not available). "Hindalco, sail and Nalco are expected to be the major losers," cautions Atherstone's Mudlapur.

However, as Jayprakash Sinha, Head (Research-PCG), Kotak Securities, points out, "The impact on corporate profitability will depend on the companies' ability to pass on the increase in cost to the end consumer and how much they can neutralise the impact through improved efficiencies." In the past, India Inc. has not just survived oil price hikes, but lived to thrive. And at this point, there's no apparent reason why it can't do so this time around as well.