Oil price risk hedging strategies usually depend on the following two factors: the risk profile, which essentially depends on the investor’s position in the oil value chain, and the maturity and sophistication of the risk-hedging processes within the organisation.
The nature of risk exposure of an organisation to fluctuations in oil prices depends on its position in the oil-value chain. An oil E&P company like Oil and Natural Gas Corporation (ONGC) is perennially exposed to the risk of any decrease in the oil prices, but an oil refining company would be largely concerned about protecting the spread between the crude oil and refined products. An oil marketing company would be concerned about the variation in the retail margin.
Assuming a free market, the oil refining and marketing companies are exposed to these risks only for the length of the input purchase- product sale period, which would typically range from few days to a couple of months. Unlike an oil refining or marketing company, however, an E&P company is exposed to the price risk for the entire duration of its business planning cycle (usually an year).
Consequently, most advanced case studies in oil price risk hedging are found in some of the leading oil E&P companies.
Based on the level of maturity and sophistication of risk management processes in the organisation, oil players use any of the following risk hedging approaches:
Passive Hedging is used by highly risk averse companies, which would like to be completely certain of the future cash flows through hedging of their entire risk exposures. It is achieved by locking a specific price either through long-term contracts between the supplier and buyer or through a derivative contract such as futures, forward or swaps that are available on most leading commodity exchanges and also as over-the-counter (OTC) bilateral contracts.
Although this strategy helps players achieve certainty of the future cash flows, it eliminates possibility of gaining from any favourable market movements.
In order to include this benefit as well in the hedge contract, players often hedge through option contracts that allow them to either buy or sell in the spot market without necessarily being committed to the hedge contract. However this imposes a huge hedging cost in the form of option premium that needs to be paid upfront at the time of hedging.
The Active Hedging approach seeks to achieve a balance between risk hedging and the cost of hedging by hedging part of the overall exposures either through long term contract or a derivative instrument and keeping the remaining exposure unhedged so as to benefit from any potential favourable market movements.
However, it is extremely important for such players to clearly define the risk appetite, i.e., the amount of money they can afford to lose on the unhedged exposures. This is usually done by estimating future losses through statistical methods like Value at Risk (VaR) or by building future market price scenarios.
(Amit Sachdev contributed to this column. The writer is executive director, KPMG)