People's Democracy

From 2G to KG – India, Mega Scams & Neo-liberalism

Prabir Purkayastha

AS we discussed in the June 19 issue of People’s Democracy, there are various dimensions to the KG Basin Gas scam. In this article, we will focus on two issues – one is the impact of share of revenue due to inflating of capital costs, the other one specific item of the increase to indicate how the books have been cooked to benefit Reliance.

As we had noted earlier, the Production Sharing Contract (PSC) has many elements to it. One area is how much of the exploration area that the private party getting the production license can retain; the other is how the profits are to be shared after taking out the costs. We have already seen how Reliance retained the entire exploration area in violation of the PSC. In this section, we will see how Reliance increased its share of profits by manipulating the capital costs.

In the PSC, the petroleum (or gas) produced is specified as cost petroleum or profit petroleum. The cost petroleum is composed of unrecovered cost of exploration and development, royalty and production cost. If this is more than 90 per cent of the total petroleum produced, then cost petroleum is capped at 90 per cent and the rest 10 per cent is considered as profit petroleum. As the capital cost is recovered, the share of profit petroleum increases till all the capital costs are recovered. After this phase, cost petroleum is restricted to royalty and production costs, unless new capital costs are incurred.

The profit share of Reliance and the government is determined by a number called the investment multiple. This is the ration of cumulative net income to cumulative capital investment in the project. Obviously, as cumulative revenue increases over time, as the capital investment becomes constant, this ratio increases as more petroleum is produced. The PSC asked for bids from different parties for the profit share they were offering to the government based on the Investment Multiple (IM). Reliance had committed the following in its bid:

The government's share in profit for any year would depend on the IM of the previous year; if Reliance could manipulate the IM such that it increases slowly, then it would retain the major share of the profits.

The capital cost increase that Reliance did – from $2.5 billion to 8.8 billion for increasing gas output from 40 MMSCD to 80 MMSCD – almost three and a half times increase for only a doubling of output does precisely this. It lowers the IM as the denominator has increased by three and a half times now while the numerator has only doubled – it skews the IM making it come down far more slowly than in the original bid and changes the profit share between Reliance and the government completely. It also makes the original bid evaluation a complete farce as the basic parameters of evaluation change completely with such a change in the IM.

If we rework the original figures of the profit with the revised capital cost and IM, the contrast is quite startling. For doubling of production, obviously the revenue also doubles. After taking out the inflated capital cost of $8.8 billion, the profit petroleum (assuming a 12 year life) also almost doubles. However, Reliance gets almost three times its original share while the government's share increases marginally. Even worse, as the government's share is received later, the net present value of such future earnings (using the usual discounting method and a discount factor of 10 per cent) remains virtually the same.

If we now look at the gas pricing issue, it is clear that Reliance had a two-fold strategy. If only gas price had increased, this would also have benefited the government, as its share would have gone up in the profit petroleum. It might still have had to shell out large amounts in fertiliser and power subsidies, but at least on this contract, would have made much more money. The second part of Reliance strategy was to increase the capital cost, by which the share of Reliance profits increases but not that of the government. From the increased about $ 14 billion of extra revenue, Reliance receives almost $ 12 billion, while the government gets a measly $ 2 billion. If we consider the Net Present Value (discounted value)  of the earnings, the governments' share is almost constant at $ 5.5 billion, while Reliance's goes up by about $6.5 billion – the entire increase in Net Present Value terms.

In the above calculations, we are not talking about grabbing extra money through sweetheart deals – inflating capital costs and then receiving a part of this increase in under-hand ways. We are only talking about what happens to the share of the profits between Reliance and the government after taking out the inflated capital costs. What the table below shows is that the Production Sharing Contract has a built-in, perverse incentive to pad capital costs. Even if there are no sweetheart deals, placing orders at a higher capital costs help Reliance in getting a larger share of the profits.

The CAG report has pointed out that the production sharing contract completely distorts the revenue sharing arrangement. Not only does Reliance not benefit by controlling costs, it actually is helped greatly by increasing costs. As can be seen from the above, even without any kick-backs and only through inflation of capital costs, Reliance gains greatly – it gets almost the entire increased production as its share of revenue.

The CAG has suggested that the existing Production Sharing Contract be scrapped and a new method of sharing revenue should be worked out. Looking at the figures, it is clear that these contracts are completely against the interests of the Indian people and must be scrapped immediately.

INFLATING

CAPITAL COSTS

The CAG draft report has not done any detailed calculations of how the costs have been inflated but has pointed out that various contracts have been arrived at completely arbitrarily. It has indicated that it will do a second round of audit where it will examine the capital costs of various packages. In this article, we will only examine one element of cost in Reliance's capital costs.

The most flagrant cooking of cost figures by Reliance is that for a Floating Production Vessel for the MA oilfield. It appears that this was a $26 million tanker, converted to a Floating Production and Storage Vessel and taken by Reliance on a 10-year bare-boat lease for 1.1 billion plus another 200 million for operating costs. Let us look at what a production vessel is and what are its costs.

Floating Production Storage and Offloading Vessels can be either manufactured entirely from scratch or converted from a tanker. In this case, Aker Floating Production converted a tanker --188,697 Ton tanker, the ST. Polar Alaska, -- it bought for $ 26 million to what it calls as a Aker SMART 1 FPSO Vessel. The question is what was the cost of this conversion?

Jurong Shipyard, Singapore, in a press release dated May 18, 2007 had given the combined cost of conversion of the oil tanker that Aker bought and another vessel as $88 million. That means that the cost of conversion of the tanker is at best two thirds of this cost – the maximum cost of this conversion would have been around $60 million. The press release indicates that the conversion included all the equipment and refurbishment required for converting the tanker. It stated, “Modification works on the FPSO Aker Smart 1 involves the installation of an internal turret, three units of 5MW steam turbine generators and another three units of 5MV gas turbine generators and new process facilities, which include crude separation and gas compression and the upgrading of the entire piping and electrical systems.” We cannot see any other major cost that would be incurred in conversion of a tanker to a FPSO.

It is clear from the above that the total cost of this conversion of the tanker to an FPSO vessel was less than $100 million. So why did Reliance shell out $1.1 billion for a 10-year lease of this vessel?

CAG draft report has pointed out that in this case, that this order was placed well before the submission for approval of the Field Development Plan, let alone its approval. CAG has also pointed out numerous problems in award of this contract including that Aker Floating Production seems to have been incorporated by the parent company just for this contract and did not meet any of the qualifying requirements set out in the specification.

As we have noted earlier, the capital cost issue is not merely that of skimming off the top by incurring fictitious or inflated capital expenditure. It changes the revenue share completely. The problem is that what happens if the government, which is supposed to protect its interest, starts colluding with the private contractor?

There are some mechanisms in place for some protection of people’s interests. However, as the CAG has pointed out, they are weak and partial. There is officially a management committee in which the government has 50 per cent nominees (2 out of 4). They are supposed to oversee all major decisions. However, they seem to have been either in collusion or sleeping at the wheel when Reliance was doing such major cooking of the books. Further, any major expenditure should be a part of the Field Development Plan and needs to be approved by the DGH and the ministry. Again, not only this did not happen, both DGH and the ministry seems to have allowed Reliance to take capital investment decisions without getting these approved. They not only did give post facto approval of decisions that Reliance  had already taken, but did so with just a cursory examination.

CAG's draft report has also held that the Production Sharing Contact being followed by the government of India has much weaker controls on the capital costs, unlike for example, Bangladesh, where a similar management committee, which has 50 per cent government nominees as in India, has to approve any expenditure above $500,000.  Such controls are entirely lacking in the Indian Production Sharing Contract.

All this goes to show that the existing production sharing contracts are heavily skewed in favour of the private players. The CAG draft report has shown similar problems in the Cairns Rajasthan contract as also the Panna Mukta Tapti contract. Instead of making any attempt to redress the problems raised by CAG, the government is in its familiar 2G mode – blanket denial anything is wrong and acting as spokespersons of the private parties.

The question of fighting corruption and corporate loot is not just that of a Lokpal Act. Undoubtedly, a strong Lokpal law would help. But even without this, people need to come together to force the government to act. It should force this government to expedite the probe against the former DGH VK Sibal, against whom CBI already has gathered evidence. There needs to be an immediate demand to scrap the production sharing contracts and a thorough probe into the fancy capital costs claimed by Reliance, Cairns and others. The time has come to clear the Aegean stables in the ministry of petroleum. Otherwise, India's quest for self-reliance in hydro-carbons would turn into that of only Reliance.