In an earnest effort to ‘clean up’ the markets and wean them off subsidies, the government, on June 16, rolled out a dynamic pricing mechanism for petrol and diesel fuel prices across India.
V Shunmugam & Jayati Mukherjee
In an earnest effort to ‘clean up’ the markets and wean them off subsidies, the government, on June 16, rolled out a dynamic pricing mechanism for petrol and diesel fuel prices across India. This means that the prices of these transport fuels are changed daily by the oil marketing companies (OMCs) based on the movement of international crude oil prices. Prior to this, the revision in fuel prices happened on a fortnightly basis. Now, daily pricing did smoothen out price fluctuations, thereby benefiting OMCs and the consumers. However, the story for the dealers has not been as pretty. According to recent reports quoting the Association of Fuel Retailers, retailers lost as much as Rs 400 crore in the first two weeks of the roll-out of the dynamic pricing.
With a fixed margin per unit of sales, retailing of motor fuel and LPG had traditionally been an attractive business. With fixed margins and fortnightly change in fuel prices as in the previous regime, the retailers managed their inventories based on expected fortnightly prices. But with a business requirement of stocking for a much longer period than a day, daily fuel prices left the retailers worried about their fixed margins especially in the current scenario of declining fuel prices, i.e. to sell high priced inventories at low prices. In the current scenario, daily pricing has restricted the price delta available to dealers to take a call on stocking up or delaying purchases that has the potential to introduce inventory uncertainties.
Daily inventory and falling price
With the current fixed commission of Rs 2.2/litre on petrol and Rs 1.5/litre on diesel, the net profit for a dealer at the end of the month will be dependent on the way the dealer manages overhead costs, transport, working capital, etc, and not the inventories. The daily price change makes inventory management key to margin protection for which they were least prepared for.
During the earlier regime of fortnightly price revision, the 15-day period would enable retailers in taking a call on stocking up or delaying purchase. Now, under dynamic pricing, while a fuel retailer stocks up fuel to be consumed over a period of a few days at a particular price, the sale price realised on account of the said fuel sold on different days varies. As a result, invariably in the era of oil price declines influencing decline in fuel prices determined daily, like the situation currently, retailers would have to suffer erosion in their fixed margin on sale of their inventory over different days. It will also be applicable when crude oil prices become highly volatile without any clear downward or upward direction.
Can hedging be a solution?
Unlike OMCs, fuel retailers being guarded with relatively stable margins in the pre-dynamic pricing era would not have bothered about anything including oil price volatility other than the level of the fixed margin. The fortnightly revision of fuel prices that followed the fixed price regime also accorded comfort level to fuel retailers by way of giving them enough lead time to advance or delay their purchases based on expected price change. Consequently, there has not been any felt need for price risk management amongst the fuel retail businesses. However, now with daily fuel pricing in place, price risk management in the form of hedging through derivatives market can be a panacea to the woes of their inventory decision-making. Since petrol and diesel are produced by refining crude oil, the correlation between the daily price movements of both with the crude oil prices holds the key to making it a suitable instrument for risk management.
Being the two major refined products, petrol or gasoline demand is a big contributor to the demand side of crude oil fundamentals. Crude oil price rises during the summer driving season in the US, where the higher demand for gasoline supports the crude oil prices during this period. Notably, in India too, dynamic daily fuel price revision is based on change in crude oil prices and, hence, is more likely to move with the crude oil prices. Therefore, unsurprisingly, the price correlation between crude oil prices (MCX futures) and petrol prices (Chandigarh IOC outlets) at a five-day lag stands a strong 87% for the three-month period of May 2017 to July 2017 (see chart).
This strong correlation clearly indicates that a fuel retailer can hedge losses in the physical position of fuel inventory with gains from counter positions on the exchange traded crude futures contracts. In other words, through a short position in crude oil futures on a commodity exchange platform at the time of his inventory accumulation, a fuel retailer can effectively manage the risk of potential price fall of his inventory of motor fuels such as petrol and diesel. Simpler said than done, an attempt to put up an accurate hedging model can be made as the daily price series becomes available for a longer period in the times to come.
Price risk management
Fuel retailers generally abide to a high standard of risk management with respect to safety, given that they are exposed to highly inflammable fuels such as petrol and diesel. Now, with the adoption of daily fuel pricing resulting in their exposure to oil price volatility, price risk management should become a key part of their business to ensure stability in margins as enjoyed during the fixed or fortnightly pricing regimes. Hedging can insulate fuel retailers from volatile price movements by ensuring stable margins and hence profitability.
Key to efficient price risk management decision by fuel retailers lies in proper understanding of their risk profile and inventory management and sales patterns. Efforts should be taken up to make fuel retailers aware of various steps in risk management, including that of accounting for hedged positions. Some amount of hand-holding and nurturing in terms of formulation of hedging solutions would go a long way in addressing the concerns arising out of ‘dynamic fuel pricing’—a global best practice in policy-making.
V Shunmugam is head of research and Jayati Mukherjee is senior analyst, Multi Commodity Exchange of India Ltd. Views are personal.