India should turn ‘oil speculator’

Politicians in India and abroad have lambasted traders who buy oil contracts for future delivery as speculators that have driven oil to $145/barrel. In fact, India itself should start buying oil futures and options. This will be a sensible risk management, not villainous speculation.

Futures are contracts for oil delivery at a specified price on a future date. Options give you the choice of taking physical delivery of oil, or settling the profit or loss between your original contract price and the market price on the day of settlement.

Politicians call this speculation. Yet, India itself bought wheat options earlier this year, in case wheat imports were needed for the food buffer in the event of insufficient wheat procurement. Luckily, plenty of wheat was procured, so India did not exercise the option of physical delivery, and simply settled the contract. This was a prudent form of insurance against a procurement shortfall. It would be silly to call it villainous speculation.

Some speculators are in the market purely for trading profits. Their presence makes it possible for physical buyers to find plenty of competitive sellers, and for physical sellers to find plenty of buyers. Without the pure traders, you could not be sure of getting insurance through the market when needed.

Today, you can book options or futures for oil delivery in any month of 2008 at around $140/barrel. I think the government should buy options to purchase 10-25% of India’s oil imports at this price for the last four months of 2008. This will provide insurance against oil spiking to $200/barrel.

Readers may protest that i am contradicting myself. A few weeks ago, i predicted that oil would fall below $100/barrel by the end of the year. How then am i now claiming that oil at $ 140/barrel might be a bargain?

Well, i made it clear last time that i was sticking my neck out, and that the prediction could go wrong. On the basis of supply and demand alone, the price should fall. But if politics intrudes, the price can soar.

The big risk is an Israeli attack on Iran’s nuclear facilities, with or without US support. More than 100 Israeli F-16 and F-15 fighter planes took part in manoeuvers over the eastern Mediterranean in June, a mock exercise for attacking Iran. This spurred ever more people to rush and buy futures.

Israel may attack before president Bush leaves office, said Ephraim Kam, deputy director of the Institute for National Security Studies in Tel Aviv, in a telephone interview reported by Bloomberg. “There is no doubt that such an operation is being considered, but it’s not going to happen tomorrow. We still have some time. The Bush administration may be more sympathetic to an Israeli operation against Iran than whoever the next president may be, so it could happen before the end of the year.”

If Iran is bombed, it will retaliate. Non-violent retaliation can take two forms. First, Iran can cut its oil production by one-third, sending oil over $200/barrel. This will involve little or no financial sacrifice for Iran, since the higher price may compensate for reduced production volume.

Second, Iran can sink several of its own merchant vessels in the Straits of Hormuz, blocking the sea lanes substantially or entirely. These navigational hazards will slash tanker traffic in the Gulf. The head of Iran’s Revolutionary Guard said on June 28 that Iran would “impose control” on the Straits if attacked. However, the Iranian foreign minister backed away from that position later, revealing internal divisions in Teheran.

The US Navy said it would not allow the Straits to be blocked. But while it can check Iran’s navy, it cannot stop that country from sinking its own vessels in the sea passage.

Teheran has the firepower to bomb oilfields, ports and offshore platforms in the region. This would cause an all-out conflagration, which Iran may wish to avoid. Instead, Iran might warn all tankers trying to take out that they risk being fired on. It could carefully target those tankers by countries least likely to retaliate. Just the threat of such action will dissuade many tankers from going to the Gulf, sending prices soaring.

attack is not certain. The US itself may hold Israel back, given the likely impact on oil prices. Yet, a big risk exists, and oil companies the world over are buying futures to lock in part of their supplies at $140/barrel in the event of hostilities.

India faces the same dilemma — that oil may fall to $100/barrel sans politics, but may also rise to $200/barrel in the event of an attack on Iran. It makes sense for India to buy insurance against the catastrophe of skyrocketing prices. That means locking into futures or options at $140/barrel for part of its requirements later this year.

Our leftist comrades may be outraged at the notion that India is joining the band of speculators. Now, all speculation may not be insurance. But all insurance is a speculative bet on possible disasters.

What do you think?