Privatisation of the energy sector is a means to an end -- the establishment of a free, fair and competitive energy market in India.
It must meet the objectives of all stakeholders -- consumers, companies, employees and owners (government and minority shareholders).
The government may have several options within the three broad categories -- executive, judicial and legislative -- but there is only one objective.
The executive option: The split of Indian Oil Corp and the subsequent privatisation of its parts.
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The option must be seen in the context of three related objectives -- (a) establishment of a competitive market (market objective), (b) enhancement of IOC's operations (company's and employees' objective), and (c) value creation for IOC shareholders (owners' objective).
IOC has a 40 per cent share of the Indian refining market and 50 per cent of the products market. It has complete hegemony of the northern and eastern markets with 90 per cent of the refining capacity and 100 per cent of the pipelines capacity in the regions.
A vertical split of the company -- not along operating segments but into two mirror parts -- can achieve the first objective.
From a competition standpoint, the northern market will likely see the least amount of competition and that, too, much later compared to the southern market.
However, a vertical split into two entities will not meet with the latter two objectives. It will result in sub-optimal scale of operations for the twin entities in an industry where scale is critical.
IOC's crude pipeline infrastructure and petrochemicals expansion are designed to make optimum use of its refining system in north India.
The proposal of splitting the company into operating segments and the privatisation of the marketing segment is the least attractive option as it does not meet any of the three objectives.
If introduction of competition for the benefit of the Indian consumer is the guiding principle, there are easier ways to do it -- (a) reducing high import tariffs which will help Indian refiners make super-normal margins, (2) removing entry barriers (investment criteria) for marketing as market forces will automatically remove frivolous players, and (3) creating an independent oil sector regulator.
The privatisation of IOC's marketing assets may result in a private sector hegemony, leading to contravention of the 'competition' objective.
At the same time, the refining segment will likely suffer a sharp erosion in profits. IOC makes only 30 per cent of its profits from refining. A decline in tariff protection will reduce the refining segment's profitability.
If the government wants to restructure IOC, the best solution would be a merger of IOC and Oil and Natural Gas Corp, India's upstream behemoth, and the subsequent privatisation of the combined entity through a sale to the public.
Globally the best and the most valuable energy companies are fully integrated -- upstream oil and gas, refining, marketing, natural gas and power.
IOC and ONGC are amongst the largest companies in India, both in terms of market capitalisation and profits. ONGC is the largest and IOC the fifth largest in terms of market capitalisation while they are first and second respectively in terms of profits based on FY03 figures.
However, globally even a combined entity would be a dwarf compared to the $240 billion market capitalisation and $11.5 billion 2002 profits of ExxonMobil, the world's most valuable energy company.
Even discounting for the stock market's astuteness in valuing companies (as Indian politicians may want to believe), ONGC's FY03 oil production was one-fourth of that of ExxonMobil while IOC's refining and marketing volumes were 17.5 per cent and 12.5 per cent of that of ExxonMobil.
A merger between IOC and ONGC would meet the objectives of both entities as ONGC has plans to expand aggressively into downstream oil while IOC is taking tentative steps upstream.
One should also note that IOC is virtually absent in two crucial parts of the energy chain -- upstream and gas.
Upstream has been the most profitable and valuable portion of an integrated oil company's portfolio historically while gas is the most dynamic and fastest-growing segment.
A merger would also involve limited impact on employees, given the very little overlap between operations of the two companies.
Finally, only a combined IOC-ONGC entity, a truly vertically integrated giant, can stake a claim to be a global player and compete with the oil majors.
A combined entity would be amongst the top 15 energy companies in the world by market capitalisation and would rank along with regional behemoths.
It would not be amiss to mention that most of today's largest energy companies (with the exception of US companies) are erstwhile state-owned entities, which have been gradually privatised by their respective governments.
A gradual privatisation through offer for sale of the combined entity -- until 51 per cent government ownership in the medium-term and consensus is built to privatise IOC-ONGC completely - can also release substantial sums of money for the government for the next several years. The combined entity's market capitalisation would be $25 billion plus.
The judicial option: A review of the Supreme Court's judgment on privatisation of Bharat Petroleum Corp and Hindustan Petroleum Corp.
The government can (and must) explore the option of a review even though the chances of a favorable review appear slim at this juncture. The law is a matter of interpretation and a review may lead to a different interpretation.
However, two eminent judges of the apex court have already ruled in favour of Parliament approval for privatisation of BPCL and HPCL as they were created through acts of Parliament.
The legislative option: An approval from Parliament.
As decreed by the Supreme Court, the government (present or future) has really no alternative with respect to the privatisation of BPCL and HPCL but to take Parliament's approval if the judicial option fails.
The executive option is not applicable for BPCL and HPCL; IOC's proposed split is an alternative plan.
The fact that the government has not considered a split of BPCL and HPCL and subsequent privatisation of the parts as a strategy to circumvent the Supreme Court judgment means that a Parliament approval is mandatory for privatisation of BPCL and HPCL in any manner, even in parts.
The timing of the next Parliament elections makes the legislative route difficult until the next polls.
The government may be concerned about uniting the opposition on a non-political issue, and highlighting latent tensions amongst the ruling coalition and its own party members with respect to privatisation.
However, for the longer-term benefit of BPCL and HPCL, the government must sacrifice political expediency and work towards building a consensus towards their privatisation.
The government may find the opposition more malleable despite its obduracy. Various state governments comprising different parties of diverse ideologies have been vigorously pursing privatisation of state-owned entities in their states.
BPCL and HPCL are good companies with solid positions in the downstream sector, particularly in marketing.
It would be unfortunate if these firms lose value due to parochial interests like what happened in the case of other state-owned enterprises in the past, most notably in the telecom sector, where tardiness resulted in a sharp erosion in the value of the privatised entities. A merger will bring out the best in them.
(The author is securities analyst with Kotak Securities. Disclaimer: He does not own any share in any stocks mentioned in the article. Kotak Securities does not own any proprietary positions in any scrips mentioned here. The article should not be construed as an investment advice.)
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