Should governments hedge oil price risk?

I had an extended email conversation last month with a respected economist (who wishes to remain anonymous) about whether governments of oil importing countries should hedge oil price. While there is a decent literature on oil price hedging by oil exporters (for example, this IMF Working Paper of 2001), there does not seem to be much on oil importers. So we ended up more or less debating this from first principles. The conversation helped clarify my thinking, and this blog post summarizes my current views on this issue.

I think that hedging oil price risk does not make much sense for the government of an oil importer for several reasons:

1. Oil imports are usually not a very large fraction of GDP; by contrast oil exports are often a major chunk of GDP for a large exporter. For most countries, oil price risk is just one among many different macroeconomic shocks that can hit the country. Just as for a company, equity capital is the best hedge against general business risks, for a country, external reserves and fiscal capacity are the best hedges against general macroeconomic shocks.
2. For a country, the really important strategic risk relating to oil is a supply disruption (embargo for example) and this can be hedged only with physical stocks (like the US strategic oil reserve).
3. A country is an amorphous entity. Probably, it is the government that will do the hedge, and private players that would consume the oil. Who pays for the hedge and who benefits from it? Does the government want the private players to get the correct price signal? Does it want to subsidize the private sector? If it is the private players who are consuming oil, why don’t we let them hedge the risk themselves?
4. Futures markets may not provide sufficient depth, flexibility and liquidity to absorb a large importer’s hedging needs. The total open interest in ICE Brent futures is roughly equal to India’s annual crude import.

Frankly, I think it makes sense for the government to hedge oil price risk only if it is running an administered price regime. In this case, we can analyse its hedging like a corporate hedging program. The administered price regime makes the government short oil (it is contracted to sell oil to the private sector at the administered price), and then it makes sense to hedge the fiscal cost by buying oil futures to offset its short position.

But an administered price regime is not a good idea. Even if, for the moment, one accepts the dubious proposition that rapid industrialization requires strategic under pricing of key inputs (labour, capital or energy), we only get an argument for energy price subsidies not for energy price stabilization. The political pressure for short term price stabilization comes from the presence of a large number of vocal consumers (think single truck owners for example) who have large exposures to crude price risk but do not have access to hedging markets. If we accept that the elasticity of demand for crude is near zero in the short term (though it may be pretty high in the long term), then unhedged entities with large crude exposures will find it difficult to tide through the short term during which they cannot reduce demand. They can be expected to be very vocal about their difficulties. The solution is to make futures markets more accessible to small and mid size companies, unincorporated businesses and even self employed individuals who need such hedges. This is what India has done by opening up futures markets to all including individuals. Most individuals might not need these markets (financial savings are the best hedge against most risks for individuals who are not in business). But it is easier to open up the markets to all than to impose complex documentation requirements that restrict access. Easy hedging eliminates the political need for administered energy prices.

With free energy pricing in place, the most sensible hedge for governments is a huge stack of foreign exchange reserves and a large pool of oil under the ground in a strategic reserve.

Posted at 9:29 pm IST on Thu, 27 Nov 2014         permanent link

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