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Oil prices have been rising in India. It has crossed `100 in some places in Rajasthan and Madhya Pradesh. Different states levy different rates of Value Added Tax (VAT) and the central government levies excise duty and cess on petroleum products. Therefore, the prices of petrol, diesel, cooking gas (LPG) have been rising continually.

How are petrol and diesel prices are determined

It is known that oil prices are now decontrolled. So international prices of oil should be the major determining factor of oil prices in India. But that has not been the case. There are several items that determine the retail prices of oil. The items are the international price of Brent Crude oil, ocean freight and domestic currency exchange rate. Secondly, there is also the oil marketing companies’ basic cost which includes refinery processing and their margins, freight cost and logistics cost. Thirdly, there are the central government taxes like excise duty and road cess. Fourthly, there is the petrol pump dealer commission. Fifthly, there are the states’ VAT and additional cess on diesel.

The Government of India collects `32.98 per litre of petrol as excise and for diesel the figure is `31.83. The VAT collection rates are different in different states. It is on an average 30% on basic value on petrol and 16.75% plus cess on diesel. In the past year, both the central government and the state governments (baring a few states) have increased taxes and VAT on oil to very high percentages. This has increased the revenue of the states and central governments. 

Possible reasons for rising oil prices

There are three ways through which oil prices may increase. One is due to rising international prices of petroleum products. Two, prices of oil may change due to change in exchange rates (rupee versus US dollar). This means India has to pay more rupees to purchase the same quantity of oil as compared to the earlier situation. Thirdly, a situation may arise where the international prices of oil and exchange rates are constant but there is a rise of prices of oil in the domestic market. This is possible only when the government levies more taxes on oil to raise higher revenue. The present situation in India reflects the last proposition.

Some important observations on correlation between oil price and inflation

1) There is a common notion that the rising oil prices can increase the levels of inflation in an economy because it causes the cost of inputs of production to rise.

2) Global observation shows that there had been a strong cause and effect relationship between inflation and oil prices during thr1970s.

3) But since the 1980s, the cause-and-effect relation between inflation and oil prices has diminished.

4) In the later phase, the Producer Price Index (PPI) which measures the price of goods at the wholesale level has a stronger correlation with oil prices. In this context, an observation published in the media is very important. Between 1970 and 2017, the correlation between oil prices and PPI was found to be 0.71 which is a strong correlation. This has been an observation of a study of the Federal Reserve Bank of St. Louis.

5) But the correlation between oil price and the Consumers Price Index (an important measure of inflation) was only 0.27 between 1970 and 2017. The gradual fall of correlation between oil prices and inflation may be due to the diminishing importance of use of industrial products and rising use of services in life - according to some economists.

The Indian context

Adity Nayar, Principal Economist, ICRA, has pointed out earlier that ICRA estimated that every `2/litre cut in the excise duty on petrol and diesel would have reduced the Indian government’s excise duty collection by `280 to `300 billion on an annualised basis in FY 2019. If excise duty on fuels was cut to absorb a portion of the price rise, it may have made it difficult for the government to meet the target for indirect taxes in FY 2019’s budget expenditure. However, ICRA assessed the likelihood of a reduction in excise duty on fuels to be low - unless crude oil prices cross $80-85/barrel. But this assessment was done more than a year ago. In the present situation, the price of fuel in the international market is low - $ 63/barrel as of now. But when the price of it came down to $18.38 on April 20 ($64.65 in January20, $55.66 on February 20 and $32.01 on March 20) due to the global lockdown, the price of fuels in India was not only high but also rising. Therefore, the main reason for the rising oil prices cannot be linked with international prices of crude oil. Rather, it is linked with the government’s policy of using fuel taxes to earn higher revenues to contain the fiscal deficit in the pandemic-ravaged Indian economy.