Karachi, February 21, 2022 (PPI-OT): Demystifying WACOG: Simple in theory; not in implementation

The theory of two key amendments in the OGRA bill is relatively straightforward i.e. 1) remove the ring-fencing of RLNG prices and include its cost in the calculation of Weighted Average Cost of Gas (WACOG), and 2) empower OGRA to decide on price hikes, to ensure smoother transmission of cost of gas into notified gas prices.

Granular details of the implementation however require more clarity to determine the efficacy in reducing circular debt and quantifying impact on different sectors.

A negative externality we see emerging is potentially higher level of UFG losses. In addition, this will also lead to higher political noise as smaller provinces resist, what is being termed as, having to share the burden of the larger province, Punjab, where most of the RLNG consumption currently exists.

Two key amendments have been approved

The government passed two key amendments in OGRA Ordinance 2002 in both the houses of Parliament, empowering OGRA to be able to decide on gas price hikes that have not been undertaken for the last 2 years. This puts a plug on the government’s ability to neutralize OGRA‟s gas price hike proposals while remove the ring-fencing of RLNG prices, consequently giving rise to gas tariff hikes across all kinds of consumers, albeit in a piecemeal fashion for this unpopular move. Salient features of the two amendments are as follows:

I- No more to RLNG ring-fencing: OGRA gas price notification for prescribed gas prices will also entail RLNG prices as the government reclassifies RLNG as “gas” from “petroleum product”.

Recapping the onset of RNLG imports in Pakistan in 2016, the government notified that the natural gas consumers shall be exempted from bearing the RLNG burden by deciding to ring-fence RLNG related volume, price, cost of pipelines, transmission as well as UFG benchmarks instead of making it a part of Weight Average Cost of Gas (WACOG). Key reasons behind ring-fencing RLNG were: 1) to avoid inflationary pressure on the domestic consumers through cross-subsidization of gas prices and 2) to avoid double taxation through gas-tariff under the GIDC law as natural gas consumers were already paying GIDC for pipeline infrastructure. However, the ring-fencing of RLNG led to generation of various anomalies in gas distribution:

i) UFG losses determination that was supposed to be bifurcated by GasCos to ensure ring-fencing was not possible to account for, primarily because both indigenous gas and RLNG are comingled and supplied through the same distribution network and through the same consumer meters. Hence, an Estimated Revenue Requirement bases UFG allowance, based on indigenous gas supplies, was being used for RLNG, causing an excessive burden on the piling of gas-based circular debt.

ii) Both the GasCos cannot ideally have separate RLNG measurement mechanism at their Transmission and Distribution Networks which puts them in a position of arbitrarily assigning the domestically produced gas and RLNG supplied to consumers.

iii) Nevertheless, ring-fencing of RLNG was only limited to accounting judgments and systems that can be only be sufficient to estimate billing as wells as actual distribution loss.

All these were completely undermining the concept of ring-fencing the RLNG while also giving birth to additional gas based circular debt, an overarching problem of Pakistan’s economy.

II- OGRA empowerment: OGRA will now be allowed to notify gas prices with less or no government intervention and public hearing.

Pakistan has witnessed gas price hike delays and/or denouncement of OGRA’s price hike proposals over the last 2 years. GasCos, both SNGP and SSGC have a cost-plus pricing mechanism, in terms of business structure, which continues to stand unfeasible as the prescribed prices continue to stand higher than the notified prices. Resultantly, their payables towards other entities have continued to pile-up over the years. It is pertinent to note that the clause of “prescribed price for any category of retail consumer for natural gas” is being replaced with “category-wise prescribed prices as determined by OGRA” which effectively brings the RLNG price in the ambit.

Since, RLNG is comingled with indigenous gas in the system, during low RLNG-based power plant generation period, i.e. winters, other consumers with low billing rates are provided the expensive RLNG which continues to keep afloat the anomalies in RLNG billing mechanism.

Potential bearings on economy and sectors

The theory of two key amendments in the OGRA bill is relatively straightforward. The granular details of the implementation of these amendments however require more clarity and will determine the efficacy of these measures towards the intended goal of reducing gas related circular debt. In addition to this, these details will also help better quantify the impact on different sectors.

New weighted price depends on portion of RLNG included in the price?

The current cost of indigenous gas included in weighted prices stands at US$4.2/mmbtu, while the imported RLNG is costing the government ~US$13/mmbtu. RLNG currently constitutes 25-30% of the country’s gas needs.

There are reports that ring fencing will not be completely eliminated and some sectors will continue to be charged the full cost of RLNG. These sectors could include RLNG based power plants (which consume about 50% of the imported LNG) and CNG sector.

The new weighted rate will depend largely on how many sectors are still charged full RLNG pricing which will in turn reduce the proportionate impact of RLNG burden on new weighted prices. In terms of sensitivity, every 5% RLNG included in the WACOG mix, increase the weighted price by ~10% on current pricing differential. If one was to assume that all RLNG imports will be included in the WACOG, then the price will increase by more than 60% from current levels. The likely scenario however is to look at a base that the RLNG plants will be charged the full cost of RLNG. Since they consume ~50% of all RLNG imported at this point, 15% of RLNG price will be adjusted in the new weighted price – leading to overall increase of 30% in weighted average prices.

New end user prices? Depends on government policy

While the amendments mandate the authorities to recover the full cost of gas, the discretionary power would remain with the federal government on pricing different sectors. It is likely that the government will not go for a uniform price across sectors and would continue some level of cross subsidy because passing on the full impact to low income gas users will be both politically damaging and a likely source of much higher UFG as theft increases due to unaffordable rates. Also moving to a full weighted pricing would entail lowering the price for certain sectors which are already paying on time – something that the government would not want to immediately do.

We hence believe a middle ground will be struck with gradual adjustments being made to all segments to ensure that full cost of gas is also recovered and sector dynamics are not totally altered.

Which will help determine sector impact

Inflation: We believe there is a muted impact of gas price hike towards inflation as the likelihood of shielding the lowest tariff consumers is extremely high as the unpopular decision is floated in the run-up to Elections 2023.

E and Ps: OGDC holds Rs322bn (Rs75/share) of overdue receivables, 82% of which belong to the GasCos, SNGP and SSGC. On the other hand, PPL’s overdue receivables of Rs260bn is expected to have a larger chunk belonging to GasCos as it holds a higher proportion of gas revenue in topline. We believe this WACOG will likely help stem the accumulation of circular debt on E and P valuations.

PSO: The state oil company also holds a potential positive bearing from the approval of WACOG legislation as nearly 53% (Rs23/share or Rs107bn) of its overdue receivables belong to SNGP.

GasCos – SNGP, SSGC: It is imperative to understand that most of the RLNG requirement is absorbed by SNGP due to higher demand from Punjab. Resultantly, SNGP has been pushing authorities for more than 100% hike in gas tariff to overcome the losses. We believe, in the event of an effective implementation, SNGP should be able to benefit the most out of the listed Gas Cos as SSGC’s tariff hike requirement for FY22 is still under 20% from current levels. Having said that major alteration in the pricing mechanism amongst sectors could lead to higher level of UFG losses for gas utilities as the higher cost of gas forces higher leakage and theft by consumers facing a higher cost of gas under the new regime.

Cement: We don’t foresee cement sector getting impacted significantly as a result of the new gas pricing mechanism. All major cement companies have various arrangements for power generation with most companies also having dual fired plants for electricity generation which can operate on both gas and furnace oil. Moreover, most cement plants in Punjab are already being charged RLNG rates which are higher than the probable rate under the WACOG formula thus moving to WACOG would likely lower the cost of electricity generation for such cement manufacturers. Companies like CHCC and LUCK however, which get charged at regular industry rates, are likely to face a negative impact. As a general rule, a Rs100/mmbtu increment in gas rate translates into a requirement of an increase of Rs5/bag in cement prices.

Fertilizer: The fertilizer industry acknowledges that decisions like WACOG need to be taken but also proposes that the industry is then de-regulated in essence. It is unclear at the moment whether a national uniform rate would be applied on it or a separate rate would be formulated for the sector. In either case, we believe that any increase in gas prices is likely to be passed on by the industry as domestic urea prices are already at c. 80% discount to international urea prices. We also believe it is more likely that a separate weighted average rate be devised for the sector.

Let us consider three scenarios of gas price hikes, only for feedstock, being implemented in a uniform fashion. In the first scenario, gas prices increase by 30% for feed (Rs91/mmbtu) in-line with our assumption for increase in industrial gas tariffs maintaining the preferential treatment of the sector. EFERT would stand as a relative beneficiary as the impact of gas cost hike on FFC would be ~Rs107/bag, whereas EFERT would only need a price increment of Rs73/bag. We highlight ~70% of the Feed gas used by EFERT‟s base plant is charged at Petroleum Policy 2012 rates, hence a lower per bag price increment would be required. On the flipside, FFBL would have a higher price increment requirement than the two as it would incur cost on DAP production as well which can’t be easily passed on to end consumer since DAP prices are determined as per international prices.

For the second scenario, we assume rates to increase to WACOG rate increasing the feed gas rate by 2.2x. Assuming the sector would pass on the impact of higher gas cost, EFERT would benefit as impact of gas cost hike on FFC would be ~Rs787/bag, whereas EFERT would only need a price increment of Rs~539/bag. FFBL would require a higher price increment and thus would be a loser in such a scenario.

In the third scenario, we take the weighted average cost for MARI fields as per average cost of production of MARI gas fields which comes out to be US$3.4/mmbtu. This would mean almost a ~98% increment in feed gas rates for the sector. Since we are assuming the sector would pass on the impact of higher gas cost, EFERT would again benefit as the impact of gas cost hike on FFC would be ~Rs348/bag, whereas EFERT would only need a price increment of ~Rs239/bag. FFBL would be losing in all the scenarios.

Chemicals: EPCL is likely to be negatively impacted due to the WACOG legislation as the company uses a natural gas connection for its gas captive power plant at Rs 1087/mmbtu. On the other hand, companies such as DOL/SPL/ICL are likely to be positively impacted due to the legislation as the companies utilize RLNG for their production requirements. LOTCHEM is likely to be unaffected as the company receives gas under the export-oriented category.

Glass and Ceramics: TGL and GHGL both are likely to be positively impacted from the WACOG legislation as the companies primarily use RLNG to meet their fuel requirements. TGL however, also has alternative sources such as FO and the company uses whichever is cheaper, while GHGL operates its container glass facilities using natural gas. GHGL’s float glass facilities are operated using RLNG. STCL on the other hand is likely to be negatively impacted as the company uses natural gas for its production process.

Textile: During the same time, the government has also approved the new Textile Policy 2020-2025, which has linked the energy rates to be provided to the textile sector at regional competitive rates from FY23, which will remain fixed on an annual basis during the Federal Budget announcement. At present, the textile sector was provided gas at a fixed price of US$6.5/mmbtu. As various studies report Pakistan’s energy rates are on a higher side as compared to the regional countries (average: US$4/mmbtu), we do not expect any potential increase in gas price for the textile sector as a result of the recent OGRA amendments.

Political pushbacks likely

While the current move to get the OGRA Amendment Bill 2021 has come through, it is pertinent to note that the three major gas producing provinces, KPK, Sindh and Balochistan are at loggerheads with Punjab to bear the burden of expensive RLNG via WACOG.

There still stands a requirement of constitutional amendment as Article 158 of Constitution of Pakistan protects the interests of these provinces, and we expect the provincial governments to shrug it off via court order and push the bill into doldrums.