Oil refineries in Pakistan may face closure if government changes its policy on "deemed duty" which currently stands at 7.5% on HSD but 7.5% on HSD equates to 2.5% of total refinery production as HSD is 1/3rd of total refinery production in Pakistan.
Overall tariff protection of 2.5% is lowest protection offered to any sector in Pakistan. For instance, automobile sector has protection of over 100%, fertiliser sector gets subsidised gas, which implies a protection of 400% and PSF has import protection of 6.5% on its entire product. It is only in case of refineries that instead of protection on all products, government has singled out one product namely HSD which is 1/3rd of the total refinery production.
It is worthwhile to mention that on one hand, government is trying to induce investment in refining sector and on the other hand it is considering changing policies which would result in forced closure of existing refineries. Setting up a refinery is capital intensive with investment running into billions of dollars, one wonders why can't government make consistent policies which are industry and investment-friendly.
The local refineries are not only strategic assets but are major source of earnings for the government and source of employment for the people. Refineries generate direct and indirect employment for more than 100,000 families or over one million Pakistanis. By way of collection and payment of various taxes which all add up to over Rs 300 billion per annum is contributed by the oil sector in Pakistan in which the refineries has a large share.
Refineries provide optimum utilisation of limited port infrastructure of Pakistan. Current port infrastructure cannot handle import of 100% demand of various petroleum products in case local refineries are forced to shut down. Ports in Pakistan would require investment to manage such demand and this investment would run into hundreds of millions of dollars.
For some time now, the word "Deemed Duty" is frequently used in the context of diesel price. Already an ambiguous term, the way it is presented in the press has created enough confusion in the minds of common readers, said an industry analyst.
Perceptions that it is an undue and unjustifiable component through which refineries are collecting huge sums and that price of diesel could be brought down by getting rid of it, are common among the people. But this is absolutely incorrect and misconstrued.
According to an official of the Ministry of Petroleum, diesel comes for the consumers from two sources; 50% each by local refineries and imported. Price of diesel for consumers is made up of four major components; ex-refinery price or landed cost of imported product, inland transportation cost, oil marketing company and dealer's margins and finally the government taxes and levies. Government recovers customs duty at the rate of 7.5% on the imported diesel, which becomes part of its landed cost. On the other hand, as the pricing formula given to the local refineries is based on import parity principle therefore the local refineries can have their price of HSD equal to the calculated landed cost of the HSD. In order to make the ex-refinery price equated with the import parity landed cost, the customs duty on HSD is made part of the ex-refinery price of HSD. This component of 7.5% included in the ex-refinery price of HSD coming from local refineries is given the name of Deemed Duty. This concept is common and acceptable in the manufacturing industry. Example can be quoted from the local manufacturers of automobiles who add a component equal to customs duties, levied on imported vehicles, in their price make-up, he added.
How did this deemed duty concept come into practice, has a historic perspective. Between 1992 and 2002, all local refineries were running under completely regulated pricing mechanism. ARL, PRL and NRL were given a minimum guaranteed rate of return @ 10% and dividend out of their profits after tax were capped @ 40% of their respective paid up capital; this formula is commonly known as 10-40 Formula.
Formula for Parco, which started in year 2000, was different as it was given a minimum 25% guaranteed return for a period of eight years. For sometime, the government meant to introduce deregulation in the oil sector so it devised in 2002 a new pricing formula for the local refineries excluding Parco, whereby the 10% guaranteed return was withdrawn and a tariff protection by way of customs duty on imports of Jet fuel, Light Diesel Oil ( LDO) and HSD was introduced. This concept was adopted from India where tariff protection for oil refineries was already in practice for sometime. ARL, PRL and NRL were, however, bound to divert profit after tax beyond 50% of their respective paid up capital, into a special reserve as funds for upgradation of these refineries are to be set off against any losses in the future.
To implement the tariff protection formula, a detailed working based on the statistics of historical prices and trends was carried out, which determined 6% on each Jet Fuel and LDO and 10% as customs duty for a reasonable profit after tax for ARL, PRL and NRL, without causing any abnormal increase in the consumer prices.
The objective was clear, GoP wanted to gradually deregulate oil sector but side by side, it also wanted stability and growth for local oil refinery industry. In the beginning, after the implementation in 2002, oil prices and the refining margins remained stable and any profit over and above 50% of paid up capital made by these refineries was retained in the special reserve. Later on, the deemed duty from Jet Fuel and LDO were withdrawn as GoP considered 10% deemed duty on HSD alone was sufficient to meet its above objectives. It was, when the international oil prices started increasing sharply in the year 2007 that the deemed duty on HSD started attracting objections from various quarters. In true sense, this should not have been the case as long as special reserves were kept within the system ensuring the funds (above 50% cap) to remain within the above said companies. As the pressure kept mounting, the government had to adjust the rate of customs and deemed duty to 7.5% in 2008.
Now on the size of this deemed duty, a common misperception is that it is a very high number. Over the last two years, the average of the deemed duty on diesel kept moving between Rs 2.25 and 2.50 per litre. As the diesel is about 30% of crude oil, this turns out as Rs 0.75 per US $1.30 per bbl of crude oil. In other words, the total protection available in shape of deemed duty for the local refiners is just US $1.30/bbl or mere 2.5% of total products, which is an insignificant protection considering the massive capital investment required to attract new entrants in the refinery sector.
Despite having deemed duty, all refineries have incurred huge losses during the last three years. If we take an aggregate for the period 2002 till December 2010, the cumulative position of all refineries excluding Parco shows a combined loss after tax of Rs 4.5 billion despite the deemed duty. This clearly exhibits insufficiency of the only protection available to local refineries, which are in true sense the strategic assets of the nation.
During the period, 1993 to 2002, under the 10-40 formula, the oil refineries received net amount of Rs 14 billion. The paid up capital of local refineries was very low and therefore they paid just around Rs 1.0 billion in terms of dividend to their shareholders. It was therefore, already an established fact before implementation of tariff protection formula in 2002, that the refineries needed some sort of protection as part of their deregulation; and the deemed duty was an alternative mechanism similar to industries like automobile and fertiliser where tariff protection is given in order for them to compete with the economies of scales conveniently dumping products in our country in the name of imports.
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