If the price of a commodity rises, a producer should generate higher profits. Therefore, one way to hedge rising commodity prices is to invest in producers. Extending the argument one step further, downstream players in the value chain have to pass on cost. Or else, they face margin pressure.
When it comes to fossil fuels and the Indian economy, the argument breaks down. India imports almost 80 per cent of its fuel needs, so it’s sensitive to global rates. But government-owned producers are not allowed to realign their prices upwards to fully match global price rises. They are also forced to share subsidy burdens. Downstream players aren’t allowed to pass on higher costs and their losses are only partially met.
As a result, the investor cannot hedge very effectively when fossils appreciate in price. At the same time, inflation goes up and government finances are impacted by massive subsidy burdens. So, what can the investor do? One possibility is to avoid anything downstream in the oil and gas value chain – don’t buy refiners, don’t buy fertiliser companies and don’t buy gas-based power generators. Don’t buy PSU producers either.
Although the private producers aren’t obliged to share in subsidy burdens, the gas prices paid to them isn’t fully market-related. The subsidised product prices that marketing PSUs are compelled to charge also puts an automatic ceiling on the profits private producers could extract by downstream refining and marketing. Private downstream players can export refined products so that is some sort of hedge, given that their refining margins are more or less globally competitive.
The trader has more flexibility in trying to extract some compensation for the mismanagement of the energy sector. He can short the refining and marketing PSUs. This is generally a profitable thing to do – every time international crude prices climb, short HPCL, BPCL and IOC.
There may also be some investment potential in renewables. A rise in the price of fossil fuels makes renewables more competitive. Scaling and technological breakthroughs have reduced costs of solar and wind considerably. The latter is arguably, commercially competitive already. There aren’t too many listed companies in this space and many of the listed companies have unattractive balance sheets. But the sector is worth looking at. It may be a long-term counter-cyclical hedge against high crude prices.
The other potential hedge is, of course, currency. If the price of fuel rises, the trade gap widens. This leads to pressure on the rupee. The dollar-rupee rate generally moves in favour of the dollar as a result. A long dollar/rupee futures position could pay off if crude stays firm.
The author is a technical and equity analyst