India - Petroleum Transport Project

Document of The World Bank FOR OFFICIAL USE ONLY 6c/AJ 3o ,L-A/ Report No. 7588-IN STAFF APPRAISAL REPORT INDIA PETROLEUM TRANSPORT PROJECT APRIL 6, 1989 Transport and Energy Operations Division Country Department IV Asia Regional Office This document has a restricted distribution and may be used by recipients only in the performance of  CURRENCY EOUIVALENTS Currency Unit - Rapee (Rs) Rs 1 - 100 P'isa US$ 1 - Rs 14.6 Rs 1 US$0.0685 Rs 1 million US$68,493 FISCAL YEAR April 1 - March 31 MEASURES AND EQUIVALENTS 1 Metric Ton (mt) - 1,000 kilograms (kg). 1 Metric Ton (mt) - 2,204 Pounds (lb) 1 Meter - 3.28 Feet 1 Kilometer (km) - 0.62 Miles 1 Cubic Meter (m3) - 35.3 Cubic Feet (cft) 1 Barrel (Bbl) - 0.159 Cubic Meter, 42 gallons 1 Metric Ton of Oil (330 API) - 7.3 Barrels 1 Normal Cubic Meter (Nm3) of Natural Gas - 37.32 Standard Cubic Feet (SCF) 1 Kilocalorie (kcal) - 3.97 British Thermal Units (Btu) 1 Bbl/d - 1 Barrel per day PRINCIPAL ABBREVIATIONS AND ACRONYMS USED BCM (BCF) - Billion cubic meters (feet) DEA - Department of Economic Affairs, Government of India EIL - Engineers India Limited ERR - Economic rate of return GOI - Government of India IDC - Interest during construction IRR - Internal rate of return IOB - Indian Oil Blending Ltd. IOC - Indian Oil Corporation Ltd. LPG - Liquefied petroleum gas MCM - Million cubic meters MCM (MCFD) - Million cubic meters (feet per day) MMCMD (MMCFD) - Million cubic meters (feet) per day MMtoe - Million metric tons of oil equivalent MMTPA - Millions of metric tons per annum NGL - Natural gas liquids NPV - Net present value OIL - Oil India Limited ONGC - Oil and Natural Gas Comamission SBM - Single Buoy Mooring System toe - (Metric) ton of oil equivaleni TCF - Trillion cubic feet  FOR OMCIL USE ONLY INDIA PE:ROLEUM TRANSPORT PROJECT Table of Contents Page No. I. THE SECTOR................................................... A. The Overview .1 B. Energy Demand ................1..... .. 1 C. Energy Supply. 3 D. Energy Balances. 6 E. The Government's Energy Strategy .8 F. Pricing Policies for Oil Products. 9 G. Investment Strategy: Increased Reliance on Oil Product Imorts .11 H. Transport of Petroleum Products in India .12 T. Involvement of the Private Sector .14 J. Management of the Sector .15 K. Bank's Role in the Sector .15 II. THE BORROWER .................................................. 17 A. Introduction .17 B. Organization and Mangement .17 C. Operating Performance .18 D. Accounts .18 E. Audit .19 F. Insurance Practices .19 G. Remuneration and Pricing System .20 H. Investment Program .20 III. THE PROJECT .22 A. Background and Objectives .22 B. Project Description .22 C. Status of Project Preparation... .......................... 24 D. Capital Cost Estimate .25 E. Project Financing .26 F. Project Iplementation .27 G. Procurement .28 H. Disbursements .31 I. Ecology and Safety .31 J. Project Reporting Requirements .32 K. Project Risks: .33 This report was prepared by Messrs. L. Wijetilleke (Sr. Chemical Engineer), P. Blackshaw (Principal Transport Economist), A.S. El-Mekkawy (Principal Petroleum Engineer), P. Pollak (Sr. Economist), M. Sergo (Sr. Financial Analyst) and H. Schober (Consultant) on the basis of an appraisal mission that visited India in October 1988. This document has arestricted distribution and may be used by recipients only in the performance of their official duties.lIts contents may not otherwise be disclosed without World Bank authorization.  - ii - Page No. IV. FINANCIAL ANALYSIS .. . 34 A. Introduction .. 34 B. Pricing System .. 34 C. IOC's Finances .. 35 D. Financial Covenants .. 39 E. Project Financial Evaluation .. 39 V. ECONOMIC EVALUATION ....................... 41 A. Introduction ....................... 41 B. Economic Evaluation of Khandla-Bhatinda Product Pipeline.. 41 C. Economic Evaluation of Single Buoy Mooring System ......... 43 D. Economic Evaluation of Refinery Components ................ 45 E. Overall Resultr of the Economic Evaluation ................ 46 VI. AGREEMEN,S AND RECOMMENDATIONS ................................ 47 ANNEXES 2.1 Organization Chart 2.2 Performance Indicators 2.3 Pricing and Margins 3.1 Project Cost Estimates 3.2 Project Implementation Schedules 3.3 Disbursem--nts 3.4 Pollution Control 3.5 Progress Reporting Requirements 4.1 Notes and Assumptions for Financial Statements 4.2 Income Statements, Balance Sheets & Funds Flow Statements 4.3 Financial Rate of Return Calculations for Pipeline 4.4 Financial Rate of Return Calculations for SBM 4.5 Financial Rate of Return Calculations for Catalytic Reformers 4.6 Financial Rate of Return Calculations for DDCS 4.7 Financial Rate of Return Calculations for Haldia Lube Block 5.1 Supply-Demand Balance of Products in North-West 5.2 Economic Cost Rail Transport Alternative: Kandla-Karnal 5.3 Product Loss Avoided: Kandla-Karnal 5.4 Economic Cost Rail Transport Alternative: Karnal-Bhatinda 5.5 Economic Evaluation Product Pipeline - Kandla-Karnal 5.6 Economic Evaluation Product Pipeline - Karnal-Bhatinda 5.7 Economic Evaluation Product Pipeline - Kandla-Bhatinda 5.8 Estimation of Economic Benefits for SBM 5.9 Economic Evaluation of SBM 5.10 Economic Evaluation of Catalytic Reformers S.l1 Economic Evaluation of Distributed Digital Control Systems 5.12 Economic Evaluation of Haldia Lube Block MAP No. IBRD 21079 - Showing Proposed Petroleum Products and Crude Oil Supply System.  - iii. - INDIA P TROLEUM TRANSPORT PROJECT Loan and Project Summary Borrower: Indian Oil Corporation Ltd. (IOC) Gua-rantor: India, acting by its President ha=m t: US$340.0 million equivalent Lending TeDms: Twenty years, including five years grace, at the standard variable interest rate. Guarantee Fee: Consistent with the Government's terms for loan guarantees to public sector enterprises. Proliect Des ription: The objectives of the Petroleum Transport project are to: (i) improve the efficiency and flexibility of petroleum transport; (ii) facilitate import of petroleum products and crude; and (iii) modernize IOC's pipeline and refinery operations. In particular, the project will provide financial support for: - a 1,450 km products pipeline from the port of Kandla to Bhatinda; - a Single Buoy Mooring (SBM) system at Salaya; - facilities to reduce the lead content of gasoline in two IOC refineries; - distributed digital control systems (DDCS) in IOC's refineries; - two 15 MW gas turbine power generators for the Digboi Refinery; - equipment and services required to improve product yield and energy conservation in refineries; - expansion of the lubricating oil complex and provision of a sulphur plant at the Haldia Refinery; and - consulting services for pipeline inspection, energy conservativn and yield optimization studies and training.  - iv - Proiect Benefits: The pipeline offers substantial savings in transport costs compa-'d to the next best alternative, rail transport. The SBM will improve the security of petroleum products supply to the nortnwest of India; other project components will improve refinery efficiency and have a beneficial environr.ental impact through energy conservation and reduced lead content in gasoline. As a reoult of the project, IOC will also get access to modern petroleum industry technology and management practices, particularly in key operational areas such as computerization, process corntrol and simulation, and production optimization. Proiect Risks: Cost over-runs and delays in project completion constitute the major project risks. The economic impact of the project is relatively insensitive to cost over- runs. A 10% cost over-run would lower the overall project rate of return from 26% to 23%. The project is more sensitive to implementation delays but the economic rationale remains robust to the likely range of risk: a two year delay would reduce the overall rate of return to 21%. Errors in demand projections are another source of risk. As product imports are the balancing item in meeting the demand-supply gap, only the Kandla-Bhatinda pipeline, which is intended for products would be affected. If the rate of growth in demand is 25% less than projected the rate of return will fall from 22% to 18%. The project reduces environmental risks; remainin. are minimized as strict environmental standards are enforced.  v Estimated Costs: Local Foreign Total -(US$ million) ----- Transport Facilities Khandla-Bhatinda PIL 269 179 448 Second SBM 5 7 12 Cat. Reformer at Barauni 38 9 47 Cat. Reformer at Digboi 15 3 18 Dist. Digital Control System 61 35 96 Power Plant at Digboi 2 16 18 Yield Optimization & Energy Conservation 20 14 34 Haldia: Lube Block & Sulphur Plant 10 6 16 Sulphur Plant 6 - 6 Techn. Assist. & Training 7 7 14 Base Cost 433 276 709 Physical contingency /a 43 28 71 Price contingency Lb 100 64 164 Total Project Cost 576/c 368 944 Interest During Construction: Bank loan - 46 46 Other loans 7 12 19 Total Finakicing Required 583 426 1,009 /a 102 of base cost. lb 212 of base cost and physical contingencies. ic Includes US$185.0 million or taxes and duties.  - vi - Financing Plan: I ~~~~~~~~~~~~~~Lgcal Fo-reig Total ----- (US$ million) ----- IBRD 47 293 340 Export and Suppliers Credits -- 75 75 IOc 536 58 594 Total financing Reauired 426 l Estimated Disbursements: IBRD Fiscal Year FY90 FY91 EY 9 M4 Annual 35 110 130 50 15 Cumulative 35 145 275 325 34b Economic Rate of Return: Kandla-Bhatinda Pipeline 22% SBM 29% Distributed Digital Control System 42% Catalytic Reformers 20% Haldia Lube Oil Block 48% Overall Project (weighted average) 26%  T. THE SECTOR A. Overview 1.1 Energy is critical for accelerating the growth of the Indian economy. As part of its efforts to reduce poverty and provide employment to a rapidly growing labor force, the Government decided to step up the growth of the economy from its currpnt average rate of about 4.5Z to 6Z during the Eighth Five Year Plan (1990-95). One of the major obstacles to accelerating economic growth will be the widening gap between the demand for energy and indigenous energy production. This poses a serious dilemma for the Government's economic planners. Closing the gap through energy imports would result in a heavy drain on foreign exchange. Allocating a larg!r share of domestic resources to increasing indigenous energy supplies would deprive other sectors, particu- larly the social sectors, of increasingly scarce resources. Rationing of energy supplies, or the other hand, would lead to serious disruptions in the economy. 1.2 There is currently a lively debate within the Government about the strategy India should adopt in dealing with this widening energy gap. Increasingly, the wisdom of the Government's current energy strategy, which had evolved in response to the sharp increase of internaticnal oil prices during the 1970s, is being questioned. The main thrust of this strategy continues to aim at reducing the use of oil products through energy conserva- tion, and substitution of domestic coal for oil products where this is techni- cally and economically feasible. Initially this strategy was quite success- ful. Despite the efforts to slow the growth of energy demand through various conservation measures and pricing, demand for energy outpaced economic growth. The availability of vast, albeit low-quality, coal reserves and the discovery of the Bombay High oilfield, however, made it possible to meet the growing domestic demand for energy, and at the same time reduce the dependence on oil imports. 1.3 In the years ahead, India may again face the possibility of a major increase of oil imports for two reasons. First, output from the Bombay High oilfield, which represents about 70? of domestic oil production, has now reached a plateau. Second, continued investments in oil and gas exploration by India's two national oil production companies, the Oil and Natural Gas Commission (ONGC) and Oil India Ltd. (OIL) have not led to any major new oil discoveries. The proposed project would, through the construction of infrastructure facilities for the transport of oil products, assist India in meeting its oil product requirements increasingly through purchases in international markets. B. Energy Demand 1.4 Demand for energy in India is closely linked to the pace of economic growth. The acceleratioh of economic growth that has taken place since the early 1980s has led to a sharp increase in the demand for energy, in particu- lar commercial fuels (i.e. oil products, coal, natural gas and electric power). Since the beginning of the Sixth Five-Year Plan (1980-85) the economy grew at an average annual rate of about 4.9 2 while the consumption of commer- cial fuels has grown at 7.32 per annum. This increase in the rate of energy consumption has been associated with a greater reliance on the use of oil  -2- products: while coal continues to account for more than 502 of energy consumption, oil products now make up about one-third of all commercial energy consumed, and hydro-electric power and natural gas account current.y for 11.72 and 5.92 of commercial energy consumption, respectively. 1.5 The factors that contribute to the rapid growth of India's energy demand fall into two broad categories,--those leading to the comparatively high energy intensity of its industrial, transport and agriculture sectors, and tho!e resulting in a shift from traditional fuels to commercial fuels. 1.6 High Energy Intensity. India's industrial sector, its transport sector, and increasingly also its agricultural sector are highly energy inten- sive. Several factors have contributed to the high energy intensity. One such factor has been the Government's policy of economic self-sufficiency. As a result of this policy, India has developed a wide industrial base. Highly energy intensive industries, such as steel, aluminum, copper, cement, petro- chemicals and fertilizer were set up when energy was comparatively inexpen- sive. Scarcity of capital has restrained these industries from replacing their energy intensive equipment, in spite of the steep rise of domestic energy prices since the early 1970s. In terms of energy intensity, India's industrial sector ranks now near the top among developing countries, and well above the average among industrial countries. 1.7 A second factor has been the Government's policy to ensure that all regions participate evenly in the benefits of economic growth, in particular employment opportunities. This policy continues to play an important role in decisions about the location of new industrial plants. As a result of this policy, industrial plants are widely dispersed all over the country. Since their access to the rail and road network is usually poor, they have to rely mostly on electric power to meet their energy needs. Partly as a result of this policy, India has developed an energy supply system that relies heavily on coal-based thermal power generation. Considering India's generally inade- quate transport systent, it is the only way to provide widely dispersed consumers with access to the country's abundant coal resources. Because of the high losses that occur in thermal power generation as well as in the transmis- sion and distribution of power, this policy contributes significantly to the high energy intensity of the economy. 1.8 A third factor has been the Government's efforts to shield the economy from the variations in rainfall caused by the monsoon. Massive investments in irrigation and widespread use of electric- and diesel-driven pumps, together with the increased mechanization of agriculture, have contri- buted to the growing energy intensity of India's agriculture. 1.9 Shift from Traditional to Commercial Fuels. While the share of i commercial fuels in India's energy c,asumption has increased sharply, tradi- tional fuels, such as fuel wocd, cow dung and vegetable wastes remain India's most important energy resources. In 1986/87, non-commercial fuels accounted ! for more than 502 of India's total energy consumption. Consumption of these fuels was equivalent to about 110 million tons of oil or about five times India's domestic oil production. Fuelwood accounts for roughly two-thirds of the consumption of traditional fuels. The remaining third consists of vege- table wastes and cow dung. In rural areas, fuelwood remains the main cooking fuel, while kerosene is mainly used for lighting. In urban areas, fuelwood is  increasingly being replaced by kerosene, electricity and LPG (liquified petro- leum gas) as a cooking fuel. Still, its comparatively low price makes fuel- wood an attractive fuel for the urban poor. 1.10 Since the steep increase in domestic oil prices during the 1970s, thte demand for fuelwood has increased sharply. Forest recerves have declined, and many regions in India experience severe shortages of fuelwood. In many regions, these shortages accelerate the depletion of forest reserves; they also force large segments of the rural population to spend more and more of their time in collecting fuel wood; and they reduce crop yields as poorer farmers have to divert an increasing share of animal wastes from use as ferti- lizer to serve as cooking fuel. To slow the process of deforestation, the Government is subsidizing the use of kerosene, which, in turn, results in high demand for this product. C. Energy Supply 1.11 Considering the size of the Indian economy and its population, India is relatively modestly endowed with energy resources. Its per capita use of energy is among the lowest in the world. and, in spite of allocating almost one-third of its public investment resources to the development of its indigenous energy resources, India remains dependent on imports to meet most of its domestic energy needs. 1.12 Ene.gy Resource Base. Although India has a wide range of commercial energy resources, including oil, natural gas, coal, hydro-electric potential, and uranium, the currently known reserves of these resources do not match the structure of its energy demand. India's (proven and probable) petroleum reserves are estimated at 581 million tons. At current consumption levels these reserves would be exhausted in 19 years. Thus, unless exploration efforts by ONGC and OIL succeed in raising production, India will need to meet its demand for petroleum products increasingly through imports of crude oil and products. Natural gas, which India is just beginning to utilize, may offer some respite. Natural gas, the reserves of which are estimated at 540 billion cubic meters (BCM), could replice some oil products. So could the development of additional hydro-electric capacity. Up to now, India has developed only about 13,000 MW of its hydro-Alectric potential, which is estimated at 100,000 MW. Coal will remain the mainstay of India's energy supply. India's coal reserves, which are estimated at more than 170 billion tons, by far exceed those of all other commercial fuels. Unfortunately, most of these reserves consist of low-quality coal. In its efforts to contain the growth of oil product imports, the Government allocates a large share of its investments to the development of coal reserves and the expansion of thermal power capacity. India has also modest reserves of uranium which coulc support a nuclear power program of about 8000 MW to 10 000 MW. 1.13 Crude Oil and Natural Gas Production. Oil production has increased dramatically over the past ten years, mainly as a result of the discovery and development of the Bombay High oilfield, which contributes about 66Z to current domestic production. In 1986/87, however, production from the Bombay High oil fields started to decline. Produztion from the two onshore regions, Assam and Gujarat, is being sustained by improved recovery levels from existing fields, augmented by production from several smaller discoveries. The steep increase in indigenous oil production provided India with a tempo- rary buffer against the economic impact of the increase in international oil  - 4- prices. The Government recognizes that this reprieve may be short-lived, and that there is a need to prepare for potentially serious energy shortfalls in the 1990s. Li its Seventh Five-Year Plan, the Government has therefore: (a) Almost doubled the public investment program for exploration and development of oil and gas resources; (b) Actively encouraged the involvement of the Indian private sector in contracting and services (drilling, data acquisition and processing) and international oil companies in oil and gas exploration; (c) Approved investments to accelerate and enhance the use of gas, which would replace some of the demand for oil products; and (d) Decided to expand the infrastructure for imports of crude oil and oil products. 1.14 India probably has more undiscovered gas than oil resources. Gas could play an important role in meeting India's energy demand in the future. While small amounts of associated gas have been produced in the Gujarat and Assam regions fot many -ears, and large quantities of associated gas have been produced since 1981 from the Bombay High oilfield, only small amounts of available gas were used commercially. Until recently, the bulk of associated gab had been flared, mainly because the necessary infrastructure for process- ing and transporting of gas had been lacking. Utilization of gas has to some extent been restricted by the absence of adequate processing, transmission and distribution facilities, and by delays in developing markets for gas. At present, natural gas accounts for only 12 of India's commercial energy consumption. 1.15 This situation is now changing as the magnitude of India's proven gas reserves becomes apparent. With the discovery of large reserves of non- associated gas in the South Bassein area offshore, in the vicinity of the Bombay High oilfield, as well as onshore in Gujarat, the Government has now drawn up plans for the utilization of these gas resources. Initially, the Government restricted the use of gas to fertilizer and petrochemical indus- tries, on the assumption that the availability of gas was quite limited. After the discovery of substantial resources of free gas, the Government has relaxed this policy, and is now seeking to expand the market to power plants and industrial users. To facilitate the marketing of gas, the Government has just completed construction of the 1700 km Hazira-Bijaipur-Jagdishpur (HBJ) gas pipeline, which will take gas from the South Bassein gas field on India's west coast to fertilizer and power plants in the interior. 1.16 There is substantial scope fcr increasing the production of oil and gas in India, both through the discovery of new reserves as well as through increasing the rate of recovery from existing fields. Estimates prepared by the Government indicate that many areas with considerable potential for dis- covering petroleum are still unexplored, and that only a fraction of the country's prognosticated oil and gas resources may have been found up to now. Bank staff estimates that about 50X of the expected oil and 75X to 80X of the expected gas resources still remain to be found. Current progniosticated petroleum reserves in India are about 17 billion tons of oil and oil equiva- lent of gas. About two-thirds of these reserves are expected to be located  offshore. Based on average global recovery factors, this would point to commercially recoverable petroleum reserves in the order of 4.5 to 5.5 billion tons. Up to now, only a quarter of these potential reserves has been proven. In view of these large potential reserves, India is justified in maintaining a large oil and gas exploration program. However, considering the large invest- ments and risks involved India will need to rely increasingly on private risk capital in its oil and gas exploration efforts and, because of the possible time lags involved in developing discoveries, expand its capabilities to import crude oil and products in order to be able to meet the growing domestic demand. 1.17 Coal Production. Because of its abundant reserves, coal remains the cornerstone of India's energy strategy. The demand for coal increased sharply when fuel oil in power and industrial steam generation was phased out and replaced by coal, in response to the increase of international oil prices during the 1970s. Power generation and industry account now for almost 802 of coal demand. To meet the rapidly growing demand of these sectors, the Government embarked on a massive investment program that favored highly mecha- nized open cast mines. Production from these mines, whira have a compara- tively short gestation period, increased steeply and accounts now for about 602 of coal production. Because these mines can only tap reserves that are c.loser to the surface, the quality of coal tends to be lower compared to that mined underground. Thus, over the years the average quality of India's coal production has been declining steadily. Although India's coal is compara- tively inexpensive (coal prices average Rs 220, equivalent to US$15, per ton at the mine), the steady deterioration of coal quality and rising transport costs have reduced it- eccaomic attraction. 1.18 Power Supply. The Government's twin objectives of: (a) achieving economic self-sufficiency; and (b) spreading economic growth as evenly as possible among regions, has accorded electric power a unique role in India. The objective of economic self-sufficiency led to investments in highly energy-intensive industries, such as aluminum smelters, steel and chemicals, and subsidized power tariffs. The objective of 'equitable economic growth' played a crucial role in locating industries in areas where unemployment was comparatively high. Electric power remains often the only means to provide these 'green field' industries with the energy they need. Mainly as a result of these policies, the demand for power continues to grow at a rate of 8-9Z per year. I- spite of lrrge investments in the expansion of generating capacity, power utilities have not been able to close the power gap. 1.19 The Government as well as consumers have taken steps to close the 'power gap' and to reduce the impact of power shortages. The Government has stepped up investments in thermal power generating capacity, since it takes on average less than half the time to build thermal power plants than hydro electric plants. By having less hydro-electric power available in the supply system, thermal power plants have to be used increasingly to meet peak load demand. The 'firing up' and 'idling' of boilers is mostly done with fuel oil. Power users have also resorted to the acquisition of 'captive power plants' that use diesel, diesel driven pumps for irrigation, and kerosene stoves in urban households. Thus, most of these measures contribute to the demand for oil products.  -6 D. Energy Balances 1.20 Table 1.1 summarizes the Government's projections of energy demand and supplies in India up to the year 2000. According to these projections, the gap between energy requirements and indigenous energy production is expected to increase,--about 17.6 million tons in 1986/87 to about 50 million tons in the year 2000. To close this gap, the Government will primarily rely on the imports of crude oil and oil products. These projections assume that indigenous oil production would increase by almost 502 over the next twelve years. The Bank's staff estimates that, without further discoveries, oil production from existing fields and fields under development could reach 38 million tons. To attain the oil production projected by the Government, ONGC and OIL would need to discover an additional 275 million tons of oil, assuming no decline in the reserves-to-production ratio. As indicated in para 1.16 only about one-fourth of India's potential of 5 billion tons of oil reserves have been proven thus far. While the addition of 275 million tons is feasible, there remains a considerable risk that oil output will fall short of this target. Oil import requirements could therefore increase to over 50 million tons by the year 2000, if exploration efforts result in no net additions to oil reserves.  -7- Table 1.1: ENERGY SUPPLIES AND THEIR USE IN INDIA, 1970 TO 2000 (Million tons of oil equivalent) 1970/71 1980/81 1986/87 1989/90 1999/2000 Energy Productioan 136.62 182.84 234.20 271.28 415.00 Oil 6.82 10.51 30.48 35.43 45.00 Gas 1.25 2.06 8.81 14.90 30.00 Coal 36.17 56.51 74.50 90.55 162.00 Electricity 8.16 10.76 17.41 19.20 47.00 Traditional Fuels 84.22 103.00 103.00 111.20 131.00 Net Imports 12.20 23.28 17.61 32.50 49.00 Oil 12.43 23.50 16.07 29.00 45.00 Coal -0.23 -0.22 1.54 3.50 4.00 Energy Requirements 148.82 206.12 251.81 303.78 464.00 Conversion and Distribution losses 16.90 36.40 55.46 60.70 73.40 Stock Changes 2.41 3.43 0.30 2.23 0.00 Energy Consumption 129.51 173.15 196.65 245.31 390.60 Industry 22.05 36.96 45.27 52.00 100.20 Transport 12.45 15.03 19.97 29.00 52.00 Agriculture 1.62 3.92 6.80 9.40 18.90 Residential/ Commercial 90.67 111.53 115.34 132.00 180.00 Non energy uses 2.71 5.70 6.72 22.22 38.00 Other uses 0.01 0.01 z.55 0.69 1.50 Source: Power and Energy Division, Planning Commission, India. 1.21 The growing import requirements for oil products constitute one of the high priority issues the Indian economy will face in the years ahead. Apart from posing a potentially heavy burden on the balance of payments, heavy investments in additional refinery (and conversion) capacity may also be required. As the following discussion of the Government's energy strategy shows, Tndia has basically three options to meet this demand. One it could increase the domestic production of fuels, such as natural gas, that would replace at least part of the demand for oil products. Two, it could import oil products, and three, it could expand its domestic refinery capacity and import crude oil. The reluctance of the Government to increase its dependence on imports of crude oil and oil products stems from the concern that it would increase India's vulnerability to large price fluctuations in international markets.  E. The Government's Energy Strategy 1.22 India's energy strategy was designed during the early 1980s in response to the sharp increase of the import bill for crude oil and petroleum products. To ease the leavy burden of oil imports the Government adopted a two pronged strategy. First, the Government allocated a larger share of its resources to the development and production cf indigenous energy resources, in particular the exploration for oil and gas, the expansion of coal and gas- based thermal power plants and the development of highly mechanized open cast coal mines. In parallel, the Government raised the prices of oil products relative to those of indigenous fuels (mainly coal and power), and rationed access to oil products where pricing policies were ineffective to slow the demand for energy and to encourage the substitution of oil products in as many end uses as were economically and technically feasible. 1.23 The Seventh Five Year Plan contains the only formal stateme~nt of the Government's energy strategy. It provides an indication of the Government's strategy objectives and thus its investment priorities. According to this statement the Government gives priority to: (a) The accelerated exploitation of coal, hydro and nuclear power; (b) Intensified exploration for oil and gas, and exploitation of oil with regard to available recoverable reserves and reasonable expectations of adding to them in the foreseeable future; (c) Advance policy planning for the large emerging gas potential; (d) Management of oil demand including formulation of a national transport fuel policy; (e) Energy conservation including interfuel substitution; (f) Increasing the productive efficiency of capacities already created and of equipment used; (g) Exploitation -f renewable energy resources, such as energy forestry, biogas, biomass, wind and solar energy, to meet especially the energy requirements of rural communities; (h) Intensification of research and development of all energy resources, particularly with regard to emerging energy technologies; (i) Design and implementation of area-based integrated rural development programs; and (j) Campaigns to educate the public about the objectives of the Government's energy strategy in order to ensure its acceptance and successful implementation. This strategy is rather comprehensive. The large number of its objectives reflects the diverse energy needs of the Indian economy, which span the growing demand for commercial fuels as well an the energy needs of India's  vast, and mostly poor rural population. Implementation of this strategy requires not only sizeable resources, but also far-reaching changes in existing policies. 1.24 The scope for allocating large additional investment resources to the energy sector is becoming increasingly limited. This reflects, in part, the fact that the energy sector is already receiving almost 30Z of planned outlays under the Seventh Five-Year Plan; in part, it is an indication of the growing demand on public resources from other sectors, in particular the social sectors. The Mid-Term Review of the Seventh elan shows that, while India is making progress towards achieving its ambitious objectives in the energy sector, the allocated resources are insufficient to provide the economy with the energy it needs. The investment requirements are particularly large in the oil, gas and refinery sectors. Major investment priorities of these sectors include: (a) The accelerated exploration for oil and gas, faster development of discoveries and greater efforts to enhance the output from mature fields; (b) The construction of infrastructure facilities for the transport of crude oil, oil products and gas (para 1.33); and (c) Modifications of existing refineries in line with the changing pattern of oil product demand and the need for greater energy conservation 1.25 Implementation of the Government's energy strategy requires changes in established policies with regard to investment, organization, institutional arrangements, financing and operational efficiency of these sectors. These policy changes will need to aim at further gains in improving the efficiency of public sector enterprises and reducing dependence on public resources. The following issues, which are critical for meeting the country's growing energy requirements in line with the twin objectives of greater operational efficiency and less dependen^e on public resources, will need to be addressed by the government: (a) Improved management of energy demand, in particular energy conserva- tion and pricing policies for oil products (para. 1.26); (b) Investment strategy: Increased reliance on oil product imports (para. 1.30); (c) Increased involvement of the private sector (para. 1.36). These issues are briefly discussed in the following paragraphs. F. Pricing Policies for Oil Products 1.26 Energy pricing policies play a key role in attaining the objectives of the Government's energy strategy. Although they are designed to achieve a multiplicity of sometimes conflicting goals, their primary objectives are to encourage energy conservation and the substitution of indigenous energy  - 10 - resources--in particular (hydro-electric) power and coal--for oil products as well as to mobilize resources for the development of indigenous energy resources. 1.27 Pricing of Oil Products. Petroleum product prices are set by the Government. In determining the price levels for the various oil products the Government aims to achieve not only the broader objectives of its energy pricing policy, but in addition wants to: (i) ensure that refineries recover their full costs; (ii) minimize regional price differences of the various products; (iii) insulate domestic consumers to the extent possible from price fluctuations in international crude oil and oil product markets; and (iv) meet at least part of the demand of poorer segm.ents of the population. To accommo- date all these objectives, the Pricing Committee, which is ultimately respon- sible for determining the prices of oil products at various points in the production and marketing chain, has devised a rather complex pricing regime. It consists essentially of three stages, the determination of ex-refinery prices. ex-storage prices, and prices to retailers/consumers. 1.28 To achieve these objectives, the Government has appointed an Oil Cost Review Committee, which determines the (ex-refinery) prices at which each of India's twelve refineries may sell their products. In setting these prices, the Committee makes sure that each refinery can fully recover its costs and achieve in addition a 12Z post tax return on investment. To insulate domestic consumers from fluctuations in the cost of imported crude oil, the Committee fixes the price of crude oil to refineries. This so-called pooled crude oil price, which is currently set at Rs 1700 per ton (equivalent to about US$15 per barrel), represents the weighted average of the cost of imported and indigenous crude oil. To arrive at uniform wholesale prices for the various oil products, regional variations in marketing and transport costs are equalized through a series of pool accounts. In addition, the marketing companies levy excise duties, which are equivalent to the customs duties for imported products and a 'product price adjustment', which represents a price premium for some products, such as gasoline, or price discounts, such as, for example, in the case of kerosine. The resulting ex-storage prices are the prices at which the marketing companies sell oil products to retailers. 1.29 Following the drop of oil prices in international markets in 1986, the Government decided not to realign prices immediately in order to (a) continue to encourage conservation, (b) discourage investment in oil-intensive technologies; and (c) take advantage of the opportunity to mobilize additional resources from the widening difference between domestic and international oil prices (Table 1.2). As a result, India's oil pricing policy has emerged as an effective vehicle for generating public revenues. In 1986/87 the industry contributed almost US$5 billion to the exchequers of the central and state Governments in the form of excise and customs duties, royalty and cess on crude and sales and corporate taxes. On the other hand, comparatively high domestic prices for oil products and industrial feedstocks add considerably to the cost of production of energy-intensive industries, such as the petrochemical industry, and therefore reduce the competitiveness of Indian industrial products in international markets. However, if prices for oil products continue to remain low in international markets, the Government will need to review the rationale for maintaining domestic prices of these products above their border equivalents, in particular with respect to prices of feedstocks, in order to ensure that intermediate inputs are priced at reasonable levels to avoid distortions among the prices of various feedstocks.  - 11 - 1.30 In addition to resulting in comparatively high product prices, the present oil product pricing policy leads also to other distortions. It is characterized by: (i) the setting up of differential product prices for different category of users--such as naphtha for fertilizers vs petrochemicals production; (ii) the charging of virtually uniform product prices (at all ex storage points) throughout India irrespective of the transport cost from the supplying refineries through a system of freight equalization charges; and (iii) -nomalies in the relationship between product prices and their close substitutes for various uses--such as the price oi gas and naphtha for the production -f fertilizer. These distortions could have serious implications on the choice of feedstocks and industrial locations. A successful long-term transformation of Indian industry towards competitiveness and an increase orientation towards exports, a major objective of the Bank in its policy dialogue with the Government, requires feedstock and energy product prices also to be competitive with and at levels comparable to, international prices. These issues are under active discussion with the Government in the context of the Bank's energy and industry work. Table 1.2: COMPARISON OF DOMESTIC AND INTERNATIONAL PRICES FOR SELECTED COMMERCIAL ENERGY RESOURCES (US Dollars per Metric Ton) Ratio of Domestic to Energy Ex-Refinery Domestic International International Resource Price Price /a Price /b Price Gasoline 163.80 743.58 161.87 4.59 Kerosene 172.19 172.24 207.05 0.83 Diesel Oil 164.17 256.55 172.64 1.49 Fuel Cil 111.05 212.96 75.48 2.82 Crude Oil N.A. 133.53 111.77 1.19 Natural Gas /c N.A. 154.11 N.A. N.A. Coal /d N.A. 35.44 53.00 0.67 /e /a Ex-storage prices at primary pricing points (including Bombay), November 1988 /b Estimated c.i.f. prices, Bombay, January 1989 /c Price in U.S. Dollars per 1,000 cubic meters. /d Estimated landed-price of coal (including freight from North Karanpura) in Bombay. /e If the difference in the calorific values of coal is taken into account, this ratio would be 1.06. G. Investment Strategy: Increased Reliance on Oil Product Imports i.31 Over the past forty years, India has built-up a refinery industry that is capable of meeting about 782 of the country's demand for oil products. It required huge investments, which the Government justified with: (a) India's need to have access to critically needed oil products; (b) its ability to take advantage of declines of crude oil prices in international markets;  - 12 - and (c) India's need to refine its indigenous production of crude oil. The Government is currently reviewing this policy of self-sufficiency in refining. Comparatively low prices of oil products in international markets, partly because of major expansions of refinery capacities in the Middle East and Singapore, and the huge investments required for expanding indigenous refining capacity provide strong incentives for a greater reliance on imports of oil products. The Government is currently considering importing about 15% of its oil product requirements. As an initial step, this policy is sound. In the years ahead, the Go,rernment will need to explore whether India can further increase its share of oil product imports without affecting price levels in international markets. 1.32 According to the Government's estimates, a policy of 852 self-suffi- ciency in refining would require an additional refining capacity of about 15 million tons of crude oil throughput by 1995, and a further capacity expansion of almost 20 million tons before the year 2000. At current prices, the cost of this investment program would be about US$9 billion. Even if these capa- city expansions are implemented on time, the Government projects that India would still need to import 11.5 million tons of oil products a year by 1995 and 14.3 million tons by the year 2000. 1.33 While the Government has yet to decide on the degree of self-suffi- ciency in refining it would like to maintain in the future, a decision has been made to delay expansion of refinery capacity in favor of investment in infrastructure facilities that would enhance India's access to international product markets. H. The Transport of Petroleum Products in India 1.34 Experience with various transport modes has shown that transportation of crude oil and petroleum products through pipelines is generally more effi- cient compared to rail and road transport. Pipelires offer several advan- tages. They eliminate the return movement of empty tankers and wagons. Delivery is faster and more reliable than with any other mode of transport. Pipeline transport is more energy efficient, and lowers the risk of environmental pollution as well as product loss during transit. In view of the congested conditions on most arterial rail and road routes the Government has adopted a transport policy which gives priority to the continued expansion of the pipeline network, particularly in corridors where the transport requirements for oil products exceed 1.25 million tons a year and where the construction of pipelines is technically feasible. This policy, which is economically sound, has led to a rapid expansion of the domestic network for crude oil, natural gas and oil products and a gradual shift in the shipment of oil products away from rail and road transport to pipelines. 1.35 The changes in the modes of transport for crude oil, gas and oil products are illustrated in Table 1.3.  - 13 - Table 1.3: PETROLEUM TRANSPORT BY MODE, 1982/83 TO 1987/88 (Million tons) Transport Mode 1982/83 1983/84 1984/85 1985/86 1986/87 1987/88 Crude Oil: Coastal Shipping 7.3 11.9 14.6 12.4 13.6 12.4 Pipeline N.A. N.A. 33.7 33.5 34.9 37.6 Products: Coastal Shipping 2.6 3.6 3.3 4.6 5.1 5.8 Rail 17.3 18.0 18.2 18.6 19.9 21.6 Road N.A. N.A. N.A. N.A. 9.7 N.A. Pipelines 6.1 7.1 7.7 8.6 9.5 9.4 Although there is a perceptible shift towards the use of pipelines for the shipment of bulk oil products, only a small portion of India's total consump- tion of these products moves actually through pipelines. Although pipeline transport would be in many cases more economical than rail and road transport, the heavy capital intensity of pipeline investments and the long time it takes to build them have been major constraints to a faster expansion. Almost all off-shore transport of crude is carried out by coastal shipping. Only a small share of the off-shore crude production is moved through 275 kilometers of off-shore pipelines. Refined products are moved by rail and tankers. Of course, all the gas production is moved through pipelines. 1.36 Table 1.4 shows the growth of India's pipeline network for crude oil, gas and oil products. About 402 of the network, which has more than doubled since 1970, is devoted to the transport of oil products. About 48X of the network is used to transport crude oil and the remaining 12? are designed for the transport of gas. Since the marketing of crude, gas and products is in the hands of the companies that produce or refine the various products, the expansion of the pipeline network is part of the overall investment program of these companies. The Indian Oil Corporation owns and operates about 55Z of the pipeline network, ONGC about 242 and Oil India Ltd. (OIL) the remaining 21Z.  - 14 - Table 1.4: GROWTH OF PETROLEUM PIPELINE NETWORK, 1971 TO 1987 (Kilometers) Type of Pipeline 1971 1975 1981 1986 1987 Crude Oil 1,437 1,525 3,365 3,416 3,435 On-shore 1,437 1,525 3,140 3,141 3,159 Off-shore 0 0 225 275 276 Petroleum Proeucts 1,789 2,917 2,111 2,713 2,749 Natural Gas 165 208 450 822 944 On-shore 165 208 224 352 468 Off-shore 0 0 226 470 476 LPG 0 0 0 0 24 NGL ( U 0 0 24 Total 3,391 3,840 5,926 6,951 7,176 The rapid growth of oil product demand will require continued large invest- ments in pipelines for crude and oil products. Over the next five years IOC plans to invest about US$1.3 billion for the construction of about 2,785 kilometers of crude and product pipelines. I. Involvement of the Private Sector 1.37 While the shift towards greater reliance on imports of oil products from international markets reduces the demand on public investment resources, construction of the necessary infrastructure facilities requires still substantial investments. The Government, which faces growing demands for resources from other sectors, is increasingly looking towards a greater parti- cipation of the private sector, particularly in oil exploration and the refinery industry. In line with its established policy to expand indigenous refinery capacity to meet about 90Z of domestic oil product needs, the Government is finding it increasingly difficult to mobilize the necessary investment resources. The Government has therefore decided to seek financial support from companies in the private sector. 1.38 Current plans for the expansion of refinery capacity include a refinery at Karnal, a refinery at Mangalore and an additional refinery in Assam. Joint venture arrangements are being considered for the planned refineries at Karnal and Mangalore. For the construction of the refinery at Karnal, Tata Chemical Company and the Indian Oil Corporation have entered into a joint venture, in which each of these companies will hold 26Z of the equity. The remaining equity will be offered to non-resident Indians (NRIs). For the construction of the refinery and petrochemical complex at Mangalore the Indian Rayon Company has entered into a joint venture with the Hindustan Petroleum Corporation. Again, each of these companies will hold 26Z of the equity, while the remaining 482 will be offered to NRIs.  - 15 - J. Management of the Sector 1.39 Although there is a gradually increasing share of private sector involvement in the oil, gas and refinery sector, the management of these sectors still rests predominantly in the hands of government agencies and a few public sector enterprises. The Ministry of Petroleum and Natural Gas provides the policy framework within which the various companies of these sectors operate. It approves the programs and budgets of these companies and monitors their performance. To carry out these tasks, the Ministry relies on the recommendations of several committees, boards and task forces. The most important body is the Oil Coordination Committee (OCC), which prepares detailed recommendations on a wide range of activities of the oil industry,--from the planning of facilities, the imports and exports of crude oil and petroleum products, allocations of crude oil to refineries in line with processing requirements, to the overall distribution of petroleum products. 1.40 Domestic oil and gas production is in the hands of the Oil and Natural Gas Commission (ONGC) and Oil India Ltd. (OIL). ONGC has the largest involvement in the petroleum sector. At present the company accounts for about 902 of domestic oil and gas exploration and production activities. OIL accounts for the remaining 10Z. The Gas Authority of India Ltd. (GAIL) is in charge of the transmission and distribution of natural gas. The Indian Oil Corporation Ltd. (IOC), is responsible for imports of crude oil and oil products. With a market share of 582, IOC is also India's largest refinery and oil product distribution company. The remaining 422 are shared by six companies. While the production, refining and distribution of oil and gas products continue to be dominated by public sector companies, the Government has in recent years encouraged direct investments and joint ventures with the private sector. As a result of these efforts, a growing portion of off-shore exploration, refining and specialized oil industry services are now carried out by private sector companies. 1.41 In addition to the Ministry of Petroleum and Natural gas, several other government agencies are involved in making decisions that affect the oil and gas industry. The Planning Commission is responsible f r the screening of investment plans, and the overall coordination of the allocation of expendi- tures under the five-year plans. The Ministry of Finance is responsible for the use of budget resources, approvals of requests involving foreign exchange expenditures, the mobilization of foreign exchange resources and taxation. The Ministry of Finance and the Planning Commission jointly review and approve the budget and investment proposals of all public sector companies. K. The Bank's Role in the Sector 1.42 Although the Bank's financial contribution to investments in the oil and transport sectors remains comparatively small, its involvement in these sectors has contributed significantly to the Government's success in reducing its dependence on oil imports, improving the efficiency of the companies in the oil and transport sectors, and attracting foreign risk capital to finance an increasing share of its petroleum exploration efforts. 1.43 While the basic objectives of the Bank's involvement in the energy sector have changed little over the years, the Bank's strategy in achieving these objectives has evolved along with the aevelopment of the sector. The  - 16 - Bank's primary objectives remain: (a) to assist the Government's efforts to develop indigenous energy resources to reduce energy shortages and lower the dependence on oil imports; (b) to improve the operational and managerial efficiency of the enterprises involved in exploration, energy production. transport and distribution; (c) to assist in efforts promoting the efficient use of energy; and (d) to reduce the dependence of public sector enterprises on public resources by improving internal resource mobilization through efficient pricing policies and cost reduction as well as by attracting additional external finance, including private risk capital. 1.44 In line with these objectives, the Bank's involvement has shifted from assistance in the development of oil resources to support for the Government's more recent efforts to bring its resources of natural gas on stream. Almost all of the projects in the oil and gas sectors included transport infrastructure facilities aimed at ensuring the efficient marketing and utilization of crude oil and gas produced under these projects. To improve the efficiency of operations in the oil, gas and refinery industries, the Bank approved in April 1982 a lending operation in the refinery sector, the Refinery rationalization Project (Ln. 2123-IN). The objective of this loan was to assist several refinery companies in modernizing their refineries, in particular in view of the rapidly growing demand for middle distillates. 1.45 Overall, the Bank's efforts have been quite successful. India's growing population and the need to accelerate economic growth in order to achieve even minimal improvements in the standards of living will require large increases in energy supplies, which will not be possible without a drastic increase in investments. In view of the widening budget deficit and the persistent scarcity of foreign exchange, the Government will need to find ways to improve internal resource mobilization, in particular in the power and coal subsectors, and attract foreign investment. In the years ahead, the Bank's involvement in the energy sector will focus on assisting the Government in: (a) implementing institut3'nal changes that would increase indigenous energy supplies, improve the use of energy, mobilize additional resources and raise the managerial and operational efficiency of public sector enterprises in the energy sector; and (b) mobilizing external finance in the form of co-financing, borrowing in international capital markets and direct foreign investment. 1.46 The proposed project fits well into this; strategy. The pipeline, which will be financed under this project gives the Indian Oil Corporation increased flexibility in supplying the domestic market with oil products. It saves the cost of expanding domestic refining capacity, and permits IOC to take advantage of favorable conditions in international oil product markets. The other components contribute mainly to improving the overall efficiency of IOC's refinery operations. However, IOC sought the Bank's assistance primarily as part of its efforts to improve its organization and managerial efficiency. Technical assistance during project implementation will contribute to IOC's own efforts to become more efficient. Most importantly, the association with the Bank through this project will ease IOC's access to international capital markets. To enhance this aspect, the Government has agreed that the loan be made directly to IOC, which would be the first timie an Indian fully publicly owned company borrows directly from the Bank.  - 17 - II. THE BORROWER A. Introduction 2.1 Indian Refineries Limited was set up in 1958 and Indian Oil Company Limited was established in 1959 to market petroleum products. The Indian Oil Corporation (IOC) was formed subsequently by merging the refining company with the marketing company. Several acquisitions followed soon after: three major oil companies that were operating in India,--Shell, Standard Vacuum and Caltex--were taken over in the 1970s; the Assam Oil Company in 1981; and 50Z of the shares in Oil India Limited in 1981. New refineries were als: built and the marketing network expanded. Today IOC operates six refineries with a total refining capacity of about 21 tiillion tons per annum at: Koyali, Mathura, Barauni, Haldia, Digboi and Guwahati. Crude oil and products are moved through a 3,850 km pipeline network: from the port of Salaya to Koyali. Mathura and Jalandhar in the northwest of India; and from the Assam oil fields in the northeast to Barauni, Haldia, and Kanpur. IOC's extensive marketing facilities include 15 LPG bottling plants, and 150 petroleum products storage and distribution terminals serving 13,500 service and retail outlets and 75 aviation refueling st'tions. In addition, direct supplies are made for defense purposes, as well as to the railway, power, fertilizer, steel and coal sectors. In 1988, IOC's volume sale of 25 million tonnes constituted 58Z share of the all-Indian market. 2.2 IOC is the largest commercial organization in India with a turnover exceeding Rs 140 billion and employing over 32,000 people. In 1986, IOC was ranked number 51 in the Fortune Magazine's list of the 500 largest industrial corporations worldwide and IOC is also one of the most efficient companies in India. During recent years, the capacity utilization of its refineries has exceeded designed throughput and its pipeline throughput in FY88 averaged 96% of design capacity, matching or exceeding standard utilization rates in industrialized countries. B. Organization and Management 2.3 IOC is a fully state-owned autonomous organization incorporated under the Indian Companies Act of 1956 with the main object of refining, transport- ing and marketing of petroleum products. The corporation has three Divisions: Refineries and Pipelines Division; Marketing Division; and Assam Oil Division (formed after taking over Assam Oil Company Ltd. in October 1981). IOC also ! has a fully equipped Research and Development Center and a fully owned subsi- diary, Indian Oil Blend4.ng Ltd. (IOB), for blending of lube oils and greases. The organization is managed by a Board of Directors appointed by the Government of India. The Board includes the Chairman, a secretary, six directors representing the Ministry of Energy and Petroleum and other GOI institutions, and five full-time functional Diroctors, namely: Director for Refineries and Pipelines, who is also in charge 3f the Assam Oil Division; Director Marketing; Director Finance; Director Personnel; and, Director R&D. The Chairman of the Board is also the CEO for the company. An organization chart is given in Annex 2.1.  - 18 - 2.4 IOC's staff is well-trained and experienced in implementing major pipeline and refinery projects, operations of pipelines and refineries, and in the distribution and marketing of petroleum products. Key senior managers and staff are familiar with internationally accepted practices in the petroleum industry, partly due to IOC's past business relations with reputed international companies, like Technip, UOP, ENI, Chevron, Shell and Bechtel. Some further training would be required, however, to bring IOC up to par with the latest technological advances in the industry. C. Operating Performance 2.5 Except for the Guwahati and Digboi refineries, which are below opti- mal size and the oldest of IOC's six refineries, the refinery operations are efficient, with throughputs generally exceeding design capacity (except when limited by lack of crude). Fuel consumption and losses are well within established standards and refining costs per ton in line with those of efficiently run refineries of similar configuration in industrialized countries. IOC's pipeline and distribution operations are also efficient; operating costs as well as energy consumption and transport losses are well within international standards for comparable pipelines. IOC's financial results have been very satisfactory, allowing IOC to fund the majority of past investments out of internally generated funds. Some relevant indicators of recent operating performance for IOC's refineries and pipelines are given in Annex 2.2. D. Accounts 2.6 The accounts are maintained on a commercial basis in accordance with the requirements of the Companies Act of 1956. Each refinery and pipeline unit constitutes a major cost center. The ex-refinery prices for each refin- ery and transportation charges for crude oil and products for each pipeline are set by GOI. The accounts for each major cost center (para. 2.7) are prepared in line with corporate guidelines to maintain uniformity. 2.7 The accounting system is designed to meet the requirements for finan- cial accounting, budgetary control, cost accounting as well as management information. For this purpose, expenditures are classified according to type and charged to cost centers, such as processing plants, utility centers, ser- vice departments, administration, overheads etc. Key performance data are compiled monthly and financial accounts quarterly for each major cost center to provide adequate information for IOC's management. Annual accounts are routinely completed, audited and published within six months of the end of IOC's fiscal year. On the whole, IOC's MIS and accounting procedures meet or surpass acceptable standards. 2.8 IOB's accounts are published separately along with those of IOC; this is a statutory requirement. Only the nominal value of IOB's shares appears as an investment in IOC's accounts and ro consolidation of the IOC/IOB accounts is undertaken. As of March 1988, IOB's equity was Rs 34.0 million, of which Rs 4.0 million was paid-up share capital. The value of IOB is therefore understated in IOC's books, but the amounts involv3d are minor compared with IOC's total assets.  - 19 - 2.9 During appraisal, IOC agreed to open a Special Account for the proj- ect, most likely with the State Bank of India. This account, including SOEs if any, will be audited annually by IOC's exteraal auditors. The quarterly project progress reports will include extracts of transactions booked in the Special Account. The amount of initial deposit on the Special Account will be US$35 million; reimbursement will be made quarterly, or whenever the account is drawn down to below 502 of the initial deposit, after IOC's fully documented application for replenishment (para. 3.18). E. Audit 2.10 IOC's annual accounts are audited by independent chartered account- ants appointed by GOI on the advice of the Comptroller and Auditor General of India to ensure that the accounts provide a true and fair view of IOC's affairs and that they are in line with the requirements of the Companies Act of 1956. Auditors are appointed for periods of three years, after which they are changed. IOC's operations are also audited by the Comptroller and Auditor General of India. This audit is a performance audit to ensure that the procedures, decisions taken and commitments made by IOC are in compliance with government regulations and are in the best interest of the Company as well as verifying the quality of the accounts. The observations of Government Auditors are placed before the Government of India for appropriate action and published in the Annual Report, which is placed before the Parliament. During negotiations assurances were obtained that IOC's audited accounts, including the special account, will be made available to the Bank within six months of the end of IOC's financial year. 2.11 IOC's operations are also audited by internal auditors on a continu- ous basis throughout the year. A General Manager for internal audit is attached to the Chairman's office. Further, an Internal Audit Department, with about 125 employees headed by an Executive Director, reports directly to Director Finance and observations are reported to the Board of Directors. Physical inventories are undertaken by IOC's Production and Materials Departments and are also checked in a revolving manner by independent physical verification teams. The Internal Audit Department and the independent auditors also verify inventories at rxndom. These audit procedures are satisfactory. F. Insurance Practices 2.12 IOC has taken insurance coverage against the following risks: loss or damage of equipment and material in transit; erection and storage damages for material and equipment used in major projects; fire and explosion in refineries and pipelines; transit damages and losses for crude, products, chemicals, spares, consumables, etc.; and, third-party personal injury/death and property damages. IOC assets are insured at replacement cost. These insurance practices are adequate and in line with the practices of the industry. During negotiations assurances were obtained that IOC will continue to maintain insurance against risks and in amounts that are consistent with industry practice.  - 20 - G. Remuneration and Pricing System 2.13 The Government has established a refinery pricing system that provides a 122 after-tax re.urn on capital employed (the sum of net fixed assets in operation and normal working capital) to the extent that these are funded by equity; interest on debt to finance such capital employ-.d is also covered by retention prices. This pricing system is based on standard norms for crude throughput, product patterns, fuel and loss and other operating costs; it provides for incentives in the form of higher returns than the basic 12Z for operating performances exceeding established norms. A more detailed description of the pricing system and an example of the calculation of refinery remunerations are given in Annex 2.3. 2.14 IOC's refineries generally process more crude oil than required oy the GOI-established standards. The actual yield patterns are also superior to the standard norms, thus providing the refineries higher returns than the standard 12Z. To ensure continued efficient operations, IOC introduced a produ^tivity linked bonus payment scheme under which employees can earn addi- tional remunerations of up to about 12Z of base wages. These bonus earnings are linked to crude throughput and throughput of major secondary processing units, reduction in fuel consumption and loss levels and reduction in over- time. IOC's employees have been able to earn bonuses of around 11Z of base wages by productivity improvements in these areas. As a result, IOC's refin- eries, during recent years, earned incentives for improvements in crude throughput and yield pattern and for reductions in fuel consumption and loss levels as compared with GOI's standards for these refineries. Based on IOC's performance, the refinery pricing system combined with the productivity-rela- ted bonuses to staff appear to provide adequate incentives for efficient oper- ations. H. Investment Progra 2.15 Since the oil crisis in the early 1970s, IOC has made investments to rehabilitate its refineries to increase throughput, improve efficiency and increase the output of high value products. The most clearly justified investments to rehabilitate IOC's existing refineries have already been under- taken and the remaining scope for further increase in throughput in these refineries is limited. To satisfy projected growth in demand for refined products in a cost-efficient manner, IOC's longer-term strategy therefore is to: (i) increase the import of products; (ii) participate in establishing new refineries as well as improve the efficiency of existing refineries; (iii) expand the capacity of existing refineries when justified; and finally, (iv) expand pipeline and distribution systems to handle the larger volumes of crude oil and products. IOC's FY90/94 investment program is designed to fit into this longer-term strategy. 2.16 IOC's FY90-94 investment program, including physical and price con- tingencies, amounts to about Rs 91.7 billion (US$6.3 billion equivalent), subject to GOI approval of all planned projects. In addition to the proposed  - 21 - project (about US$1.0 billion), IOC plans to expand the Gujarat, Koyali and Mathura refineries and add conversion facilities for heavy oil processing (about US$1.4 billion), participate in a new refinery at Karnal (total cost about US$1.5 billion), and expand its pipeline and distribution systems, as well as improve the efficiency of existing refineries (about US$2.4 billion). This investment program is ambitious compared with past undertakings and will require IOC to seek external funding, in addition to the proposed Bank loan, in the order of about US$2.7 billion equivalent; the difference (about US$3.2 billion) would be covered by IOC's internal cash generation. Some projects in IOC's FY90-94 investment program may be delayed, however, if adequate funding is not available. 2.17 In recent years, IOC has funded about 802 of its capital expenditures out of internally generated funds. The extraordinary funding needs for IOC's F,90-94 investment program will, however, require new financing policies for IOC. The feasibility of suppliers' credits, commercial bank loans, bond issues, etc. were studied and GOI/IOC agreed to make more use of such external funding sources. IOC is also likely to reactivate its public deposit scheme, which was suspended in 1986. This scheme could proviae funds amounting to about US$400 million (a third of IOC's eyaity) according to current regulations. 2.18 During appraisal, the Bank was given an opportunity to review IOC's FY90-94 investment plan and tentative funding plan. To ensure that IOC's managerial and financial resources will not become overcommitted, the Bank will be given an opportunity to review any major changes to these plans and to exchange views with IOC before such changes are implemented. Such reviews would also enable the Bank to assist IOC to finance investments which the Bank and IOC agree are economically and financially justified. During negotiations, assurances were obtained that the Bank will be given an opportunity to review annually any major change to IOC's FY90-94 investment plan and to exchange views with IOC before the changes are implemented. Any additional investment exceeding the equivalent of US$50 million would in any given year be considered a major change.  - 22 - III. THE PROJECT A. Background and Objectives 3.1 Petroleum consumption in India was about 43 million metric tons per annum (MMTPA) in 1986/87 and is projected to double by the year 2000. Consumption in the northwest of India is growing considerably faster than in the rest of the country; its share of the total consumption is expected to increase from a current 30? to 362. Consistent with the national strategy outlined in paras 1.30-1.32, IOC, the principal supplier and marketer of petroleum products in the region, plans to meet this growing demand by a combination of increased product imports and increased refinery capacity (in turn requiring increased imports of crude oil). Annex 5.1 summarizes IOC's plans for meeting the demand for major products in the northwest; further details are provided in paras 5.2-5.4. These plans will require a new petroleum products pipeline and augmentation of the crude oil supply system for the existing and new refineries. (See map IBRD 21079.) Petroleum products destined for the northwest region are currently imported at the Kandla port and distributed to retailers by rail and road. However, the existing transportation system--road and rail--will not be able to cope with the projected volumes. A pipeline has been determined to be the least-cost and most economic means for transporting the petroleum products from Kandla to distribution points supplying the northwest region. The existing crude oil supply system is limited to about 10.2 MMTPA, the maximum capacity based on present tanker size and traffic handled by the offshore mooring and off- loading facility (SBM) at Salaya. A second SBM is required to accommodate the projected increased crude oil throughput for the existing Koyali and Mathura refineries, which are being expanded. A more extensive augmentation of the crude oil supply system will be required before the Karnal refinery goes on- stream. 3.2 The primary objective of the project is to support the govermnent and IOC in providing the necessary operational flexibility and in improving the overall efficiency of the petroleum product supply sector by: (i) reducing the cost of domestic transport of petroleum products; (ii) facilitating import of petroleum products, thus providing IOC with the means to respond quickly to shifts in product demand patterns and foregoing the need for more costly and high-risk investments that would be required to change refinery yield patterns; (iii) improving the operating efficiency of IOC's refineries; and (iv) upgrading practices used in the operations and maintenance of IOC pipe- line network and distribution facilities. Secondary objectives are: techno- logy transfer in pipeline operations, corrosion control, computerizing refin- ery operations, process optimization and removal of lead from motor-gasoline. B. Project Description 3.3 The project includes the following components: (a) 1,454 km product pipeline from the Port of Kandla to Bhatinda: The initial pipeline capacity will be 5.0 MMTPA in the Kandla-Karnal section (22" diameter) and 1.5 MMTPA in the Karnal-Bhatinda (14" diameter) section. There are provisions for expanding the capa- city of the Kandla-Karnal section to 6.0 MMTPA (through mechanical modification or the application of chemical drag reducers) and the Karnal-Bhatinda section to 2.5 MMTPA (throagh additional pumping capacity).  - 23 - (b) A Second Single Buoy Mooring System (SBM):l/ The existing offshore terminal in the Gulf of Kutch presently handles about 10 MMTPA of Bombay High and imported crudes which is beyond the design capacity of the SBM. The proposed second SBM is required to supply the addi- tional crude to be processed. at the Koyali and Mathura refineries. (c) Minimizing Lead Content in Motor Gasoline from Eastern Sector Refin- eries: This component provides for the installation of catalytic reforming units with associated facilities at the Barauni and Digboi refineries. IOC will then be able to reduce the lead content in the motor gasoline produced at these refineries from the current level of 0.56 to 0.15 grams per liter by September 1992 as mandated by the Department of the Environment. Reformate produced by catalytic reforming of naphtha and gasoline from processes similar to fluid catalytic cracking are of sufficiently high octane number so that when blended with the other gasoline stock in the refinery, with minimal lead addition, a gasoline with the required octane number is produced. After installation of these two reformers, all IOC refineries will be able to meet the lead content mandate except the Guwahati refinery, which has too small a capacity for economic reforming. Its gasoline output will be blended into gasoline from the Bongaigoan refineries to meet the required octane number specification. (d) Distributed Digital Control System (DDCS) for IOC's Refineries: This project component is designed to modernize instrumentation and enhance process control optimization capabilities of Guwahati, Barauni, Gujarat, Haldia, and Mathura refineries by installation of Distributed Digital Control Systems (DDCS). Presently, except for a few process units, instrumentation is pneumatic, and response to system changes is slower than with the more modern electronic DDCS. The project component will include provision for the required micro- processor and supporting computer facilities. Installation of DDCS will facilitate optimization of refinery operations and yield improvements, reduction in energy consumption, enhance safety, reduce time needed to remedy process changes reported by monitoring instruments or to change operating conditions, quicker plant shutdown and start-up, and thereby increase on-stream time. The scope of work for each refinery, including hardware, will be defined by consultants to be engaged under the project. (e) Captive Power Plant at the Digboi Refinery: Two gas turbine power generators, each generating 15 MW of power, will provide a stable source of electricity to the refinery. With the rapid growth in demand for electricity from the national grid, power interruptions and dips have become more frequent resulting in disruption of operations. The captive power plant will supply electricity to critical refinery equipment and will use hydrocarbon gas from refinery process units as fuel. 1/ An SBM is a large buoy used to moor, load and unload tankers that could not otherwise anchor in coastal waters. In addition to the buoy, the system comprises floating hoses, a manifold (PLEM), submarine pipelines and onshore receiving facilities.  - 24 - (f) Yield Optimization and Eneray Conservation: Under the Technical Assistance and Training Component (para 3.3, h), project consultants will carry-out studies to identify equipment modifications and configuration changes needed to optimize refinery yields and conserve energy at Guwahati, Barauni, Koyali, Mathura and Haldia refineries. The yield optimization and energy conservation component vill provide equipment and services necessary to implement recommendations that will emerge from the yield optimization and energy conservation study. (g) Haldia Lube Block, This component deals with the expansion of the Haldia Refinery lubricating oil base stock facility by 60,000 metric tons per annum. Along with the expansion of the lubricating oil complex, a sulphur plant will be installed to recover the sulphur from sulphur containing gas streams, which would otherwise be discharged to the atmosphere and ultimately form sulphuric and sulphurous acids with detrimental effects on the environment. (h) Technical Assistance and TraininR: The principal consulting services included under this project component are: (i) studies to design energy conservation and yield optimization programs for Guwahati, Barauni, Koyali, Mathura and Haldia refineries; (ii) a pipeline corrosion survey and assistance in improving operations, maintenance and inspection of IOC's pipeline network; (iii) studies to identify and design schemes for modernization of instrumentation at Guwahati, Barauni, Haldia and Mathura refineries by installing distributed digital control systems; and (iv) design of a stafL training program, including the establishment of a Corporate Management Training Insti- tute and development of training curricula for the center, identifi- cation and provision of training aids for the existing training cen- ters and the identification of training requirements of, and appro- priate training opportunities for, senior level IOC staff in the oil industry abroad. Approximately 300 man-months (mm) of expatriate consulting service are estimated to be required for technical assis- tance and studies and 50 mm for training. Also included in this project component are process simulators, training aids, computer hardware and software and special equipment and instruments needed for carrying out the pipeline corrosion surveys and tests. C. Status of Project Preparation 3.4 IOC has completed a detailed feasibility study establishing that a pipeline from Kandli to Bhatinda is the least-cost and most economic transport mode for petroleum products supplied to the northwest region. The study has determined the optimum pipeline size, routing and other essential design para- meters. Bank staff have reviewed the IOC study and are in agreement with the conclusions. IOC will commence detailed project design and engineering on completion of financing arrangements and their approval by the government. Similarly, IOC has prepared a detailed project report for the second offshore terminal at Salaya based on the installation of a second SBM and is in a posi- tion to begin detailed design and engineering. Most preliminary bid packages were submitted to the Bank for review at the time of project appraisal. 3.5 For the refinery components, IOC has prepared a feasibility study and established the design basis for the catalytic reformers to be installed at the Digboi and Barauni refineries. IOC needs Government approval and finan- cing to proceed with implementation of this component. IOC's preliminary  - 25 - studies have shown that conversion of instrumentation in the refineries and off-site facilities to Distributed Digital Control Systems is justified by the increased refinery throughput and yield improvements. Consultants to be financed under the proposed Bank loan will, when appointed, begin an in-depth study of the application of the digital control system to each of IOC's -efin- eries except Digboi, which will not be converted because of its age and small size. D. Capital Cost Estimate 3.6 The estimated total project cost including taxes, duties (US$185 million equivalent) and contingencies is US$944 million of which US$368 million (39Z) is expected to be for foreign exchange expenditures. The proposed US$340 million Bank loan represents 34Z of the total financing required (including interest during construction). The detailed project cost estimated in Indian rupees and US dollars appears in Annex 3.1 and is summarized in Table 3.1 below. Table 3.1: PROJECT COST SUMMARY In Rupees MIllion In US$ mIllion Local F .E. Totsl Local F.E. Total Kandla-Bhatinda P/L 3,925 2,617 6,542 269 179 448 Second SBM 77 103 180 S 7 12 Barauni Cat. Reformer 560 126 676 3s 9 47 Digbol Cat. Reformer 216 46 260 1s 3 18 Dist. Digital Control system. 887 617 1,404 61 35 96 Digboi Captive Power Plant (Gas Turbine) 30 240 270 2 16 18 Energy Conservation A Yield Opt. 300 200 500 20 14 84 Mald!a Lube Block 156 83 239 10 6 16 Sulphur Plant 86 6 90 6 - 6 Techn. Assist. A Training 100 100 200 7 7 14 Base cost 6,326 4,036 10,360 433 276 709 Contingencies: Physical /a 632 404 1,036 43 28 71 Price lb 1.454 929 2.383 100 64 184 Total Project Cost/c 8,411 6,368 13,779 576 ge8 944 IDC: Bank Loan - e76 876 - 46 46 Others 100 176 275 7 12 19 Total Financing Required 8.611 6,218 14.729 583 426 1.009 / 10X of base cost. 21X of base cost and physical contingency. Includes Rs 2,700 million (US3186.0 million) taxes and duties; estimated cost not of taxes and duties = Rs 11,080 million (USS769 million).  - 26 - 3.7 The cost estimates are based on average FY89 prices with the major base costs estimated by IOC from informal price quotations, costs incurred on previous and ongoing projects suitably updated, and other in-house cost data. Consulting services financed by the Bank are estimated to total 350 man-months at an average cost of US$20,000 per man-month and are broken down as follows: refinery studies (75), pipeline surveys and tests (100), distributed digital control systems (125) and training (50). A sum of US$0.5 million is included for training abroad. Process simulators, training aids, computer hardware and software and special equipment and instruments required for technical assis- tance and training are estimated to cost US$6.5 million. A physical contin- gency of 102 was applied to the base cost; which was considered to be appro- priate given the state of project preparation and preliminary engineering carried out for the project components. The price contingency on foreign exchange is calculated according to the Bankwide price contingency rates of 5.32 for FY89/90 and 4.12 per annum thereafter, and domestic price contin- gencies are based on annual rates of 8? in 1989/90 and 72 in the years thereafter. E. Project Financing 3.8 The following financing plan has been prepared for the project, including US$65 million equivalent of capitalized IDC: Table 3.2: PROJECT FINANCING PLAN (US$ million) Local Foreign Total Percent IBRD Loan 47 293 340 34 Co-financing e.g. suppliers' credit - 75 75 7 IOC 536 58 594 59 Total 583 426 1,009 100 3.9 In addition to IDC, IOC is expected to finance most local project costs from internally generated funds and the Bank would only finance local costs included in the turnkey contracts for the pipeline and the DDCSs. The line pipe, estimated to cost about US$75 million, could be financed by suppliers' credit or bilateral loans, considering the keen competition in the steel industry worldwide. During appraisal, GOI/IOC agreed that external co- financing for the line pipe component for about US$75 million could be arranged. During negotiations assurances were obtained that cofinancing of US$75.0 million equivalent will be arranged for the financing of the Kandla- Bhatinda line pipe. The proposed Bank loan would finance the balance of the foreign exchange requirements of US$293 million and US$47 million equivalent of eligible local costs, which would represent 342 of the total financing required. The proposed loan includes also a provision for up to US$20 million for retroactive financing for expenditures incurred after December 1, 1988. The Government would bear the foreign exchange and interest rate risks. For loan conditions see para. 4.12.  - 27 - 3.10 Proceeds of the proposed Bank loan would be allocated as follows: Table 3.3: ALLOCATION OF THE LOAN Amount Allocated (USS million Z of Expenditures Category equivalent) to be financed 1. Equipment, materials, 295.0 engineering and installation (a) directly imported 100Z of foreign expendi- tures (b) locally manufactured 100? of local expendi- tures (ex-factory) (c) imported and procured locally 65Z (d) works 70X 2. Consultant services 15.0 100? of foreign or local and training expenditures 3. Unallocated 30.0 Total 340.0 F. Project Implementation 3.11 IOC has wide experience in carrying out various kinds of petroleum projects and will undertake full responsibility for implementing this project. The Kandla-Bhatinda petroleum product pipeline and the second SBM system will be implemented by IOC's pipeline division, assisted during the engineering and construction stages by expatriate consultants to supplement expertise not available in IOC or in India. Material and equipment inspection will be assigned to a firm specializing in these services. The iine pipe will be procured separately. The Kandla-Karnal section of the product pipeline as well as the SBM with its offshore pipeline will be supplied and installed under separate turnkey contracts. Separate procurement packages suitable for local competitive bidding will be prepared for the Karnal-Bhatinda section of the products pipeline. Implementation of the refinery project components are the responsibility of IOC's refinery division whose implementation procedures and methods will essentially be the same as those of the pipeline division. Engineers India Ltd. (EIL), the major engineering firm in India's petroleum sector, will provide the necessary assistance for detailed design and backup during implementation of the two catalytic reformers which will be supplied and installed under a turnkey contract. Off-site facilities not readily incorporated wit)in the turnkey contract will be contracted locally. The  - 28 - Distributed Digital Control System conversions will be contracted on a supply- and-install basis with the assistance of the expatriate consultant retained for the study, engineering and project preparation activities. 3.12 Bank staff have reviewed thoroughly IOC's implementation plans and capabilities and are satisfied that project implementation will be carried out satisfactorily. Maximum use of turnkey contracting will ease the supervision load and should help maintain a tight implementation schedule. Implementation schedules appearing in Annex 3.2 show both the pipeline and SBM projects com- pleted within 33 and 30 months respectively of approval to proceed. The cata- lytic reformers are scheduled to be completed within 30 months of award of contracts and the DDCS conversions over a three-year period. The implementation schedules are considered realistic, barring unforeseen delays that may be caused by factors such as problems that could arise during selection of contractors. There is, however, no basis to extend implementation schedules to accommodate unpredictable factors. Under normal circumstances, the project components can be implemented within the time schedules given. G. Procurement 3.13 Procurement arrangements for the project are summarized in Table 3.4 below.  - 29 - Table 3.4: SUMMARY OF PROCUREMENT ARRANGEMENTS (US$ Million) ICB LCB Other /a Total Kandla-Bhatinda P/L 325 8 263 596 (177) (-) (1) (178) Second SBM 14 2 - 16 (12) (-) (-) (12) Reformers Barauni Reformer 48 - 13 61 (36) - (2) (38) Digboi Reformer 20 - 4 24 (16) - (2) (18) Captive Power Plant 22 - 3 25 (10) _ (1) (11) Distributed Digital Control System 128 - - 128 (45) - - (45) Energy ConservationL and Yield Optimiza- tion Program 38 - 8 46 (15) - (2) S17) Haldia Refinery Lube Oil Block 18 - 4 22 (8) - (2) (10) Sulphur Plant at Haldia Refinery 7 - 1 8 (1) _ (-) (1) Technical Assistance and Training - - 18 18 - - (10) 210) Total 620 10 314 944 (320) ( (20) (340) /a Borrower's own procurement procedures; limited international bidding; and consulting services under the Bank guidelines. Note: Figures in parentheses are the prospective amounts financed by the Bank loan.  - 30 - 3.14 The Bank's Precurement Guidelines will apply to: (a) the Kandla-Karnal section of the products pipeline and the offshore portion of the SBM installation under turnkey contracts in accordance with international competitive bidding (ICB) procedures open to all prequalified contractors; (b) the equipment, materials and services required for the Barauni and Digboi catalytic reformers, captive power plant, the distributed digital control systems, and the Haldia lube block (including the sulphur plant) under ICB procedures; (c) the small value equipment and materials required for the project, and which are either needed in emergencies or available only from a limited number of sources, under limited international bidding (LIB) procedures or local or international shopping procedures as appropriate; and (d) studies and technical services under the Bank's Guidelines for the Use of Consultants. 3.15 IOC will use its own procurement procedures for the supply of line pipe estimated to cost about US$75 million, for which it will request financing terms from the bidders, and for the small diameter Karnal-Bhatinda section of the products pipeline which it plans to finance from its internally generated funds. Works of small value and not likely to attract foreign bidders (housing, offices, preliminary works, etc.) will be procured through local competitive bidding (LCB) procedures. Bank staff have reviewed IOC's procurement procedures and found them satisfactory. 3.16 The Bank's standard domestic preference provisions will apply for the evaluation and comparison of bids submitt3d under ICB procedures. All procure- ment documents relating to bids valued over US$1.0 million will be subject to Bank prior review; those under this value will be submitted for post-award review.2/ Goods and services costing less than $100,000 or between US$100,000 and US$200,000 may be purchased directly by IOC using either international and local shopping or limited international bidding procedures, respectively, limited to an aggregate of US$20.0 million. It is proposed that retroactive financing in the amount of US$20 million for expenditures incurred after project appraisal in October 1988 be allowed to cover payments expected to be made by IOC for services and equipment procured in accotdance with the Bank's procurement guidelines before the proposed loan is signed. 2/ It is estimated that the project procurement requirements will be covered by about 20 procurement documents; of these about ten are estimated to have a value in excess of US$1.0 million each and a total value of US$415 million. The Bank has already reviewed and cleared the largest of these bidding documents, for the Kandla-Bhatinda pipeline.  - 31 - H. Disbursements 3.17 The Bank loan is projected to be disbursed as shown in Annex 3.3 and summarized in Table 3.5 appearing below. The rate of disbursement is based on the loan becoming effective by mid 1989 and that it will be disbursed over a period of five years. This is not fully in conformity with the Banks June 1988 standard seven-year disbursement profile for energy projects in India. However a shorter project duration is justified taking into account the completion times recorded for similar IOC projects and the fact thaL the use of turnkey single responsibility contracts for major project components will facilitate implementation. Projected disbursements are based on the initial deposit of US$35 million into the special account being made in FY90 and signing of contracts for the pipeline, SBM and DDCS components in FY91. There'xre, substantial disbursements are projected over the early years. Table 3.5: DISBURSEMENT OF THE BANK LOAN (US$ Million) BANK FY FY90 FY91 FY92 FY93 FY94 Annual 35 110 130 50 15 Cumulative 35 145 275 325 340 3.18 To facilitate disbursement, a Special Account will be opened with an initial deposit in US$35 million equivalent, the estimated average expendi- tures for a five-month period. The account will be opened in US dollars in a bank acceptable to the Bank. Applications for replenishment of the Special Accouint will be submitted quarterly or whenever the Special Account is drawn down to 502 of its initial deposit, whichever comes first. Disbursements will be made against priced contracts for the goods, services and works procured under the Bank loan, and SOEs--if any. Interim certification of works completed and costed at unit rates in the contracts will be done by IOC's construction supervision team and certified by IOC. Disbursements for train- ing overseas will be made against the actual costs of travel, subsistence and tuition or training fees. Disbursements against statements of expenditure will be made for the training component and for goods or services costing less than US$300,000. Documents supporting the expenditure statements will be retained by IOC and made available for review by Bank supervision missions. During negotiations, instructions for the operation of the Special Account will be provided to IOC and agreement will be sought that IOC will open an account in a bank satisfactory to the Bank. I. Ecology and Safety 3.19 As described more fully in Annex 3.4, IOC complies with or exceeds the standards of India's environmental protection regulations which are as stringent as those in the developed countries. The net environmental effect  - 32 - associated with the refinery project components will be benign and in propor- tion to the reduced atmospheric lead content in urban areas when the lower levels of lead in motor gasoline are achieved. Refinery emissions are currently measured a minimum of four times a day as well as after process upsets. Supervision missions will compare emission measurements with Bank and WHO standards. Due consideration to environment and energy conservation is being taken in the design of the pipeline and SBM components. Under normal circumstances, any environmental impact will be reversible and should be limited in duration to the construction period. Compared to alternative modes of transport, the pipeline has clear advantages, namely less spillage, less evaporation and air pollution and less energy consumption. 3.20 Some temporary disturbances of short duration will occur during pipe- line construction while clearing the right-of-way and preparing the pipeline ditch. However, once the pipeline has been installed, the trench will be covered and the right-of-way restored to its original condition for the growth of grass, crops and other vegetation except large trees. In forested areas, which are avoided to the extent practical, cutting of trees will be restricted to the minimum possible by adjusting the pipeline's alignment. During opera- tions, some small leakages can be expected at the pumping stations. Oily water separators will be installed at these locations to reduce the oil con- tent to permissible levels before any effluent is discharged from the sta- tions. The SBM will also cause some temporary disturbances during construc- tion of the submarine pipeline and fasten4ng of the mooring unit to the sea floor, but the effect will be temporary and of short duration. Judging from 11 years experience with the existing SBM, oil spills from the SBM operation should not cause a pollution problem. Two tugs which assist the crude oil off-loading operation are equ ?ped with chemical dispersants and manned by crews trained to apply the chemicals. Overall control of oil spill clean-up rests with the Kandla Port Trust. The Trust and the Indian Coast Guard patrol the area for oil spills and other pollution by vessels calling at the port. 3.21 IJC's petroleum facilities are designed and constructed in compliance with the strictest international and Indian safety standards, and the organi- zation is fully prepared to respond to an accident or emergency condition. At all installations, an accident or emergency condition will activate a disaster control plan which will set in motion the particular contingency actions required to deal with the specific emergency which has taken place. For the products pipeline, operating variables will be continuously monitored by the supervising control system which will immediately isolate and limit the emer- gency condition to the smallest practical area. During negotiations, assurances will be sought that IOC will continue to take adequate precautions in line with industry practices to protect its workers and the environment during implementation of the project. J. Project Reporting Requirements 3.22 IOC will submit to the Bank quarterly progress reports for the proj- ect components in accordance with the contents and format outlined in Annex 3.5. Within six months after the closing date of the Bank loan, IOC will prepare and submit to the Bank a project completion report. The report will undertake a retrospective review and analysis of the major activities of the project, its aims and accomplishments and the performance of the participants including the Bank. An outline and instruction for preparing the c'impletion report was provided to IOC during negotiations.  - 33 - K. Project Risks 3.23 Cost overruns and delays in project completion constitute the major project risks. As detailed in para. 5.18, the economic impact of the project is relatively insensitive to cost overruns: a 102 cost overrun would have the project's overall economic rate of return reduce from 26Z to 232. The impact of the project is more sensitive to implementation delays but the economic rationale remains robust to the likely range of risk: a two year delay in completing all components would reduce the overall rate of return to 21%. 3.24 Errors in demand projections are another source of risk that may affect the economic rate of return of the Kand'.a-Bhatinda Pipeline, which is intended for products. If the rate of growth in demand is 252 less than expected, the rate of return on this component would fall from 222 to 182, which is still satisfactory. 3.25 A further risk is that the margins between products and crude oil might increase to a level which could make import of crude oil and domestic refining clearly more economic than importing products. Even under such a scenario, the investment risk is minimal as the pipeline could be readily converted to transport of crude oil. 3.26 Environmental risks during construction and operation are considered minimal given the strict enforcement of environmental -rotection standards by the Government and IOC's record of compliance with these standards. They are c-rtainly less than the risks which would pertain in the absence of the project. For example, without the Kandla-Bhatinda pipeline, products would be transported by rail, with a higher probability of accidents and spillage. Similarly, a mishap at the crude oil receiving facility at Salaya is more likely in the absence of the project, because excessive utilization and occu- pancy of the existing SBM would preclude proper maintenance.  - 34 - IV. FINANCIAL ANALYSIS A. Introduction 4.1 IOC's main financial objectives are: to ensure an adequate return on capital employed and to maintain a reasonable dividend to GOI, its share- holder; to ensure maximum economy in expenditures; and to generate sufficient internal resources to fund a substantial portion of capital expenditures. Over the past decade, IOC has been remarkably successful in achieving these objectives; dividends were steadily increased from 62 of paid-up capital to the current 18Z, and IOC has funded about 80X of capital expenditures out of inteLaal sources. This development has been made possible by an impressive growth over the same period; sales increased by a yearly average of 172, fixed assets by 15X and profit-after-tax by 22Z. IOC's FY88 turnover of Rs 144 billion was the highest of any commercial company in India. FY88 profit- after-tax of Rs 4.6 billion also makes IOC one of India's most profitable companies. In FY88, IOC contributed Rs 26 billion to the central exchequer in income tax and duties alone; GOI benefited further from dividends, commodity taxes and excise duties. 4.2 To keep up with projected growth in demand for refined products, IOC plans to grow even faster in the five years to come. The funding of IOC's ambitious FY90-94 investment program will, according to financial projections given in this chapter, require more use of external funding sources than in the past. GOI has agreed to IOC increasing its funding from external sources and IOC's borrowing directly from the Bank is in line with this policy directive. Once the investment program has been implemented, IOC's internal cash generation will increase substantially permitting the repayment of long- term debt as well as increased dividends to GOI. B. Pricing System 4.3 The GOI-approved remuneration and pricing system (para. 2.13 and Annex 2.3) is the main determinant of IOC's financial performance. This system has protected IOC from the volatility of products and crude prices in international markets during recent years and has permitted IOC to fund its capital outlays largely out of internally generated funds as well as maintain a reasonable dividend. The remuneration and pricing system also provides IOC with adequate incentives for efficiency improvements; IOC's refinery, pipeline and distribution operations compare favorably with those of efficiently run companies outside India. 4.4 In the short run, however, this remuneration system may have draw- backs that need some further comment. The 'capital employed," on which IOC is entitled to a return and reimbursement of interes- paid, consists of net fixed assets in operation plus 'normative' working capital (45 days of crude throughput for refineries processing imported crude and 35 days for other refineries). Capital works in progress are not entitled to a return until put into operation. This means that during periods in which IOC's depreciation of  - 35 - fixed assets (averaging 102 p.a) about equals the value of assets put into operation, IOC's net profits are likely to stagnate; this is expected to occur in FY89-91. On the other hand, when substantial new fixed assets are put into operation, IOC's net profits rises sharply; this is forecast to occur from 1992. 4.5 The pricing and remuneration system is applied to the operation of each refinery and major pipeline unit as a whole. The result is that each discrete investment will produce an after-tax return of 122 plus whatever incentives, recognized under the system for efficiency improvements, are attributable to the investment; the total return would be about 152 based on IOC'S past experience. Under these circumstances, it is not very meaningful to calculate a financial rate of return to IOC on specific investments; the total return of IOC investments, without differentiating as to where the benefits accrue--GOI or IOC--, is a better measure of the financial viability of IOC projects. This is the approach used for financial IRR calculations in this chapter. C. IOC's Finances 4.6 IOC's financial statements for FY84-88 and projections for FY89-95 are given in Annexes 4.2. Projections are based on the Bank's commodity forecasts for crude oil, inflation in India at about 72 p.a., increase in IOC's sales volume of 62 p.a., and increases in wages of about 22 p.a. in real terms (see Annex 4.2). A summary of IOC's income statements for FY86-88 and projections for FY89-94 are given below:  - 36 - Actual Projections FY ending 3/81: 1986 1987 1988 1989 1990 1991 1992 1993 1994 (Rs Billion) Gross Margin on Sales /a 12.2 15.0 17.0 18.4 19.7 21.7 24.5 31.4 35.2 Operating Cost 10.1 11.0 11.8 12.5 13.3 14.8 16.5 19.6 20.3 Operating Income 2.1 4.0 5.2 5.9 6.4 6.9 8.0 11.8 14.9 Net Income 1.3 4.3/b 4.1 4.7 4.8 4.5 5.6 9.1 11.3 Operating Ratio (Z) Ic 83 74 69 68 67 63 54 52 50 Rate of Return (2) /d 20 21 48 45 46 44 40 36 29 /a Regulated ex-refinery prices for products less actual cost for crude oil and purchased products. lb FY87 net profit was boosted by extraordinary income, due to retroac- tive price adjustments that were accounted for in 1987. Ic Operating costs as a percentage of gross margin. /d Operating income less income tax as a percentage of net fixed assets in operation valued at cost of acquisition; this rate of return concept is different from the regulated one described in Annex 2.3. 4.7 During the project period, the volume of sales is expected to grow 6Z p.a., duo to projected inflation and product price increases, sales revenues are expected to grow on average 152 per year, gross fixed assets 242 per year, gross margin on sales 12Z per year and operating costs 102 per year. However, due to the GOI regulation of IOC's return, IOC's net profit will stagnate in FY89-91, mainly for reasons given in para. 4.4 above. IOC's operating ratio is expected to decline steadily during the project period due to efficiency improvements and higher interest payments.l/ The high rate of return in FY88-92 is mainly due to a relatively low rate base; after the commissioning of major capital investments in FY93-94, IOC's rate of return will decline to a more normal 25-30?. 4.8 IOC's financial position as of March 31, 1988 and projections for March 31, 1994, the end of the project period, are given below: 1/ The remuneration system provides for a gross margin on sales that cover interest payments on loans to finance IOC's capital employed (see Annex 2.3).  - 37 - FY Ending March 31: 19 3 1994 (Rs Billions) Net Fixed Assets in Op. 7.5 28Z 49.7 47Z Capital Works in Progr. 3.3 12Z 33.6 32Z Investments 11.9 45Z 0.8 12 Working Capital, Net 3.9 152 20.6 202 Total Assets 26.6 1002 104.7 1002 Stockholder's Equity 17.3 652 56.0 532 Long-term Debt 9.3 352 48.7 47Z Total Capitalization 26.6 1002 104.7 1002 Current Ratio (times) 1.2 1.5 4.9 IOC's financial position is strong with long-term debt only about 352 of total capitalization. At the end of the project period, long-term debt is expected to equal about 472 of total capitalization, but this share is likely to decrease starting in FY95, when new capital expenditures are expected to slow down and major capital works will be commissioned and start to earn revenues. IOC's current ratio is expected to increase from 1.2 to 1.5 during the project period, which would provide for adequate liquidity. 4.10 IOC's fixed assets are at cost of acquisition and may be undervalued as compared with replacement cost. However, most fixed assets are fairly young; in FY89 about 402 were less than five years old and, in FY94, over 602 will be younger than five years. Further, inflation in India has been rela- tively moderate. IOC's valuation of fixed assets is, therefore, not causing any major distortions of its financial statements.  - 38 - 4.11 IOC's projected funds flow statement for FY90-94 is presented below: FY 90-94 Rs Billions 2 Sources Internal Cash Generation 68.8 75 Less: Debt Service 12.7 14 Tax payments 10.6 12 Dividends 1.1 1 Increase in WC 14.7 16 Net Internal Cash Generation 29.7 32 Liquidation of Investments 17.2 19 Total Cash from Int. Sources 46.9 51 New Long-Term Debt 44.8 49 Total Sources available for Cap. Exp. 91.7 100 Application Capital Expenditures 91.7 100 4.12 IOC expects to fund about 512 of its FY90-94 investment program out of internal sources. This is satisfactory considering the high level of capital expenditures planned for the period. The proposed Bank loan of US$340 million (Rs 4,950 billion equivalent) would finance about 5 of IOC's FY90-94 investment program. The Bank will lend directly to IOC, on the Bank's standard terms for India, with the guarantee of GOI. The foreign exchange and variable interest rate risks will be borne by IOC. IOC will also pay a fee to GOI for its guarantee. The total cost of the Bank loan to IOC will depend on the future exchange variations between the Indian rupee and the Bank's currency pool. If future exchange variations follow the pattern of 1984-88, the total cost to IOC would not be less than the commercial rate, currently about 142, at which IOC can borrow from local commercial banks. 4.13 In addition to IOC's internal funds and the proposed Bank loan, about Rs 44.0 billion (US$2,700 million equivalent) would be required for the FY90-94 investment program. During appraisal, the feasibility of suppliers credits, commercial bank credits, bond issues, public deposits, etc. was dis- cussed with GOI and IOC and it was agreed that IOC would increase its use of  - 39 - such external sources for the funding of its FY90-94 investment program. During loan negotiations, assurances from IOC were obtained that adequate funds will be allocated to the project to ensure its timely completion. D. Financial Covenants 4.14 The financial projections for IOC indicate that IOC's financial per- formance will continue to be satisfactory In terms of rate of return on assets and cash generation under the GOI-established pricing and remuneration system. During negotiations, assurances were obtained from IOC that it will maintain: (i) a current ratio of not less than 1.2; (ii) a debt/equity ratio below 60/40; and (iii) a debt service coverage of not less than 2.0 times; assurances were als3 obtained from GOI that the refinery pricing system will not be changed in a way that would be detrimental to IOC's financial viability. Financial reporting and audit and IOC assurances that necessary funds will be allocated to the project to ensure its timely completion have been dealt with in paras. 2.10 and 4.13. In this context, GOI/IOC agreed to arrange for US$75 million in co-financing for the line pipe for the proposed project (para 3.9). The FY9o-94 investment program is the largest ever undertaken by IOC and is estimated at US$6.3 billion equivalent; the financing of this program will require that about US$3.0 billion equivalent be raised from external sources. To ensure that IOC's managerial and financial resources are not overcommitted, agreement was reached with GOI/IOC that the Bank will be given an opportunity to review and exchange views with IOC on any major change in IOC's FY90-94 investment plans (para. 2.18). E. Project Financial Evaluation 4.15 As stated in para. 4.5 above, it is more meaidngful to analyze the financial viability of projects and their components without taking into consideration to what extent benefits accrue to IOC or to GOI. The financial IRRs below, therefore, reflect the total financial return on IOC investments. The assumptions and calculations for these IRRs are given in Annexes 4.3 to 4.7. 4.16 The Kandla-Bhatinda pipeline is the main project component and con- stitutes 632 of the total project cost; the rationale for its design is given in paras. 5.3-5.5. The financial IRR calculations are based on the estimated incremental capital and operating expenditures attributable to the pipeline and include the costs of products required to fill tanks and the pipeline among capital cost. The benefit of the pipeline is assumed to equal the sales price of the products (less excise duties and distribution costs from the pipeline terminal to the consumers) minus the CIF cost Kandla f,r products (including normal port charges, taxes and duties). The resulting IRR of this component is 4422/ (Annex 4.3). A sensitivity analysis indicates that with 102 higher capital costs or 102 lower revenues, the IRR would still exceed 40Z. 2/ The financial rate of return is not strictly comparable with the ERR, due to different assumptions regarding benefits; for the ERR, pipeline benefits are assumed to equal the avoided economic cost of the next best alternative, railway transport.  - 40 - 4.17 The second single buoy mooring (SBM) system at Salaya constitutes about 22 of the total project cost. The SBM is mainly justified on security of supply grounds; a complete breakdown or the existing SBM would interrupt the supply to the north-west of India of petroleum products equal to 11.2 million mtpa of crude oil for about three months. In any one year, the probability of a complete breakdo-in is assessed at 1.5Z, while the probability of less serious damage to the buoy (entailing a supply interruption of 15 days) is assessed at 3Z. The benefits of the second SBM are assumed to equal the sales value of products (less excise duties and distribution costs) minus the cost of crude (including port charges, taxes, duties, chemIcals and other direct refining costs) for the expected volume of products that would not reach the consumers in case of disaster. Another benefit is that ship waiting times will be reduced; for more detail, see Annex 4.4. On this basis, the IRR for the SBM would be 16Z; with 10Z higher costs or 1OZ lower revinues, the IRR would still exceed 102. 4.18 The catalytic reformers (about 9Z of total project cost) will convert the naphtha feedstock into higher value reformate (a high octane gasoline blending component) and other products. Valuing the changes in product slate at import parity prices, the IRRs of this project component would be 142 for Barauni and 14Z for Digboi. The IRR would exceed 122 in both cases even with 102 higher costs or 1OZ lower benefits (Annex 4.5). The catalytic reformers are also justified by their beneficial impact on the environment and the need to comply with GOI established standards on the maximum lead content in gasoline. 4.19 The distributed digital control system (DDCS), which is about 142 of the total project cost, will increase the distillate recovery from IOC's refineries and reduce fuel consumption and losses. Valuing the increased distillate recovery and the fuel savings at import party prices, the IRR of this project component would be 272 (Annex 4.6). Even with 102 higher costs and 21! lower benefits, the IRR would be 25Z. 4.20 The revamp of the Haldia Lube Block, including the sulphur unit, is about 32 of total project cost and will increase the production of high value lube oils and diesel and decrease fuel oil and kerosene output. Valuing the changes in product slate at import parity prices (which are close to ex- refinery prices), the IRR of this project component would be 28Z (Annex 4.7). Even with 10Z higher capital costs, or 10Z lower benefits, the IRR would exceed 252. 4.21 No IRR has been calculated for the energy conservation and yield optimization components; the technical, economic and financial feasibility of these components will be reviewed by the Bank once the feasibility studies are completed. Neither has an IRR been calculated for the technical assistance provided under the project.  - 41 - V. ECONOMIC EVALUATION A. Introduction 5.1 Benefits have been quantified, and economic rates of return computed, for the Kandla-Bhatinda Product Pipeline, the Single Buoy Mooring System at Salaya, the Catalytic Reformers, the Distributed Digital Control Systems and the Haldia Lube Block. Together, these items account for about 90Z of total project costs. B. Economic Evaluation of Kandla-Bhatinda Product Pipeline Demand Projections 5.2 In 1985 the Ministry of Petroleum constituted a Committee on Supply Measures, comprising representatives from the oil industry, Planning Commission, and the Ministries of Petroleum & Natural Gas, Railways and Surface Transport, to examine and recommend various measures to ensure adequate supplies of petroleum products throughout India until the year 2005. The Committee reported in January 1988 and the following analysis is based on the Committee's projections, which seem reasonable. 5.3 The region to be served by the proposed pipeline covers what is referred to as the northwest and Koyali-Kandla-Okha areas, embracing Deihi, Punjab, Haryana, Jammu and Kashmir, Himachal Pradesh, western Uttar Pradesh, Gujarat, Rajasthan, and a major portion of Madhya Pradesh. The demand for major products 1/ in this region is projected to grow from 11.3 million tons per annum (MMTPA) in 1988 to 33 MMTPA by 2005, implying an annual growth rate of about 6.5Z, compared with 7Z per annum since 1980. In 1988, 8.4 MMTAA of the 11.3 MMTPA total demand was met by two regional refineries at Koyali and Mathura, which are producing at capacity. The balance of 2.9 MMTPA was met by products brought in through Kandla (2.2 MMTPA) and by net transfers from other regions (0.7 MMTPA). Revamping and debottlenecking of the Koyali and Mathura refineries will increase their combined output of major products by about 1 MMTPA by 1993. GOI has also approved construction of a new grass-root refinery at Karnal, which is expected to produce 2.7 MMTPA of major products in its initial commissioning year of 1995 and 4.2 MMTPA thereafter. However, these increases in refinery capacity will be insufficient to keep pace with demand, and the net regional deficit of major products to be met by imports through Kandla is projected to reach 7.1 MMTPA in 1994, decline to 5.1 MMTPA following the commissioning of the Karnal refinery, then progressively increase to 14.7 MMTPA by 2005 (Annex 5.1). Of course, additional refinery capacity, over and above that already approved, might be developed, and this possibility has been provided for in designing the pipeline capacity (next para.). 5.4 IOC's distribution plans for the region are based on minimum transport cost as determined by a linear programming model capable of handling up to 5,400 columns/variables and 1,500 rows/constraints. The model identifies the least-cost channel of supplying each major product to each 1/ Motor Spirit (MS), Aviation Turbine Fuel (ATF), Kerosene(SKO), High Speed Diesel (HSD), and Light Diesel Oil (LDO).  - 42