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    “Mauka” to hedge India’s Future

    By

    March 30, 2015

    This piece is not a usual reporting on the daily Indian economics. Rather, it suggests a possible policy initiative having potential of making India independent from the nerve wrenching volatility in energy prices for the next 4 years. Apart from an extraordinary financial stability, it will build a platform whereon India can fire on all of its cylinders and come out shining. The utopian target of USD 20tn will then not be difficult to achieve.

    India’s GDP could grow to $20 trillion if the average annual economic

    growth for the next 25 years is maintained at 10%

    Building the Fundamentals

    As a long term player, as I’d like to think of myself, India presently needs to build up its fiscal and monetary base in order to reap the much discussed demographic dividend which we talk about – we will leave China behind by 2025 to take the title of most populous nation. It is well understood that it is not only the internal factors which need to be dealt with, it is the external climate also which has to be addressed. The delicate nature of the world economy, ready to fall of the cliff at slightest of force, creates a global environment that pulls you back on every breakout on the upside.

    From outflow of funds on account of increase in the interest rates of the countries in the West, to sharp acceleration in the commodity prices, massive external borrowings and the intrinsic inter-dependence of all nations on each other for commerce and trade – all these play a crucial role in determining the quantum of a country’s prosperity and success.

    We propose to tackle one such obstruction cum opportunity – the fluctuations on account of movement in the Brent crude – the international benchmark for pricing of petroleum products.

    The phenomenal swing in Brent crude over last one year from

    $115/barrel in June’14 to less than $50 in March’15

    The Relevance

    Oil is a commodity which makes the Indian machinery run smooth. It is not an overstatement if I say that after gold, the only commodity behind which we Indians are most crazy is oil. To put this in perspective let me put across to you the hard facts –

    1) No.4 – Our standing in the world in terms oil consumption stands at 3.8 million barrels per day (mb/d)

    2) By 2020 India is projected to consume 4.7 mb/d overtaking Japan as the third largest global consumer of oil and responsible for almost 5% of world oil demand. It is also expected that by 2035, India’s oil demand will have reached 8.1 mb/d.

    3) The transport sector accounts for approximately 50% of India’s total oil demand.

    4) About 62% of the crude imported into India came from the Middle East, with the large majority originating in Saudi Arabia (20%) and Iraq (13%). Nigeria and Angola are two major African nations exporting to oil to India.

    5) India is a price taker in the global market and any international price hike dents the current account in a material way.

    Present Situation

    India imports nearly 70% of its crude oil requirements – costing USD 165bn in 2013-14. Our annual imports stand at USD 440 bn, with oil occupying almost a third of this share. With exports of USD 330bn, we stare at a trade deficit of more than USD 100bn annually. This shortfall has to be matched with the precious foreign exchange reserves, currently at USD 340 bn. It’s not wrong to say that our oil import bill takes away the shine from India’s otherwise at par performance.

    India’s foreign exchange reserves (in mn dollars) since 2005

    In the long run, if we can insulate ourselves from such externalities then we can raise our hopes for accelerated economic growth and social well-being. With every dollar decrease in Brent crude, the government’s import bill comes down by Rs. 4,000 crore. Cheap crude not only reduces the country’s import bill, but also augments government’s efforts to keep inflation low and stable by curtailing fuel subsidies. It sharply reduces the pressure of current account deficit (CAD) and helps create a healthy foreign exchange reserve, which further strengthens the rupee against the dollar.

    The Solution- Fuel Hedging

    A hedge is a mechanism by which future uncertainty is tamed by entering in to a contract with another party. A hedge simply aims to eliminate or reduce any substantial loss for the parties involved.

    While hedge is a pretty well spread phenomenon, what we intend to discuss is its scale.

    What if India hedges its entire fuel needs of the next 4 years?

    The forex rates play a crucial role for we are heavily dependent on imports for our fuel requirements. The dramatic oil price movements compounded by forex fluctuations leaves our Finance Minster with high blood pressure; we sure don’t want Mr. Jaitley to go through this strain anymore. How about we take ourselves to a safer ground, focusing to improve the internal synergies rather than worry about price movements.

    Strategy

    The Govt. of India should go ahead and use the forward market and buy Brent crude forward contracts of an amount equivalent to the sum of projected oil imports over the next 4 years.

    This strategy, if implemented, will mitigate the volatility in the oil prices and close associated geo-political risks.

    Supposedly we enter the contract at $50 a barrel. This basically means we end up paying for oil at $50 irrespective of its price in the global markets over next 4 years. Let’s consider the 3 situations which can arise –

    1) The Price Increases-

    If price shoot up astronomically and reach earlier levels of $110, then we would be saving an amount equivalent to a year of our present exports, and this is after ensuring we don’t loose anyplace else.

    2) The Price Stays Put-

    No Gain. No loss. One thing though – Peace of mind, guaranteed!

    3) The Price Decreases-

    This is the tricky part. All India can do is put in place the controls and tread steadily. “The rear-view mirror is always clearer than the windshield”. With world moving towards clean energy, a fair chance should be given to the prices to nose-dive. But, the fact remains we are well suited at current levels – next we explain it how.

    Economic Rationale behind the Hedge

    Simply put, the Brent crude levels hovering from USD40- 50 a barrel make sense. While some predict the price to fall down below USD 30, we must keep is in mind the good old quote “One in hand is better than two in the bush”.

    The decline of close to a 50% in oil prices from $115/barrel in June, 2014 to kissing the bottom at $50 in early March prove to be a boon for India –

    1) It aids the Centre Govt. reach its fiscal deficit target of 4.1% by helping do away with a significant part of subsidies amounting to Rs 1,48,000 crores on fuel. It leads to savings amounting to more than Rs 48,000 crores (0.4% of the GDP) for the exchequer.

    2) It helps reduce the CAD to reach less than 1% of the GDP

    3) It results into extra disposable income of more than Rs 3,40,000 crores in the hands of individuals, Corporates and Government and thus helps to boost demand and consumption.

    4) Petrol prices have come down by 17 per cent to Rs 61.1 a litre from their peak of Rs 73.5 a litre in June last year. Diesel prices, too, have been reduced by 13 per cent since then.

    Now extrapolate these savings for 4 years and the scenario should be a very favourable one. The decision would not only help India secure its energy needs, but would also bestow a much needed base to the energy prices which have been swinging for far too long. Exposure to borrowings and foreign exchange fluctuations on account of instability in the global economy, forex movement and increased borrowing cost has been affecting overall performance and growth of the country.

    If the plan comes into force within an approving framework much would be done to immune us from needless planning, and spare us time to revamp domestic structures without worrying about the matters on the international front.

    It won’t be wrong to conclude that currently India finds itself in a sweet spot,

    all that I ask is – Why not hedge it?

    The policy proposed is not the blogger’s brainchild, but that of a well-known equity investor and market advisor – Mr. SK Gupta, MD, Star Finvest Pvt. Ltd.

     

    Views presented in the article are those of the author and not of ED.

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