Risk Management has been looked upon as rocket science by many finance professionals leave alone the layman individual. The introduction of derivative trading in India with BSE and NSE allowing trading in Sensex Futures has still not gained ground. Risk Management tactics employed by State Electricity Boards (SEBs) and the government of India in terms of the Escrow account failed miserably. The Indian government has now permitted oil companies in India to hedge against commodity price risks while importing crude and petroleum products. This initiative has been taken by the Indian government in a bid to protect the economy from the volatility of international crude prices. All oil companies having underlying exposures in crude and petroleum products will now be allowed to import and hedge future prices against the drastic volatility of the prices in the hydrocarbon sector. This has almost become a necessity for a country like India which imports 70 percent of its petroleum requirement and needs to be protected against such price movements in the International oil markets.
Oil companies such as the Indian Oil Corporation (IOC), Reliance Petroleum and MRPL are expected to be the beneficiaries of this move from the government. The hedging facility is to be subjected to detailed guidelines to be issued by the RBI and is expected to make Indian producers more efficient and enable them to compete in the International markets. The immediate beneficiaries of the decision will be the Industry experts opine that hedging instruments which are used for other commodities like sugar etc. are like insurance, both for the buyer and the seller, while the buyer can protect his interests by locking future physical deliveries at prices quoted at present, the seller too can protect his interest by contracting sales at a price which may fall in the consequent months.
The volatility in the International Oil markets can be gauged by the fact that oil prices have been roller coasting during the period December 1999 and April-May 2000. The prices in December stood at a historic low of barely $10 a barrel while by April-May it moved up to over $31 a barrel. Oil companies have gained or lost significantly due to the lack of price risk hedging instruments and have been unable to protect their future interests. Trading in oil futures (crude and petroleum products) take place at three exchanges across the world namely The Singapore Mercantile (Symex), The International Petroleum Exchange and The New York Mercantile (Nymex). India is mainly dealing with the International Petroleum Exchange at London.
The hedging mechanism is based on a benchmark crude for which price quotes are available. Each of the above exchanges that trade in oil futures have their own crude benchmarks. The Nymex has "Brent" which is crude from the North Sea as its benchmark while India will use the Dubai crude as its benchmark. India exports Dubai crude to supplement its oil requirements.
In the oil futures market, the quotes are usually for a period of about six months and the buyer of the future needs to take a position for a particular quantity to be physically delivered at a particular point of time. The advantage for the buyer would be that if prices moved up by the time that the physical delivery of the product takes place, the buyer is compensated with an adjustment and a settlement with the difference being paid back. The buyer thus is able to hedge against an increase in the prices of crude and petroleum products. In the case wherein there is a fall in the prices of crude and petroleum products then the sellers interest is protected as the delivery is made on the agreed price by the buyer.
For the Indian market the relevance of the permission by the government allowing oil companies to hedge against price risks in the crude and petroleum products markets lies in the facts that
Large crude buyers such as the Indian Oil Corporation, Reliance Petroleum and MRPL will be able to improve profitability.
The impact of the volatile international oil prices can be tamed by being able to hedge against price hikes using oil futures.
Lastly this will enable the Indian oil companies to gear up to competition from global oil players such as Morgan Stanley and Citibank who are poised the enter the Indian markets.
Deepak V Kuriakose