Oil refining and marketing companies have been at the center of uncertainty stemming from under-recoveries and volatile crack margins.
Treasury management in the oil refining and marketing business is required to be increasingly integrated with a clear focus on visibility and management of cash flows.
Sharp currency movements and interest rate servicing burden has further led to variability in rupee cash flows from one quarter to another.
Increasing de-regulation of petroleum product pricing has increased the onus of profitability management for oil refining and marketing companies. Volatile earnings have prompted oil refining and marketing companies to explore upstream opportunities to provide long-term stability.
Financial risk has also introduced variability in cash flows for standalone refiners who have been insulated from bearing the under-recovery burden from marketing of fuels.
As the oil refining and marketing industry in India seeks a more integrated play across the oil and gas value chain, protecting cash flows from the core refining business, until commercial production from upstream assets provides sustainable cash flows, is critical for long-term business viability.
The role of treasury management for oil refining and marketing companies has traditionally been fragmented with management of currency risk, oil price risk, debt and liquidity management being undertaken separately without assessing cash flow linkages across the value chain.
Certain refiners continue to hedge currency risk on a transaction basis and manage oil price risk through selective hedging of crack margins and inventory hedges.
The largest concern for stakeholders in the ability of a long-term hedging program to sustain with the risk of speculation invariably creeping into a sub-optimal decision making structure for oil price risk management. Debt servicing and cash flow management have progressed independent of other treasury functions with surplus/deficit management decisions being driven by availability of surplus cash and available bank limits as opposed to clear predictability of cash flows from the underlying business.
Treasury management in the oil refining and marketing business is required to be increasingly integrated with a clear focus on visibility and management of cash flows. Financial risk management is required to be far more cash flow-centric than protecting transaction rates recorded for the purpose of accounting.
Prevailing accounting practices related to inventory valuation and mark-to-market of derivatives have in many cases deterred effective financial risk management and increased earnings volatility.
Treasury management for the oil refining business, whether inclusive of marketing or with interests in upstream assets, is required to factor in the following:
- Oil price risk management should provide cash flow stability by locking in cracks over a longer period of time with reference to budgeted cash flows as opposed to market movements.
- Oil price risk management programs focused purely on crack hedging are inadequate without reference to inventory price risk, timing risk and basis risk.
- Currency risk management should be focused on providing certainty of INR cash flows once GRM certainty in US$ terms is improved.
- In a dollarized business and with a view on global upstream assets, cost of debt servicing should be benchmarked with US dollar borrowing cost. Incurring higher rupee interest cost in a dollarized business and to fund dollarized assets may prove to be sub-optimal both from a currency risk and borrowing cost perspective.
- Effective currency and oil price risk management provides for enhanced cash flow visibility. With increasing de-regulation in petroleum product pricing to stem under-recoveries, the ability of a refiner to forecast cash flows with increasing accuracy is critical for debt management and surplus deployment decisions.
- The introduction of IFRS and hedge accounting provisions contained therein provide refiners an opportunity to align accounting profit and loss with real cash flow hedging gain/loss in each quarter.
- Integrated treasury structure, policy and strategy are critical for simultaneous assessment of risk and cash flows. A structured decision making process that emanates from such a holistic assessment is important to improve the efficiency and transparency of treasury management.
This document has been complied by us with a view to help oil refining and marketing companies re-assess their financial risk profile, impact of variable cash flows and treasury management practices that may be adopted to introduce a greater degree of cash flow stability.
We hope that you find this document insightful. In case you need any further perspective, we will be glad to interact with you.
Hemal H. Shah
Partner - Financial Services Risk Management
Ernst & Young Pvt. Ltd.