While the proposal to allow price risks in crude and petroleum products to be hedged in the world futures markets is undoubtedly welcome and was actually long overdue (this author when he was associated with the Tata Economic Consultancy Services, had in fact recommended such hedging operations to the then Ministry of Petroleum and Natural Gas as early as in May 1986 in hisreport submitted to the Ministry), it is difficult to understand the curbs which the authorities seek to impose on hedging by oil producers and refiners.

Although prohibition on pure speculative activity may perhaps be inevitable in the prevailing economic and foreign exchange situation of the country, the rationale on restricting hedge deals to only the underlying physical transactions is hard to appreciate.

Although as a prelude to eventually dismantling the administered price mechanism, the government has initiated some steps at liberalisation of the petroleum sector, the domestic prices of crude oil and petroleum products are still fixed at almost all stages and all levels -- vertically (for downstream products) as well as laterally (for different geographical regions) -- in such a manner as to yield adequate margins to different market functionaries.

No doubt, the cost-plus formula for indigenous crude oil has been withdrawn; but it has been replaced by a minimum floor price to ensure assuredminimum return on investment. Similarly, retention pricing for refineries have been abolished. However, refinery gate prices are fixed instead of most petroleum products on adjusted import parity pricing basis.

At the other end, consumer prices for all major petroleum products, except naptha, are still administered. Consequently, the domestic production, marketing and storage of crude oil and petroleum products do not involve much price risks. Thanks to the administered price policy, the average sale price of all petroleum products together (despite cross-subsidisation of a few products like kerosene oil and LPG) is invariably well above both the domestic -- onshore as well as offshore -- and imported crude oil prices.

Not surprisingly, the petroleum sector has become a major source of revenue not only to those engaged in oil exploration, production, refining and distribution, but also to the Central and State exchequers (owing to excise, customs and sales tax) and the local authorities (due to eitheroctroi or entry tax).

Since, notwithstanding the avowed long-term apparent aim at moving towards market mechanism in petroleum pricing, the authorities are unlikely to abandon the administered high price policy in most petroleum products, especially at the consumer level, in the near future (not so much due to its contribution to exchequers as its impact on the much-needed energy conservation and improvement in fuel efficiency), domestic production, as also imports, of crude oil and few petroleum product) would hardly need any facility for hedging price risks.

Moreover, with free market operations, the prices of even subsidised petroleum products like kerosene oil and LPG will rise, and not fall, to the benefit of the refineries. In these circumstances, hedging in the international commodity exchanges as a risk management tool has little practical use to the oil refineries in the country. Yet, if used intelligently and judiciously, the world energy futures markets can help reduce the import costs of crudeand petroleum products.

But such use need not partake the character of hedges as commonly defined in commodity economics text books, which require entering into counter transactions in the futures market against the underlying physical market commitments. Going by this standard definition, import deals could be hedged only through sales in the futures market.

However, as stated earlier, since the administered sale prices of petroleum products,in India, are much higher, and would continue to remain so for a long time to come, than the import prices of either crude oil or petroleum products, assuring attractive returns to the refineries, the need for hedging import contracts to avoid or reduce the risks of possible fall in the prices of petroleum products just does not arise.

What is really worrisome for India are the import costs. Imports of all hydrocarbon products and their derivatives presently account for almost one fourth of India's total commodity imports in value terms. Currently, import of POL(petroleum, oil and lubricants) aggregate around as much as 60 million tonnes annually valued at over US$12 billion.

Worse still, with domestic crude production far from rising and refining capacity expanding rapidly (with entry of private and joint sector refineries), imports of crude oil are slated to skyrocket in the coming years, leading possibly to further deterioration of the growing current account deficit in the external sector.

It is therefore, imperative for the agencies engaged in importing crude oil and its refinery products to seize opportunities to cut import costs. At prevailing prices a reduction in import prices of crude oil by just 50 cents a barrel would result in a saving of over $300 million in foreign exchange for the country. The selective and proper use of international energy exchanges can surely assist in cutting such import costs for POL products.

As a matter of fact, contrary to the widely held belief, the purpose of hedging in a futures market is not so much to avoid pricerisks as to avert loses, without forsaking the gains on the physical market transactions. While the stereotype risks avoidance hedging against the underlying physical transaction may not be able to achieve that objective always (the statistical probability may be just 50 per cent which actually puts hedging on part with non-hedging), the futures market can be used selectively in a variety of other ways to secure better prices to the physical market functionaries.

To illustrate, the oil refineries and other agencies importing crude oil and petroleum products can use international exchanges in at least three different ways to cut import costs.

First, as soon as the agencies decided on import of hydrocarbon oil and/ or its products, it may be useful for them to buy immediately the crude oil and or heating oil futures contracts, as the case may be, of equivalent volumes at NYMEX or IPE especially if the futures price for the desired delivery schedule is less than the prevailing physical market price foreither spot or requisite forward shipment.

In fact, it may be desirable to buy in the futures so long as the futures price does not exceed the physical market price by more than the storage cost. Be that as it may, not only will such buying in the futures lock in directly the import price at a lower level (since the futures is either lower than the physical market price or less than the latter plus the storage costs), but also provide an opportunity to `shop' around for a more favourable spot or long term contract buying later. In either case, the total import and storage bill will tend to reduce.

(This is a first of a two part article on the subject. The second part will be published on August 2. The author is an independent consulting economist)