The Hindu Business Line : Impact of crude price — RBI may prefer status quo monetary policy

The RBI has stated that an upturn in the inflation numbers would be countered with prompt and effective (monetary policy) action. If global oil prices rise further, there will be pressure to hike domestic oil prices. An analysis of the price patterns and trends in the global crude oil markets is, therefore, essential to gain an insight into how the domestic interest rate markets are going to shape up.

THE PASS-THROUGH of crude prices is the most critical factor influencing domestic inflation, states the Reserve Bank of India (RBI) in its first quarterly review of monetary policy for 2005-06.

The RBI also states that any upturn in the inflation numbers (from the current relatively low levels of 4.25 per cent) would be countered with prompt and effective (monetary policy) action.

There cannot be a clearer guide to the central bank's monetary policy stance than this. If global oil prices rise further, there will be pressure to hike domestic oil prices. The pass-through impact of oil prices on the general price level would then be accentuated.

Given this background, an analysis of the price patterns and trends in the global crude oil markets is essential to gain an insight into how the domestic interest rate markets are going to shape up.

Such a study indicates that global crude oil prices could possibly be flattening out in the near term — say, over the next four-five months — but the longer-term crude oil futures indicate good inventory hedging interest.

Such hedging interest implies continued uncertainty about supplies keeping pace with demand. Users of the commodity therefore see a high level of convenience in inventoring it.

The upshot is: In the near term (say, the next four-five months), the pressure on the Wholesale Price Index from the oil group of commodities could ease. This could mean that as in its just concluded monetary policy review, the RBI could possibly hold fire in its October review as well. But beyond that, it is anybody's guess if the RBI will continue to place the same level of emphasis on the pass-through effect of oil prices (on the general cost/prices structure in the economy) for determining interest rates.

Different price patterns in futures

The prognosis about oil prices flattening in the near term basically draws its support from the price patterns seen in the oil futures market over the past few months.

The Table gives the spot and futures prices of crude oil (WTI) from the New York Mercantile Exchange (NYMEX) for the past half year.

A key parameter in the forward pricing of consumption commodities such as oil/metals (as opposed to investment commodities such as gold/silver) is the "convenience" or benefits from physical possession of the commodity.

This "convenience yield" means that the forward price of consumption commodities is generally a decreasing function of the time to maturity. Longer the maturity, lower the price. But, the Table shows that the expected pattern of forward prices is not obtained in the oil market.

The forward prices for many of the sample dates are an increasing function of time — as is normally the case for investment commodities. For instance, on July 26, with spot $56.79 a barrel, the September contract was quoting at $59.20, and the December, at $60.99. The same pattern was noticed even earlier in March.

Scope for arbitrage and price flattening

This pattern of prices would seem to provide opportunities for arbitraging the spot/forward price differential.

An investor could short a futures contract, buy the commodity spot and store it for the maturity of the futures. He could then deliver under the futures and pocket a riskless profit, provided his costs of financing and storing the commodity do not wipe out the positive differential between the spot and forward prices.

It is this expected arbitraging of the spot/forward pricing differential that could possibly help flatten prices around the current levels close to $60, as the spot market purchases and subsequent inventoring/delivery create a buffer stock of the commodity.

Such a capping of prices around the current levels could provide breathing time for oil-consuming nations such as India to finetune their overall policy responses to the structural issues here.

The short-term monetary policy response could be like what the RBI has done in its quarterly review. Stand pat and monitor closely the evolving situation. But an analysis of longer-term futures prices shows that the market is naturally attaching a high level of "convenience yield" to the physical possession of stocks.

Longer-term oil contracts on the NYMEX (more than six months) are displaying the classical pattern of a decreasing function of time. The overall policy response then has to reckon with a structural pattern in the trading, pricing and inventoring of oil. It is quite inevitable that all arms of economic policy are drawn in to tackle this issue in a co-ordinated manner — be it tariff, exchange rate, interest rate, or demand management policy.

(The author is Associate Vice-President, Treasury, ING Vysya Bank Ltd. The views are personal.)

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