The quest for transparent pricing benchmarks has led to a fair degree of standardization in pricing benchmarks for crude oil and products.
Lack of clarity in dollarized nature of cash flows has led to variety of hedging strategies
Standardization of benchmarks has also led to standardization in the currency in which crude oil and petroleum products are priced. Pricing of both crude oil and products is based on benchmarks denominated in US$.
Even where petroleum products are sold domestically, international benchmarks are used to determine the price of products.
The current subsidy mechanism has led to under-recoveries and compensation of under-recoveries through a scheme of oil bonds. This has led to many refiners to have an incorrect notion that pricing of products is denominated in INR.
Integrated oil refining and marketing companies are required to evaluate cash flows from the two segments of the business as follows:
- Refining margins are purely a function of dollarized pricing of crude and products.
- Marketing margins are a function of dollarized pricing by refining operations and the net INR value realizable from customers. Net realizable value from customers should factor in rupee value of discounts, subsidies and value of oil bonds received.
Accordingly, once the integrated oil refining and marketing company has locked in the rupee value of refining margins, all other cash flows following the transfer from refinery are INR denominated and are attributable to marketing margin.
Lack of clarity in dollarized nature of cash flows has led to variety of hedging strategies ranging from taking no action to protect the rupee value of cash flows to hedging buyer’s credit on crude shipments by buying dollars forward.
Given the dollarized nature of cash flow management of currency risk is required to focus on the following two aspects:
- Eliminating mismatches between timing of pricing out of products at refinery gate and pricing-in of crude purchases
- Locking in the rupee value of refining margins
*Refer to the attached PDF for source information