NOT HEDGING OIL PRICES IS REALLY DUMB

Governments and bureaucracies were never designed to produce strategic thinking and efficient outcomes. Decision making requires courage, and when the primary objective is self-preservation, courage takes a back seat. As a small-government libertarian I don’t expect much from governments or their bureaucracies, but sometimes even I am shocked at their level of incompetence and irresponsibility.

In preparing for a lecture recently I was astounded to read that oil companies in India, which incidentally are owned and managed by the government, do not hedge their oil purchases. I reread that several times and then further cross-checked it from other sources. Yes, India, the world’s third largest importer of oil does not hedge away the risk of increasing oil prices. Indian citizens are entirely at the mercy of the global oil market because of irresponsible and ignorant policymakers. Even the smallest export company knows that it can protect itself from foreign exchange risk by hedging. But India which imports almost $ 120 billion worth of oil every year does not protect itself from the risk of rising oil prices.

Shameful, astounding, and downright dumb.

Here are some facts. Crude oil imports make up 40% of India’s total imports. India spends $ 350 million a day to pay for its oil imports. This means that as oil prices increase India’s current account deficit ( the excess of imports over exports) increases. As a result of both increasing demand and rising oil prices, India’s crude oil imports rose by 28 per cent in the first quarter of 2018 which caused the current account deficit to increase sharply to USD 13.0 billion or 2% percent of GDP, from USD 2.6 billion, or 0.4 percent of GDP, in the same period of the previous fiscal year.

This level of current account deficit is unsustainable for a country that desperately needs capital to invest in its physical and human capital. Compound this with a falling rupee, and the situation starts to get very serious for an economy that is running on fumes. The last thing we need is oil-price-induced inflation that chokes the life out of businesses that are struggling to find their feet after the demonetization debacle and a poorly implemented GST policy.

But, you say, there is nothing the government can do about rising oil prices. After all the price of oil is determined in the global market and the Indian government has no control over them. True, but there are financial instruments available that can effectively hedge these price increases. The market for Oil Futures and Options contracts is extremely liquid. Even the smallest countries–Morocco, Ghana, Lichtenstein–use these instruments to hedge against oil price increases. These instruments are like an insurance policy that mitigate the risk of an adverse price increase by allowing oil companies to lock in the price of imported oil. If oil companies in India were privately owned, you can rest assured that every single cent of oil they imported would have been hedged against a price increase.

It is, therefore, shocking that Indian policymakers would put the country at such tremendous risk by not hedging against oil price increases. And the worst part is that the mechanism is not that complicated–a first-year Finance student would know how to use these instruments.

Let me briefly explain these hedging instruments. Since India is a big purchaser of oil, it can offset the risk of an increase in oil prices with a long position in oil futures. A loss from an increase in the underlying asset–crude oil–would be offset by a gain from a long futures contract.  Today, for example, the market price of crude oil is 68.75, and the July 2019 futures contracts at the world’s largest commodity exchange The Chicago Mercantile Exchange (CME) are priced at 62.4. An oil company can buy these futures contracts at no cost and lock in a price of 62.4 between now and July 2019. In other words, the oil company locks in a price of 62.4 irrespective of the price of oil in the global market. The risk you ask. The risk is that if the market price of oil goes below 62.4 between now and July 2019, then the benefit of that price decrease is lost. So while there is always the possibility that oil prices can drop it is the risk of a price increase that threatens the economy and that can be hedged away using oil futures contracts.

There are also other instruments available. An Options contract on crude oil would, for a small premium, allow oil companies to hedge against a price increase and still allow the benefit from a price decrease. Again the pricing of these instruments is not rocket science, but for some bizarre reason, India’s bureaucratic mandarins fail to use these instruments. It might be that they don’t understand how to use them, or that they are intimidated by the mathematics required to set up the proper hedge ratios, but there are plenty of experts available who could help them in the process. Ironically, India’s largest commodity exchange, MCX, recently started trading in oil futures and options contracts. So there is plenty of expertise available, but it is hard to think that India’s bureaucratic machinery would allow outside experts to break their stranglehold on policymaking.

India can control the price it pays for its substantial oil imports by using financial instruments that almost every other country uses. But its government and bureaucracy prefer to put the citizens at great risk because they probably don’t understand the meaning of hedging or the use of these instruments. Bureaucracy, it is rightly said, is the death of all sound work.

I thought that there would be nothing that Indian bureaucracy could do that would ever surprise me, but not hedging oil prices is the dumbest thing I have ever heard. Government is not show business–millions of Indians depend on their government to show sound judgement and to protect their interests. Not hedging the price of a commodity on which the economy is so heavily dependent is grossly irresponsible.

The Indian government should order all oil companies to set up hedging strategies immediately. A carefully crafted hedging strategy could result in savings of about $10 billion a year, which is equal to India’s entire education budget for a year. When someone tells me there is a shortage of funds in India, I cringe. There is apparently a greater shortage of grey matter than greenbacks.