Oil minister Veerappa Moily today categorically ruled out rolling back the decision to allow state-run oil retailers raise prices of diesel by up to Rs 0.50 a litre each month, citing economic concerns.
The government plans to gradually align the cost with market rates in a bid to reduce the ballooning subsidy bill and budget deficit.
"Diesel subsidy has to take place as it is necessary ... The red flag and concerns that have been raised are natural, but we also have to take care of the finances and India's sovereign rating, among other things," Mr Moily told reporters in Jaipur, on the sidelines of the Congress Party's Chintan Shivir.
After including local sales tax or VAT, price of diesel for retail users went up by 50 paisa to Rs Rs 47.65 a litre in Delhi. Bulk users, which consumer around 17.77 per cent of the total diesel sales in the country, will pay Rs 56.88 a litre in Delhi.
Mr. Moily said diesel and petrol had been deregulated by the BJP-led NDA government in 2002, but the UPA government had continued to subsidise diesel, the nation's most consumed fuel.
"This (deregulation) has been going on even during the days of NDA," he said. "(There were demands that) there should be deregulation of diesel and this is the only commodity where we have the regulations."
Although the government has pared its economic growth projections for the year, it raised its forecast for diesel consumption ahead of the decision.
Diesel demand in the country is expected to rise 8.3 per cent in the fiscal year ending March, to 1.43 million barrels per day (bpd), up from a prior forecast of 5.9 per cent.
The country exported about 416,000 bpd of diesel in 2011-12, the bulk of that by Reliance Industries, operator of the world's biggest refining complex.
The government, which owns about 78 per cent of Oil India, is likely to raise more than $500 million by selling 10 per cent in the explorer and producer early next month, said sources with direct knowledge of the plan.
Raising the diesel price may also help revive a 10 per cent stake sale in retailer IndianOil, which hired six banks in 2010 to prepare for the sale only to shelve the issue as its earnings worsened because of the subsidies, although people familiar with the matter said such a sale was unlikely to happen soon.
Selling shares in state companies is a central plank of the government's plan to bring the deficit down to 5.3 per cent of gross domestic product for the financial year ending March and avoid a credit downgrade from global ratings agencies.
The subsidy burden of India's state oil producers and retailers has also been a worry for overseas investors, who are usually the biggest buyers of large share deals in Asia's third-largest economy.
"The element of cynicism around the public-sector oil firms will reduce a great deal after this decision," said Jagannadham Thunuguntla, equity head at SMC Global Securities. "It augurs well for the divestment programme."
The government, which fixes the retail price of diesel, on Thursday told retailers to raise prices in small amounts every month, a move that should also improve revenues in the sector. At the same time, it removed price controls for bulk sales, which account for about 18 per cent of total demand.
Indian stocks, bonds and the rupee all rallied on the government's decision with the rupee at its highest level in nearly two-and-half months on Friday.
"In aggregate the decision would help attract more investment in the oil and other sectors from foreign investors," said a senior finance ministry official, who declined to be named because of a restriction on speaking to the media in the run-up to the Indian budget release.
While shares in India's state-run oil refiners rallied, the decision to sweep away subsidies for bulk sales could create an opportunity for private rivals Reliance Industries and Essar Oil, which may look to broaden their market share.
Large-scale diesel sales account for about 18 per cent of the total demand of some 522 million barrels a year. State-run IOC, India's biggest refiner, owns about 80 per cent of the market.
"If there is a level playing field, we will be in the market and we will be competitive. We are looking at being in the market in this segment," said L K Gupta, chief executive of Essar Oil, the country's second-largest private refiner.
Reliance, owner of the world's largest refining complex, with 1.2 million barrels per day (bpd) capacity on India's west coast, could also look to sell more in its backyard.
"There will definitely be an impact on volumes," said IOC's director of marketing, M Nene. "Earlier there were three players, now there will be three more," he added.
Private refiners might offer better credit terms, discounts and service to bulk customers, Mr. Nene added.
Along with IOC, state-run HPCL and Bharat Petroleum sell to bulk customers, which include railways and defence industries in the state sector and cement companies, miners and power plants among private clients.
Serious competition in bulk sales is still seen some way off, with private refiners lacking the marketing infrastructure, and many big state-owned clients having annual contracts.
While a difference remains between bulk and retail prices, large-scale customers may be tempted to buy as much as they can in the market where subsidies continue.
"We have to be very vigilant at the retail level as we should not be permitting supply of diesel from the retail outlets to consumers who are not entitled to get such supplies," said Mr. Nene of IOC.
Nomura analysts said in a Friday note that "higher prices for bulk sales should reduce the bulk market size," as private companies would have lots of incentives to resort to retail purchases to cut costs.
Most foreign buyers stayed away from a $2.6 billion stock auction in Oil and Natural Gas (ONGC) in March last year.
Uncertainty about its subsidy burden was one of the reasons for the poor response to the issue that was bailed out by state financial investors.
State-run upstream oil companies Oil India, ONGC and GAIL (India), sell refined products and crude oil to state retailers at a discount, which hurts earnings and dims investor appetite.
"The biggest challenge in an offering by a public sector oil company is to answer all the investor queries around the subsidy mechanism and its impact on the earnings outlook," said a source.
"The government's diesel price move is surely a good step and brings clarity about their financials, which will boost demand for shares," said the source.
Analysts said producers such as Oil India would benefit most from the diesel price hike, given they have been selling crude oil and associate products at a discount and could be allowed to charge higher prices.
Shares in Oil India rose as much as 20 per cent on Friday, adding $1.1 billion to its market value, while the Sensex was up 0.6 per cent. The stock gave up some of its gains later and was trading up about 10.2 per cent.
At the current market price, 10 per cent of Oil India is valued at about $630 million. The government usually auctions shares to investors at a discount to the market price to ensure demand.
The diesel hike comes at a time when Railways is facing an acute financial crunch. Earnings from passengers and freight have failed to meet the target in the current fiscal year. The annual plan allocation has also been reduced from Rs. 60,000 crore to Rs. 51,000 crore this year.
As per the government's decision, bulk consumers such as Railways and state transport corporations will have to buy diesel at market price. The Railways procures about 250 crore litres per year from oil companies for its fleet of 4,500 diesel locomotives hauling both passenger and freight trains.
Railways had recently hiked passenger fares in all classes to earn additional revenue of Rs. 6,600 crore in a year. The passenger fare hike will come into effect from January 22.
The three oil PSUs - Indian Oil, Hindustan Petroleum and Bbharat Petroleum - supply fuel providing a subsidy of 30 paisa per litre as Railways is a bulk consumer of diesel. However, with the subsidy gone, Railways will have to buy fuel at market rate, which is likely to hit hard the national transporter.
Asked about the impact of the decision on Railways, Mr. Moily said it will "largely" have no impact as bulk buyers purchase other inputs and fuels at commercial rates. "They are all running commercially and ultimately they have to find their own budget," he said.
(With inputs from agencies)