View: India can become a rule-maker in the global oil trade instead of the rule-taker it is today

By Amit Bhandari

Even though the centre of gravity of global oil trade has shifted from the West to Asia, the oil trade is still managed on western exchanges.

That means prices are set using western benchmarks — Brent and West Texas Intermediate — & the medium for exchange remains the dollar. This anomaly puts Asian countries at a disadvantage that will only grow worse with time as trade becomes increasingly skewed toward Asia.

But a solution is within reach. India needs to push for a bigger role for its exchanges and currency in the oil trade. This will help improve its energy security and create a bigger international role for the rupee. China is already pushing its own commodity exchanges and currency as an alternative to the petrodollar. India, with its open markets and transparent regulation, has a distinct advantage over China. But it must seize the opportunity soon.

The benefits of exploiting India’s strengths are considerable. Widespread use of the dollar as the international medium of exchange has long kept down borrowing costs for the US government and consumers. It also has given the US enormous geopolitical leverage, as demonstrated most recently by its ability to impose and enforce sanctions against Iran, Venezuela and Russia.

Many governments, including India, have publicly said that they don’t recognise these unilateral sanctions. But companies in these countries comply as they otherwise could lose access to the US financial system, which would be catastrophic for any large commercial entity.

Financial trade in oil is increasingly out of sync with the physical trade. Due to its increasing shale oil production, the US is no longer the top importer of oil, China is. Four of the five top importers — China, India, Japan and South Korea — are in Asia. And India is expected to be the major driver of future growth in oil demand at a time when oil consumption in western countries is flat or declining.

The New Oil Capital?
Asian commodity exchanges can play a larger role in the oil trade by getting buyers and sellers together and helping producers and consumers hedge their risks. This role doesn’t have to be restricted to India’s own market. It can extend to international trade and, thereby, play a global role in price discovery and in setting new benchmarks.

China already has established a new exchange in Shanghai: the International Energy Exchange (IEE). It has a large trading volume, but the trading pattern indicates that most of this trade is speculative, and not linked to physical trade. Moreover, China’s record of interfering in financial markets and its opaque regulatory framework makes it a dodgy prospect for international finance. India, with its better regulated markets, can offer a better Asian alternative.

India’s Multi Commodity Exchange (MCX) already features trading in oil contracts. But the activity almost entirely involves contracts close to expiry. To function fully, an exchange requires buyers and sellers involved in actual trade of the underlying commodity. India has ample buyers. But its domestic oil production is low and mostly comes from government companies, so there are no natural sellers of oil futures and options here.

This can be changed, however, by establishing Exchange Traded Funds (ETF) for crude oil on Indian exchanges — like existing ETFs for gold that are run by many mutual funds. Owners of such ETFs become natural sellers of long-duration options and futures, thus improving market liquidity.

Once ETFs are established, the next step will be to bring in long-dated futures and options for the ‘Indian basket’ — a new benchmark that reflects consumption patterns that prevail in India (and Asia generally).

An added benefit of establishing crude-oil ETFs will be that the underlying oil, which would be physically stored in India, could be used in an emergency. In effect, it would become the strategic petroleum reserve that GoI is trying to create using public money. Crude oil is unusable until it is refined.

For the exchange to serve as a hedging tool, contracts on oil products (diesel, petrol, aviation fuel, etc) will have to be introduced, so that oil consumers could cover their risk in case of price fluctuations. The biggest party at risk to high oil prices, of course, remains the government, which had to subsidise consumers for nearly a decade (2005-15) when oil prices were high. Since GoI carries the risk of oil prices rising again, it can use the exchange to hedge against certain scenarios (if, say, the price of oil rises above $100 a barrel).

Other governments, including Mexico, Uruguay and Jamaica, have used financial market hedges to protect themselves against oil price fluctuations. GoI could use an Indian commodity exchange for the same purpose.

Oil Head to Fin Head
In the short run, having a vibrant commodity exchange operating in India will create thousands of high-paying financial jobs and help Indian consumers hedge against the risk of energy price fluctuations. Physical settlement of these contracts will require creation of tens, if not hundreds, of millions of barrels of storage infrastructure, which can double as astrategic reserve in emergencies.

In the longer run, becoming a centre of energy trade that sets energy price benchmarks will elevate India to a central position in the global financial system.