The Hindu Business Line : Why not hedge away oil price shocks?

The sharp rise in oil and other commodity prices over the past several months and its possible adverse impact on inflation/inflation expectations has been a matter of deep concern to governments and policy makers the world over. This concern has been particularly acute in emerging economies such as India.

How to reconcile the soaring energy requirements of a rapidly expanding economy and the inevitable price pressures brought on by such surging demand with the objective of non-inflationary growth? As has been pointed out by the Reserve Bank of India, the greatest challenge now is to manage the transition to a higher level of economic growth without entrenching higher inflation expectations.

Double-digit economic growth and stable/low inflation (around 4 per cent) may not be mutually exclusive objectives. The exercise to attain that, though, could be painful for many economic agents in the interim — such as the Indian oil companies for instance.

Blind alley

The oil companies possibly are bearing the brunt of the policy-makers’ reluctance to subject the domestic price level to the full force of international/market prices. In a complex social and political environment, it does not appear conceivable that the oil pricing mechanism will move to a market-driven format any time soon.

The APM, for instance, was officially dismantled earlier in this decade but is now again well in operation, de facto. Debate and discussion on oil pricing is endless, though it seems futile as all debate finally zeroes in on a market-driven pricing mechanism as the only panacea.

It (market-determined end product prices) may be the ideal solution. But what is surprising about the oil debate is that there seems to be not much of a focus on interim, alternative solutions, which, incidentally, may also be market-related.

Hedging input costs

In a scenario where there are constraints on end-product prices on the selling side, it is surprising that the oil companies have not attempted to more fully hedge the risks of rising raw material prices and attempted to fix their input costs. An analysis of petroleum statistics shows that only around 3-4 per cent of the total imports of crude oil are being hedged by the oil companies. In 2006-07, Indian crude imports were around 90 million tonnes.

To be sure, the hedging ratio of Indian companies is no different from what prevails globally. Indeed, even though the global oil derivatives markets provide a very good platform for hedging for both oil producers and consumers — with contracts stretching out as far as 10 years — the use of this market for hedging has been historically limited.

For instance, as on November 7, 2007, the total volume of outstanding futures contracts (the open interest) for various forward maturities up to December 2008 on the NYMEX and the ICE amounted to around 1.8 billion barrels. Against that, crude production in the next 12 months will be around 30 billion barrels (assuming a production of 85 million barrels per day – the current figure) giving a hedge ratio of around 6 per cent. This has been the case historically also.

Reasons for low hedging

There are a number of structural reasons for the low level of hedging by both oil producers and consumers globally. As far as consumers are concerned, in a competitive environment, unless all players in an industry hedge their consumption of oil, it does not make sense for individual companies to do so. Companies which do not follow industry practice will be subjecting their earnings to greater variability.

More generally, as far as consumers are concerned, the absence of hedging markets with respect to their end products on the selling side inherently limits their hedging. Airline companies, for instance, do not have forward markets for airline tickets.

Also, the price of airline tickets will vary in future with the spot price of oil. Where input price pressures can be passed on to the selling side, the incentive for hedging is weak.

On the production side, many countries with state-owned producers also do not hedge their future production. Even commercial oil producers such as an Exxon or BP are not in the market for hedging in any noticeable way.

This is quite understandable given the structural trend in oil prices over the past many years. Indeed, oil, more than possibly any other commodity, has proved that the futures price curve — for assets which carry a high degree of positive systematic risk — may be significantly understating the expected future spot price of the asset. That is, while oil (because of the high convenience yields associated with holding physical stocks) displays an inverted forward price curve (backwardation), the curve does not necessarily capture the future spot price to any degree of accuracy.

For instance, the futures price curve in February 2006, when spot oil was quoting around $53/55, indicated the forward price for maturities up to December 2007 to be in the range of $60/62. But where are spot prices now? And such divergences between the futures curve and the realised spot prices have occurred many times in the past also.

Costs and calculation

It is this divergence between the futures curve and realised spot prices which should provide a powerful incentive for big consumers such as India to have a structured hedging programme in place. The “industry competitors” argument does not anyway apply here because of the constraints in end-product pricing.

What are the costs of hedging? Assuming the current margin costs of around $6500 per contract of 1000 barrels, the entire Indian import of 90 million tonnes in 2006-07 would have involved a margin outlay of around $4.5 billion – that is around Rs18,000 crore – if Indian companies had taken long hedges on the NYMEX in early 2006, based on the then spot price of around $55.

This margin deposit would have earned some interest (say 3.5/4 per cent) and given the structural trend in prices, the companies would have been able to take back a good part of the margin deposits as mark-to-market profits on the futures positions (over and above the maintenance margins). Most importantly, the input oil costs would have been hedged and fixed based on the futures price curve which prevailed in February/March 2006. It may have been possible then to hold the line on end-product prices as the hedging on the input side effectively lowers the costs relative to the prevailing spot market.

And, who is to fund the cash outlay on the margins required on long futures positions? Note that the Government issued oil bonds worth at least Rs 12,000-13,000 crore in 2006-07. More had been issued in the earlier years also. A hedging policy could mean that, instead of oil bonds, an equivalent amount of money goes into margin deposits.

The cash outflow for placing margins, of course, will be immediate. The advantage still is that with hedging, the importer is able to fix his costs. And unless oil prices fall, there would be no more cash outflow on account of margin calls. A policy of “no hedging and issuing oil bonds”, on the other hand, means that the quantum of bonds (to be) issued could be open-ended.

It, of course, is quite easy in hindsight to point out all this. It is also important to remember that hedging need not always provide the most optimal solutions. And there may be a number of operational issues (key among them being the level of hedging interest among oil producers) to be tackled before Indian companies can institute a structured hedging programme. But, still, the absence of a debate on how India as a big consuming nation can hedge its oil price risks is somewhat disconcerting.

(The author is Vice-President (Research), Shriram Group Companies, Chennai. These are his personal views.)

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