[Economy Q] Oil hedging and its impact on Oil subsidy

[Economy Q] Oil hedging and its impact on Oil subsidy

Rahul asked,

what 'Oil Hedging' means and how is it related to the subsidies given by the govt. on oil products??

Answer

hedge= a fence or compound wall built to protect your property.

hedging = a method of preventing risk.

Oil prices go up and down very rapidly due to unpredictable and unforeseeable events, such as political unrest in Egypt and Libya.

So buyers enter in futures and options contracts with the producers to prevent themselves from such unpredictable price rises.

For example,

Indian Oil Co. makes an options contract with Libyan supplier in October 2010, that on Feb 2011 Libyan supplier will send 5000 barrels @ 70$ each.

Now due to unrest in Libya in February, the oil prices have escalated to 90$/barrel but still that Libyan supplier is bound by contract to sell 5000 barrels @ 70$ each to the Indian company.

So Indian company prevented the risk of having  to pay higher prices.

This is oil hedging.

But suppose there was no riots in Libya and in fact they had discovered a new big oil well, and thanks to the extra oil supply, Barrel prices went down to 20$ per barrel! In that case Indian oil company would cancel to options contract and would loose the premium money paid on the contract.

how is Oil Hedging related to the subsidies given by the govt. on oil products?

Sorry I don't have exact idea, but i think if Oil headgeing prevents Indian Oil Companies from big price rise, then Government has to pay less subsidy on oil products.