 These are not the best of times in the world of derivatives. Derivatives or contracts which derive their values from the values of underlying financial / real assets (such as stocks, bonds, currencies, gold, crude oil, copper, wheat, rice) have been at the receiving end of severe criticism.
Informed (and justified) criticism has focused on the complexity and, in turn, the near impossibility of valuing certain kinds of derivative instruments when there is a break in the markets or in market confidence. This criticism has been primarily directed at the complex structured derivatives spawned off from basic residential mortgage-backed securities in the US. These structured derivatives (CMOs, CDOs and the like) have been behind the larger financial markets crisis which erupted last August.
Deliberate disguise of speculative structures...
We can also add complex currency derivatives to the above list. Structured by a number of banks in India in the past couple of years and sold to their corporate customers, these complex structures have generated considerable losses for the buyers in recent months - both unrealized and unrealized. The basic problem here has been the deliberate disguise of speculative structures as hedging structures, with the disguise being wittingly or unwittingly lapped up by user companies.
Uninformed criticism
The two examples cited above have only added to the long list of disasters and losses in derivatives markets in the past couple of decades. It is important, though, to understand that the disasters / losses were generated not because derivatives are inherently sinister creatures. Rather, poor levels of awareness and understanding of these instruments which encouraged non-transparent and predatory selling practices have been behind the major blow ups we have seen.
In the banking sector, poorly designed incentive and compensation structures which reward short-term profits (generated by derivatives sales staff) but discount longer term risk-adjusted performance have also played a big part in encouraging opaque product selling and pushing user companies into taking large speculative currency positions under the notion that they were hedging their operating revenue / cost exposures.
Uninformed criticism...
Uninformed criticism, though, has taken off from these recurrent loss episodes in derivatives markets. Extrapolating, these critics have given an ideological twist by labeling the current financial system as an ‘Anglo-Saxon’ conspiracy and have ‘explained’ how the futures markets in the US, for instance, have pushed spot prices of commodities up and have benefited only Wall Street and not farmers / other producers. The long and short of these criticisms - derivatives markets serve no useful purpose, only enrich a cabal of speculators and are not necessary for India's financial / industrial / agricultural sectors.
Unfortunately, these criticisms exhibit both factual inaccuracies as well as limited conceptual understanding of derivatives markets and products. The risk, though, is of public policy formulation being influenced by such uninformed criticism and thereby failing to derive the economic benefits which informed use of these products can provide.
To be sure, derivatives markets are not paragons of virtue. But which market is? Product abuse, fraud, manipulation, opacity in operations, overcharging customers... are prevalent in even the simplest of markets for finance, goods and services. The panacea for all this is much higher levels of customer awareness, vastly tighter regulation and quick, strong legal remedies. Banning markets or products is not the solution. And, certainly, now is not the era when 'ideology' should drive financial or economic policies. Whatever is best in whatever system should be imbibed. The larger objectives of reasonable price stability and (sustainable) economic growth should be the main drivers of public policy with respect to markets, products and instruments. In other words, while the bath water is indeed contaminated, public policy should not throw the baby also out.
Facts and understanding at discount
 Statistics from the New York Mercantile Exchange (NYMEX) and the Intercontinental Exchange (ICE) in London (as of 10 June, 2008) show that the total outstanding futures position in crude oil (in the 2 exchanges) in monetary terms amounts to around $ 300 billion as on date (calculated as number of contracts outstanding x barrels per contract x current market price per barrel).
Against that, a commentator, in his article recently, quotes a foreign news agency that "hedge funds have taken a $ 12 trillion - yes trillions - bet on oil through oil futures."
The latest Bank for International Settlements (BIS) statistics show that the notional value of commodity derivatives outstanding in the OTC markets (ie non-exchange), as of December 2007, was $ 8.3 trillion. Therefore, the value of crude oil contracts outstanding on both the exchanges as well as OTC is a full 30 per cent off the $ 12 trillion figure the commentator has given. The commentator's figure would actually be even more off the mark as we have considered the entire $ 8.3 trillion OTC outstanding under crude oil.
Swaps used mostly for hedging
 This factual inaccuracy is a relatively minor manifestation of the uninformed nature of the criticism. A deeper study of the components of the outstanding contract value would reveal more of the critics' limited understanding of derivatives. As is obvious from the figures above, oil derivatives activity in the OTC markets is preponderant in relation to that in the exchanges. And within OTC outstanding value, forward and swap contracts dominate - accounting for as much as 67 per cent of all outstanding value, rising from 37 per cent in 2005. These 2 points - the dominance of OTC activity and within OTC of forwards and swaps - are important because speculation through the OTC market is inherently difficult and, therefore, limited. The OTC is a market for hedging entity-specific and idiosyncratic risk where contracts are tailor, made to suit maturities, the amounts at risk, etc of counterparties. Swaps also are instruments which are predominantly used as hedging vehicles rather than as speculative vehicles.
To be sure, speculation does take place through both the exchange and OTC markets. Its level, though, should not be exaggerated.
On the whole and as the bottom line, we can say this about the role of speculation in pushing up prices - only if speculators have absolute control over physical possession of the commodity they are buying into, can it lead to price rises which are, on a sustained basis, out of tune with fundamentals. The critics, therefore, should examine how much physical control the hedge funds / Wall Street firms exercise over oil.
At another place, talking about agricultural futures, the same commentator says that the rise in grain futures prices does not benefit farmers but only Wall Street, as the farmers have already sold the futures to Wall Street funds. So what the farmers lost, Wall Street gained, the commentary adds.
Hedging for price certainty...
Here, the commentator should note that if the farmer has sold grain futures as a hedge against the price falling, he continues to be effectively protected at the price he has sold at. There is no monetary loss he is incurring, though he may incur an opportunity loss. But, it should be understood that the objective of hedging is to obtain price certainty for the product being sold and, therefore, hedging may not always produce the most optimal results. Therefore, the farmer should not and will not be concerned if the Wall Street firms he has sold to make a gain on their futures positions. As long as the farmer gets the price which covers his costs (the farmer would otherwise not sell futures), the farmer is indifferent.
Many commentators do not seem to understand the difference between hedging and speculation in the first place and more so about doing that through derivatives. It must be reiterated that no loss can be incurred in hedging through any instrument, including derivatives.
Having said this, this writer believes that agricultural futures would be appropriate in India only if certain essential conditions in the cash markets are complied with. This has nothing to do with the inherent characteristics of derivatives products as such but only has to do with the institutional setting necessary for agri markets to use these products effectively. We, instead, focus our attention on the economic benefits which futures markets in oil can possibly provide for the Indian economy / consumer.
Informed use of oil derivatives 
Can we have a situation where whatever the rise (or for that matter, fall) in the international price of oil, the Indian oil companies are able to hold the local price line, provide stability in oil product prices and still not bleed?
Hedging price risk through the oil derivatives markets holds that potential.
Hedging input costs
 In a scenario where there are constraints on end-product prices on the selling side, it is surprising that the oil companies have not attempted to more fully hedge the risks of rising raw material prices and attempted to fix their input costs. An analysis of petroleum statistics shows that only around 3-4 per cent of the total imports of crude oil are being hedged by the oil companies. In 2007-08, Indian crude imports were around 100 million tonnes.
To be sure, hedging activity of Indian companies (through the futures exchanges) is no different from what prevails globally. Indeed, even though the global oil futures markets provide a good platform for hedging for both oil producers and consumers - with contracts stretching out as far as 5 years - the use of this market for institutional hedging has been historically limited.
For instance, as on 10 June, 2008, the total volume of outstanding futures contracts (the open interest) for various forward maturities up to December 2009 on the NYMEX and the ICE amounted to around 1.8 billion barrels. Against that, crude production in the next 12 months will be close to 30 billion barrels (assuming a production of 85 million barrels per day - the current figure). The futures outstanding to physical production ratio is therefore 6 per cent and the hedge ratio will be even lower than this. This has been the case in earlier years also.
Reasons for low hedging
 There are a number of structural reasons for the low level of institutional hedging by both oil producers and consumers globally. As far as consumers are concerned, in a competitive environment, unless all players in an industry hedge their consumption of oil, it does not make sense for individual companies to do so. Companies which do not follow industry practice will be subjecting their earnings to greater variability.
More generally, as far as consumers are concerned, the absence of hedging markets with respect to their end products on the selling side inherently limits their hedging. Airline companies, for instance, do not have forward markets for airline tickets. Also, the price of airline tickets will vary in future with the spot price of oil. Where input price pressures can be passed on to the selling side, the incentive for hedging is weak.
Many oil producers do not hedge risks...
On the production side, many countries with state-owned producers also do not hedge their future production. Even commercial oil producers such as an Exxon or BP are not in the market for hedging in any noticeable way.
This is quite understandable given the structural trend in oil prices over the past many years. Indeed, oil, more than possibly any other commodity, has proved that the futures price curve - for assets which carry a high degree of positive systematic risk - may be understating the expected future spot price of the asset. That is, while oil (because of the high convenience yields associated with holding physical stocks) displays an inverted forward price curve (backwardation), the curve does not necessarily capture the future spot price to any degree of accuracy.
For instance, the futures price curve in November 2007 shown above, when spot oil was quoting around $95, indicated the forward price for June 2008 at $ 90 and still lower for farther maturities. But where are spot and futures prices now? (See futures price curve as on 10 June, 2008 given above). And such divergences between the futures curve and the realised spot prices have occurred many times in the past also.
Costs and benefits
It is this divergence between the futures curve and realised spot prices which should provide a powerful incentive for big consumers such as India to have a structured hedging programme in place. The 'industry competitors' argument does not anyway apply here because end-product pricing constraints apply to all players in India.
What are the costs of hedging? Assuming the current margin costs of around $ 10,000 per contract of 1000 barrels, the entire Indian import of 100 million tonnes in 2007-08 would have involved a margin outlay of around $ 6/7 billion - that is around Rs.28,000 crore - if Indian companies had taken long hedges on the NYMEX in early 2007, based on the then spot price of around $65.
This margin deposit may have earned some interest (2 or 3 per cent) and given the structural trend in prices, the companies would have been able to take back a good part of the margin deposits as mark-to-market profits on the futures positions (over and above the maintenance margins). Most importantly, the input oil costs would have been hedged and fixed based on the futures price curve which prevailed early in 2007. It may have been possible then to hold the line on end-product prices as the hedging on the input side effectively lowers the costs relative to the prevailing spot market.
Hedging vs oil bonds
And, who is to fund the cash outlay on the margins required on long futures positions? Note that the Government issued oil bonds worth at least Rs 15,000 crore in 2006-07 and more than Rs.20,000 crore in 2007-08. More had been issued in the earlier years also. A hedging policy could mean that, instead of oil bonds, an equivalent amount of money goes into margin deposits.
The cash outflow for placing margins, of course, will be immediate. The advantage still is that with hedging, the importer is able to fix his costs. And unless oil prices fall, there would be no more cash outflow on account of margin calls. A policy of "no hedging and issuing oil bonds," on the other hand, means that the quantum of bonds (to be) issued could be open-ended. In 2008-09, for instance, oil bonds issue has been estimated at more than Rs.90,000 crore.
It, of course, is quite easy on hindsight to point out all this. It is also important to remember that hedging need not always provide the most optimal solutions. And there may be a number of operational issues (key among them being the level of hedging interest among oil producers) to be tackled before Indian companies can institute a structured hedging program.
But, still, the absence of a debate on how India as a big consuming nation can hedge its oil price risks is disconcerting. The misunderstanding of and paranoia about derivatives and the uninformed criticism that follows only compound the difficulties the country faces on the oil economy front.
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