Don't make hefty profits. It doesn't matter even if you are selling a product whose pricing has been deregulated by the government. That seems to be the message from the verdict by Competition Commission of Pakistan (CCP) this week.
The CCP imposed the heftiest penalty in its history on two leading fertilizer manufactures, Fauji Fertilizer Company (FFC) and Engro Corporation (ENGRO), due to what CCP calls unreasonably high pricing. Urea prices did skyrocket by 86 percent between November 2010 and October 2011 - undoubtedly a heavy blow to the end users. But why did the price increase?
The extended gas curtailment at the SNGPL network forced Engro to increase the price to offset production losses from its new plant. As rightly noted in CCP's report, gas curtailment did not hit other players such as the FFC, yet the latter followed the price increase initiated by Engro.
There is no doubt that urea market is not highly competitive, as the demand exceeds local supply, ensuring that every locally produced unit is sold. FFC found itself in good position to take advantage of the situation and cashed-in on Engro's move, knowing that it wouldn't hurt its sales as local prices at any given time are at steep discount to imported urea.
The situation would surely have not prevailed had the government kept its word on the sovereign guarantee that it gave to Engro. The reason why fertilizer market continues to be uncompetitive is because of the government's inability to provide sufficient gas - making allowance for imports of over a million tons every year.
Unsurprisingly, the profitability rose, especially for the FFC, which benefitted from the price hike without facing a major increase in input cost. Understandably, FFC registered a massive increase in gross profits, with gross margins touching 62 percent, deemed unreasonable by the CCP.
The CCP termed the one-off surge in gross margin as the highest in any other industry or any other country. This is a tall claim, and one needs to go no further than having a look at the gross profits enjoyed by OGDC for instance, which has constantly hovered around 70 percent in the past five years. In FFC's defense, it was just a result of its plant being connected to Mari network, letting it take advantage.
CCP's stance would have been understandable, had local prices gone past the imported urea prices, which was clearly not the case. Even after accounting for the subsidy on feedstock gas, local manufacturers still offer huge benefits to the farmers. The benefit to farmers provided by local manufacturers, in terms of the price differential to imported urea was Rs83 billion in 2012 - well over the amount of feedstock subsidy.
The fertilizer industry is not the one asking for feedstock gas subsidy. Instead, they are of the view that if they get their full quota of gas, urea prices would come down naturally, even without feedstock gas subsidy. The cost of gas curtailment is significantly higher than the profits made by the local players - as it costs the government Rs47 billion in FY11 alone on account of urea imports.
Furthermore, CCP's enquiry report also mentions the significantly lower urea prices in markets such as India, which is not exactly an apple-to-apple comparison. Urea is so heavily subsidized in India that it costs around $11 billion annually to their government. Surely Pakistan has no business subsidizing urea to this extent, which would cost the exchequer nearly $4 billion if prices are matched with those in India, which are currently hovering around one-fourth the urea price in Pakistan.
The ban seems harsh on local urea players, who are still pretty much observing the spirit of the Fertilizer Policy 2001 - i.e. to keep prices affordable for the farmers. The alternate option of imports is nearly 30 percent more expensive than the locally produced urea. The only way out to induce more competition in the market is restoration of gas supply to all fertilizer units, which would eventually rationalize the product prices.