With crude oil prices firming up from decade lows, experts have started suggesting that the Indian government hedge part of its imports by locking in at lower prices for the future.
Admittedly, hedging of oil by importing countries is not very common but is gaining traction. Egypt, Ghana, and Jamaica have started hedging. Neighbouring Pakistan is also contemplating hedging oil at a sovereign level to take advantage of the soft oil prices. Exporters do routinely hedge their oil. For example, Mexico saves billions of dollars hedging its oil exports.
In India, public sector oil marketing companies don’t hedge oil beyond the level of their immediate imports. This is done just to protect their margins, and not really to gain from price fluctuations. Besides, there is a real concern about accountability. Oil marketing companies are worried about accountability and the possible fallout if such bets go wrong.
Therefore, experts are suggesting that it is time that the government chipped in as a sovereign oil hedger, perhaps by taking hedging as a Cabinet decision.
“Taking a cue from sovereigns which undertake such programmes, India could consider hedging the risk through the Ministry of Finance as the hedges would protect and benefit the fiscal position of the county,” said Zarin Daruwala, CEO of Standard Chartered Bank, India, who has suggested the government to seriously consider hedging.
“The execution could, of course, lean on the experience of oil marketing companies, which have desks which undertake hedges to protect margins,” Daruwala said, adding that the country probably doesn’t need to hedge for the coming year, as oil prices are likely to remain soft.
“But for the year after that, we could consider at least a quarter of our imports. This kind of opportunity will only come once in five years. Prices won’t remain this soft and the fiscal impact of the government’s stimulus measures this year will spill over to the next year. Our estimates suggest we can save as much as between 0.5 to 1.0 per cent of GDP with the right kind of hedging,” Daruwala said.
Crude oil prices have taken a massive hit in the last two months, and the future prices also turned negative for the first ever in April. The average of daily crude oil prices, for the Indian basket of crude, in April was at $19.90 per barrel, less than a third of the $71 per barrel seen in April last year. The daily price average for March was $33.36 per barrel, close to half of $64.31 per barrel average recorded for January this year. The future prices on some oil indices briefly touched negative levels for the month of April, as supply far exceeded demand.
For April, India imported 17.27 million tonnes of crude oil and for the full financial year 2019-2020, India imported 226.95 million tonnes of crude oil. During FY20, India imported 60 per cent crude from the Middle East, followed by 15.2 per cent from Africa, according to Petroleum Planning & Analysis Cell (PPAC) data. The annual growth rate in net import is about 4 per cent. Typically, the import is a mixture of sweet (Brent ) and Sour (Dubai/Oman).
Considering these huge numbers involved, an effective hedging strategy can save a considerable amount of money for the government, Confederation of Indian Industry (CII) has suggested the government.
Bidisha Ganguly, chief economist of CII explained that assuming the foreign exchange rates of close to Rs 75.5 a dollar, just one dollar increase in price per barrel would entail an additional outgo of about Rs 11,800 crore per annum.
She further explained that about a $10 increase in per barrel prices impact the gross domestic product (GDP) by 10-15 basis points, and increases inflation by 15-20 basis points. The fiscal deficit can widen by 0.1-0.5 per cent of GDP if oil prices increase by $10, and current account deficit can turn negative by 0.5 per cent of the GDP.
“Therefore, the sovereign must protect itself from such rise in oil prices. The related idea is that oil prices are now low, but they won’t remain low for a long time. It will start rising very soon, already you are seeing the futures are showing higher prices,” Ganguly said.
Why no hedging
State-run oil companies do not typically hedge for crude oil prices, a senior official from one of the three oil marketing companies (OMC) said.
“State-owned oil refining companies don’t hedge crude and do not trade in the paper market. Our hedging is only crack spread to protect our costs,” he said.
Refineries’ product prices are adjusted based on cracks with respect to crude benchmarks and so more often than not the external crude price variation in small percentages does not affect them significantly over the financial year. Since they have to procure mostly using tendering processes and months in advance, they only see this as procurement of raw material.
There is also a lack of trading desks whose objectives include minimising the risk and gaining value from crude related transactions by leveraging the asset base, according to Rahool Panandiker, managing director and partner at Boston Consulting Group.
According to the OMC executive quoted above, in India, the concept of hedging is considered speculation. “Suppose, I hedge at $25 per barrel, the instruments used involved either paying a commission to keep it as $25 and another instrument allows for a range, where if it goes up I am reimbursed and if it falls, I will need to pay. Both these instruments involved speculation and we are not allowed to speculate on public money,” the executive said, requesting anonymity.
The government also does not actively encourage oil marketing companies to hedge. And fearing accountability in case of a loss, the oil marketing companies don’t hedge.
According to Panandiker, the strategy to not hedge has led to a big hit in terms of inventory losses towards the end of FY20 – due to the sudden crude price drop. “Now they will see some of this as inventory gains (crude they bought during low prices) – but it will only cover up the entire loss when prices are much closer to earlier price levels.”
Industry experts point out private refiners in India have a robust crude hedging policy in place, however, the extent of exposure hedged is not disclosed.
The hedging mechanism
The best way to hedge oil is through buying derivatives – swaps or call options. Most seaborne crude prices and derivatives are broadly linked to Brent prices given they are very liquid and easily observable.
The traditional ways of securing cheaper oil, such as acquiring oil fields, or contracting for oil at a fixed price, are not feasible anymore, a Singapore-based senior commodity trader explained.
Swaps can be used as a forward contract, where the county locks in a fixed rate to buy oil. It has no upfront cost, however, if oil prices fall, the country still will have to buy the oil at the contractual rate.
The brent swap levels for FY22 and FY23 are now at $41 per barrel and $44 per barrel, respectively.
Another way is a call option, in which the country pays a premium which protects against oil prices going up. At the same time, if oil prices fall, the country can still buy the oil at market prices. The premium, though, is the sunk cost. Most customers participate in call options, the commodity trader explained.
The Brent Call Option Levels for FY22 is $45 for a $5.25 per barrel premium, and $60 for a $1.80 per barrel premium.