Can India become rule-maker in the global oil trade?
Even though the centre of gravity of global oil trade has shifted from the West to Asia, the oil trade is still managed on Western exchanges. That means prices are set using Western benchmarks (Brent and West Texas Intermediate), and the medium for exchange remains the US dollar. This anomaly puts Asian countries at a disadvantage that will only grow worse with time as trade becomes increasingly skewed toward Asia. But a solution is within reach: India needs to push for a bigger role for its exchanges and currency in the oil trade. This will help improve the country’s energy security and create a bigger international role for the rupee.
But the time to act is now. China already is challenging Western dominance by pushing its own commodity exchanges and currency as an alternative to the petrodollar. India, with its open markets and transparent regulation, has a distinct advantage over China, but it must seize the opportunity soon.
The benefits of exploiting India’s strengths are considerable. Widespread use of the US dollar as the international medium of exchange has long kept down borrowing costs for the American government and consumers. It also has given the US enormous geopolitical leverage – as demonstrated by its ability to impose and enforce sanctions against Iran, Venezuela and Russia. Many governments, including India, have publicly said that they don’t recognise these unilateral sanctions, but companies in these countries quietly comply because they otherwise could lose access to the US financial system, which would be catastrophic for any large commercial entity.
Physical trade has shifted
There is no question that the financial trade in oil is increasingly out of sync with the physical trade. Due to its increasing shale-oil production, the US is no longer the top importer of oil – China is. Four of the five top importers of oil – China, India, Japan, and South Korea – are in Asia. And Asia, led by India, is expected to be the major driver of future growth in oil demand, at a time when oil consumption in Western countries is flat or declining.
Asian commodity exchanges can play a larger role in the oil trade by getting buyers and sellers together and helping producers and consumers hedge their risks. This role doesn’t have to be restricted to India’s own market; it can extend to international trade and thereby play a global role in price discovery and in setting new benchmarks. China already has established a new exchange in Shanghai – the International Energy Exchange. It has a large trading volume, but the trading pattern indicates that most of this trade is speculative, and not linked to physical trade. Moreover, China’s record of interfering in financial markets and its opaque regulatory framework makes it a dodgy prospect for international finance. India, with its better regulated markets, can offer a better Asian alternative. That India is the third largest user and importer of oil, with growing demand and without China’s geopolitical agenda of replacing Western institutions makes India’s case stronger.
How can it be done?
India’s Multi-commodity Exchange already features trading in oil contracts, but the activity almost entirely involves contracts close to expiry. To function fully, an exchange requires buyers and sellers involved in actual trade of the underlying commodity. India has ample buyers, but its domestic oil production is low and mostly comes from government companies, so there are no natural sellers of oil futures and options in India.
This can be changed, however, by establishing Exchange Traded Funds (ETF) for crude oil on Indian exchanges – like existing ETFs for gold that are run by many mutual funds. Owners of such ETFs become natural sellers of long-duration options and futures, thus improving market liquidity. Once ETFs are established, the next step will be to bring in long-dated futures and options for the ‘Indian basket’ – a new benchmark that reflects consumption patterns that prevail in India (and Asia generally). An added benefit of establishing crude-oil ETFs will be that the underlying oil, which would be physically stored in India, could be used in an emergency. In effect, it would become the strategic petroleum reserve that the government is trying to create using public money.
Crude oil is unusable until it is refined; for the exchange to serve as a hedging tool, contracts on oil products – such as diesel, petrol and aviation fuel – will have to be introduced so that oil consumers could cover their risk in case of price fluctuations. The biggest at-risk party to high oil prices of course, remains the government, which had to subsidise consumers for nearly a decade (2005-15) when oil prices were high. Since the government carries the risk should oil prices rise again, it can use the exchange to hedge against certain scenarios (if, say, the price of oil rises above $100 per barrel). Other governments, including Mexico, Uruguay and Jamaica, have used financial market hedges to protect themselves against oil price fluctuations; the Indian government could use an Indian commodity exchange for the same purpose.
In the short run, having a vibrant commodity exchange operating in India will create thousands of high-paying finance jobs and help Indian consumers hedge against the risk of energy price fluctuations. Physical settlement of these contracts will require creation of tens (if not hundreds) of millions of barrels of storage infrastructure, which can double as a strategic reserve in emergencies. In the longer run, becoming a centre of energy trade that sets energy price benchmarks will elevate India to a central position in the global financial system. India, in short, can become a rule-maker in the global oil trade instead of the rule-taker it is today.
(The study has been authored by Amit Bhandari)