Negative freight margins in the price of fuel ?

Documents reveal that the regulator has imposed penalties on refineries through IFEM adjustments, but how does this work?

By Ahmad Ahmadani & Asad Ullah Kamran

Every litre of fuel you consume no matter where you are in Pakistan has the same selling price – the one determined by the Oil Gas and Regulatory Authority (OGRA). The cost of transporting fuel to different parts of the country is, however, not the same. It obviously costs more to transport fuel to the north of the country, given that it mostly lands or is refined in the southern ports.

To ensure the price remains equal, the regulator has a pricing mechanism called the Inland Freight Equalisation Margin (IFEM). Don’t worry, it isn’t as complicated as it sounds – and by the end of this, you’ll get the gist of it, and something else very interesting about it.

This margin is charged on every litre of fuel we purchase. Now a question might arise: Why is this margin equal across the board, since a litre of petrol sold all the way up north in Gilgit would have significantly higher transport costs as compared to the same litre of petrol sold in Karachi.

To simplify these complicated calculations, which will be explained in more detail below, what you need to understand is that the costs of freight or transportation are averaged and then accumulated in a mutual pool of funds. The pool is then dispersed between different oil marketing companies (OMCs) based on each individual company’s cost of freight.

So far this is routine. But what happens if the margin is negative? After every two weeks OGRA issues a notification announcing the prices of fuels for the upcoming fortnight. In September of last year, in one of these notifications where the prices of fuels were announced, Profit noticed an interesting peculiarity in the breakdown of the new price, a negative IFEM.

What this essentially means is that OMC’s are bearing the cost of transportation, and the benefit is being reaped by the consum- ers in the form of lower fuel prices.

To explain how we got here, Profit went digging. So basically the fuel you’re getting at a petrol station might not be what you think. According to the industry standard, the fuel has to have a Real Octane Number (RON) 92, whereas in reality that is not always the case.

Based on this, OGRA imposes fines on some refineries who produce fuel that is not in line with the standard highlighted by the regulator. According to one source within the industry, “in the last two years approximately a penalty of 2 billion has accumulated on [some] refineries”.

The build-up of fuel prices more recently has started reflecting a negative IFEM. In September, 2022, the price build up of diesel included an IFEM of negative Rs 1.76, which is odd given the purpose of this margin.

This marked the beginning of a new style of control the government imposes over fuel prices. Since the start of October last year, there’s been a negative IFEM on diesel, and similarly on two occasions the price of petrol also reflected a negative IFEM.

This penalty is in line with the rules laid down by the regulator which states that a penalty would be imposed on the production and sale of fuel that is of lower quality than the prescribed standard.

To understand this better, we need to understand how the margins work.

How does IFEM work?

The IFEM was first introduced back in 2006. It was a measure introduced by the government to maintain consistency in the pricing of fuel in different parts of the country.

According to documents published by OGRA, regardless of the distance travelled, the mode of transportation employed, or the associated transportation costs, this mechanism was used to ensure equalised rates at the 29 Depot Locations across the nation.

A “Product Movement Plan (PMP)” is prepared by each OMC and presented to the OCAC IFEM Sub-Committee. The PMP balances supply and demand across different regions by matching supply sources with the various regions of the country.

According to policy directives issued by the Ministry of Petroleum, the “IFEM is to be recommended by the OCAC under the self management system”.

To cross check this recommendation, OGRA has decided to set up six monthly independent audits that will cover all of the IFEM system’s formalities and functionalities to ensure “the authenticity and transparency” of the system.

Based on the PMP for 29 depots/locations, area-wise volumes, and the most cost-effective mode of transportation for each product across the three possible modes, (namely pipeline, rail, and road) the cost for each OMC is determined.

Applying location-based freight rates to PMP volumes yields the product-specific OMC mentioned cost. Product-specific industry noted costs, also known as OMC IFEM, are determined using a weighted average of OMC specific noted costs.

Negative IFEM?

Now common sense would dictate that the freight margin would always be positive given the fact that any transportation of fuel from one part of the country to another would involve certain costs. But that hasn’t been the case over the recent past.

At this point, it’s first imperative to understand the rules and regulations dictating operations in the industry. According to official documents received by Profit, the negative IFEM is a reflection of the “RON (Real Octane Number) Penalty Factor” imposed on refineries.

You might ask what the “RON Penalty Factor” is. It is essentially an indicator for the quality of the fuel. According to the industry rules laid down by the regulator in 2016, OMC’s and refineries are “allowed to import a minimum 92 RON PMG (Premier Motor Gasoline)”.

In these documents the pricing of fuel is based on Pakistan State Oil’s (PSO) actual landed import price of the 92 RON fuel, other refineries and OMCs would also price their products on “the basis of PSO actual landed import price, as per the current practice”.

According to sources in the Petroleum Division, however, domestic refineries do not have the necessary configuration to meet the standards established by the regulator. In 2016 when these rules were introduced a waiver of two years was given to the refineries to upgrade their machinery to comply with the new fuel quality standards.

During this time frame, refineries were given relaxation in terms of quality standards of the fuel only under the understanding that refineries will reconfigure their machinery to produce the 92 RON standard fuel.

The same source in the Petroleum Division stated that there are currently five refineries in Pakistan, only two out of these five, namely Parco and Cynergyico Pk Limited are producing RON 92. The other three, Pakistan Refinery Limited (PRL), National Refinery Limited (NRL) and Attock Refinery Limited (ARL) produce RON 90, 91 and sometimes 92.

The quality of the fuel is also based on the type of crude available, and other technical factors are also involved. The documents that Profit have at their disposal also elaborate how local OMCs acquiring fuel from these refineries can blend imported better quality fuel with local fuel to “improve the specification of the retail product to around 90-92 RON PMG”. However, to make it clear, there is no obligation on refineries to blend the product prior to selling it to OMCs.

Now, as for how the RON penalty factor works, it is “derived from the actual difference between monthly average FOB (Free on board) US $ per barrel price of PMG 92 RON and PMG 95 RON as per Mean of Platts Singapore (at the time now it is determined through the Platt’s Oilgram)”.

To illustrate how it works consider this example, if the FOB price of 95 RON PMG is quoted at say $ 50 per barrel and the price of 92 RON PMG is quoted at say $ 45 per barrel the difference is of $ 5. Now this is divided by 3 to arrive at the “per unit RON Penalty Factor”, which would yield a value of $ 1.6.

To arrive at the penalty amount for 90 RON PMG, the per unity penalty factor is multiplied by the difference in RON values, for 90 RON it would be multiplied by 2. Whereas in the case of 87 RON it would be multiplied by 5.

To summarise this example, through the information in the documents, “under the prevailing equalised petroleum products pricing system, the ex-refinery price for PMG 87/90 RON will be the same as that of PSO actual landed import price of 92 RON PMG subject to RON penalty differential adjustment in monthly pricing/IFEM mechanism by OGRA”.

Another confidential report received by Profit also corroborates OGRA’s explanation above.

In these documents, it is stated that, “the adjustment of refineries Mogas RON differential of Rs 264.90 million has been made in PSO’s Mogas noted cost of February, 2023, to reduce the burden on general consumers.”

The document further breaks down the penalty amount levied on various refineries. Attock Refinery Limited accounts for 46.9% of the total at Rs 124.3 million, Pakistan Refinery Limited and National Refinery Limited are required to pay Rs 53.7 million and Rs 86.6 million respectively.

Now even though we as the consumers are getting the benefit of a lower fuel price from the fines imposed on some refineries, there is however some inequity or inefficiency here. If two people purchase fuel at two different petrol stations and one of the fuel stations is selling fuel at a lower octane number, it would mean that one of the consumers would gain a higher benefit by getting the regulated quality fuel (92 RON) from the petrol station at a lower price. Whereas the other consumer is getting fuel at the same price, but would be getting a lower quality fuel for the same price.

The inequity in the disbursement of a benefit to the consumers is somewhat unsettling, and even though billions of rupees have been passed on to the end consumers, very little attention has been paid to this. n