The highly volatile oil prices are expected to increase by $3 or more over the current level which calls for resorting to risk management at the earliest, says the study `Privatising Risk Management, Indian Petroleum Sector'.

Further, the study maintains that on examining the stochastic properties of global crude oil prices, India is unlikely to reap any significant benefit by operating the oil pool account, since the account is based on the assumption that international crude prices follow a mean-regressive process.

India's annual crude oil import is placed at around 50 million tonnes (or 366.50 million barrels), valued at $8.063 billion (at $22 per barrel).

Considering a cost of $1.61 million dollars as transaction costs (for risk management), the total import bill could be lower at $8.05934 billion if one cent is saved on abarrel, yielding a total savings of $3.67 million, or Rs 157.60 million, according to the study released recently by Chennai-based Business Intelligence Unit.

India has always been extremely vulnerable to international crude price volatility and long-term price changes. Also, the domestic energy sector is undergoing a transformation and the entire crude importing system is expected to undergo a radical change. All of these calls for effective risk management and a private one at that.

The government is working on a framework for allowing oil companies to use futures and options to hedge in international markets in crude and petroleum products. Even when the total deregulation of the domestic hydrocarbon sector is two years away, the risk management learning process may start now, more so in the areas of risk mitigation, profit planning, and savings.

According to the study, the privatisation of risk management in the context of crude oil and refinery products does not however, require the establishmentof an onshore exchange for trading in crude oil futures and options as has been suggested by the U Sundararajan Committee.

"Establishing an onshore exchange may not be necessary because global competition is already fierce and if established, it may not be economically viable", the report maintains.

There are three main international exchanges offering trading in energy futures. These are New York Mercantile Exchange (NYMEX), the International Petroleum Exchange (IPE), London, and the Singapore International Monetary Exchange (SIMEX), which provides the extension of IPE in the Asian region. Existence of these three exchanges preempts the formation of another exchange in the region.

Crude oil is different from other commodities, in that it is produced in many countries, in locations generally far removed from consuming areas, and must be transported, processed, stored, distributed and marketed. This is a complex operation in which each stage requires enormous capital as well as technical and managerialskills of high order.

A deregulated scenario will expose the hydrocarbon sector to the harsh and uncertain world of the marketplace. A major risk factor arises from the volatility of international crude prices, because of the peculiarity of the world situation in crude oil.

Further, since the Indian refinery sector would depend more on imported crude, exchange rate risk would be an all important factor, the other significant risk that refineries face is interest rate risk, on account of the capital intensive nature of the industry and the high leverage employed.

The stakes are high this year (1999-2000) and will remain so in the future too. For the government at stake would be a substantial part of Rs 100 billion that is expected to be realised from disinvestment of its equity in the refining and marketing companies in the public sector, For refineries it would be their future competitiveness and their long term profitability which are at stake.

While the short term risks could be met by futures andoptions, the long-term risks could be managed by using longer-dated futures contracts or options on futures, commodity swaps or by using exchange of futures for physicals (EFP).

One of the most important risk to be managed by the oil companies in a deregulated world would be the variability of refining margins. "Crude prices and product prices fluctuate dramatically, as a result of which spreads would also be affected by significant volatility. In some periods margins would be high for refineries, while in other times, profitability would be squeezed.

For this purpose, a crack spread options contract is an important tool for refineries and downstream marketers who need to protect against the changing relationship between crude and product markets caused by changes in crude supply and product demand, seasonal market dynamics in petroleum products and changing inventory patterns and replacement costs.

Lastly, the report calls for privatisation of risk management, which it says, is a prerequisite forprivatising and deregulation of the hydrocarbon sector.