Cowboy Capitalism: The Curious Case of Reliance KG Basin Gas Business

February 24, 2013

By Rahul Varman[1]

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I. Background
While everyone recognises the significance of petroleum industry for an economy like India, the real happenings and intricacies of the sector do not often make the news. At best these days one hears a lot about the high and ever increasing prices of the petroleum products. It is only recently due to the commotion created by the leading lights of anti-corruption movement that the gas business of the Reliance corporation (henceforth RIL) has come for some public attention though earlier also it generated some interest when the two Ambani brothers were sparring about it. And yet in the mainstream media one hardly finds any meaningful analysis on the issue. At best there are news reports about the ongoing standoff between the corporation and the government and even such reports are lost on lay people due to the technicalities and the specificities of the petroleum business. An attempt is being made here to bring out the key issues involved that a citizen ought to be concerned about, given that it is all about claims on the precious energy resources of the country.

Before we get into the issues involved some background details of the Reliance KG gas business will be in order. Though the hydrocarbon reserves belong to the people of the country and state is supposed to be their custodian, in 1999 the government came up with the New Exploration Licensing Policy (NELP) allowing private players to enter the fray. Right in the first round, at that time, undivided RIL (i.e., before RIL was divided between the two brothers) bagged the contract for exploring deep water D6 block of the Krishna Godavari river basin in Andhra Pradesh constituting an area of 7645 square kilometres. A production sharing contract (PSC) was signed in April 2000 between the government and RIL and its minor (10 percent) partner, NIKO Resources Ltd (a Canadian corporation), for exploration and production of gas/oil. The KG Basin is considered to be the largest natural gas basin in India. A total of 19 discoveries have been made in the block during 2002-08, 18 of gas and one of oil; in two of them a declaration of ‘commercial discovery’ was made in 2003-04 in an area of 340 square kilometres as those were substantial gas reserves; later commercial oil discovery was made in MA oil fields in an area of 50 square kilometres.[2] It is Ministry of Petroleum and Natural Gas (MoPNG) which is supposed to take care of the exploration and production of natural resources while an office of Directorate General of Hydrocarbons (DGH) was created in 1993 as the key regulator for the petroleum business in the country.[3]

In 2011 the Comptroller and Auditor General (CAG) of India came up with a report on Performance Audit of Hydrocarbon Production Sharing Contracts in which the Reliance D6 gas business was taken up for a detailed scrutiny. The report offers significant insights about all the three aspects of the business: its exploration, investments involved, as well as pricing of the gas produced; we will take up these issues both on the basis of the CAG report [4] as well as the available media accounts.

II. Exploration at KG Basin D6 Block
The production sharing contract [5] has a built-in mechanism for progressive surrender of exploration area back to the government as the contractor discovers gas for commercial production in specific pockets and as it delineates certain portions as relatively less promising. The idea goes into the very heart of NELP: that the state lacks capital for rapid expansion in exploration and production of petroleum resources of the nation; hence the private parties are being invited for a time bound exploration and then forfeit the rest of the area back to the government. The objective is further twofold: one, to prevent hoarding of natural resources by the private parties without tapping them, like we have seen both in case of coal and spectrum in recent times; and two, to get a better price for the resources: as oil and gas are discovered in the basin, the neighbouring areas are likely to fetch better prices in the next round of ‘auctions’ for further exploration, like what happens with land prices.

Thus in the contract the exploration was divided into three phases and at the end of each of the first two phases the contractor was supposed to relinquish 25% of the area and finally after the phase III, it was to hold on to only that area where the operator ‘discovered’ the petroleum resources in commercially viable quantities after drilling wells and was committed to develop further for production, rest all area was supposed to go back to the government. According to CAG, phase I of preliminary ‘exploration’ got over in June 2004 and RIL gave notice of beginning phase III in 2005, but without relinquishing any part of the original area of basin allocated to them in 2000. For phase III exploration the original end date was June 2007 and was extended to July 2008 by MoPNG, but the end result is that RIL has held on to the entire 7600 square kilometre basin for exploration till today instead of 390 square kilometres from which it had begun commercially tapping petroleum reserves after the phase III. Though Reliance had not drilled any wells in most of the area yet the ministry in a volte face of its earlier stance in February 2009 decided to declare the whole of it as ‘discovery area’ and thus practically awarding it to Reliance for future exploration “in gross violation of the contract”, according to CAG.

The Ever-expanding ‘Discovery Area’
As per the contract, ‘discovery area’ is only that area, where “based on discovery and results obtained from… wells drilled… the contractor is of the opinion that petroleum is … likely to be produced in commercial quantities.” Thus the concept of discovery area is inextricably linked to drilled wells and findings of petroleum deposits that are recoverable. In this case the contractor till 2010 had drilled wells only in one specific area in the North West of the total block allocated to them. To begin with DGH did not agree to RIL’s insistence of not relinquishing any area before moving to phase II in May 2004, but according to CAG, it “capitulated” within an year! It was now willing to let the exploration continue based on seismic data, which, as per the contract, was clearly a part of phase I which had to be finished before moving to phase II of drilling exploratory wells. Now DGH found it ‘prudent’ for Reliance to analyse the seismic data on a ‘fast track basis’ and that would also allow them to mark the area of relinquishment ‘in a proper manner’, DGH argued. One of the things Reliance said in its defence was that it lacked ‘ultra deep-water rigs’ for exploratory drilling in the deeper Southeast parts of the block underlining the point that seismic data by itself is inadequate for ‘discovery’.

In July 2006, DGH permitted RIL to enter phase III without surrendering any area, since the data showed “continuity of discovery” in the whole block, of course based on Reliance’s seismic data. According to the contractor the hydrocarbon bearing channels were continuing throughout the block and had the potentiality to produce gas in commercial quantities. Interestingly even the seismic surveys covered only a part of the block. CAG has documented that MoPNG resisted this idea in 2006-2007, but had also come round to the view of DGH (and Reliance) by 2008 and approved the Reliance proposal of declaring the entire area to be ‘discovery’ by February 2009. CAG asserts that the idea of relinquishing of ‘undiscovered’ area of the D6 block was lost in a “sea of correspondence” between RIL and DGH (later DGH and MoPNG) and the contractor kept insisting that “the petroleum was likely” to exist and hence the whole area should be declared “discovery area”. The only little problem with the plea is that this is not what is meant by ‘discovery’ as per the contract signed by RIL and which they preferred to conveniently ignore and DGH and MoPNG were willing to comply. As CAG concluded:

The contractor’s opinion that petroleum was “likely” to exist in the entire contract area and ‘could be produced after an exhaustive exploratory/ appraisal programme’ is not in consonance with the PSC definition of ‘discovery area’ which is centred on ‘existence’ of petroleum, based on wells drilled in that part (p. 39).

III. Reliance Investments in KG D6 Block
The contract is supposed to be based on the idea that the contractor takes the risk for exploration in terms of initial investments, but in turn is rewarded with adequate returns along with a mechanism for profit sharing with the government. Thus the contract has built in a concept of an ‘investment multiplier’ (IM), that is, the ratio of cumulative net income to cumulative capital investment in the project. As the investment multiplier goes progressively up (because the initial investment stagnates while revenues keep adding up) and the contractor has received adequate returns, the government share in the profits will go up increasingly. Thus the contract bid actually seeks the profit sharing plan of the prospective operator at specific points of IM and obviously the attractiveness of a bid will depend upon the kind of profit sharing that a bidder is willing to commit to the government. Here the KG D6 contract turns quite interesting. The profit sharing plan in the PSC reads as follows: for IM less than 1.5 [6] it is 10%, IM between 1.5 and 2 it is 16%, till 2.5 it is 28% and when IM is expected to go above 2.5, most interestingly, the government share in profits promised by the contractor jump to 85%!

Now in order to understand the implications of this curious looking profit sharing plan we need to get into the actual details of investments in the Reliance KG basin gas business. Initially, D6 was expected to produce 40 mmscmd (million metric standard cubic meters per day) of gas, which was subsequently revised to 80 mmscmd. The initial development cost was envisaged to be $2.4 billion in May 2004, which was revised through an “addendum” in 2006 to $5.2 billion in the first phase and $3.6 billion in the second phase. So while the contractor claimed that the gas output would double, at the same time the required investment almost quadrupled![7] If we connect it with the profit sharing schedule where the government share jumps from 28% to 85% when the IM crosses 2.5, it could be well anticipated that the operator will do everything possible to keep it below 2.5, and one obvious way to do that is to keep increasing the denominator by adding up the investment required. In fact CAG commented, “The private contractors have inadequate incentives to reduce capital expenditure—and substantial incentive to increase capital expenditure or ‘front end’ capital expenditure, so as to retain the IM in lower slabs… (p. xvi)” The CAG has also observed that the $3.6 billion development cost for the second phase has the possibility of being hiked up in future in the same way as the first phase.

Thus as per the CAG report there is every reason to believe that these investment costs have been doctored and in fact it also identifies several such mechanisms: award on single party bids, post hoc revision in scope, specifications, and amount of bids, substantial changes in orders, etc. CAG has specially mentioned ‘serious deficiencies” in the award of $1.1 billion order for a floating production, storage and offloading (FPSO) vessel (for oil production) from Aker Floating Production. In fact CAG points out that many of the single bid contracts were handed out to the Aker group companies amounting to more than $2 billion and that Aker had no prior experience of an FPSO. Based on an analysis of the CAG report, Purkayastha observes [8],

Reliance therefore can make a double killing — by over invoicing the capital costs, it can skim money from the top. In addition, by ensuring that the capital costs take a longer time to recover, it takes out its major share of the profit right in the beginning. Not only did the Directorate General of Hydrocarbons accept this increase in capital cost, which under the contract it need not have accepted, it did so in unseemly haste – it took a scant 53 days to go through cost increase of nearly $ 6.3 billion! Some wizardry indeed.

IV. Pricing of Reliance KG D6 Gas
Another aspect worth noting that has been part of the ongoing drama about Reliance gas has been its pricing. Till Reliance came into the fray when only the public sector was involved in gas business, it was the government that would administer the gas prices. It needs to be noted that the gas prices have serious implications for two of the critical industries, fertilizer and power, where it is a vital input; for instance 10% of electricity in the country is being produced through gas. Thus before 2009 Oil and Natural Gas Corporation (ONGC, a PSU) gas was being sold at the rate of $1.83 per unit. In 2004, RIL bid a price of $2.34 per unit to National Thermal Power Corporation (NTPC, a PSU) against international competitive bidding. The gas was meant for its 2600 MW Kawas and Gandhar power projects and the offer was for 17 years. NTPC accepted the offer and issued a Letter of Intent, which in turn was accepted and confirmed by RIL. But then RIL had second thoughts about its bid and refused to sign a Gas Sale and Purchase Agreement forcing NTPC to file a suit against RIL in Bombay High Court in December 2005; the case is still sub judice.[9]

Meanwhile the two Ambani brothers, who between them literally ran RIL like their personal fief in spite of all the facade of it being a publicly held corporation, began fighting for the crown jewel of KG gas as the RIL empire was being split between them after the death of their father. The entity which executed the contract with the government in 2000 was split into two companies — RIL and RNRL (Reliance Natural Resources Ltd). As RIL was supposed to supply gas to RNRL (later merged with Reliance Power, part of the younger brother’s stable), price of the gas became part of the dispute. In June 2005, the two brothers had a private settlement which included issues regarding utilisation and pricing of the gas between them, as if it was a personal property of the family, completely oblivious to the fact that the gas belonged to the nation and RIL had signed a contract with the government only for exploration and production.

In 2007 matter of KG D6 gas price was referred to an Empowered group of ministers (EGoM) led by the then finance minister, Pranab Mukherjee, who approved a rate of $4.2 per unit for five years. This undermined the ongoing NTPC plea for $2.34 price in the court as then the government itself was fixing the higher gas price for RIL! It might be noted that till 2008 ONGC was being paid only $1.83 per unit of gas. The $4.2 price was supposedly done on the basis of RIL’s price “discovery.” Reliance’s so called price discovery was to ask a selected set of bidders (from the user industries) to quote a gas price according to a formulae which fixed the price within a narrow range of $4.54 to $4.75. With this as the basis, Reliance declared the “discovered” price to be $4.59/ unit which was later revised to $4.3. The Government then magnanimously decided that the right price was $4.2 and claimed that it was arrived at through a “discovery” mechanism.[10] It is also worth emphasising that the EGoM decided this price going completely against the recommendations of a committee headed by the cabinet secretary which had strongly objected to the Reliance proposal. Former principal advisor (energy) to the Planning Commission, Surya Sethi sums up this confusion well:

The fact of the matter is $4.2 valid price for natural gas… is the highest price that anybody has received for natural gas anywhere. And while you say cost of production you know various figures came out: somebody has said one dollar but nobody has claimed cost of production more than 1.43 or some such number but there are numbers to show probably it is 99 cents also… Why under that situation we are paying 4.2 dollars is completely beyond me at least. As I said, this was discussed, this was demonstrated (that) this is not the way to price natural gas but yet the EGoM decided to go with that price.[11]

Now in October 2012, Reliance has sought an ‘import parity’ price of $14.2 for KG D6 gas, straightaway more than three time increase, even before the period of present fixed price gets over in Aril 2014 and a committee headed by the chairman of the PM’s economic advisory council has been formed to look into it.[12] While RIL had in its submission to the Supreme Court in the gas supply row with RNRL stated that it was merely a contractor who is bound by government decision on price and sale of gas in ‘national interest’ (thus arguing for $4.2 price from RNRL as determined by EGoM and not the $2.34 that the younger brother was claiming as per their ‘family’ contract), the company in January this year wrote to the petroleum ministry seeking revision of “discriminatory” and “sub-market” price. Thus, while in its dispute with the younger brother RIL conveniently wanted to follow the government determined price in 2008 since that was almost double than what the younger brother was willing to offer, it now wants to go with the international prices (because apparently it is significantly higher) and is ready to contest the same government determined price!

It might be argued that the Government also stands to gain out of high gas prices. But this is only partly true. As gas is the major feedstock for fertiliser production and also a fuel for power, this gain has to be offset against the resulting higher fertiliser and power prices. If the cost of fertiliser and power goes up, so does the government subsidy. So while the RIL would pocket the benefit of the higher cost of gas, the government would have to pay out a much higher subsidy which more than counteracts the gains from the increased gas prices. In fact the committee headed by the cabinet secretary had pointed out that higher gas prices would result in prohibitive fertiliser and power subsidies in its input to the EGoM [13] in 2007. This should be compounded with the overall deleterious effect on the economy of rising power and fertiliser costs.

In a still evolving suspense (or horror?) story, the gas production from D6 came down to 31 million standard cubic metres per day in 2012 from 61 mmscmd in 2010, while the production was supposed to reach 80 mmscmd by 2012-13.[14] Reliance took the stand that there were ‘technical snags’, while government kept pleading for hike in production. They have also revised the estimates of gas reserves in the basin to 20% of their earlier estimates. Such precipitous decline in production has to be analysed in light of Reliance’s persistent demand for threefold hike in gas prices. Most likely the snags will magically disappear once the government gives in to the demand for price hike! In August 2012 Andhra Chief Minister voiced the concern to the Prime Minister that Reliance was “deliberately reducing the production”.[15] In fact part of the ongoing dispute between the ministry and RIL has been whether, with such low level of production, the latter has the right to charge the massive capital investment (made for 2.5 times the present production) as ‘cost’ and thus deny the government its share of profits (see Section III). Last year the solicitor general advised the ministry that, “the costs/expenditure incurred in constructing production/ processing facilities and pipelines that are currently underutilized/ have excess capacity cannot be recovered against the value of petroleum” and according to media reports [16] close to $2 billion should be ‘disallowed’ and recovered from the contractor. As of last year, RIL has already recovered $5.26 billion out of an investment of $5.69 billion. According to a senior MoPNG official quoted in The Hindu, [17]

Every 1 mmscmd drop in production of gas means a loss of 210 MW of power capacity. Power plants in various parts of the country to the capacity of nearly 20,000 MW with bank guarantees of around Rs. 30,000 crore are lying idle without gas. Fertilizer was being imported more than anticipated due to the fall in gas output from the KG basin. This is a huge loss to the nation, and who knows if gas production was being suppressed for want of revised price.

V. Conclusion
Let us summarise the evolving state of affairs of the Reliance KG basin gas business in the last 12 years:
• Once the corporation bagged the contract in 2000 for exploration and production, RIL began with asserting that the whole basin is full of gas through ‘continuity’ of hydrocarbon bearing channels and convinced the government to declare all of the 7600 square kilometres as ‘discovery area’ in 2009 after a protracted battle based on thin seismic evidence at best and against both the word and spirit of the contract that they had signed with the government; according to the CAG the ‘discovery area’ as per the contract was mere 5% of this area, the rest should have been surrendered back to the government in three stages.
• Then they jacked up the investments involved by quadrupling it, at least on paper, while doubling the capacity of commercial production, thus quickly skimming off their investments while drastically reducing/ delaying the profit sharing with the government. Most likely, as CAG stresses, it has cooked up the books to earn handsome returns out of this investment as well.
• At the same time, they have refused to honour their commitment to NTPC to sell the gas at $2.34 and instead have been able to force the government to grant them a price of $4.2, all the while when ONGC was being allowed a price of $1.83.
• And the latest is that RIL is seeking an ‘import parity’ price of $14.2 while the production from the fields has come down to 31 mmscmd (from 61) when it was actually supposed to go up to 80, apparently due to ‘technical snags’ and lack of gas!
• In the meantime, in spite of lack of gas and production, Reliance has managed to offload a 30% stake in 23 hydrocarbon blocks, including D6, to British Petroleum for $7.2 billion in 2011 and the deal was cleared by none other than a cabinet committee headed by the Prime Minister. Never mind that Reliance was supposed to be only the contractor and the assets belonged to the people of the country!

How do we make an overall sense of this ongoing farce of Reliance KG D6 gas? After recognising the problems of Reliance’s turnabout in seeking higher prices while drastically reducing the production, this is what Business Standard, a leading business daily of the country, prescribes recently:

This should also be a lesson as to the structural problems with India’s exploitation of natural resources. In a pure market with strong regulation, rather than this interlinked mesh of concessions, subsidies and faulty contracts, such problems would not arise. The government must move towards such models in future (emphasis added).[18]

But what is this oxymoron called ‘pure market with strong regulation’ that the Business Standard (BS) prescribes? By ‘pure market’ if BS meant a Smithian market where actors are ‘price takers’ then how do you bring it when there are only a handful of petroleum corporations across the globe and an industry that requires huge investments? And even those corporations are often tied up with one another like the present case where British Petroleum is a partner in D6 block. More importantly, how do you let market forces play when it comes to finite resources like petroleum, that too in the public domain and where the demand seems to continuously outpace the supply? Only Business Standard and all the ideologues of ‘markets’ can enlighten us about this! Perhaps that is why they need to add regulations for good measure to their idea of ‘pure markets’. Now theoretically ‘pure markets’ ought to be self regulated, at least that is what Smith meant by the ‘invisible hand’ of the market. But given the problem that there are no ‘free markets’, advocates of markets need to grudgingly append the suggestion of regulation to their demand for ‘markets’.

Coming to regulations, again it can only be BS that can educate us about their idea of ‘strong regulation’, but it is interesting to note the imperious attitude of Reliance towards the regulating bodies and their attempts at enforcing their mandate: when caught on the wrong foot or questioned by any of them, RIL has simply dismissed them either as if they do not have enough technical sophistication, or that they are being very ‘bureaucratic’ in their approach, and the government is repeatedly exhorted to be ‘flexible’ and understand the complexities of business.[19] It is in this context that we need to put the recent debate on the relevance and role of CAG [20] and the fine report that they have come up with in this case, the only substantial analysis that is available on the happenings at KG D6 block. Can we imagine the state of affairs once such state bodies are further neutralised, sometimes in the name of corruption, sometimes for ‘efficiency’, and at other times for the sake of markets?

But if ‘development’ and ‘growth’ is reduced only to earning profits by the corporations, we cannot fault Reliance on that count. A 2008 Goldman Sachs report estimated RIL’s internal rate of return (IRR) from the fields at 33 percent, second-highest in the world among the top 190 projects surveyed. It seems effectively D6 contributed nearly one-third to RIL’s Earnings before Income Tax (EBIT) and Morgan Stanley attributed about Rs 745 per Reliance share of the target price of Rs 1,322 to its exploration and production (E&P) business according to a Business World report.[21] Perhaps the most appropriate interpretation of this Reliance story is that it is all about profits with markets and regulations being only a smokescreen in the sense that, whenever market distortions are pointed out the ideologues claim a failure of regulations (and therefore that of the government) and when a regulating body tries to do its job scrupulously (like the CAG in this case), the market zealots cry foul and claim that this will distort the market! Welcome to the cowboy country of Reliance: nature, people and public institutions be damned!

[Comments and suggestions of Manali Chakrabarti and Arun Agrawal are gratefully acknowledged. An earlier and shorter version of this article will be published in Alternative Economic Survey 2013.]

Notes:
1. Comments and suggestions of Manali Chakrabarti and Arun Agrawal are gratefully acknowledged. An earlier and shorter version of this article will be published in Alternative Economic Survey 2013.

2. Oil constitutes only a small part of the petroleum reserves discovered in KG D6, hence the primary focus here is on gas and related issues.

3. Petroleum is being used here in a broad sense to include both crude oil and natural gas.

4. Comptroller and Auditor General of India, Performance Audit of Hydrocarbon Production Sharing Contracts, Report No. 19 of 2011-12. The report is based primarily on the 2003-08 records of the government and 2006-08 records of the contractor.

5. References to the contract are primarily from the CAG report.

6. That is, when cumulative net income is 1.5 times the accumulated investments.

7. What happened to ‘economies of scale’ in this case?

8. Purkayastha, Prabir, The Reliance KG Gas Scam, Newsclick, June 16, 2011.

9. Chowdhury, Nishith, KG BASIN GAS : Sordid Saga of Duplicity and Subterfuge: http://indiacurrentaffairs.org/kg-basin-gas-sordid-saga-of-duplicity-and-subterfuge-nishith-chowdhury/, accessed on Dec 04, 2012.

10. Purkayastha, Prabir, op. cit.

11. Newsclick Production, KG Basin deal : Murky valuation of Gas prices & Production costs
11-July-2011, http://newsclick.in/india/kg-basin-deal-murky-valuation-gas-prices-production-costs, accessed on 06/12/2012.

12. MoPNG as well as the power sector have been contesting Reliance’s plea for the hike in price, and estimated profit hike for the corporation will be in the range of $8 billion if the govt. agrees for the price hike (http://www.thehindu.com/business/Industry/article3442556.ece#, accessed on 16/12/2012).

13. Chowdhury, Nishith, op. cit.

14. http://www.indianexpress.com/news/reliance-kgd6-reserves-est-off-80–niko/964902/1, accessed on Dec 13, 2012.

15. The Economic Times, Kiran Kumar Reddy urges PM to look into KG basin gas production issue, Aug 22, 2012.

16. Mint, Govt seeks to protect KG D6 revenue share, Nov. 21, 2011.

17. Mehduda, Sujoy, Manmohan set to end reliance on Jaipal for oil and gas, The Hindu, Oct 27, 2012.

18. http://business-standard.com/india/news/gas-stand-firmmove-on/480800/

19. Witness for instance the latest controversy where Reliance has simply refused to share information beyond the accounting books with CAG saying that it is a private entity.

20. Besides petroleum on other natural resources as well, like coal and spectrum

21. Dubey, Rajeev, The Great Gas Hunt, Business World, 19 Apr 2010.

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