Swap reversal: OMC investors need to watch

Apart from making a quick buck by going long on the dollar, traders might short oil PSUs; if rupee weakens, there could be other implications

One of the seasonal themes in the energy market is the rising demand for fuel oil as the northern hemisphere enters the winter season. Another theme has been the rising production of shale gas by the US. This has altered the global supply-demand scenario. However, if the US economy is out of recession and into a phase of expansion, energy demand from the world's largest economy is also bound to rise. A third theme, specific to India, is that a weaker rupee makes energy more expensive, since most of India's fuel is imported. The second half of the year also generally sees rising energy demand from the Indian economy because it is the 'busy season'.

Put these together and pressure on the bottom lines of Indian public-sector oil marketers or refiners is normal in the third quarter and especially the fourth. I don't see why this year will be different. The rupee is likely to stay much weaker than most people estimated in March-April. This increases the burden on importers such as BPCL, IOC and HPCL, since they aren't allowed to export finished products, which would earn some forex back. Ironically, the deep drop in the rupee's value in the second quarter triggered some review of the retail pricing mechanism. However, while a system of staggered diesel price increases was put into place, the rupee fell so fast the underrecoveries actually increased.

Demand for dollars from public-sector units (PSUs) is itself one of the key pressure points for Indian reserves. It comes up every month when these companies need to source dollars to buy crude. Out of desperation, the Reserve Bank of India (RBI) arranged a swap system in late August. That has its own dangers.

The very fact that the details of these swaps have not been released makes one suspect the dangers are significant. RBI gives the oil PSUs dollar in an off-market swap transaction. A swap usually sets a fixed exchange rate for both legs. The rate set for the transaction and the date of reversal is not known, though it is assumed the reversals will be sometime in February-March 2014. No benchmark interest rates have been mentioned for either the dollar or the rupee. Again, it is believed the oil PSUs have picked up $14-15 billion via the swap mechanism. Either these swaps have to be endlessly rolled over or at some stage, the refiners will have to buy dollars from the market. If the market rate varies a lot from the agreed swap rate, somebody could get hurt. The PSU might have to pay more for its dollars or the bank receive less than it would have, in a normal transaction. It's not much of a deal for the government, since it owns both the oil PSUs concerned and the bank. However, there are minority shareholders and they could bear the brunt of any problems that arise. The other issue is that the demand for dollars will suddenly rise when the swaps are being reversed. In a normal month, oil PSUs pick up $8-9 billion worth of dollars. Between August and October, they were being supplied directly via swaps. In November, they are believed to have picked up roughly one-third of requirements from the open market and this is a prime cause of rupee weakness in the past couple of weeks. It could be extremely entertaining for forex traders if the swaps start reversing as the US Federal Reserve tapers. There could be every chance of a sharp drop in the rupee, since there would be dollar outflows from foreign institutional investors cutting stakes as demand for dollars spiked due to oil PSUs reversing swaps. Quite apart from the chances of making a quick gain at that stage by going long on the dollar, the trader could get a chance to short the oil PSUs. If swap reversal actually triggers a trend of rupee weakness or reinforces an existing trend, there will be other implications for investors.