Indian Railways is one of the largest consumers of bulk commodities like Oil & Lubricants, Steel, Cement etc. We stand completely exposed to the price
volatility of these bulk commodities. Not only we take no effort to reduce or mitigate the risk of price increase, we also accept additional risk of price
increases by incorporating price variation clause in our contract agreements. We can easily manage and mitigate these financial risks by using derivatives.
Most organisation use financial derivative instruments like options, swaps, futures, and collars to hedge against price volatility. Southwest airlines has
hedged
70% of its fuel at $51 a barrel (which compares favourably to the current approx $150). Should we not use these standardised legal financial instruments
readily available in the markets and save our costs?
Hedging against price increase
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 prashant73 |
Hedging against price increase |
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Posts: 22 (07/11/08 16:01:04) |
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freefall |
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Posts: 171 (07/14/08 06:26:02) |
IR purchases its oil from public sector undertakings. Thus, on its own IR cannot insulate itself from the vagaries of oil market. However, can't the IOC
save itself from this fate using derivative market? The answer is - no. As a relic of the old license-permit-quota raj, future trading is allowed only in six
commodities and crude oil is not one of them. In fact, our oil companies have been begging the government to allow them to trade in futures.
Future trading is not a cost free exercise. Nothing comes free. Neither lunches, nor futures. If IOC wants to enter into future trading they have to incur the cost of future trading. What it means is that their cost of procurement will be higher than normal. Is it good or bad for them? It depends. Had they bought those futures in 2001, then they would have made a killing by now, because in 2001 no one foresaw that cost of crude oil will be so high today. (If someone had foreseen the price rise at that time, the cost of future would have been very high). However, if IOC want to but it now, when the market is already volatile, then it may not be a good idea because looking to the volatility of the market the cost of future itself will be very high. Let us understand that future trading is a company's way of managing risk at a cost. It is not a way of earning some handsome profit in anticipation of inflation. In the long term, profits and losses will even out for the company and they will be able provide a steady stream of returns to their shareholders based on their own fundamentals rather than the vagaries of the market. Our PVC is also based on the same philosophy though it works in a different manner. When we enter into a contract for two years, we are essentially buying a future and let us remember that every future has a cost. In the absence of a PVC , the cost of this future trading goes straight into the rates of the items quoted by the contractor. However, contracting is not our core business. For us, it is neither a source of profit nor of loss; it is simply a means of getting things done at a FAIR price. Contractual variations are not going to affect our bottom line. Therefore, does it make sense for us to incorporate the cost of futures in our contracts? For smaller contracts of of short duration, this cost may not be much, but for larger contracts of longer duration this cost will be higher as a proportion of the contract. When prices fluctuate someone has to carry the cost of risk. In case of no PVC, this risk is carried by the contractor (and of course he does not carry it for free). In case of PVC, the risk is carried by us. IR's PVC policy is based on a sound economic principle. Since contracting is not our core business, we carry all the risk of price change and force the contractor's to compete on their ability to deliver at a competitive price - not on their ability to speculate on prices of commodity. (We do carry the the cost of risk in no PVC contracts, but they are small value and small duration and hence neglected).
Last Edited By: freefall
07/14/08 07:52:54.
Edited 2 times.
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prashant73 |
Hedging against price increase | ||
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Posts: 23 (07/14/08 13:53:31) |
Thank you Sir, for your erudite comments. A brief rejoinder: While I understand that derivatives instruments carry a cost, most organisations use them
succesfully and regularly to safeguard against price volatility, maintain predictable cash flows and most importantly save enormous costs. There is no reason
why we should completely ignore the possibility of using hedging techniques that are used world over. Also, I was refering to all kinds of derivative
instruments and not just futures. Also, futures are not like forward rate agreements where the actual delivery of the commodity may take place. Trading in
commodity futures generally occurs on margins and the deal is closed by taking counterposition by selling long or short. Our procurement decision is seperate
transaction and that has no relationship with buying derivatives. The gain in trading in derivatives only helps in reducing the financial impact of the
increase in procurement cost. Even if IOC is allowed futures in oil, it may not pass on the financial benefit to IR. IR will have to create a positive cash
flow by derivative trading so that it effectively hedges itself against increase in price rise. My only submission is that we need to acknowledge the existence
of hedging instruments, understand how they are used and then assess whether or not to invest in them. As of now nobody in IR even talks about possibility of
hedging.
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scmitra |
Future Trading. | ||
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Posts: 568 (07/14/08 21:09:56) |
Prashant
Hindsight is a wonderful tool and a wonderfool tool! When it is in your favour, you look prescient and when it is against you look pre-teenish. Your observations on futures trading of oil is also based on the luxury of hindsight which is never available when decisions are to be made. Commentary on markets are always done in hindsight. When the markets were high, the whole country was saying that sensex might go upto 25 K and when it is down, the Cassandras are out there saying that it may go down to 10K! What happenes when hedghing itself leads to very many losses? The is it adviseable to go for hedging against hedging? My point is that esoteric derivative trading has proved to be the bane of financial sector as has bene seen during last few months. Should we also jump on the badwagon? scm |
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prashant73 |
wonderful or wonderfool | ||
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Posts: 24 (07/15/08 05:22:34) |
Saurabh,
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freefall |
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Posts: 172 (07/15/08 05:43:58) |
Derivative instruments are not meant to achieve any cost saving. They are meant to manage volatility of balance sheet - at a price.
Let us take a simple example. Suppose my business is heavily dependent on the price of crude oil. Current crude oil price is $100 per barrel. I do not know the price of crude oil 5 years since now. However, my next 5 year investment planning is based on the estimated price of crude oil at $150 per barrel during this period. Now, managing the risk of price volatility of crude oil is not my core business. My core business is something else. Therefore, I hire someone (an investment bank) to manage this risk for me at agreed fees and then I can go back focusing on the fundamentals of my business. If my investment bank had full information on crude oil price for next 5 years, it will calculate the weighted average price, find out the difference, add its fees and sell me the right to buy crude oil at $150 per barrel for next 5 years at this price. For example, if bank's estimated price is $160 per barrel, bank will charge $10 as the difference in price, add a price of volatility risk, add its own fees and sell me the future at this price. As we can see, there is no way for a company to consistently save in this arrangement unless the company is able to find an investment banker who is really stupid and who consistently charges less than the fair market price. In case of a rational company and a rational investment banker, company will loose out some times, gain sometimes and eventually will become even MINUS the fees paid to the investment banker. The legitimate question here is that why would a rational company enter into such deal where in the long run it does not gain anything but has to incur fees of the investment banker. The simple answer is that company's total value is tied to its share price, which in turn is tied to the volatility of its balance sheet. Thus, a company is poorer by the amount paid to the investment banker but has saved the erosion of its brand value. When company's like Southwest Airlines are purchasing futures, they are not expecting to achieve any consistent cost savings through this. If they did, then folks sitting opposite them at Goldman Sachs earning seven figure incomes in dollar deserve to be fired. Whether we want to manage the risk of commodity price (future/ forward/ swap), the risk of stock price (calls and puts) or the risk of fluctuation in foreign currency exchange rate (hedge fund), the underlying economic principle remains the same - "There is no money left on the table." or in more technical terms "no arbitrage rule" or in the wisdom of Chicago school, "you cannot consistently beat the market over a long run." Does it mean that derivative markets are irrelevant for IR? They would be relevant for IR only if IR's total value is tied to its share price or if IR is allowed to purchase its fuel directly from the international market bypassing the IOC. Else, not. Even when both the conditions are fulfilled, derivative markets cannot act as a source of cost saving. They are not designed for that. The route to cost saving is the old unsexy, unglamorous, focus-on-fundamentals route: find out the cost drivers and consume less of them; reduce workforce; increase utilization of rakes, locos, tracks; increase productivity of human capital. There is no magic bullet for prosperity. |
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scmitra |
Freefalling Wisdom! | ||
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Posts: 569 (07/15/08 22:35:11) |
Very erudite rendition there, Freefall!
Prashant and Freefall, I would also like to understand one more thing. For every guy who makes money in this hedging or any kind of speculation based on probabilistic prices, there is always a group of body or individual who are loosing exactly that much. As the total money flowing in the system remains constant, for every set of winner, there is a set of loser. In your example of Southwest Airlines, just imagine the other side. Southwest came up with a winner. But the company which bore the brunt of this hedge must be bleeding now! Now if the oil prices were not on viagra and if it was somewhere around $31 , Southwest Management would have been sacked in no time! Hence it is just a matter of chance on which side you turn up with! Do educate me more on this topic. Seems a scary topic though! scm |
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freefall |
Hedging against price increase | ||
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Posts: 173 (07/16/08 03:05:23) |
For every guy who makes money in this hedging or any kind of speculation based on probabilistic prices, there is always a group of body or individual
who are loosing exactly that much. As the total money flowing in the system remains constant, for every set of winner, there is a set of loser. In your example
of Southwest Airlines, just imagine the other side. Southwest came up with a winner. But the company which bore the brunt of this hedge must be bleeding
now!
True. But no one enters the hedging market to make money, just as no one buys insurance to become rich. In the long run, neither the party selling the derivative instrument, nor the party buying it, is any richer because of this transaction. OK. Let me take back my previous statement. Actually the buyer and the seller both are now richer, because, once the volatility part has been taken care of, they can focus on their business in a more meaningful manner and thus create more wealth. However, we have to understand that it is not the sale/ purchase of derivative that creates any wealth. It is the business that creates the wealth. If the volatility of diesel or steel prices is hampering railways ability to effectively run the trains then derivative markets can certainly provide us that stability - AT A PRICE. However, we cannot and should not expect to create any wealth by timing our sale/purchase of financial instruments. For us, the wealth has to be created by moving wheels on rails. Entering derivative market with the expectation of earning a higher profit or saving cost through that market is a wrong motive. That market is not designed for that. It is designed for something else. The higher profit or cost savings have to come through fundamentals of your own business. The derivative market can only help you to some extent in managing the volatility of your cash flow - if that is a problem for you. However, creating real wealth is still the domain of the business, not the financial market. Even the investment bank that brokers the sale/ purchase of derivative instruments does not create any wealth by timing the sale/ purchase of instruments. It creates wealth by selling its risk management expertise, just as we create wealth by selling transport services.
Last Edited By: freefall
07/16/08 03:28:10.
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prashant73 |
value drivers | ||
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Posts: 25 (07/16/08 06:00:36) |
"No one buys insurance to become rich". I agree completely because insurance derivative is not designed for upside gains. It's only meant to take care of downside risks. Thus even if "no one buys insurance to become rich... not buying insurance can certainly make you poor". You don't become rich by having car insurance. But if you don't have car insurance, and have an accident you will be a lot poorer. Southwest has hedged oil at $51, American airlines hedges at $89 and Easyjet has hedged poorly. The result is that Southwest is still recording profits, American airlines is able to survive and easyjet is in a spot of trouble. All the three airlines are excellent in operations and have sound business fundamentals, but thet reacted to the volatility of fuel prices in different ways. And they have to bear the consequences accordingly. Focussing on business fundamentals is imperative. One of the fundamentals is lower operating expenses. The low cost airlines concept is perfected by
Southwest airlines. Every business school uses southwest airlines to depict excellence in operations managment. So they are the best in class as far as
business fundamentals go. In the last 35 years they have outperformed the airlines industry consistently. Not only because they buy derivative instruments...
but because they create value across all the business performance drivers. Managing volatility and price shocks so as to reduce operating expenses is one of
the value driver.
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freefall |
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Posts: 174 (07/16/08 06:51:44) |
For the record, the only commodities legally allowed in India for futures trades are agricultural products, bullion and base metals. Even in agricultural
products, trading in rice and wheat futures has been banned recently. Trading in oil futures is of course illegal. Steel is the only legally permitted futures
trade commodity that may be of some interest for railways. But I doubt whether the steel price volatility can really impact our bottom line.
Last Edited By: freefall
07/17/08 01:52:29.
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scmitra |
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Posts: 570 (07/16/08 20:27:57) |
"But no one enters the hedging market to make money, just as no one buys insurance to become rich."
An illuminating sentence loaded with all the possible enlightenment the topic could afford. Thanks Freefall. scm |
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prashant73 |
Derivatives Revisited | ||
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Posts: 27 (11/16/08 05:48:17) |
No one buys insurance to become rich...but we do buy insurance to save ourselves from getting poor. And that is the only purpose an insurance instrument
serves... and at a cost, but a small cost compared to the risk.
And many organisations do enter the hedging market... NOT TO MAKE MONEY but for effective risk management, as there are suitable products for varied requirements. (Repetition? ...It is!) Oil prices have dropped sharply, and will remain so in the near future. It does seem like a good time to think about investing in Oil futures to hedge against future price shocks. The global credit crunch and recession will work in our favour as our cost of capital is still unaffected. Reactions??? (illuminating or otherwise) |
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