IOC Risk Management Policy for Hedging Oil Inventories RISK MANAGEMENT POLICY FOR HEDGING OIL INVENTORIES

1) Background: 1.1 Inventories Indian Oil Corporation (IOC), the largest downstream refining and marketing company in the country, operates a mammoth supply chain spanning the length and breadth of the nation. The broad petro-product mix, to meet diverse needs, warrants the handling of variety of crude oils and petro products besides numerous intermediate streams in the complex process of refining crude oil and supplying 'products to the domestic market. Besides feedstock & intermediate streams, inventories of different types of petroproducts like LPG, Kerosene, Diesel, Jet Fuel, Petrol and Fuel Oil have to be maintained at numerous locations like Ports, Refineries, Pipeline installations, Marketing depots, Airports etc. to ensure uninterrupted availability of products. To service such a huge supply chain, IOC carries inventories in the range of 10 MMT of crude oil/feedstock and products which are valued at Rs.35000 crores (approx) as of 30 June 12. However, since inventories are valued at cost or net releasable value, whichever is lower, the volatile oil prices during any accounting period can have a major impact on corporate profitability through adventitious gains/losses. 1.2 Oil Price Volatility During recent years, international oil market has witnessed extreme fluctuations in the crude oil and petroleum product prices. A graph below shows the fluctuation in yearly crude oil prices & product prices.

Though not representative of operational efficiency, such fluctuations in oil prices can have a major impact on the inventory value, which in turn can have a disproportionate affect on the profitability. Hence, corporate profitability is susceptible to the vagaries of international oil prices. 2) Inventory Values - Adventitious Gains/Losses The quantity and value of inventories of crude oil and finished product and changes thereof over the immediately preceding quarter is shown alongside. Though the inventory quantities are little changed over a period of time, the values vary significantly due to volatile oil prices. The pictorial below shows the quantity (line graph with reference to left axis) and inventory value (bar graph with reference to right axis). It would be seen that quantity variation is within a narrow band whereas value of inventory has varied significantly.

After taking into account the changes in quantity of inventory by taking previous quarter as base, on an average, the magnitude of adventitious gains or losses (taken on absolute basis) have been of the order of Rs.1000 crores over the last 14 quarters thereby, pointing to a need for hedging inventory risks.

3) Inventory valuation - Accounting Policy The Accounting Policy followed by IOC in respect of Valuation of Inventories is in line with the provisions of Accounting Standard (AS) 2, 'Valuation of Inventories' issued by the Institute of Chartered Accountants of India which is mandatory in nature. The details of the Accounting Policy followed by the Company with regard to Valuation of Inventories are given below: a. Raw Materials

Raw materials, including crude oil are valued at cost determined on weighted average basis or net realizable value, whichever is lower. Stock in Process is valued at raw material cost plus conversion costs as applicable or net realizable value, whichever is lower.

b. Stock-in-Trade

Finished products, other than lubricants, are valued at cost determined on 'First in First Out' basis or net realizable value, whichever is lower. Cost of Finished Products internally produced is determined based on crude cost and processing cost.

Lubricants are valued at cost and weighted average basis or net realizable value, whichever is lower. Cost of lubricants internally produced is determined based on cost of inputs and processing, cost.

Imported products in transit are valued at CIF cost-or net realizable value whichever is lower.

Due to oil price volatility in the market and the inventory valuation policy based on accounting standards applicable in the country, situations could occur where the inventory value is lower than the cost. Therefore, use of swap and options will be necessary to cover risks.

4) Hedging Oil Inventories - Methodology 4.1 Crude oil and major petro-products like Petrol, Jet fuel, Kerosene, HSD and Fuel oil are held in storage to keep the hydrocarbon supply & distribution chain well supplied. These inventories also act as shock absorbers to the supply chain but result in oil price risk for IOC which is required to maintain huge stocks. 4.2 As the RBI approval allows a tenor of maximum one year forward, the hedging will be done for 12 months forward or lower viz on 01st April 07, the hedging will be done till 31 Mar 08. On 01st July 07, the hedging will be done till 30th June 08 and so on. 4.3 To hedge these risks, in the beginning of the year, IOC can sell 'Swaps' or buy 'put options' on Crude oil/Products for the ending period of the quarter or year. Also, it is possible to use calendar period spreads or option on calendar period spreads to hedge the price variation in inventory valuation between a quarter or year. The following alternatives can be adopted. 4.3.1 Hedging inventory for whole year: 4.3.1.1 Sell a swap for the ending period of year. 4.3.1.2 Buy a put option for the ending period of year. For example, lets say on 01st April 07, the opening inventory value was USD 70/bbl. To protect the inventory fluctuation for whole Financial Year 2007-08, IOC can sell a swap/buy a put option on crude oil for Mar 2008 at say USD 65/bbl. In this case, the fluctuation in, inventory value for a Financial Year 2007-08 is hedged at USD 5/bbl viz (USD 70-USD 65). While in case of swap the upside participation is not possible, put option provides the flexibility of upside benefit at a cost. 4.3.2 Hedging inventory for a Quarter: 4.3.2.1 Sell a swap for the ending period of Quarter.

4.3.2.2 Buy a put option'for1he ending period of Quarter. 4.3.3 Hedging inventory through calendar spreads: 4.3.3.1 Sell a swap on calendar spread for the ending period of Quarters viz Sep-June 07, Dec-Sep 07 & Mar 08Dec'07. 4.3.3.2 Buy a put option on calendar spread for the ending period of Quarters. For example, lets say on 01st April 07, the opening inventory value was USD 70/bbl. To protect the inventory fluctuation for whole Financial Year 2007-08, IOC can sell a swap or buy a put' option for the quarter ending 30 June 07 (which is the immediate ending quarter) and can sell a swap of calendar spread or buy a put option on calendar spread for the subsequent quarters viz Sep-Jun 07, Dec-Sep 07 & Mar 08-Dec07. This will ensure that the inventory value between beginning and end of the accounting period is more or less stable. These hedging contracts will be cash settled with actual prices for the above periods. It is to be noted that IOC will be required to pay premium (either upfront or at settlement) for buying put option. Besides above, in the money or out of the money options or combination of options like collar, seagull etc (with no inflow of premium) will also be considered. 5) Risk Management of Inventories -Tools and Procedure: 5.1 Risk Management instruments (tools): Risk Management instruments from the OTC market can be used as under:

Swaps on crude oil and petroleum products Swaps on calendar spreads of crude oil and petroleum products Floor on crude oil and petroleum products Floor on calendar spreads of crude oil and petroleum products

Combination of options like Collars and Seagulls on crude oil and petroleum products and spread thereof - where there is no implied inflow of premium.

5.2 Market: In line with existing practice of hedging of imports/exports/refining margins, OTC Singapore market shall be used. The activity on Petroleum Exchanges viz. use of Futures/Options shall be taken up in due course. Based on approval of Board of Directors of 10C to use instruments traded on the Petroleum Exchanges for hedging of oil price risk, overseas banking arrangements and appointment of a panel of approved exchange brokers shall be done. 5.3 Tenure: The tenure of the hedge contract will be limited to a maximum of one year forward viz. 12 months. 5.4 Volume to be hedged: A maximum of upto 50% of the inventories based on the volumes in the quarter preceding the previous quarter. 5.5 Tools - Price linkage and publication to be used: 5.5.1 Inventory - Crude oil: Price linkage to Dubai and Brent in the OTC market. In case it is considered necessary to use linkage of other crude oils, then the same shall be done with the approval of the Approving Authority indicated in the policy. 5.5.2 Inventory-Petroleum Products: Price linkage to Crude oil (Dubai or Brent dated), Naphtha, Gasoline, Jet/Kerosene, Gasoil and High Sulphur Fuel Oil. In case it is considered necessary to use linkage to other products or Crude oil, the same shall be done with approval of Approving Authority.

The publication to be used in the OTC tools for hedging inventories shall be Platts in line with prices used for purchases/sales. 5.6 Registered Counter-parties for OTC tools: To minimize risk of non-performance in use of OTC tools, a detailed process of registration of counter-parties had been undertaken prior to undertaking hedging activities in respect of import of crude oil and petroleum products, refining margins, etc. The registration of counterparties is an on-going process and parties are registered with the approval of the Director (Finance), IOC. This process shall be continued. Counterparties registered for providing risk management tools in respect of physical imports/exports/refining margins shall be eligible for providing tools for inventory hedging. The list of counter-parties who have signed ISDA Agreements with IOC is attached as Annexure-1. 5.7 Route of finalization of Risk Management contracts for inventory hedging: The route for finalization of the Risk Management contracts through the OTC markets shall be done in a transparent manner through issue of tenders to all registered parties on IOC list for Risk Management contracts. The validity period of the tenders for price bid shall be about 5 minutes in line with existing practice or as decided by the approving authority from time to time. 5.8 Approving Authority: The approving authority for entering/book-out of all the Risk Management contracts for inventory hedging whether through OTC or the Futures Exchanges shall be as under: 5.8.1 Director (Finance) for Chairman or any officer(s) authorized by any of them: i. A maximum of 2,000,000 bbls per each derivative transaction.

ii.

For the purpose of determining the volume of 2,000,000 bbls each derivative transaction shall mean that the volume limit shall apply separately to each individual tool viz. swaps 'options', etc.

iii.

However, the total outstanding volume of the transactions which can be approved by Director (Finance) or Chairman or any officer(s) authorized by any of them shall not exceed 24.0 million barrels at any given time. For this purpose, the volume of tools that had been priced out/settled in the normal course or closed our prematurely, will not be considered.

The outstanding volume for inventory hedging is over and above the outstanding volume of 24 million bbls approved and in place in respect of Risk Management for imports/exports and refining margins. 5.8.2 ESC: For volume above 2,000,000 bbls in any one transaction or for outstanding volume exceeding 24.0 million barrels 5.9 Bankers for the hedging transaction: A separate account already opened by IOC with State Bank of India for hedging of oil imports/exports and refining margins shall be used for inventory hedging also. 5.10 Implementing Agencies: The implementing agencies for the risk management tools shall be as under: 5.10.1 Based on the approval of approving authority, the contract shall be entered into with the counter-party on the registered mailing list. The contract shall contain all the terms and conditions of the OTC contract including the International Swaps & Derivative Association (1SDA) documentation signed between IOC and counter-party. 5.10.2 Thereafter, the contract shall be forwarded to Finance Dept., IOC, Refinery Head Office (RHO), and New Delhi for implementation.

5.10.3 The Finance Dept., RHO shall carryout the necessary coordination with the parties and ensures that all the financial transactions pertaining to risk management are carried out through the designated account of IOC in SBI for hedging. The names/designations of officials handling this activity and interacting with SBl would be informed by Finance Dept., RHO to SBI along with necessary details. 5.11 Management Information Systems: 5.11.1 Market to Market Daily reports on the mark to market price for the hedged position shall be put up to the Head of the Dept., not below the rank of General Manager of the International Trade Department. To ensure that the Mark to Market position of the derivative contracts represents true market value, the quotes of major bankers/traders/Pricing Publications that are proving quotes on a regular basis shall be used. In case of options or combinations thereof, the Mark to. Market positions will be based on the swap quotes as above. 5.11.2 Every month, the exposures/hedge positions of the inventory hedging will be put up to Director (Finance) by IT Deptt. 5.11.3 On a half yearly basis, the list of settled contracts and open positions in respect of hedged positions shall be put up to the Board of Directors. 5.12 Audit The contracts for OTC tools and Futures/Options contracts shall be audited by Internal Audit Group of IOC once every quarter or more often if considered necessary. The contracts shall be made available to Government Audit and other statutory authorities.

List of Registered Counter-parties who have signed ISDA Documentation with IOC 1. Vitol S.A, Geneva 2. BNP Paribas, Paris 3. Citibank N.A, USA 4. BP Oil International Limited, London 5. Bank of America N.A, USA 6. Phibro LLC 7. Glencare Commodities Limited, London 8. Morgan Stanley Capital Group Inc 9. Barclays Bank Plc, London 10. Mitsui Energy Risk Management Ltd 11. Hess Energy Trading Company LLC 12. Societe Generale, France 13. Macquarie Bank Ltd

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