34) Why not hedge away oil price shocks?

The sharp rise in oil and other commodity prices over the past several months and its possible adverse impact on inflation/inflation expectations has been a matter of deep concern to governments and policy makers the world over. This concern has been particularly acute in emerging economies such as India.

How to reconcile the soaring energy requirements of a rapidly expanding economy and the inevitable price pressures brought on by such surging demand with the objective of non-inflationary growth? As has been pointed out by the Reserve Bank of India, the greatest challenge now is to manage the transition to a higher level of economic growth without entrenching higher inflation expectations.

Double-digit economic growth and stable/low inflation (around 4 per cent) may not be mutually exclusive objectives. The exercise to attain that, though, could be painful for many economic agents in the interim — such as the Indian oil companies for instance.Blind alley

The oil companies possibly are bearing the brunt of the policy-makers’ reluctance to subject the domestic price level to the full force of international/market prices. In a complex social and political environment, it does not appear conceivable that the oil pricing mechanism will move to a market-driven format any time soon.

The APM, for instance, was officially dismantled earlier in this decade but is now again well in operation, de facto. Debate and discussion on oil pricing is endless, though it seems futile as all debate finally zeroes in on a market-driven pricing mechanism as the only panacea.

It (market-determined end product prices) may be the ideal solution. But what is surprising about the oil debate is that there seems to be not much of a focus on interim, alternative solutions, which, incidentally, may also be market-related. Hedging input costs

In a scenario where there are constraints on end-product prices on the selling side, it is surprising that the oil companies have not attempted to more fully hedge the risks of rising raw material prices and attempted to fix their input costs. An analysis of petroleum statistics shows that only around 3-4 per cent of the total imports of crude oil are being hedged by the oil companies. In 2006-07, Indian crude imports were around 90 million tonnes.

To be sure, the hedging ratio of Indian companies is no different from what prevails globally. Indeed, even though the global oil derivatives markets provide a very good platform for hedging for both oil producers and consumers — with contracts stretching out as far as 10 years — the use of this market for hedging has been historically limited.

For instance, as on November 7, 2007, the total volume of outstanding futures contracts (the open interest) for various forward maturities up to December 2008 on the NYMEX and the ICE amounted to around 1.8 billion barrels. Against that, crude production in the next 12 months will be around 30 billion barrels (assuming a production of 85 million barrels per day – the current figure) giving a hedge ratio of around 6 per cent. This has been the case historically also.Reasons for low hedging

There are a number of structural reasons for the low level of hedging by both oil producers and consumers globally. As far as consumers are concerned, in a competitive environment, unless all players in an industry hedge their consumption of oil, it does not make sense for individual companies to do so. Companies which do not follow industry practice will be subjecting their earnings to greater variability.

More generally, as far as consumers are concerned, the absence of hedging markets with respect to their end products on the selling side inherently limits their hedging. Airline companies, for instance, do not have forward markets for airline tickets.

Also, the price of airline tickets will vary in future with the spot price of oil. Where input price pressures can be passed on to the selling side, the incentive for hedging is weak.
On the production side, many countries with state-owned producers also do not hedge their future production. Even commercial oil producers such as an Exxon or BP are not in the market for hedging in any noticeable way.

This is quite understandable given the structural trend in oil prices over the past many years. Indeed, oil, more than possibly any other commodity, has proved that the futures price curve — for assets which carry a high degree of positive systematic risk — may be significantly understating the expected future spot price of the asset. That is, while oil (because of the high convenience yields associated with holding physical stocks) displays an inverted forward price curve (backwardation), the curve does not necessarily capture the future spot price to any degree of accuracy.

For instance, the futures price curve in February 2006, when spot oil was quoting around $53/55, indicated the forward price for maturities up to December 2007 to be in the range of $60/62. But where are spot prices now? And such divergences between the futures curve and the realised spot prices have occurred many times in the past also. Costs and calculation
It is this divergence between the futures curve and realised spot prices which should provide a powerful incentive for big consumers such as India to have a structured hedging programme in place. The “industry competitors” argument does not anyway apply here because of the constraints in end-product pricing.

What are the costs of hedging? Assuming the current margin costs of around $6500 per contract of 1000 barrels, the entire Indian import of 90 million tonnes in 2006-07 would have involved a margin outlay of around $4.5 billion – that is around Rs18,000 crore – if Indian companies had taken long hedges on the NYMEX in early 2006, based on the then spot price of around $55.
This margin deposit would have earned some interest (say 3.5/4 per cent) and given the structural trend in prices, the companies would have been able to take back a good part of the margin deposits as mark-to-market profits on the futures positions (over and above the maintenance margins). Most importantly, the input oil costs would have been hedged and fixed based on the futures price curve which prevailed in February/March 2006. It may have been possible then to hold the line on end-product prices as the hedging on the input side effectively lowers the costs relative to the prevailing spot market.

And, who is to fund the cash outlay on the margins required on long futures positions? Note that the Government issued oil bonds worth at least Rs 12,000-13,000 crore in 2006-07. More had been issued in the earlier years also. A hedging policy could mean that, instead of oil bonds, an equivalent amount of money goes into margin deposits.

The cash outflow for placing margins, of course, will be immediate. The advantage still is that with hedging, the importer is able to fix his costs. And unless oil prices fall, there would be no more cash outflow on account of margin calls. A policy of “no hedging and issuing oil bonds”, on the other hand, means that the quantum of bonds (to be) issued could be open-ended.

It, of course, is quite easy in hindsight to point out all this. It is also important to remember that hedging need not always provide the most optimal solutions. And there may be a number of operational issues (key among them being the level of hedging interest among oil producers) to be tackled before Indian companies can institute a structured hedging programme. But, still, the absence of a debate on how India as a big consuming nation can hedge its oil price risks is somewhat disconcerting.

33) No alarm bells over rising oil prices

Crude oil price jumped to an all-time high towards the end of October. Growing tensions in northern Iraq, supply outages from Nigeria and the worries over Iran’s nuclear programme will continue to fuel oil price increases. There is unlikely to be any relief even in the next year.

Analysts forecast that the average price in 2008 will be $70 per barrel. During January-September 2007, the average Brent price was $67 per barrel.

While oil price surges cause oil-import-intensive economies to panic, India, which is also in the same bandwagon and depends almost entirely on imported oil, seems almost unfazed.

The country depends on imports for 80 per cent of its crude oil requirement. The average price of imported crude rose by a whopping 22-plus per cent during the past two years. Notwithstanding this, the country’s GDP grew at an impressive 8-9 per cent against the world average of 5 per cent.

There are basically three factors which have helped insulate the Indian economy from the impact of rising oil prices. Effect on manufacturing

First, the manufacturing sector, the key driver of economic growth over the past few years, is not oil-sensitive. According to FICCI, a survey of 417 medium and large firms revealed that the energy bill constituted 20 per cent of the production cost. Of this, oil energy accounted for only 20 per cent. This means oil made up only one-fifth of the energy bill. Thus, oil prices have not had much of an impact on manufacturing growth. Exports offset import burden

Second, the recent spurt in oil product exports have cushioned the impact on the balance of payments. Petroleum product exports have emerged the biggest foreign exchange earners, notwithstanding the substantial dependence on imported crude. During the past two years, petroleum products were the biggest item among the single group of exports in the export basket. They accounted for about 11 per cent and 15 per cent in the total exports during 2005-06 and 2006-07 respectively. Petroleum product exports grew by 67 per cent and 59 per cent during 2005-06 and 2006-07 respectively. This largely counterbalanced the heavy burden of crude oil imports on the balance of payment.

While imports of petroleum products (mainly crude oil) amounted to $45 billion and $57 billion in 2005-06 and 2006-07, respectively, exports of the same rose to $11 billion and $18 billion respectively. This helped offset over one-third of the oil import burden on the balance of payment. Global hub for refining

India is emerging as a global hub for oil refining. The cost-effectiveness of oil refining has drawn the attention of several MNCs. This is because India is logistically well-placed for refineries in terms of oil imports from West Asia and is better placed to help serve the large consumption needs of petroleum products of adjoining countries.
To become a global hub for petroleum product exports, India plans to add about 60 per cent to its existing capacity over five years. The present refining capacity is 149 million tonnes per annum. Another 90 million tonnes are proposed to be added by 2012. The domestic consumption is estimated to touch 196 million tonnes by then. This leaves a balance of 43 million tonnes, which are to be exported. At the average export price level of 2006-07, petroleum product exports may touch $23 billion.Controlled price mechanism

Third, the prices of petroleum products are not determined by the free market mechanism. The prices of certain petroleum products which have larger bearing on inflation are kept artificially low.

Even though the Administrative Price Mechanism (by which the prices of petroleum products were controlled by the government since oil nationalisation in the 1970s) was done away in April 2002, the prices of major petroleum products still continue to be under control regime through backdoor. About 60 per cent of the petroleum product prices are controlled by the Government.

The prices of four products, which have an impact on inflation, are petrol, diesel, kerosene and LPG. These account for 60 per cent of the total petroleum product consumption in the country.

Currently, over 95 per cent of the marketing of these four price-sensitive products are controlled by the Government through its public sector oil marketing companies — Indian Oil Corporation, Bharat Petroleum Corporation and Hindustan Petroleum Corporation. These companies are not free to set prices based on the crude oil prices; the prices are decided by the Ministry of Petroleum and Natural Gas. Social, political reasons
The Ministry, while fixing the prices, takes into consideration, besides economic reasons, several social and political implications. For some petroleum products, social and political reasons overshadow the economic implications.

There is a huge subsidy on kerosene and LPG prices. LPG and kerosene prices have not changed since early 2005, whereas petrol and diesel prices have been tinkered with eight times. The huge subsidy on LPG and kerosene have resulted in their prices ruling at less than half of that in Pakistan; this despite Pakistan importing crude oil at a preferential rate. While the prices of kerosene and LPG are Rs 9.09 per litre and Rs 294.74 per cylinder respectively in Delhi, they are sold (in Indian rupee terms) at Rs 23.64 per litre and Rs 427.90 per cylinder respectively in Karachi

As public sector oil marketing companies continue to control the prices and distribution of petroleum products, the fear of any major impact on the economy seems unfounded.

32) Lessons from US crisis

The crisis is leading to fears that the US credit market may reach a gridlock and the country itself may be facing a recession due to shortage of credit, since banks have problems raising further funds. The problem has spread to European banks as well.

The collapse of the titans of Wall Street should open our eyes to the potential potholes in the road ahead. Universal banking can be a glamorous model, but it has its risks.

The sub-prime crisis has taken a heavy toll on banks around the world. US banks have been most vulnerable since sub-prime house loans rose to high levels in the US in the last few years. Banks lent more and more to sub-prime house owners, aided and abetted by the liberal flow of funds from Wall Street investment banks, which sold these loans in securitised packages to investors, who were tempted by the above par interest rates yielded by the loans.

The banks soon came to realise that the sub-prime loans had more than expected default rates and underwent heavy losses. The investment banks have also taken a heavy hit. The crisis is leading to fears that the US credit market may face a gridlock and the US itself may be facing a recession due to shortage of credit, since banks have problems raising further funds. The problem has spread to European banks as well, taking down even the venerable UBS.Assessing losses

The magnitude of losses faced by US banks and other developed country institutions is still being assessed. Analysts of Goldman Sachs — which incidentally has come out unscathed — estimate that the losses may run into hundreds of billions of dollars, especially when the third quarter results of banks and institutions are unveiled.
The Citibank group itself has disclosed losses of as much as $8-9 billion . Some estimates coming in from respectable bank analysts pitch possible losses at as high as $50 billion. The losses are, indeed, heavy.

There were also similar crippling losses at Bear Stearns, the investment bank, and the leader of bulls, Merrill Lynch, again in billions of dollars. The CEOs lost their jobs, although in typical American fashion, they were paid handsome retirement bonuses running into millions of dollars.Going about it differently

The media has been running a series of exposés on the behaviour of these banks. Fortune wrote a derisive article entitled “What were they smoking?” But, by and large, the Americans have been relatively relaxed about the manner in which the system has dealt with the chiefs of banks. It perhaps speaks of the tolerance and maturity of the American business system that it takes both risk and reward in a calm and composed manner.

Not for them the hoopla of CBI or FBI investigations or FBI experts or non-experts raiding CEOs’ houses and offices, subjecting them to public humiliation and condemning the system to a fear of taking any decision. Nor has there been a call for a Joint Parliamentary or Congressional Committee comprising non-expert Members of Parliament or Congress treating the country to a spectacle of a Roman circus, shooting questions on how and why a particular banker took or did not take a lending decision. Much heat and not much light came out of our own Parliamentary enquiries.

Unlike in the Indian case, there was no accusing finger pointed at the bank supervisor — the central bank, in the American case. Questions were not raised as to what the central bank was doing when the banks were lending. The public at large was aware that it is the banker’s job to manage his loans and investments, a supervisor can only lay down guidelines and prudential norms and inspect from time to time. It cannot be expected to micromanage banks — which is what some members of the Indian political class expected in 1991.

True, some questions were raised in the US about the Federal Reserve’s benign interest policy, which had allegedly led to loans being disbursed too liberally. But that was considered a central banker’s privilege — whether to raise or lower interest rates. Conglomerate model

A more material aspect of the US banking debate, which is threatening a global recession, is how valid is the US conglomerate banking model, on which India and other developing countries, barring China, are shaping their banking system.

Citibank, for example, became a massive conglomerate employing nearly 3,00,000 people, with an insurance wing and investment bank and private equity arms. True, it grew through many acquisitions in Sandy Weill’s days. The latest CEO, Chuck Prince, who has now quit, tried to cut down the number of businesses.

Whether a universal bank model, such as Citibank, is managerially the optimal one is being hotly debated. Analysts are arguing that Citibank has become too much of a massive conglomerate for the top to manage. Calls are out for breaking it up. Arguments will, no doubt, be found for keeping it whole.

But the warning signals are there for Indian banks to read. Should we go the same way? Or should we try to manage complexity better in the under-served financial scenario in India?

There are doubtless advantages to the universal banking model. A bank, which lends money to its customers, gains access to a large market for selling insurance, mutual fund products and investment advice.

There is synergy between the different operations. So, the logic for selling insurance, credit card, mutual fund under the same umbrella! But management has to be appropriately strengthened. Supervision also has to be discrete and separately organised.

An important question raised in this context is whether Basle-II norms were themselves responsible, to some extent, for banks resorting to special purpose vehicle housing securitised assets formed out of their loans.
In one sense, this point of view gains support from the fact that banks, which securitise loans and take them off their balance sheets, require that much less capital. But Basle-II norms also put rating agencies in the centre of the risk computation.

Rating agencies have been criticised for their role in assessing the riskiness of securitised packages of sub-prime loans, which were sold to investors.

But the extent to which securitisation distances the originators — the lenders — from the packages that are sold to investors is a telling point in the criticism that Basle-II norms have been partly responsible for the latest crisis.
Once lenders sell off their securitised packages to investors, they stop taking care about the performance of their borrowers — or so it has turned out. This is partly the result of the way in which the American investment banks used securitisation. But we have to ensure that the model gets the full impact of continued monitoring of the loans disbursed even after they are packaged and sold.Potential potholes

The collapse of the titans of Wall Street, the heavy losses that have hurt the bankers of the US and Europe, should open our eyes to the potential potholes in the road ahead. Universal banking can be a glamorous model, but it has its risks.

Securitisation may look like an easy way out of Basle-II norms, but it can lead to disaster unless the loans securitised are continually followed up. True, supervisors cannot shirk their responsibilities. But the overall responsibility remains squarely on the lender to ensure that the loans are properly disbursed and monitored, investments are properly accounted for.

After all, the banker has a heavy responsibility. Millions trust their savings to him or her.

The way Citibank’s Chuck Prince or Merrill Lynch’s O’Neil has gone is standing warning to the chiefs of all financial institutions around the world. They have to take risks, but not too much, seems to be the abiding lesson. Otherwise, they may risk not only their jobs and their banks but also the national economy.