The fundamental things apply

How the US financial crisis offers instructive pointers to the dilemma of Indian oil companies

Apples and oranges should not be compared. And when they are, the results can be misleading. Notwithstanding that, I am going to make such a comparison, focusing on the links between the financial crisis in the West and the burgeoning debt position of the public sector oil companies IOC, BPCL and HPCL. I realize that I could be accused of trivialising the former and exaggerating the latter. That is clearly not my intent. I know that the West has been hit by an unprecedented financial tsunami which has already reshaped Wall Street and which may well redefine the ideological underpinnings of the capitalist system. The tsunami will one day recede but its consequences will be global, radical and long lasting. I also know that by contrast the oil companies face no more than a localised albeit perhaps from their perspective, thunderous downpour. Their exposure to Indian banks has grown alarmingly and their management must wonder how they will ever redeem this debt, but the amounts involved do not at least for the present, pose a systemic risk. Were corrective steps taken now, the financial consequence need be no worse than an uncomfortable drench. I make the comparison because there are some similaritiesalbeit tenuous but more so because I want to draw attention even at the risk of exaggeration to the potential consequences of our current petroleum product pricing policy.

The financial jargon of mortgage-backed securities, collateralised debt obligations, credit default swaps etc tends to obscure a simple fact. The present crisis has occurred because the 8216;Masters of the Universe8217; in Wall Street forgot that the business cycle cannot be wished away through mathematical brilliance and financial sleight of hand. Markets do rise but they will also inevitably fall. There is no inexorable one way bet. The Masters forgot this fundamental when they looked at the US housing market. They assumed that house prices would only go up and that housing loans were therefore a secure bet. Were the borrowers to default the house would be 8216;possessed8217; and sold at a profit. Such was their conviction that they extended loans to people with no income, no jobs and no other assets the 8216;ninja8217; borrower; they allowed borrowers to repay only the interest charges and they 8216;sliced and diced8217; the loans for sale to others equally confident in the linearly upward trend in house prices. They all got it horribly wrong. The housing market did collapse; the borrowers did default; the collateralised homes could not be sold and the lenders found themselves saddled with 8220;toxic8221; assets that they did not have the capital to support. The consequence: a liquidity and credit crunch not felt since the Great Depression of 1929.

The oil marketing companies can also trace their financial difficulties to a simple fundamental. The international suppliers of crude oil will not accept paper IOUs. They want hard cash. To meet this demand the companies have essentially two options. They can either generate the cash through internal operations or they can borrow from the banks. The government8217;s current product pricing policy has foreclosed the first option. The difference between the government-mandated cap on the price of petrol, diesel, kerosene and LPG and the cost of manufacturing and marketing these products will, in 2008-09, result in an underrecovery loss for the companies of approximately Rs. 160,000 crore. The second option of borrowing has therefore been the only route. Under normal circumstances this too would have been closed. For banks do not or rather should not lend to fund losses. But these are not 8216;normal8217; conditions. The government cannot clearly allow the companies to run out of cash and so they have 8216;persuaded8217; the public sector banks to make the loans. The three companies have reportedly ratcheted up borrowings in excess of Rs. 100,000 crores.

Against the backdrop of the present financial crisis certain questions must be asked. How will these loans be repaid? Who will pick up the tab in the event of a default? What could be the implications for the banks of such 8216;subprime8217; lending.

I do not have the answers to these questions but two trends seem clear. First the companies will be hard pressed to repay the banks. After all they are not investing this money in productive assets but to remain operationally afloat. Sure the companies could sell off some of their assets like real estate, apartment blocks and may be even a refinery or two. But would our politics allow that? I doubt it. These companies have no doubt a hugely valuable asset-base but given the nature of the political and regulatory environment, much of it is effectively 8216;dead8217; capital. Second, the government will not allow the companies or the banks to go under. It would come to their rescue if it ever seemed that the companies had come too close to the edge. The question should be asked 8212; what might be the implications of such 8216;moral hazard8217;? Management know that they can do little to improve the finances of their company and they also know that the government will in the ultimate analysis cover their losses. Does this not create that recipe for increased risk taking? I know that the public sector is not known to be risk taking but still one should ponder the longer-term consequences of managerial imprudence and nonchalance.

Regulatory authorities in the West did not take the collapse of the housing market in August 2007 and the early default of US subprime mortgages seriously enough. They responded with ad hoc solutions rather than with a comprehensive plan. The present crisis might well have been averted had they done the latter. In similar vein, our government today is not looking at the financial difficulties of the oil companies through a holistic prism. If there is one lesson that we can draw from the Western crisis it is that there is no ducking from fundamentals. The taxpayer usually picks up the tab when one tries to do so.

The writer is chairman, Shell Group in India. Views expressed are personal.