Oil bonds were invented more than a decade ago during the tenure of the United Front government when the present finance minister was serving in the same post. Arguably, they might have been a clever way of keeping rising petroleum subsidies off the government's budget books during a temporary spurt in world oil prices.

What is becoming increasingly clear is that they are an opaque and hugely inadequate response to the current problem of sustained increases (over the last five years) in global oil prices.

Let us understand why and look at some alternatives.

To begin with the obvious, the need for oil bonds, or any kind of subsidy, arises only because of the government's policy of keeping the consumer price of key distillates (diesel, petrol, kerosene and LPG cylinders) fixed over long periods of time in the face of rising international prices of oil.

The tortuous process of dismantling the decades old regime of the administered price mechanism (APM) in petroleum products came tantalizingly close to success during the NDA government.

But it didn't quite make it and the successor UPA government has firmly entrenched the system of price controls and subsidies. Once price controls are imposed, the issue of subsidies follows naturally. The only questions relate to their precise form and content.

http://www.rediff.com/money/2008/may/22oil.htm Oil to hit $200 a barrel: Indian analyst

The lure of oil bonds as the preferred form of subsidy is twofold. First, and most importantly, in our system of cash-based government budgeting (and with no obligation to publish a government balance sheet) the transfer of oil bonds to the government-controlled oil marketing companies (OMCs: IOC, HPCL [Get Quote] and BPCL [Get Quote]) can be kept off the budget. It does not affect the fiscal and revenue deficits of the central government at the time of transfer.

This is a great advantage, especially when fiscal responsibility laws mandate specified targets for such deficits.

Secondly, the cash impact of the bonds, in the form of interest payments to the holders and final repayment, is postponed and attenuated over time. From the viewpoint of the OMCs, of course, these features of oil bonds are huge negatives.

They can't use petro bonds to buy oil or defray operational expenses. The flow of interest earnings is a trickle in relation to needs and only cumulates over time. Attempts to sell the bonds for cash typically result in large discounts, that is, when they are allowed to be traded at all.

The economic consequences of petro bonds are not very similar to the obvious alternative of transparent cash subsidies from government to OMCs. In the latter case, government savings would fall (widening revenue deficit) and government borrowing requirements would increase (because of a higher fiscal deficit), with attendant upward pressures on interest rates and "crowding out" of private investment. In the oil bond case the OMCs take the hit in their profits, leading to lower taxes, lower retained earnings and lower distributed profits (to government), thus reducing public savings in all three ways.

And with less ready cash, the OMCs are driven to higher borrowings to meet their operational and investment expenses, resulting in similar upward pressure on interest rates in the economy.

To rub salt into the wound, the government is not even transferring oil bonds equivalent to the full amount of the OMCs' "under-recoveries" (a euphemism for their price-control-caused losses).

According to reports of the latest government decision relating to OMC under-recoveries in 2007/8 (fixed at Rs 70,000 crore by government), only half will be compensated by government through oil bonds, a third will be extracted from the profits of the producing companies (ONGC [Get Quote], OIL and GAIL) and the remaining 17 per cent will be "borne" by the OMCs (that is, they won't be compensated at all!).

Notice, OMCs receive their dubious oil bonds in a very tardy manner: the end-February government budget owned up to only Rs 11,257 crores of petro bond transfers, whereas the recently determined amount due for 2007/8 by the 50% formula is Rs 35,000 crore (not clear by when the remainder of this total will be transferred).

Another major anomaly of the present system is that the burden of oil subsidies falls almost exclusively on the government-controlled marketing and producing companies.

The private refiners (such as Reliance [Get Quote] and Essar) are raking in revenues exporting their products at soaring world prices. As one astute observer pointed out, what is happening is a de facto privatization of the Indian oil [Get Quote] and gas industry, with government companies being ground down by mounting losses and private ones thriving. Whether this result is occurring by accident or design is a moot question.

With world oil prices at $125/bbl (and possibly headed north) and our consumer prices calibrated at below $60/bbl (for break even), it is painfully obvious that the system is unsustainable.

"Under-recoveries" in 2008/9 are estimated to range between Rs 150,000 crore and Rs 200,000 crore! It is not just the viability of our oil and gas navaratnas that is at stake. The OMCs are finding it increasingly difficult to fund their operations. Talk of de facto rationing of diesel and LPG has already hit the headlines.

Very soon the government will find itself squeezed between the rock of having to raise prices and the hard place of rationing/queues/black markets.

What are the alternatives to the present disintegrating system? Basically, we need two things: a much more transparent and operationally viable system of subsidy (for as long as it is required) and a calibrated path to raising petroleum product prices to increasingly reflect the hard facts of global scarcity.

The switch to a transparent cash subsidy from government to OMCs can and should be accomplished swiftly. Yes, the deficit targets of the fiscal responsibility law will be breached by wide margins. But in the present environment the official deficit numbers simply hide huge repressed deficits without being able to mitigate their adverse economic consequences.

Making the hidden deficits transparent may help generate more pressures for corrective action. Perhaps more importantly, the spectre of OMC-cash-shortage-driven disruptions to supply of oil products can be laid to rest.

As for price increases, only two things are obvious. You can't make a full price correction overnight. And you can't postpone the correction for ever. If, as seems likely, the world price of oil is likely to stay above $100/bbl for the foreseeable future, Indian producers and consumers have to adjust to that hard fact of life.

Some targeted subsidies can be kept for a long time. For the rest, there really is no viable alternative to adjustment. Whether that adjustment is done over one, two or three years will depend much more on politics than economics. The longer it is postponed, the greater will be the economic damage.

The author is Honorary Professor at ICRIER and former Chief Economic Adviser to Government of India. The views expressed are personal.