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Jaimini Bhagwati: Strategic oil reserves and other options
Jaimini Bhagwati / New Delhi February 8, 2007
Policies to hedge against the exposure to disruptions in supplies and sustained high prices should be complemented by financial strategies.
 
In 2005-06, Indian oil imports were $43 billion or 30 per cent of total imports. In 2006-07, the oil import bill is expected to be around $50 billion, or about 6 per cent of GDP. At current levels of oil imports, a one dollar change in the price of oil changes the annual import bill by $800 million. This article discusses strategies to reduce the risk of disruptions in oil supplies and exposure to consistently high oil prices caused by war or other unanticipated politically driven events. 

NET INCOME (NI) IN US$ MILLION 
& EARNINGS PER SHARE (EPS) IN US$
 

EXXON

BP*

RDS**

NI EPS NI EPS NI EPS
1996

-

-

 4,227 0.38 8,886

-

1997 11,732 1.64 5,478 0.33 7,753

-

1998 8,144 1.15 2,714 0.20 350

-

1999 7,910 1.12 4,704 0.28 8,584 2.12
2000 15,806 2.25 10,209 0.53 12,719 3.46
2001 15,320 2.16 6,617 0.38 10,664 1.45
2002 11,460 1.62 6,872 0.25 9,659 1.38
2003 21,510 3.15 12,681 0.56 12,395 1.77
2004 25,330 3.89 17,884 0.71 19,257 2.77
2005 36,130 5.71 22,448 0.92 26,261 3.84
2006 39,500 6.62

-

-

-

-

BP* - British Petroleum; RDS** - Royal Dutch Shell
Source: Company net income statements

 
Although opinions vary widely, the Iraq war, which started in March 2003, and the continuing tension in West Asia are estimated to have raised the price of oil by about $10 per barrel. Iraq’s peak oil production before the war was 3.5 million barrels per day (bpd) and now it is about 1.5 million bpd (1 million bpd of production is approximately equivalent to 50 million tonnes annually). OPEC increased production as prices went over $70 per barrel and let us assume that the “extra” production halved the so-called war premium from $10 to $5 per barrel. That is, with all other factors held constant, oil importers paid $5 more per barrel and India’s oil import bill in 2005-06 was higher by $4 billion due to the war.
 
It is difficult to estimate this war premium with any precision since some of the causal factors are political and cannot be modelled. Exporters are paying a part of it through increased production since it is in their longer-term interest to prevent substitute products from developing. Irrespective of who is bearing what proportion of the enhanced cost, petroleum exporters/processors are receiving a part of the war premium. This can be demonstrated by drilling (pun unintended) down from the country to the corporate level. The net income after taxes and the earnings per share of three global oil companies for the last 10 years are shown in the table above.
 
It can be seen from the table that net income has risen sharply for the three firms from 2003 onwards. Earnings per share have tripled for Exxon between 2000-01 and 2006 and doubled for British Petroleum and Shell. It appears that the tension in West Asia has helped major international oil companies in the near term and probably would not hurt them in the medium to long term. This is not to suggest any conspiracy but to highlight that while war in Iraq hurts oil-importing countries it boosts net income for oil companies. End-results that are so sharply divergent make it that much more difficult to arrive at internationally cooperative solutions.
 
Some argue that the principal reason for the sharp increase in oil prices in the last few years is the rising demand for oil in India and China rather than the tension in West Asia. In 2005-06, the United States consumed about 1,050 million tonnes of oil, which was 25 per cent of global oil production. In comparison, China consumed 360 million tonnes and India about 140 million tonnes in the last one year. While the growth rates of oil consumption in these two Asian countries are relatively high, their combined consumption is still less than half that of the US. Except perhaps at the margin, India and China remain price-takers and not price-makers as far as international oil prices are concerned.
 
In January 2006, the Cabinet Committee on Economic Affairs (CCEA) approved the setting up of a strategic oil reserve for India within the public sector. It was reported a year ago that this reserve would be built up to 5 million tonnes over nine years. At the current annual consumption of 140-145 million tonnes, this volume of strategic oil reserves would cover about 12 days of usage. In contrast, the US maintains about 40 days worth of strategic oil reserves and Japan about 180 days. It was reported recently that China may maintain as much as 150 million tonnes, which would be adequate for five months.
 
Obviously, each country has to work out for itself the tradeoff between costs and benefits of holding strategic oil reserves. The current cost of importing 5 million tonnes of oil is about $2 billion. Assuming a 5 per cent risk-less rate of return, the financial cost of holding 5 million tonnes of oil would be about $100 million per annum. In addition, there would be storage and personnel costs. It appears that no significant hedging benefit would be realised by holding such a low volume of strategic oil reserves.
 
In the context of guarding against disruptions in oil supplies, the geographical distribution of India’s sources of oil imports needs to be further widened to reduce exposure to West Asia (at present 65-70 per cent of India’s oil imports come from this region). Including Central Asia and the Caspian Sea area would complement ongoing efforts to increase oil equity exposure in Russia, Latin America and Africa. Instead of spending at least $100 million per annum to hold a small amount of strategic reserves it would probably be more efficient to set up rolling oil price hedges on a six-monthly basis for, say, a quarter of the annual import bill with a cap, for example, of $2 above the current spot price and a floor of, say, $30 per barrel. The cost of buying caps on oil prices could be partly paid by selling floors and the above-mentioned numbers are purely illustrative. In addition, portfolio investments in the publicly traded stock of oil majors such as Exxon, Royal Shell and British Petroleum could be considered since their profits, and by extension dividends and share price appreciation, are positively correlated to disturbances in West Asia. To sum up, multi-pronged real sector policies to hedge against the exposure to disruptions in oil supplies and sustained high prices should be complemented by financial strategies.

j.bhagwati@gmail.com  

 
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