Gas is an exhaustible resource and it does not also have a global market like any other commodities that can be easily traded internationally. The determination of an "economic" price of gas therefore involves difficult conceptual problems (since market does not provide much guidance for it) and depends on country-specific circumstances.

One plausible way of conceptualizing the economic pricing of gas is by considering that the cost of using an extra unit of it now is the cost that will be incurred for importing an equivalent amount of fuel (e.g. fuel oil, coal or gas) when domestic gas will be exhausted. However, because of society's time preference of income (or money), the future cost needs to be discounted to convert it to its present cost equivalent. Three factors are thus crucially important for the determination of the present economic price of gas: (i) the predicted year of gas exhaustion, (ii) the projected import price of alternative fuels at that time, and (iii) the social rate of discount. For this report, we use a social discount rate of 8 percent per annum, which is admittedly arbitrary, but seems reasonable by the standard of social cost-benefit analysis.

It should be noted that the idea of estimating an equivalent amount of fuel to replace, say, 1 mcf of gas is not a straightforward one. In the energy discourse in Bangladesh, the equivalence of energy from different sources is measured in terms of their heat generating capacity. This is not an ideal basis to determine the "economic price equivalents", which are those prices that would make the production costs equal for producing, say, one unit of electricity by using alternative fuels. Such price equivalence usually differs from the one derived from the purely physical concept of energy equivalence, depending on the relative efficiency and costs of alternative technologies associated with the use of different fuels. The concept of "economic price equivalents" (sometimes called "replacement equivalents") is a useful tool for energy planning, but not yet familiar in the energy discourse in Bangladesh.

To make some rough calculations, we estimate the equivalent price of imported fuels for replacing gas in the medium to long run to be US$ 6 per mcf of gas. For this we have taken into consideration several factors. The above price of gas roughly corresponds to the medium to long run oil price projections of around $35-40 per barrel of crude oil (notwithstanding the current price hike) converted by the conventional energy equivalence between gas and fuel oil. Another relevant factor is the existing prices of natural gas and fuel oil in countries such as Canada where both the energy sources are abundantly used for electricity generation; the assumption being that market forces would bring the relative prices close to "replacement equivalents". For example, the 2004 plant-gate price of fuel oil in Canada was US$ 41 per barrel and that of natural gas $5.42 per mcf. A third consideration is the current negotiations regarding the possible price of gas imported through pipeline in this region (such as by China or India from Myanmar); this price is likely to be nearly $5 per mcf.

According to some estimates, the country will run out of gas in ten year's time (by 2016) given the domestic gas demand projections along with the estimated "proven and probable" discovered gas reserves. Applying the annual discount rate, the implied present economic price of gas works out to be $2.78, which would rise by 8 percent annually during the ten year period (after which imported fuels will replace domestic gas). It should be noted that the estimated present economic price of gas is highly sensitive to the assumed gas exhaustion year. Thus, extending the exhaustion year by 5 years and 10 years (that is, year 2021 and 2026) would reduce the current economic price to $1.86 and $1.28 respectively. If, on the other hand, it is assumed that the country will need to start importing fuel to partially replace gas even before the exhaustion year (because, say, the oil fields are not developed in time to meet domestic supply), then that will be the year when the economic price of gas becomes equal to the equivalent price of imported fuel. The projected economic price will also need to be revised whenever new information will be available regarding the domestic gas supply-demand scenario.

While the economic price is projected to escalate annually under any given scenario, it is interesting to see what would be the equivalent price in a sale contract in which the price in dollar terms were to remain unchanged from year to year. This is not the simple annual average of the projected price, since paying a higher amount in the initial years is not the same as doing so in the later years (again because of the social discount rate). The annual price of gas in the above three scenarios of gas exhaustion in 10, 15 and 20 years works out as $4.14, $3.31 and $2.60 respectively. If we assume the replacement price of imported energy to be $5, instead of $6 as assumed above, these prices will proportionately change to $3.45, $2.76 and $2.13 respectively.

The above analysis shows the crucial importance of strengthening gas exploration efforts to determine the country's gas reserves, since such knowledge is essential for making long run plans for gas utilization. In all probability, Bangladesh has gas reserves to last a much longer time than is indicated by the currently available estimates of proven reserves. As the estimate of proven gas reserves increases, and provided enough investments are made in developing the gas fields to meet domestic demand, the estimate of economic price of gas will have to be revised downward. But prudent economic planning should not rely too much on risky assumptions. This is a fundamental problem in making commitments regarding the ensured supply of gas at a pre-determined price as is sought in Tata's proposal.

A conceptually less appealing but practical way of finding an economic price of gas would be to estimate the average cost of producing an extra unit of gas and then add a premium on it, the premium being the rent earned for the ownership of gas. Additional gas production in Bangladesh will come largely from the fields operated by the IOCs. The average cost of this gas would depend on the share that Petrobangla gets and the price charged by the IOCs for the remaining share. This will vary depending on the stage of the project life cycle (involving the cost-recovery phase) and between different PSCs as well as between off-shore and inland gas. The transmission cost will have to be then added to get the end-user gas cost. Rough estimates suggest that the average wellhead cost may be $2.00 to $2.20/mcf in the cost recovery phase and $1.24/mcf in the later phase. Averaging this and adding a transmission cost of $0.20/mcf and a minimum premium of $1.00 will work out to be around $2.90.

The estimation of economic price of gas is important not only for negotiating the terms of contracts for prospective FDIs, it has much wider implications for determining the most economically beneficial use of gas. It is "wasteful" to use an extra unit of gas for uses from which society gets benefit less than the economic price of gas. When it is argued that exporting gas can jeopardize the country's energy security, it must be recognized that using gas wastefully for domestic use can equally do so. In particular, when long-run commitment is being made for supplying gas, such as in setting up a fertilizer factory, the social benefit from the investment involved needs to be assessed on the basis of appropriate pricing of gas (along with the option of importing fertilizer instead of producing domestically). Whether gas and fertiliser prices should be subsidized for the benefit of farmers, and by how much, is an altogether different issue.

Bangladesh has a history of subsidised gas supply. Almost 70 percent of the gas produced annually is sold to the state-owned fertiliser factories and power plants at a highly subsidised price of $1 per mcf. The private power producers also buy gas at a subsidised price of $2 per mcf. The joint-venture fertiliser factory, KAFCO, has been supplied gas at an average price of $1.22 for ten years; only recently the price has been raised to $2.34 which is also about the price now charged for industrial use of gas.

Wahiduddin Mahmud is a renowned economist. Part III of this report will appear tomorrow.