Why public sector oil companies fight shy of actively hedging price risks

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The nature of risk exposure of an organisation to fluctuations in oil prices considerably depends on its position in the oil value chain. MR PARTHA BARDHAN, EXECUTIVE DIRECTOR, KPMG (INDIA)

MR PARTHA BARDHAN, Executive Director, KPMG (India)
MR PARTHA BARDHAN, Executive Director, KPMG (India)

It may seem good to read that crude price recently hit this year's lowest. This, despite the disheartening statements from the Finance Minister that consumers aren't going to benefit from the softening of international crude prices, because the gains would only go to offset subsidies and reduce the burden of oil bonds. At the time of writing,

has a story dated October 18 headlined `Crude oil rises as OPEC meets tomorrow to decide on output cuts'. The reference is to the Organisation of Petroleum Exporting Countries, which pumps about 40 per cent of the world's oil', and its efforts `to stem a three-month slide in prices'.

Reactions to oil price fluctuations have been varied. "Investors have responded positively to the 25 per cent fall in the oil price by shaking off their aversion to risk and putting their cash to work," reports

People's Daily Online

, citing a survey by Merrill Lynch. "Lower prices for oil and other commodities spell bad news for global emerging markets, and investors are starting to turn away. For the first time in five years, asset allocators have taken a net underweight position in emerging market equities," reads a snatch.

Nigeria's 2007 Budget may come under serious threat, predicts a report by Crusoe Osagie dated October 18, on

, Nigeria. In Sri Lanka, the Governor of Central Bank, Nivard Cabraal, has been advising the government to go for `hedging arrangements with suitable counter parties to mitigate the adversaries arising from high and volatile international oil prices,' as one learns from an interview dated October 9 on


Hedging, as Chicago Board of Trade explains, is "the practice of offsetting the price risk inherent in any cash market position by taking an equal but opposite position in the futures market." Hedging is the transferring of the risk of loss due to adverse price movement through the purchase or sale of contracts in the futures markets, says Futures and Options Market Terminology on


To know more about hedging as a strategy to manage oil price risks,

Business Line

contacted Mr Partha Bardhan, Executive Director, KPMG (India). A veteran in oil and gas consulting, he has handled BPR (business process reengineering), IT (information technology) strategy, valuation and other projects for companies such as Shell, BP Amoco, Cairn Energy, Indian Oil, ONGC (Oil and Natural Gas Corporation), Reliance, BPCL (Bharat Petroleum Corporation Ltd) and GAIL. Here is Mr Bardhan's take on a few questions.

What are the determinants of oil price risk hedging strategies adopted by oil players?

Two factors. One, the risk profile, which essentially depends on their position in the oil value chain. And, two, maturity and sophistication of the risk hedging processes within the organisation.

Risk profile...

The nature of risk exposure of an organisation to fluctuations in oil prices considerably depends on its position in the oil value chain. For instance, an E&P (exploration and production) company like ONGC is perennially exposed to the risk of any decrease in the oil prices. In contrast, an oil refining company would be largely concerned about protecting the spread between crude oil and refined products (gasoline, diesel, naphtha, etc.).

And an oil marketing company would be concerned about the variation in the retail margin, that is, the difference in the refinery price and the retail price at the end-consumer level.

How are each of these categories exposed to risk?

Assuming a free market, the oil refining and marketing companies are exposed to these risks only for the length of the input purchase to product sale period, which would typically range from few days to couple of months. But an E&P company is exposed to the price risk for the entire duration of its business planning cycle (usually a year), thus exposing it to significantly higher quantum of oil price risk with potential to impact the bottom-line as well the top-line. Consequently, most advanced case studies in oil price risk hedging are found in some of the leading oil E&P companies.

You mentioned about `maturity and sophistication' of risk management.

Yes, this is evident in the risk hedging approach adopted, passive or active. Passive hedging is used by highly risk averse companies, which would like to be completely certain of the future cash flows through hedging of their entire risk exposures. It is achieved by locking a specific price either through long-term contracts between the supplier and buyer or through a derivative contract such as futures, forward or swaps that are available on most leading commodity exchanges (e.g., NYMEX, CBOT in US and MCX in India) and also as over-the-counter (OTC) bilateral contracts.

Passive hedging looks like the ideal way to hedge, by ensuring certainty of future cash flows. Or, is there more to it?

True, this strategy helps players achieve certainty of the future cash flows. But it eliminates possibility of gaining from any favourable market movements.

To illustrate, if an E&P company enters into a long-term supply contract with a buyer to sell crude at $60/bbl (barrel), it would not be able to benefit if the crude prices increase beyond $60/bbl.

Is there a way to have the cake and eat it too?

Yes, but it comes with a cost. The way to include the benefit of price changes in the hedge contract is to resort to option contracts, which allow one to either buy or sell in the spot market without necessarily being committed to the hedge contract.

However, this imposes a huge hedging cost in the form of option premium that needs to be paid upfront at the time of hedging. For example, the cost of an option premium could be $3-10/bbl depending on the tenure of option contract.

What is the alternative?

Active hedging. This approach seeks to achieve a balance between risk hedging and the cost of hedging by hedging part of the overall exposures either through long-term contract or a derivative instrument, and keeping the remaining exposure un-hedged so as to benefit from any potential favourable market movements on the un-hedged part.

However, it is extremely important for such players to clearly define the risk appetite, i.e., the amount of money they can afford to lose on the un-hedged exposures due to potential unfavourable market movements. This is usually done by estimating future losses through statistical methods like Value at Risk (VaR) or by building future market price scenarios.

What are Indian oil companies doing about hedging?

Most of the Indian oil companies (except Reliance) being public sector undertakings, are unable to actively hedge their risk. In any trading activity, when an organisation hedges its portfolio, it is primarily taking positions in the future market and operating within a pre-defined band of possible loss or gain. Of course, on a deal-to-deal basis, if you analyse, some deals would be making losses and some profit.

How does being a PSU stand in the way of hedging?

In a private sector organisation, a trader's or the trading division's performances are evaluated based on its set Key Performance Indicators (KPIs), which of course include profitability over a period of time. Thus a trader is not necessarily `questioned' for its failure to `make profit' from any specific deal, unless there is a trend to indicate that the trader's performance is in the downturn.

In PSU set-up, this is not necessarily true, and hence the trading desk is likely to be more `conservative'. Indian Oil, BPCL and HPCL are currently trading in the global market and do hedge their portfolio. Reliance of course does it at a greater level. ONGC was in the process of setting up a trading desk, but it is possibly still not fully operational. GAIL is starting a trading desk.

Does the ICAI (Institute of Chartered Accountants of India) say anything about disclosure of hedging transactions?

The ICAI is yet to come out with some specific recommendations or accounting standard for hedging transaction. However, the RBI requires all such hedging transactions done in international markets to be supported by underlying exposures and it has to be periodically reported to the RBI.

D. Murali

(This article was published in the Business Line print edition dated October 19, 2006)
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