Should we lock oil prices for future?

Fri, 23 Jan Pre-Open

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Oil prices have had a huge significance as far as fortunes of Indian economy are concerned. In fact, it would not be wrong to say that after Modi Government’s rise to power, it is the key factor that has set the stage for some of the key policy changes - such as diesel deregulation and rate cut (lower oil prices leading to lower inflation).

With 80% of the crude oil requirement being met by imports, oil has been a major culprit behind poor state finances. It adversely impacts not just current account balance (due to higher outgo for imports), but fiscal deficit as well (in the form of fuel subsidy burden). The falling oil prices have been a boon for Indian economy - be it the Government, oil and gas sector (barring Private explorers) and last but not the least, the common man. But one thing is very obvious. The oil prices currently are trading below the level of US$ 50 per barrel, thus rendering production for a lot of companies unviable. Hence, we will not be surprised to see oil prices to up. Which means that whatever recovery and reforms we have witnessed in the recent past could be standing on a very slippery ground. The good times could last only till the time oil prices remain low.

Or, as long as we ensure that the price at which India imports remain low, irrespective of the global prices. As suggested in an article in Livemint, there are two ways to achieve this - building oil reserves or hedging/locking the price of oil.

As far as the first option is concerned, efforts are already underway. But there is a likelihood of oil prices going up by the time such storage capacities are ready. Coming to second option - hedging oil - since oil has already slipped below US$ 50 per barrel, locking prices at US$ 50 per barrel through a hedge should not be very costly. It is expected to not only lead to current account surplus but also indirectly save enough money to take care of subsidies (which anyway will be lower with oil price at US$ 50 per barrel). It will lead to a sound fiscal health, thus setting the stage for unleashing crucial reforms in the economy.

While a lot of private oil companies are already doing this, state run oil refiners are hesitant to insure oil prices. Unlike their private peers, they lack the flexibility (being Government owned) and do not have the appetite to bear losses in case the bet goes wrong. Since these companies are already reliant on Government for subsides, any losses in hedging will be detrimental for their financial health.

While this is a matter of concern, we believe in such a case (where hedging bets go wrong), the state run companies could be convinced if they are given more autonomy in day to day operations and fuel pricing decisions. However, as far as long term solution is concerned, we believe that with oil, there is not just the price risk, but supply risk as well. And building reserves could be the second best solution to that, next to becoming self reliant for oil needs. However, that is easier said than done and will take time. Until then, perhaps the best way to play lower oil prices is to hedge oil.