Mr. S.V.Narasimhan Director(Finance) Indian Oil Corporation Ltd

1. Refining Outlook and Risk Management Mr. S.V.Narasimhan Director(Finance) Indian Oil Corporation Ltd

2. Presentation Covers…. • Refining Outlook • Features of oil refining • Refining capacity utilization • Capacity addition vs demand • Risk Management • Need for Risk Management • Hedging tools and markets • Practical considerations

3. Oil Refining – Defining features • Capital and Technology intensive • Long gestation period • Large investment needs: • To meet rising demand for oil • Spec changes for modern engines & environment issues • Transport fuel the drivers – need for upgrading bottom of the barrel • Low margin – occasional cycles of boom Investment - a risky proposition

4. Singapore: Gross Refining Margin (Dubai) Occasional boom Source- IEA • Prolonged periods of low, even negative margins • Considerable volatility in the margins from month to month • Occasional boom serves to tide over long periods of poor margins • Domestic pricing policies restrict oil companies much needed margins to fund future expansions,quality upgradation projects, etc

5. Global refinery utilization rate Source:BP • In last 5 years, despite refining capacity additions, utilization rates soared to new highs. • Effective utilization rates exceeded 95% at times considering planned and unplanned shutdowns.

6. Planned refinery additions(mid 2008-end 2009) Source: Goldman Sachs

7. Refining additions Vs. Demand- 2001-12 (million barrels per day) • Trend reversal • Substantial refining capacity additions - 2008 onwards • During 2002-07, Refinery capacity additions lagged demand, leading to high margins/prices. • Refining capacity additions to exceed incremental demand over 2008-2012, pointing towards softening margins Source: BP,Goldman Sachs and PEL

8. Refineries’ Dilemma : To build or not? Build capacity Risk of unsustainable margins Delay capacity additions Loss of opportunity • Risks to Refining investments: • Demand growth uncertainty, particularly transport fuels • Light/Heavy differentials and sweet/sour differentials • NOC structure of Asia– not geared purely to economics – can lead to overcapacity Derivatives available to mitigate risk of poor economics.

9. Existing refineries Extreme volatility in refining margins Under-recoveries from domestic products sale Customers seeking fixed prices Fluctuation in inventory valuation New Refinery Projects Over capacity- weak margins High investment – poor returns Competition in international market for export oriented refineries Indian Refiners:Need for Risk Management • RBI regulations: • Permits hedging of risks to existing refineries like margins, inventory, domestic product sales, etc. • Hedging of new refinery projects not permitted

10. Risk Management - Advantages • Smoothens/reduces revenue volatility for existing refiners • Facilitates remaining within budget • Enables judicious deployment of funds, thereby ensuring timely project implementation • Protect against price spikes • Flexibility to hedge limited volumes allowing to tap market opportunities for remaining volume • Exit possible under unfavourable circumstances

11. Markets for hedging MARKETS OTC MARKETS 1. SINGAPORE 2. LONDON 3. NEW YORK PETROLEUM EXCHANGES 1. NYMEX, NEW YORK 2. IPE,LONDON 3. TOCOM, TOKYO 4. DME,DUBAI 5. MCX/NCDEX, INDIA

12. Dubai Forward price volatility:Q308 Final settlement price for Q308:$113.48/bbl Source: Morgan Stanley, Platt’s

13. GO vs Dubai Forward price volatility:Q308 Final settlement price for Q308:$25.7/bbl Source: Morgan Stanley, Platt’s

14. Hedging tools available for Refiners • Refining margins hedging • Options and swaps • Individual Crack spreads • Composite refining margins • Inventory hedging • Options and swaps • Crude oil • Products

15. Refiners hedging (illustration) • Hedging assures fixed margin • Mechanism of hedging margin: • Margins go up: Higher revenue on physical sales offsets outgo on derivative contract. • Margins go down: Lower revenues on physical sales offset by inflow on derivative contracts • Domestic price controls: Higher margins not realised on physical sales but cash outgo on derivatives occurs. This poses additional risk. Hence, need for a consistent and transparent policy. Refinery Margin hedging- Illustration Crack ratio is based on product pattern of the refineries Naphtha: 15% (Sell 150 bbls) Crude 100% Buy 1000 bbls Kerosene: 15% ( Sell 150 bbls) Gasoil: 50% (Sell 500 bbls) HSFO 20% (Sell 200 bbls)

16. Swap: Gasoil-Dubai Crack (illustration) Swap transaction Swap level - $25/bbl

17. Put Option- Gasoil vs Dubai (illustration) Strike-$25/bbl Premium-$3/bbl Strike Price: $25/bbl, Premium : $3/bbl

18. Hedging practice – Oil companies Oil companies follow diverse hedging strategies, but volume is typically limited unlike end users who hedge large volumes.

19. Hedging activity – Refiners in SE Asia As per trading sources

20. Practical considerations- Steep backwardation Source: Platt's, Morgan Stanley • When Gasoil/Dubai spot cracks were at record high of $42.67, Q-4-08 and Q-1-09 were available at $6.6/bbl and $7.7/bbl respectively higher than the spot level. • Such Backwardation present a serious dilemma for the hedgers!

21. Practical considerations-Steep contango Source: Platt's, Morgan Stanley • When Brent spot price was at $86.69/bbl on 16th Sep 08, Q-1-09 and Q-2-09 were at $94.81/bbl and $96.26/bbl respectively viz. almost $8.1/bbl and $9.6/bbl higher than spot price. • Such sharp contango present a serious dilemma for the hedgers!

22. Practical considerations: When to hedge 15/7/08 31/7/08 15/8/08 15/9/08 • Forward prices changed dramatically in a span of few days . • Timing of entry is crucial – Yet no scientific way to time the market Source:Morgan Stanley

23. Practical Consideration: Options premium Source: NYMEX • Buying Call Options ‘At the Money(ATM)’ or ‘Out of the Money’(OTM) involve significant premium payout.

24. Risk Management Policy – Key issues

25. Risk Management Policy – Key issues

26. Derivative Disasters China Aviation Oil (2004) Amaranth (2006) $ 550 million loss. Resulted from selling Options & faulty M2M reports $ 6 billion loss. One of the biggest collapses in Hedge fund history Mitsui (2006) $81 million loss. Inappropriate trading and reporting Societe Generale (2008) Euro 5 billion(approx) loss. Failure of internal controls and faulty reporting systems. Risk Management - Adequate Controls • Prudent Risk Management strategy is essential. • Systematic reconciliation of internal transaction/positions • Periodic reporting to Board, Management and regulatory agencies

27. Thank You

28. US Gulf Coast(USGC)-Gross Refining Margin (Brent crude) Source- IEA • Prolonged periods of low, even negative margins • Considerable volatility in the margins from month to month • Occasional boom time serve to tide over long periods of poor margins Source- IEA

29. North West Europe- Gross Refining Margin (Brent crude) Source- IEA • Considerable volatility in the margins from month to month • Occasional boom time serve to tide over long periods of poor margins Source- IEA

30. High volatility in prices: WTI (2007-2008) Source: Platt's

31. Dubai Forward price volatility:Q408 $/bbl Source: Morgan Stanley

32. Trading on Exchanges – Some issues • NYMEX and ICE are the major energy international exchanges. • Use of exchanges involves huge basis risk • During the period Jan’07 to Sep’08, • Brent dated and ICE Brent showed a strong positive correlation of 0.93. Actual ICE Brent vs Brent (Dated) differential showed substantial variation viz high basis risk Source: Platt’s

33. Risk Management – To summarise India Specific • Exposure of Indian companies essentially to Asian oil and petro-products • NYMEX and IPE are major petroleum exchanges but do not have liquid Asia specific commodity contracts. • No AG related derivative contracts – Singapore market used as proxy. • Universal • Does not ensure best margin – Only predetermined margin can be hedged. • Options hedging involves substantial costs • Backwardated markets – can lock into lower margins than currently prevailing • Timing of entry – crucial in margin that can be locked into