What a hedged crude oil exposure would mean for the Indian economy.
By V Shunmugam
With multi-year high imports during FY19 estimated at 226.5 million tonnes, India is third-largest importer of crude oil, and likely to soon become the second largest. Crude oil also being the second-largest import item amounting to $112 billion, nearly 25% of India’s gross imports in FY19, contributes significantly to trade and current account deficits, and adds to the vulnerabilities associated with a buyer in an oligopolistic market for crude oil—wherein supplies are managed to meet the price expectations of producers.
If imports of estimated 1,660 million barrels is hedged with an option position of, say, $64 per barrel of Indian basket crude oil (prevailing at the time of Budget 2018-19), the option premium payment obligation for one year call with an annualised volatility as in FY19 and a risk-free interest rate of 6.6% (364-days T-bill rate) tantamounts to Rs 64,915 crore. Against this, the average price of Indian basket crude oil based on actual imports during 2018-19 stood about $70 (69.88), resulting in an additional cost of Rs 73,083 crore to the economic stakeholders. This illustrates a potential direct saving of about Rs 8,168 crore with hedging using a call option. What are the other benefits?
Researchers estimate a 10% increase in crude oil will impact economic growth numbers by 0.1-0.15%. Besides, there is a strong correlation between the inflation parameters such as WPI (0.83) and CPI (0.8) with the price of Indian crude basket. No wonder, as unhedged energy exposure would tend to permeate in various ways into the pricing of various goods and services that form part of inflation numbers.
The estimated average price of crude purchases by oil marketing companies (OMCs) gets factored into various budget estimates, including the subsidy bill. Therefore, a hedged price of crude oil and an average of the same will provide for better stability to budgetary estimates and can provide for well-planned, low-cost fund-raising by the government and businesses. A stable and predictable pricing regime will also result in lower inflation, especially when crude and its derivative products together directly account for 13.25% and 4.4% of the wholesale and consumer price index, respectively, and indirectly get priced in most goods and services, through cost transmissions through services and logistics that are energy-intensive, such as transportation. An RBI study (Mint Street Memo #17, January 2019) suggests that a rise of crude prices by $10 can push inflation up by about 49 basis points and the fiscal deficit by about 43 basis points. To the common man, a stable crude oil price regime can translate into stable fuel spend and, therefore, stable expenses and savings.
An important positive externality from contained inflation with hedged crude prices is a stable interest rate regime, which moderates borrowing costs. Empirical analysis of the past 5-year trends in inflation and interest rates indicates strong correlation between consumer price inflation and government borrowing rates—both short-term 91-day T-bill (0.64) and long-term 10-year G-Sec (0.71). With monetary policy largely dependent on the expected inflationary scenario for setting up of policy rates, the imported inflation due to pass-through of unhedged volatility in crude oil prices may drive domestic rates up, increasing borrowing costs as seen in the high crude price regimes during 2011-15. A back-of-the-envelope calculation indicates that a reduction in inflation by 50bps is likely to result in savings of Rs 2,300 crore in interest costs on government borrowing.
Besides, as energy and related sectors—refining, transportation, synthetic fibres, aviation, fertilisers, plastics—constitute about 15% of GDP, any instability in crude prices impacts these sectors. Unhedged oil price not only leads to actual price pass-on, but also the pass-on of premiums arising out of price expectations of market participants, a combination that can amplify the volatility impact on prices of goods and services as they pass through several hands before they are consumed. It is the reason fleet operators, including most airlines in the developed world with healthy balance sheets, hedge their fuel exposure, providing for competitive pricing.
The culture of hedging is associated not only with the availability of suitable financial instruments, but also with access to such instruments, besides the knowledge of hedging, a state mandate, a friendlier accounting regime, a regulatory requirement for risk and risk management reporting, etc. In the absence of all these, hedging is rare and random among businesses, which explains why crude oil prices are highly correlated with inflation in India unlike in developed economies.
Another important positive externality from stable crude prices is stable exchange rate regime brought in by certainty and predictability to external trade deals and hence current account deficit.
With an understanding of the benefits of hedging crude oil prices, the question is how to fund the cost of hedging? Three possible policy options may be considered.
The first is to mandate OMCs to hedge their exposure and pass on the cost of hedging to consumers in the form of a hedging cess either directly or through appropriate fiscal measures. The second option would be to raise public funds through oil bonds at a discounted rate and a bonus linked to favourable crude oil prices movements (a 10% of MTM profits from favourable movement of prices). The third is to mandate all major user industries to gradually move towards hedging their crude oil exposures and pass the costs related to hedging to consumers.
In reality, finding a bank or treasury to offer all related hedge cover needs will not be possible and the same would need to be cultivated over a period of time through constant engagements in energy markets to seek option writer/OTC hedge provider institutions with the backing of appropriate market instruments. Meanwhile, it is crucial to develop domestic financial institutions and businesses to provide hedged covers to stakeholders in Indian energy markets, providing for development of domestic markets for OTC products.
Given the $5-trillion ambitions and a heavy dependence on crude oil imports, energy volatility would remain a key hurdle for the economy till cost-efficient hedge instruments are popularised. Hedging against volatility of imported energy products would not only stabilise spending on energy products, but also safeguard against currency and interest rate instability, and safeguarding country’s energy requirements against the impact of unpredictable geopolitics and the interests of producer groups.
The author is head, Research, MCX. Views are personal