Financial Hedge For India’s Oil Risk – Analysis

The time is right for Indian policy-makers to lock-in energy prices for the long-term at current levels. Not only will this consolidate the gains, but even other long-term solutions—acquiring oil fields, pushing for renewable energy, and adopting electric vehicles—won’t help if there is a price spike in the short-term.

This is where India can use financial markets. With futures and options, India can protect itself in the worst case scenario—of oil prices reaching 2010-14 levels over $100 per barrel again.

Locking-in prices using futures

A futures contract allows the holder to buy or sell an asset at a pre-decided price on an agreed date. For instance, it is possible on 12 January 2016 to buy a Brent crude oil future for December 2016 at a price of $38.3 per barrel on the International Commodity Exchange, London. In this case, the contract holder has agreed to buy a defined quantity at this price, irrespective of how the price of oil moves (See Table 1).

Table 1: How futures can play out in various scenarios

Brent Feb 16 futures ($/barrel)	30.68
Brent Dec 16 futures ($/barrel)	38.30
India’s monthly oil import (million barrels)	91
Scenarios (loss/gain, $ mn) for 1 month of imports
Oil at $20/barrel	-1,655
Oil at $30.68/barrel (Current Price)	-693
Oil at $50/barrel	1,064.7
Oil at $80/barrel	3,795
Oil at $100/barrel	5,614
Oil at $111/barrel (average price for 2011 & 12)	6,616

Source: Gateway House calculations

Capping prices through options

A call option’ gives the holder the right, but not the obligation, to buy an asset at a specified price on a specified date. For this right, the holder has to pay a price—the premium—to the seller. So it is possible on 12 January 2016 to buy a call option for crude oil at a strike price of $60 per barrel for December 2016, at a premium of $1.06 per barrel. This contract has no value if the oil price stays below the strike price, but the buyer is protected from any price increases beyond this level (See Table 2).

Table 2: How call options can play out in different scenarios

Call option premium for December, $60 strike price ($/barrel)	1.06
Cost of hedging 1 months oil imports (91 mn barrels) $ mn	96.5
Scenarios (loss/gain), $ mn for 1 month of imports
Oil at $20/barrel	-96.5
Oil at $30.68/barrel (current price)	-96.5
Oil at $50/barrel	-96.5
Oil at $80/barrel	1,723
Oil at $100/barrel	3,543
Oil at $111/barrel (average price for 2011 & 12)	4,544

Source: Gateway House calculations

Buying call options against a potential price spike is a better strategy than futures because they provide protection against an untoward event, while the downside is capped.

India needs to use this insurance for some year still other longer-term strategies such as acquiring oil fields and using renewable energy become prevalent.

Can India hedge?

In theory yes, but not in practice.

The Reserve Bank of India permits oil companies to hedge “exposures arising from import of crude oil and export of petroleum products.” [4] In theory, this permits the public sector oil companies—Bharat Petroleum, Hindustan Petroleum and Indian Oil—to hedge their crude oil imports. In practice, however, the oil companies have done very little hedging, and none for crude oil so far because of the restrictions they work under.[5],[6]

Besides, companies are not the best instruments for such a policy. If these companies hedge their crude oil imports and the price of oil shoots up, they will not profit—the benefit will accrue to consumers. So while the companies bear the cost of hedging, they don’t get the upside. This is unfair to a commercial enterprise and to its shareholders.

Who should hedge?

Hedging should be done by those directly affected by the asset in question. The risk of high prices is borne by consumers, who pay more if oil prices are high,and partly by the Ministry of Finance, which has had to step in with subsidies to protect retail consumers over the past decade.

A part of the gain from the current low price of oil has been retained by the government as higher taxes on petroleum products. If these taxes are reversed to cushion the blow of higher prices, the government will lose even if it does not provide any subsidies.

In mature economies such as the U.S., companies exposed to oil prices hedge for themselves. Many small-sized oil producers have used hedging to lock in their selling prices—agreeing to forego potential gains for a guaranteed return.[7] U.S.-based airlines also try to hedge their fuel cost, the major operating expense, on a regular basis.[8]

In India too, large oil users such as airlines, telecom firms, and logistics companies can hedge themselves, if needed. While small consumers don’t have the scale or financial sophistication to hedge, the Ministry of Finance may have to step in if prices rise—and it can hedge to cover its own exposure and to protect small consumers.

If the finance ministry wants to step into this arena, it must formulate ground rules and a framework, including these:

• The ministry can set up a unit for hedging, with energy companies as advisors. Based on its assessment of risk, this unit can buy options to cover India’s oil risk.
• Petroleum prices are unpredictable and decisions on hedging will be commercial calls, taken with incomplete information. The decision-maker cannot be penalised post-facto with the benefit of hindsight.
• The entire crude oil exposure need not be hedged—only the proportion for which the ministry will have to step in with subsidies or tax breaks.
• This unit should windup within a specific time frame—the time it takes to implement longer-term strategies to lock-in energy prices.

The current opportunity—of locking-in a gain of $80 billion per year—is too big to miss without due consideration of all these possibilities.

About the author:
*Amit Bhandari is Fellow, Energy & Environment Studies, Gateway House.

Source:
This feature was written for Gateway House: Indian Council on Global Relations.

References:
[1] Krishnan, Barani and Simon Falush, ‘Oil down Again to 12-year Low; $30 Handle Looks More Likely.’  Reuters, 7 January 2016, <http://www.reuters.com/article/us-global-oil-idUSKBN0UL02520160107> (Accessed January 15 2016)

[2] Ministry of Petroleum & Natural Gas, Government of India, Ready Reckoner: Snapshot of India’s Oil & Gas Data, pp 5, December 1 2015 <http://ppac.org.in/WriteReadData/Reports/201512210818264696331SnapshotofIndia’sOil&Gasdata-November2015.pdf> (Accessed January 15 2016)

[3] Ministry of Finance, Government of India, Reduction in Subsidy, July 10 2014, <http://pib.nic.in/newsite/PrintRelease.aspx?relid=106437> (Accessed January 15 2016)

[4] Reserve Bank of India, Government of India, Hedging of Price Risk in Commodities, July 4 2014, <https://rbi.org.in/Scripts/FAQView.aspx?Id=74> (Accessed January 15 2016)

[5] Rajeev Jayaswal, ET Bureau, ‘Prime Minister’s Office Will Discuss RBI’s Proposal to Hedge Crude Import Risks.’ November 4, 2014 <http://articles.economictimes.indiatimes.com/2014-11-04/news/55757752_1_indian-oil-corp-bharat-petroleum-corp-brent-crude> (Accessed January 15 2016)

[6] ‘State Refiners Reluctant to Hedge Oil Purchases – Sources.’ Reuters, November 4 2014, <http://in.reuters.com/article/india-oil-idINKBN0IO1C720141104> (Accessed January 15 2016)

[7] McNeely, Allison and Asjylyn Loder, ‘How the Worst Performing Oil Companies Are Making More Than Exxon’, Bloomberg, August 19 2015 <http://www.bloomberg.com/news/articles/2015-08-19/oil-patch-s-biggest-losers-sell-crude-for-more-than-exxon-mobil> (Accessed January 15 2016)

[8] Dastin, Jeffrey, ‘U.S. Airlines Return to Fuel Hedging, Get Burned Again.’, Reuters, July 23 2015 <http://www.reuters.com/article/us-airlines-usa-fueloil-idUSKCN0PX2QZ20150723> (Accessed January 15 2016)