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Sunday, February 22, 2009

A simple solution to end the retail fuel pricing mess...

Domestic retail fuel prices (largely petrol and diesel) were to be deregulated (and made market determined) long back... But they haven't and have landed up in a big soup - the cost of subsidies on government finances is large, PSU oil marketing companies were on the verge of bankruptcy a few months back... And though in principle, everyone agrees that the subsidies on petrol and diesel prices cannot continue at this rate, there isn't a good alternative. So here's one simple solution...

Firstly, the objective of any domestic pricing regime (lets accept that domestic fuel prices cannot be completely deregulated for at least the next few years) is

1. Prices should correspond to international prices, but not be as volatile as international crude prices
2. Oil PSUs must realise a fair price for their product, lest we make them bankrupt...
3. The pricing mechanism should be transparent and not subjective prerogative of the government in charge or oil minister in charge.

So the solution i have is that domestic prices be linked to a 'moving average' of international oil price with domestic prices being rest weekly or monthly. The moving average could be a 30 day moving average or 60 day or 90 day or 365 day depending on the smoothening we desire. Obviously, the higher the period, the smoother the domestic prices relative to international prices.

Now, this moving average solves all problems. It makes domestic prices respond to rising or falling international price of Oil - but depending on the smoothening factor with a lag. So week to week or month to month domestic prices don't jump around in volatile manner and so consumers are protected from the volatility. It ensures that Oil companies recover a fair price, there will be a lag but it will work both ways, they will earn slightly less in an upcycle of oil prices and slightly more when prices correct. The mechanism is transparent in that the reset period and smoothening factor are both known ex ante and so not subject to whims and fancies of incumbent government or oil minister.

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