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De-Risking Rising Oil Prices – Analysis

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The price of petroleum has risen by almost 40% since February 2015 because of geopolitical tensions. This spike underlines the need for India to hedge its energy imports using a mix of financial markets and asset purchases.

By Amit Bhandari*

After falling more than 60% from 2014 levels, the price of petroleum has risen sharply—from $46.7 per barrel in early February to $66.5 per barrel in early May. As a result, the price of India’s crude basket, which is a mix of Oman, Dubai, and Brent crude, has gone up by 40%.[1]

The increase is not an outcome of a demand-supply mismatch. In its latest Oil Market Report, the International Energy Agency says the price rose in April and May despite “persistently high global supply and continued stock build.” [2]

World oil supply has increased by 3.2 million barrels per day (mbpd) over the last year, while demand during 2015 is expected to rise by 1.1 mbpd. This indicates a comfortable demand-supply situation, and points to the possibility of rising geopolitical tensions in West Asia pushing up the price of oil globally.

Gateway House has earlier said that energy prices will not worry India in 2015, barring a catastrophic event in a major oil producing country such as Iran or Saudi Arabia. Now, adverse developments in both these countries have indeed increased the chances of such an event.

The Yemen crisis

In late March, Saudi Arabia launched the ‘Decisive Storm’ campaign to dislodge the Houthi (Shia) faction in Yemen. Saudi air strikes started on 25 March—when the price of the Indian crude basket was $53.31 per barrel.[3] It increased to $66.5 per barrel by early May.

The intervention in Yemen is seen by many as an attempt by the Sunni states, led by Saudi Arabia, to prevent Iran, a Shia power, from spreading its influence. In late April, Saudi fighters prevented an Iranian aircraft, ostensibly carrying aid, from landing in Yemen, by bombing the runway. On two occasions, Iran either intercepted or tried to intercept merchant ships in the Persian Gulf.

Tensions can flare for a range of unpredictable reasons—sea-mines in the Strait of Hormuz, attacks on civilian ships (as had happened during the 1980-88 Iran-Iraq war), attacks on oil installations in Iran’s territorial waters and the shooting-down of a civilian airliner— all of this has happened in the Persian Gulf in the past.

Changes in Saudi royalty

The other development in West Asia has been a change in the line of succession of the Saudi royal family. So far, kingship in Saudi Arabia was based on agnatic seniority, but it will now be confined to one branch of the family.[4]

The Saudi royal family has hundreds of princes, and it is possible that some of them may be dissatisfied at being cut out of the succession line. This can create a potential risk. It is a low probability and hard to quantify risk, and it is likely that nothing may happen. However, any such instability will be damaging to the global energy market—Saudi Arabia produces over 10 mbpd of oil and a disruption of supply will shatter the global demand-supply equilibrium.[5]

India imports a total of 3mbpd of oil from various countries.[6] And high prices arising from such instability will be very damaging.

What India can do

The Indian economy has suffered when global oil prices were high. It hurt industry and forced the government to give billions of dollars in subsidy, thus damaging public finances. The fall in petroleum prices has been a stroke of luck for India, and to derive the maximum benefit from this fall India can tie up oil supplies in physical and financial markets to hedge its short-and long-term energy exposure.

Buying oil futures: Petroleum is one of the most traded commodities on global exchanges in London and New York. Most of the global trade is in Brent and India’s oil import basket is correlated to the price of Brent. Therefore, Brent futures and options can be used to hedge India’s oil imports.

Futures contracts are available several months, and even a few years, in advance. For instance, in May 2015, it is possible to buy or sell oil futures up to December 2017. This means a buyer of oilcan lock in the price today for purchases 30 months later.

As an importer, India should use these instruments to lock in low prices. This hedging can be done by the state-owned oil companies, because they are buying the petroleum and they understand the dynamics of the oil market. To enable hedging, the Ministry of Petroleum will have to create guidelines, such as the price levels at which hedging is to be done. And it will have to give leeway to the companies in creating these hedges.

This will also require a change of attitude. Hedging is like buying insurance: the buyer pays a premium to guard against a major catastrophe, not with the expectation of using it. Oil price hedging will mostly involve small expenses, money spent to lock-in prices. Secondly, some commercial decisions do go wrong; this is a part of any business. Oil companies should not be unduly penalised for such decisions, and an enabling environment and policy must be created.

Buying oil companies: Financial hedging has a limitation—it can only be done for a limited time. India will be importing oil 10 and 20 years from now as well. The way to de-risk these prices is to buy oil fields.

Public sector major ONGC has been buying oil fields across the world for a decade. It has spent over $20 billion,[7] has assets producing 8 million tons of oil and gas annually, [8] and it has the balance sheet strength to make more purchases. Most of ONGC’s purchases have been made in the high oil price regime of the past few years.

The low price of oil presents an opportunity: the stock prices of independent oil companies with oil and gas fields have fallen by 60-70% in some cases. UK-listed Tullow Oil, which made a large discovery in Uganda recently, is an example. The market-capitalisation of the firm, the price at which the entire shareholding can be bought, has fallen 52% in the past year. Several other small and mid-size oil companies are listed on global exchanges, and can be purchased for their assets. Owning these oil fields will help India to lock in prices for the future as well.

As a large importer of energy, high prices have hamstrung India in the past. India can use the low energy prices window to effectively lock in the prices and de-risk the economy from geopolitical tensions and economic swings. But to ensure this, policy makers and companies must act fast, while this opportunity is available.

About the author:
*Amit Bhandari
is Fellow, Energy & Environment Studies, Gateway House. This feature was written for Gateway House: Indian Council on Global Relations.

[1] Press Information Bureau, Daily Crude Oil Price of Indian Basket Was US$ 46.73/bbl on 30.01.2015, February 2015, < http://pib.nic.in/newsite/erelease.aspx?relid=115120> and Press Information Bureau, Global Crude Oil Price of Indian Basket Was US$ 66.54 per Bbl on 06.05.2015, May 2015, <http://pib.nic.in/newsite/erelease.aspx?relid=121316

[2] International Energy Agency, Oil Market Report, May 2015, <https://www.iea.org/oilmarketreport/omrpublic/>

[3] Press Information Bureau, Global Crude Oil Price of Indian Basket Was US$ 53.31 per Bbl on 25.03.2015, March 2015, <http://pib.nic.in/newsite/erelease.aspx?relid=117712>

[4] Al Jazeera, Saudi King Replaces Crown Prince in Cabinet Reshuffle, April 2015, <http://www.aljazeera.com/news/2015/04/saudi-king-salman-replaces-crown-prince-cabinet-reshuffle-150429020021160.html>

[5] BP, BP statistical Review of World Energy, June 2014, p. 10, <http://www.bp.com/content/dam/bp/pdf/Energy-economics/statistical-review-2014/BP-statistical-review-of-world-energy-2014-full-report.pdf>

[6] OPEC, Monthly Oil Market Report, April 2015, p. 83, <http://www.bp.com/en/global/corporate/about-bp/energy-economics/statistical-review-of-world-energy.html>

[7] ONGC Videsh Limited, ONGC Videsh Limited—Working globally for the energy security of India, < http://www.ongcvidesh.com/company/about-ovl/>

[8] Bombay Stock Exchange, ONGC Videsh Declares FY15 Financial Results, May 2015, <http://www.bseindia.com/xml-data/corpfiling/AttachLive/E19CBA38_6A70_40DE_84F9_4725D67BFE96_185336.pdf>

Gateway House

Gateway House

Gateway House: Indian Council on Global Relations is a foreign policy think-tank established in 2009, to engage India’s leading corporations and individuals in debate and scholarship on India’s foreign policy and its role in global affairs. Gateway House’s studies programme will be at the heart of the institute’s scholarship, with original research by global and local scholars in Geo-economics, Geopolitics, Foreign Policy analysis, Bilateral relations, Democracy and nation-building, National security, ethnic conflict and terrorism, Science, technology and innovation, and Energy and Environment.

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