## Tuesday, May 27, 2008

by Malay Makkar.

### Recent events

India is one of the world's largest importers of edible oil. Soybean and palm oil account for a major share of Indian imports. India's oil consumption is roughly about 120 lakh metric tonnes (MT) of which about 70 lakh MT is imported. Of the oils imported by India, Soyabean and palm form the primary constituents, since these are produced in sufficient quantities to be exported by the US and Malaysia and hence, are relatively cheaper. Futures contracts on NCDEX and MCX had daily turnover of roughly Rs.400 crore a day and Rs.100 crore a day, respectively.

In early May 2008, soyabean oil prices were 30% higher than the level of the previous year. The government believes that futures trading has helped induce this price rise. Hence, on 7 May 2008, futures trading was suspended for soyabean oil for four months (along with this, futures on potato, chana and rubber were also banned). All existing futures contracts were liquidated at the closing price as on that date on the respective exchanges. Owing to fears that such a move was imminent, the open interest on NCDEX, MCX and NBOT in soyabean oil had already halved to 0.15 million MT. For a comparison, monthly consumption is roughly a million MT.

Using powers under the Essential Commodities Act, 1955, various state governments have imposed stock limits on the edible oil traders in their states. On 10 May, the UP government imposed an inventory ceiling of 25 MT for any trader of edible oil. Large traders who normally carried stock in excess of 250 MT are now forced to live within a tiny limit of 25 MT. Similar stock limits were also imposed by the Maharashtra Government the same week. The central government has also advised state governments to strengthen their enforcement machinery to act against hoarding' edible oil.

### How much risk does an oil importer carry?

The task of importing Soyabean and palm oil exposes the edible oil trade to fluctuations in prices occurring internationally. A fall in price of the commodity has a severe impact, since it leads to losses and lower valuations of even the existing inventory. Oil refiners in India quote a daily selling price for the oils based on the international trends. The benchmark exchanges for trade in these two oils are the Chicago Board of Trade for soya oil and the Malaysian Derivatives Exchange for palm oil. In order to derisk or hedge their future risks, importers short-sell futures contracts. Selling futures helps in assuring a constant return to the importer and removes the uncertainty that he might have faced without a similar contract.

A standard oil tanker usually ferries 30,000 MT of oil. For one such shipment, the value at risk for the importer is large. From January 2008 onwards, the standard deviation of change in daily prices of soy oil has been $44.2 per tonne of oil. In other words an importers shipment could vary in value everyday by about$1.33 million dollars a day. No importer is willing to take that big a risk; since the return on investments (if the company is lucky) is only about 1% (around \$0.36 million). Thus it becomes essential for any businessman who imports edible oil to be able to lock in his future selling prices and hence assure himself of the returns. But by banning the futures products, the government has taken away this risk mitigation tool from importers. Bereft of hedging using futures, importers impose bigger markups upon the local economy, thus exacerbating inflation.

### Impact of the ban

In absence of an avenue for price discovery, the entire trade channel consisting of distributors, wholesalers and retailers has lost a price signaling method. They are unable to observe market estimates of future prices. Due to this confusion, there is less long-term planning (through forward contracts) and there is more short-term cash trading. This in turn poses new problems for the business. Firstly, it increases the possibilities of stock outs occurring and forces the suppliers to frequently replenish the shelves of the retailers. Secondly, the oil refining companies are losing out since higher stocks have to be maintained in their own godowns for frequent replenishment requirements of the retailers and lesser stocks can be pushed down the supply chain. Additionally, increased transportation costs associated with repetitive distribution of small quantities of goods is expensive for the companies and reduces energy efficiency of the economy.

There are indirect effects also. Higher uncertainty has made firms involved in this trade more risky and reduced their access to borrowing. Firms are using their own capital for holding inventories which is adversely affecting new investment.

The importers are now forced to hedge their risks on foreign exchanges like Chicago and Malaysian derivatives exchanges. While this should work well in theory, in practice, there are many impediments against doing this correctly and fully owing to the system of capital controls that India has against use of offshore derivatives markets.

Indian finance professionals stand to lose since companies are reluctant to hire new traders and maintain on their rolls, since the ban has been imposed. This adversely affects the building-up of derivatives competence in India.

Due to lack of a pan India benchmark price, inter-regional arbitrage opportunities have appeared. The prices in spot markets have jumped and traders are making a killing by exploiting these informational asymmetries. Moreover, small time traders who cannot be out of business for a long time will now resort to forwards contracts (the number 2' market that survives even though futures trading has been banned) and hence the risks in the whole system will be magnified as counter party risks will also appear. Finally, the prices will now align themselves completely to international markets. When our local crops are harvested price discovery will be difficult as the price discovery mechanism will take its signals from international exchanges.

### Impact of imposition of stock limits

A short term effect will be that people will be forced to reduce their existing inventories of oil. This will please the policy makers who think hoarding is bad. But holding large inventories is essential to a well functioning trade. With lower stocks the overall business will go down and shortages will appear in a few months. Lower business volumes also imply loss in income for all the people involved in the process - the refiners, brokers, distributors (and lower tax revenues for the government). In order to circumvent the state wise stock limits oil companies will be forced to open oil depots in states which do not have stock limits. And then oil will be routed to other states through them.

Another way to circumvent the system is by opening a large number of firms by the same individual. For example a distributor earlier maintaining stocks of about 250 Tons on any given day will now open 10 firms in his name thereby fulfilling the condition of 25 Tons per firms stock limit also but maintaining his usual oil stock also. All this will simply lead to more corruption in the system; it constitutes a bias in favour of less ethical companies.

### Government import of edible oils

The government has floated tenders for import of oil about 12 lakh MT of oil in the coming 12 months. By this action, the government, in one step, has replaced the private sector and emerged as the single largest importer of oil into India. This is inconsistent with the efforts in other industries in India, where the government has retreated from business into the core tasks of public goods. The decision of the government to move into this business reduces the incentives of firms to invest and build businesses.

Moreover, the imported oil will be available only to poor people through the public distribution channel but the remaining market (read the middle class) has to deal with the troubled private trade. Companies who were selling to poor people would lose market share.

It is possible that in order to lower the oil prices, the government may also release this imported oil in the markets by floating tenders in the Indian markets. In absence of clarity about the government's future policies, importers will remain unwilling to import oil. This could lead to acute difficulties in coming months.

1. Nice piece of work. Good deal of thought and study seems to have gone in preparing it.

2. Seriously good stuff. The 'aam aadmi' is already facing the double whammy of slowed growth due to ham-handed measures like these and the ineffectiveness of these measures in terms of results. Any kind of distortion introduced into a marketplace always has the effect of creating perverse incentives for not so ethical businesses which abound in India. For 60 years plus we have witnessed the in-effectiveness of creating distortions through executive fiats and abuse of discretionary powers but the political class and bureaucrats are yet to learn. Perhaps they don't care for medium term or longer term results and are happy to create short term distortions and the polity lurches from one crises to another.

3. Hey Ajay,

What is your take on the fall of the rupee v/s the dollar?

4. Very good analysis of the specific Govt. actions mentioned. Its quite apparent from the study (as well as from the result)that the first two actions, i.e., Futures Suspension and Imposition of stock limits might go against the idea of Govt behind the imposition of these measures (price reduction).
The last one, i.e., direct imports by the Govt. with a subsidy in local sales through PDS could actually depress the prices locally, but also could flare up the international markets and thereby creating a larger dis-incentive for any private player to import oil, thereby reducing the supply.

5. Is the author a student of SCMHRD ??.....because I know him quite well as only he can come up with such an inspiring work in commodities

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