Concept paper on Crude Oil Inventory Hedging

1) Background:
1.1 Inventory
Bharat Petroleum Corporation Limited (BPCL) operates large supply chain
spanning the length and breadth of the nation. To service such a huge supply
chain, BPCL carries large inventories of crude oil. However, since inventories are
valued at cost or net releasable value, whichever is lower, the volatile oil prices
during any accounting period can have a major impact on corporate profitability
through adventitious gains/losses. As per Business Plan 15-16, Mumbai Refinery
& Kochi Refinery moving average inventory target decided as14 & 23 days
respectively.
1.2 Oil Price Volatility
During recent years, international oil market has witnessed fluctuations in the
crude oil prices. A graph below shows the fluctuation in monthly crude oil prices.

Such fluctuations in oil prices can have a major impact on the inventory value,
which in turn can have a disproportionate affect on the profitability. Hence,
corporate profitability is susceptible to the vagaries of international oil prices.

2) Inventory Values - Adventitious Gains/Losses

The quantity and value of inventories of crude oil and changes thereof over the
immediately preceding quarters is shown alongside. Though the inventory
quantities are little changed over a period of time, the values vary significantly
due to volatile oil prices.
Total MR & KR Crude Oil Inventory (including transit)

Year

Quarters

Imported Crude
Closing stock
(Million MT)
(Physical + In
transit)

201112

Q1
Q2
Q3
Q4

0.989
0.936
1.040
0.690

3942.1
3834.0
4701.3
3316.9

3942.1
3834.0
4701.3
3316.9

201213

Q1
Q2
Q3
Q4

1.402
1.227
1.099
0.591

5978.6
5805.4
5152.2
2766.6

5876.8
5805.4
5152.2
2626.1

201314

Q1
Q2
Q3
Q4

1.049
1.156
1.143
0.591

4825.0
6405.6
6170.2
3089.9

4825.0
6201.9
6010.9
2989.9

201415

Q1
Q2
Q3
Q4

1.321
1.322
0.888
1.135

6866.1
6315.3
2788.2
3092.9

6807.4
5955.9
2625.7
3092.9

Crude
Original
value (Rs
Crores)

Crude
Revised value
(Rs Crores)

Net
difference
(Rs Crores)

101.9

140.4

203.7
159.3
99.9
58.7
359.4
162.5

The pictorial below shows the quantity (bar graph with reference to right Y axis)
and crude value (line graph with reference to left Y axis). It would be seen that
quantity variation is within a narrow band whereas value of inventory has varied
significantly.

After taking into account the changes in quantity of inventory, the magnitude of
change (on absolute basis) for crude oil price have been in the order of Rs.1000
crores over the last 16 quarters. Thus there is a need for hedging crude oil
inventory.

3) Inventory valuation - Accounting Policy

The Accounting Policy followed by BPCL in respect of Valuation of Inventories is
in line with the provisions of Accounting Standard (AS) 2, 'Valuation of
Inventories' issued by the Institute of Chartered Accountants of India which is
mandatory in nature.
The details of the Accounting Policy followed by the Company with regard to
Valuation of Inventories are given below:
a. Raw Materials

Raw materials, including crude oil are valued at cost determined on

weighted average basis or net realisable value, whichever is lower.
Stock in Process is valued at raw material cost plus conversion costs as
applicable or net realisable value, whichever is lower.

Due to oil price volatility in the market and the inventory valuation policy based
on accounting standards applicable in the country, situations could occur where
the inventory value is lower than the cost. Therefore, use of swap and options will
be necessary to cover risks.

4) Hedging Oil Inventories - Methodology

4.1 As the RBI approval allows a tenor of maximum one year forward, the
hedging will be done for 12 months forward or lower viz on 01st April 15, the
hedging will be done till 31 Mar 16. On 01st July 15, the hedging will be done till
30th June 16 and so on.
4.2 To hedge these risks, in the beginning of the year, BPCL can sell 'Swaps' or
buy 'put options' on Crude oil/Products for the ending period of the quarter or
year. Also, it is possible to use calendar period spreads or option on calendar
period spreads to hedge the price variation in inventory valuation between a
quarter or year. The following alternatives can be adopted.
4.2.1 Hedging inventory for a Quarter:
4.2.1.1 Sell a swap for the ending period of Quarter.
4.2.1.2 Buy a put option for1he ending period of Quarter.
4.2.2 Hedging inventory through calendar spreads:
4.2.2.1 Sell a swap on calendar spread for the ending period of Quarters viz DecSep15, Mar 16-Dec15. (Or Buy a swap on calender spread for the ending
period of Quarters viz Sep-Dec15, Dec15-Mar16.)
4.2.2.2 Buy a put option on calendar spread for the ending period of Quarters.
For example, on 1-April-15, the opening inventory value was USD 55/bbl. To
protect the inventory fluctuation for whole Financial Year 2015-16, BPCL can sell
a swap or buy a put' option for the quarter ending 30 Jun15 (which is the
immediate ending quarter). BPCL can sell a swap of calendar spread or buy a
put option on calendar spread for the subsequent quarters viz Dec-Sep15 &
Mar16-Dec15. This will ensure that the inventory value between beginning and
end of the accounting period is more or less stable.
These hedging contracts will be cash settled with actual prices for the above
periods. It is to be noted that BPCL will be required to pay premium (either
upfront or at settlement) for buying put option. Besides above, in the money or
out of the money options or combination of options like collar, seagull etc (with no
inflow of premium) will also be considered.

5) Risk Management of Inventories -Tools and Procedure:

5.1 Risk Management instruments (tools):
Risk Management instruments from the OTC market can be used as under:

Swaps on crude oil

Swaps on calendar spreads of crude oil
Floor on crude oil (i.e Put Option)
Floor on calendar spreads of crude oil (i.e Put Option)
Combination of options like Collars and Seagulls on crude oil and spread
thereof - where there is no implied inflow of premium.

5.2 Market:
In line with existing practice of hedging of imports/exports/refining margins, OTC
Singapore market shall be used.
5.3 Tenure:
The tenure of the hedge contract will be limited to a maximum of one year
forward viz. 12 months as per RBI guidelines
5.4 Volume to be hedged:
A maximum of upto 50% of the inventories based on the volumes in the quarter
preceding the previous quarter can be hedged as per RBI guidelines.
5.5 Tools - Price linkage and publication to be used:
5.5.1 Inventory - Crude oil: Price linkage to Dubai and Brent in the OTC market.