Risk-managing oil prices
New Delhi   21-Aug-2010

Managing oil prices without subsidies is no job for the faint hearted. President Obama recently renewed his failed budget pledge of last year to remove $36 billion tax breaks given to oil companies, in face of widespread protest by the industry. In Europe the subsidies to energy producers as free issue of sellable carbon permits are in addition to several other tax breaks given for North Sea exploration and downstream refining industries. In China subsidies have kept oil prices pegged at less than three fourths of India while Indonesia and Malaysia subsidise up to 50% of oil prices on a much smaller import bill, to keep domestic consumers happy.

 This skewed nature of oil pricing has occurred over the years as governments struggled to control the volatility of oil after it jumped from the $22-$28 per barrel price band in the nineties to the $50-$100 band during 2001-2010. The Indian government is perhaps the first major oil importing nation to do away with subsidies and would have to manage purchase prices effectively to ensure minimum volatility.

 One of the ways to achieve this is to help oil marketing companies (OMCs) create a large buffer stock of both crude oil as well as refined petrol and diesel. This means an effective increase of oil storage capacities both at sea by leasing oil tankers as well as at offshore terminals by hiring free storage capacities. For this to happen, the cash flow of these marketing companies - IOC, HPCL and Bharat Petroleum - had to be given a boost so that they could buy oil from the international spot markets. The subsidy system that locked up the OMC liquidity for months as the government held on to the disbursements had to go, to ensure that the OMCs are empowered with ready cash for market operations.

 Oil prices at the international markets fluctuate more due to the volatility induced in oil futures at the ICE and NYMEX Commodity Exchanges by the trading cartel of the big oil companies BP, Shell and Total and the big banks like Morgan Stanley and Goldman Sachs. The beleaguered oil giant BP lost its trading team leader Chris Paine at London to Vitol recently while Brightoil the Chinese trading arm that plays the South China bunker market poached a dozen other executives in a bid to control trading at the Singapore commodity exchange. Brightoil with an asset base of $1.5 billion sub-leases around 100,000 tonnes of storage capacity in Singapore and 450,000 tonnes in South China and has become one of the biggest traders of marine oil in the region since its entry into the market only a year back.

 The commodities markets of oil is an extremely volatile market, and professional traders are needed to source the cargoes, plan the blendings and trade positions in the swap markets. The expertise at the commodities trading floor has to be supplemented by strong cash flow, high speed physical buying, swapping and innovative supply chain management of the product mix.

 Creating price inversions by stockpiling and buying bulk before the demand peaks is a known and tested method to reduce prices. It helps to hold purchases at peak demand and reduce the difference between spot prices and future prices. This makes it difficult for the speculators to hold stocks as the cost of storage is often more than the price difference. Speculators like Morgan Stanley or Goldman Sachs normally take advantage of this price difference in a contango trade, but in May this year when China and US stockpiled heavily, hedge funds, Wall Street banks and bull operators panicked and squared up.

 US stockpiles had crossed a record 37 million barrels at Cushing Oklahoma leading to wide spreads between the WTI and Brent Oil that eventually dragged down oil prices after some dogged resistance. China too had sharply increased both its owned and leased out oil storage facilities and refinery capacity and increased its oil purchases by as much as 30% to meet future contingencies. COSCO the Chinese shipping giant has taken delivery of a dozen oil tankers from its $2.3 billion order with Greek shipbuilders placed in 2005 and is now investing in the famous Greek shipyard Piraeaus to augment its shipbuilding capacity.

 BP's financial dilemma following the Gulf oil spill and Europe's debt crisis has presented an unique opportunity to augment the supply chain of nations looking to reduce its energy costs. Refineries and ready to store offshore storage facilities are becoming available at reasonable prices both on lease as well as on outright purchase basis. Besides oil tanker monthly lease rates have climbed only marginally after bottoming out in April this year. For Indian OMCs it is right time to play the markets as well as build up capacities needed to store and refine oil and reduce energy prices.