May-June 2008 Vol 3 Issue 3
PRESIDENT’S MESSAGE
INSIDE THIS ISSUE:
A lot has happened and continues to happen since our last newsletter. In tune with the changing times, Our Institute has decided to allow practicing members to advertise in the media. It has also allowed articled assistants to undergo training outside India. Plans are on the anvil to design country - specific courses for students. It is heartening to note the pioneering initiatives taken by our parent body. With inflation continuing to climb northwards, officials in the North block are grappling to come to terms with the challenge of soaring prices. As accountants, I feel , we have the responsibilities to foster and safeguard the economic growth and stability of our country .Towards this end , we can definitely help our clients by advising them on measures of costcutting & control. The talent pipeline is an issue that affects every area of the profession. Our Institute has unveiled plans for a course for second tier of accountants:” Accounting Technicians” . While these efforts are important, I believe that our exemplary reputation may be the most significant element in convincing young, financially talented people to join & stick with the CA profession. If we don't demonstrate that we are an exciting and relevant profession that makes a difference, then we will lose them to other careers. I renew my call to all members to maximize the benefits from SOA by attending monthly meetings, networking with your peers and by enrolling new members. With Best Regards, CA. S. SANKARAN
President’s Message & Editorial
1
Secretary’s Report
2
Understanding Derivatives
3-4
Template of significant accounting policies – NACAS compliant
5-6
What are the real reasons for rise in oil prices?
7-8
EDITORIAL There was a time when we used to get chain letters in the name of some God which would exhort us to take some 7 or 10 copies of the same and post to some friends, promising nice surprises for the doer and predicting doom for those who would dare not. Things are hi-tech today with letters and post cards having been replaced by e-mails and sms'. Some of the powerpoint attachments to such e-mails which are in the form of attitude enhancements and confidenceboosters are really nice and make our days brighter. (Well, you also get some ridiculous ones occasionally from some self-effacing -no, not due to modesty but due to cowardice - elements that provide no more than some tiny rib-tickling sensations, but that is not what we are too concerned!). In spite of such 'day-brightening' missives, it becomes very difficult to keep one's positive attitude high, when all that one sees around him look bleak a n d h a z y. T h e a p o l o g y f o r a Government that is at the Centre (which is in ICU - courtesy Nuclear
1
deal, Inflation and the Left), in spite of the poll-intended gift of Rs. 60,000 crores as waiver of farm loans, is reeling under multi level pressures such as the galloping inflation (at double digits, it sure is anything but ONIDA), communists' twin attacks on price rise and nuclear deal (with Bush set to go in a few months, even US cannot afford to grant time to Dr Manmohan Singh), continuing mayhem in capital markets etc. The subject of inflation is on everybody's lips these days and though there is an apparent 'crude' reason for it, the politics behind the oil economics still seems to be a mind boggling issue, controlled by an 'interested' mafia that could well comprise of US Government and some top-notch names of AngloAmerican oil futures traders/ bankers and perhaps even the (erstwhile?) OPEC. Be that as it may, mighty enough to be comprehended by lesser mortals like us, the bottomline is that the oil price hike is driving every other cost crazy, leaving the common man, consisting of poorer and middle income sections of the society high and dry. The rich guys who 'play' in stocks have their
own tales of woe with stock market plummeting to new lows every day and their own margin pressures choking them beyond tolerance levels. Businessmen are struggling with their multiple miseries like the cascading taxes (excise, service tax, VAT, IT, FBT, MAT, DDT etc) of all forms besides bankers induced NPA & SARFESI threats. Exporters are suffering from 'dollar' as well as 'derivatives' difficulties. Agriculturists have no respite from private moneylenders, lower procurement prices and erratic monsoons. Virtually, no one is happy. And that is the precise achievement of the governance we have been cursed with. This is the nation we are seeing being built (or destroyed?). What are we, CAs, the supposedly intelligent and society-conscious profession going to be doing about all these? Do we or don't we have any moral and social responsibility to do whatever little that we can? Or, are we going to simply sit back and relax and even take pride to be a partner in this kind of nation building? Isn't it time to touch, why, even shake our conscience a little? Regards, P.S. Prabhakar
Auditor May – June 2008
SECRETARY’S REPORT Many years ago there was a popular radio programme "Looking back and looking forward" by 'Bobby Talyarkhan' on Indian cricket.How I wish we can have such a clinical analysis on the state of our profession as it is now.As the ICAI celebrates its Diamond jubilee, a very joyous moment for all of us we need to make lot of self introspection too.While we do Due diligence, Valuation, Credit rating,Limited
r e v i e w, U n l i m i t e d B a l a n c e sheetfor our clients, it is a pity we seldom do anything for ourselves.Time we do some soul searching and SOA can take initiative in this regard.I request our members to share their thoughts with us so that we can forward to ICAI. As part of our effort to facilitate a better rapport with the Income tax department we are planning to have an interactive session with the tax officials on matters of common intrerest. The meeting probably will be held in July at the Income tax auditorium and members should avail this
opportunity by giving value added suggestions.Depending on the response to this we can have similar interaction with the Company law affairs depatrment too. If these exercises remove a few irritants , I think we would have made our day We also invite articles, useful information, current happenings from our members which can be published in our newsletter if we find them good.By this I feel there will be more involvement of our members to the activities of SOA. Bye for now. S Ramakrishnan
LETTERS TO (AND A REPLY FROM) EDITOR Dear Shri Prabhakar, This is to congratulate you on your article on the Budget 2008. I fully agree that the present Finance Minister has complicated the law more than any previous incumbent. While the corporate inflows have increased, the amount of tax collected from individuals has not grown adequately. The editorial was also good. With kind regards, Arvind P. Datar Dear Mr Editor Prabhakar, Received "AUDITOR" though bit late as usual. The Articles by Mr N.V. Balaji and Mr V.M.V. Subha Rao are very useful and worthwhile. Many such useful and informative articles are necessary along with some latest Circulars and court decisions . My humble submission to you is to avoid cutting jokes at the expense of the Professions and Govt. officials. It does not serve any purpose but on the other hand it will be inviting only irks from the readers. It is our official organ hence adequate care has to be taken. With Greetings Yours Sincerely, K. Ananthachari Reply to Sri K. Ananthachari by the Editor Dear Sir, Thanks for your mail and for your comments as well. It has been our practice to blend useful and professionally informative articles with unbiased and fearless expression of views on the various aspects of professional lives. Your reference to my editorial - which you had mentioned as 'cutting jokes' - is I am afraid, is not fully appreciative of the agonising feeling that I had brought out. It was hardly 'joking' in nature. Nothing I have written is farther from truth and everyone knows it. I cannot be writing goody goody things all the time for two reasons: (a) there are not much goody goody things to write about and (b) there are many other who write about whatever that are available and there has to be someone who calls a spade a spade. There are many people who congratulate and appreciate me on my writing which they call 'bold' during their conversations to me and are saying that only Auditor is a differently run publication among the various others. I would request you to recall my very first editorial in which I had written as below: "Perhaps it will be in order to set a broad agenda for our journal or newsletter or whatever we may choose to call it - but before that, we have to admit that we are aware that there are several publications catering to the profession, some of which are really good in content quality and some rich in information dissemination. Quite candidly, we can, if we want to, get deluged in the flood of information. We have intensely debated among ourselves that in the obtaining scenario, do we need one more publication? Assuming we do, is it going to make any difference? Is it going to simply keep reflecting the issues already deliberated in other publications? Is it going to be yet another pious, non-controversial, feel good publication that will find its way to a designated corner in the generally dark junk rooms in the offices of our brethren? "Yes" will be the answer to the first two questions but it will be "No" to the other two. I think that this sets the broad agenda...... There will be no dearth for informative journalism, hard facts, poignant issues, satire & sarcasm, expressions of ecstasy and dismay, words of caution and advice, manifestation of dreams and visions, news & views on matters of professional interest and so on......" Sir, I do not think I have swerved away from what I promised. For latest circulars and court decisions, there are plenty of other publications already and I am of the firm opinion that we should not replicate them over and over. Finally, I have not got one (except of course, yours) mail or even oral feedback from any member to indicate that they are irked. With my best personal regards and pranams, Prabhakar
Auditor May– June 2008
2
Understanding Derivatives R Sivakumar, FCA & Sumod Tom Thomas Recent times have been witnessing a lot of news and views on 'derivatives'. A financial product that has gained the status of 'eminence', 'Derivative' is something that cannot afford to remain aloof from the discerning minds of accountants any longer. As it is felt essential that the Accountant should understand the fundamentals clearly as also conceptually and should also be a(be)ware of AS 30, 31 & 32, this article is presented with a focus on fundamentals and also as an analysis (in a limited sense) as to what went wrong. (The issues are brought out in general without going into the depths). Let us start with a simple example concerning exports. A Ltd an Indian company exports a product to X Ltd. in United States on 01.04.2008 for a value of USD 100,000 with a credit period of three months. There could be many scenarios of this example. Scenario 1: The invoice is in INR of Rs.40 lakhs. If X Ltd. pays this amount on 30.06.2008 this scenario becomes a simple case of an export sale and realization without any risk. Scenario 2: The invoice is in USD. The exchange rate on 01.04.2008 is Rs.40.00/-. If A Ltd. does not cover the 3
exchange risk and leave it open and if X Ltd. pays this amount the net realization for A Ltd. would be Rs.42 lakhs if the exchange rate would be Rs.42/on 30.06.2008 or Rs.38 lakhs if the exchange rate would be Rs.38/-. In this scenario risk emerges on the exchange rate fluctuation. If the risk is not covered there arises an exchange gain or loss. Scenario 3: Continuing the Scenario 2 - if A Ltd. enters into a forward cover, say, at the rate of Rs.42/- per USD, A Ltd. is certain of realizing Rs.42 lakhs
The underlying asset for currency options is foreign exchange. The currency options are calls and puts on sums of foreign currency. They are the right but not the obligation. irrespective of the exchange rate as on 30.06.2008. However there is a cost element attached to entering into a forward contract.
fundamentally contingent contracts whose values are derived from some underlying asset like currencies, bonds, stocks, interest rates, commodities etc. Vanilla & Exotic Generally the limit to the number of the instruments on which derivatives can be built is left to the imagination of the human mind. In fact, we have derivatives on weather also. Some derivatives are simple and known as “vanillas” and others are complex and are known as “exotics”. No matter how complex, all derivatives are nothing but the variations and the combinations of the four basic types such as Forward, Futures, Swaps and Options. Scenario 3 clearly depicts the derivative representing the forward contract. There could be many variations of these types independently. However, this article restricts itself to the fourth type of derivatives namely Options. The underlying asset for currency options is foreign exchange. The currency options are calls and puts on sums of foreign currency. They are the right but not the obligation to buy or sell a sum of currency at a fixed strike price on or before the option's expiration date.
Hitherto the above three scenarios have been quite common in the business world. Most of the firms have been practicing Scenario 3 and there has been no difficulty in understanding the fundamentals, concepts and also the accounting aspects. In general Scenario 3 Consider the following option on also forms part of a derivative dollar/yen: instrument. USD call/JPY put Derivative defined: In simple F a c e a m o u n t i n d o l l a r s t e r m s , d e r i v a t i v e s a r e $10,000,000
Auditor May – June 2008
Option put/call Yen put Option expiry 90 days Strike 110.00 Exercise European This option is a call option on the U.S. dollar (USD) or equivalently, a put option on the Japanese yen (JPY). It grants its owner the right but not the obligation to receive $10,000,000 in exchange for delivery of 1,100,000,000 yen ($10 million X 110.00) at option expiration. This is an example of a standard, or vanilla, currency option. European exercise means that an option can be exercised only on the last day of its life. Upon exercise, a currency option triggers a spot foreign exchange transaction done at the strike price and for settlement on the spot value date. Barring exceptional circumstances, this option should be exercised if the spot exchange rate is above 110.00 on the expiration date. Likewise, a USD put/JPY call struck at the 110.00 should be exercised at expiration if the spot exchange rate is below 110.00. Exotic Options: An exotic currency option is an option that has some nonstandard feature that sets it apart from ordinary vanilla currency options. The foreign exchange market is a fertile ground for the invention of new exotic options. The most popular exotic currency option is the barrier option. One type of barrier option is the knock-out option. A knock-out option is similar to a vanilla option except for the existence of a barrier exchange rate, called the outAuditor May – June 2008
USD Put JPY Call {the right to sell 1 USD by receiving 110.00 J P Y } . H o w e v e r, t h e r e c e n t contracts entered into by most of the parties were the reverse. In this scenario JPY appreciated against the USD {1 USD = 100 JPY}and the net result was the huge loss encountered by the parties. Elaborating further for every USD the loss would have been 10 JPY. If the contract were to be for 1 million USD then the loss would have been 10 million JPY. Apart from this type of contract certain parties went in Continuing the Scenario 3, one for the exotic options and the could understand the extension loss became quite heavy. As per of the same leading to option. the Accounting Standard the ICAI gave a direction that these As per the Accounting losses have to be charged off to Standard the ICAI gave a the Profit and Loss account for direction that these losses all such contracts entered into by have to be charged off to the parties on the basis of mark the Profit and Loss account to market. for all such contracts Issues: entered into by the parties Arising out of the option on the basis of mark to contracts the following are the market. issues debated widely: strike, which when breached would cause the option to extinguish at any time during the option's life. For example, one could add an out-strike at 115.00 to the previously mentioned USD call/JPY put. This would mean that if dollar/yen were to trade at 115.00 before expiration, the option would cease to exist. Naturally, this option must cost less than its vanilla counterpart, which cannot be knocked out regardless of where dollar/yen trades.
Assume that A Ltd. had entered a. W h e t h e r e n t e r i n g i n t o a n into an export contract at the option contract is speculative beginning of each month for a in nature and therefore the similar value with different legality of such contracts. parties. Hence it is a case of b. Reserve Bank of India has receiving USD 100,000 at the allowed cross currency end of each month beginning options and hence whether from 30.06.2008. A Ltd. now the option contract entered enters into an option contract into is an extension of the with a bank for cross currency. export contracts. This contract can take the c. Will the Income Tax authorities following dimensions. view such losses as a Assuming the forward rate of I business loss or will they USD = 110.00 JPY and 1 USD = disallow the same as 40 INR the exchange rate of 1 speculative? INR = 2.75 JPY. Ideally it is (To be continued‌..) preferable for A Ltd. to buy a 4
Template of significant accounting policies – NACAS compliant R.G. Rajan, FCA A Chartered Accountant in attest function today is caught between the Devil and the Deep Sea. While on the one hand, he has ICAI notified standards to ensure compliance of, on the other hand, he has the NACAS (National Advisory Committee on Accounting Standards) notified accounting standards notified by NACAS. (Of course, ICAI has conceded that it would align their Accounting Standards with that of NACAS though the aligning process is yet to get complete). With the applicability prescriptions of ICAI and NACAS differing, our member Mr R.G.Rajan, has come out with a template version (applicable to an IT company members can customize to their needs) of significant accounting policies, keeping in mind the requirements of NACAS, which can be used by our members in discharging their attest responsibility, suitably modifying this to suit their requirements. Thank you, Rajan. Editor Significant Accounting Policies & Other Disclosures to the financial statements for the year ended 31st March 2008 Background X Private Limited is an international information technology consulting company delivers business solutions through global software development. X is focused on software development products and implementation in the field of financial services. X is headquartered in Chennai, India. The company is a Small and Medium size Company (SMC) as defined in the general instructions in respect of accounting standards notified under the Companies Act, 1956. Accordingly, the company has complied with the accounting standards as applicable to a Small and Medium size Company. 1.1 Significant accounting policies a) Basis of preparation of financial statements The financial statements have been prepared on the historical cost basis in accordance with the Generally Accepted Accounting Principles (GAAP) in India and comply with the mandatory
b)
c)
d)
e)
accounting standards as specified in the Companies (Accounting Standard) Rules 2006. All items of income and expenditure that have a material bearing on the financial statements are recognized on accrual basis. Fixed assets Fixed assets are stated at historical cost less accumulated depreciation. Cost includes all expenses directly attributable to bringing the assets to its working condition for its intended use. Depreciation Depreciation on fixed assets is computed from the date of installation and ready for use, on straight-line method at the rates and in the manner specified in Schedule XIV of the Act. Depreciation on additions / deletions has been provided on a pro-rata basis. Expenditure Expenses are accounted on accrual basis and provisions are made for all known losses and liabilities. Costs associated with providing various services are accrued at the time when related revenues are recognized. Revenue Recognition Software Development -Revenue is recognized in respect of software development and products on basis of contractual terms, when the right to receive the sums under the contracts are reasonably established. In respect of contracts of development and implementation, revenue is recognized on the percentage of completion method, where the outcome of the contact can be reliably estimated, based on proportion of the cost to the total estimated cost. Where the out come of the contact cannot be reliably estimated, contract revenue is recognized only to the extent of cost incurred, of which recovery is probable. Where the estimated contract cost is expected to exceed the corresponding contract value, such excess cost is provided for. Cost and earnings in excess of billings are classified as unbilled revenue. While billing in excess of cost and earnings is classified as
f) (i) (a)
(b)
(c)
(d)
g)
unearned revenue. Interest Income - Interest on deposits is accounted on accrual basis. Employee Benefits Long Term Employee Benefits Defined Contribution Plan The company has a defined contribution plan in the form of a Provident fund scheme for its staff and pension scheme under the employee's pension scheme 1995 for all its employees, which are administered by the Provident fund commissioner. The above mentioned schemes are classified as defined contribution plan as the company has no further obligation beyond making the contributions. The company's contributions to the defined contribution plans are charged to profit and loss account as incurred. Defined Benefit Plan The company has defined benefit plan for post retirement benefit in the form of gratuity for all its employees. Liability for defined benefit plan is provided on the basis of valuations, as at the balance sheet date, carried out by an independent actuary. The actuarial valuation method used by the independent actuary for measuring the liability is the Projected Unit Credit Method. Te r m i n a t i o n b e n e f i t s a r e recognized as an expense as and when incurred. Actuarial gains and losses comprise experience adjustments and the effects of changes in actuarial assumptions and are recognized immediately in the profit and loss account as income or expense. Foreign exchange transactions and effects of changes in foreign exchange rates. Foreign exchange transactions are recorded at the exchange rates prevailing on the date of transaction. Foreign currency monetary items are translated into rupees at the exchange rate prevailing on the balance sheet date. The effect of exchange rate differences is charged off to profit and loss account.
Auditor May – June 2008
h)
Earnings per share Basic earnings per share, is calculated by dividing the net profit/(loss) for the period attributable to the equity shareholders by the weighted average number of shares outstanding during the year. i) Taxes on Income Tax expenses comprise of current, deferred, fringe benefit tax. Provision for income tax and fringe benefit tax is made on the basis of the estimated taxable income / fringe benefits as per the provisions of income tax act, 1961 and the relevant finance act, after taking into consideration judicial pronouncements and opinions of the company's tax advisors. Tax payments are setoff against provisions. Deferred tax resulting from timing differences between the book and tax profits is accounted for at the current rate of tax to the extent that the timing differences are expected to crystallize. Deferred tax asset arising out of brought forward losses are recognized when there is a virtual certainty supported by confirmed evidence that such assets will be realized. j) Use of Estimates The preparation of financial statements in conformity with GAAP requires management to make estimates and assumptions that affect the reported balances of assets and liabilities and disclosures relating to contingent assets and liabilities as at the date of financial statements and reported amounts of income and expenses during the period. Examples such estimates include provisions for taxes, depreciation. k) Provisions and Contingent liabilities Provisions are recognized when the company has a present obligation as a result of past event, for which it is probable that a cash outflow will be required and a reliable estimate can be made of the amount of the obligation. Provisions are not discounted to their present value and are determined based on best estimate required to settle the obligation at the balance sheet date. Theses are reviewed at each balance sheet date and adjusted to reflect the current management estimates. Contingent liabilities are disclosed when the company has a possible obligation and it is probable that a cash outflow will not be required to settle the obligation. l) Related party disclosure (i) Party where control exists : a. Zaa Inc, USA b. zaa infotech Private Limited (ii) Key Management personal of the company a. Name : XY b. Category : Director (iii) Transaction during the year a. Zaa Inc, USA Sale of Software Rs.87,25,400 Recovery of expenses Rs. 2,91,200 b. Zaa infotech Private Limited Receivables Rs. 1,76,628 c. XY Salary, bonus & incentives Rs. 4,19,700 (iv) Outstanding as at 31st March 2008 a. Received in advance Zaa Inc, USA Rs.13,58,980
Auditor May – June 2008
(The figures above are for the financial year 2007-08, data for the financial year 2006-07 were not provided as the standard become applicable for this company only for the financial year 2007- 08 onwards only) m) Impairment of Assets The company assesses at each balance sheet whether there is any indication that an asset (including goodwill) may be impaired. If any such indication exists, the company assesses the recoverable amount of the asset on reasonable estimate basis. If such recoverable amount of the asset is less than its carrying amount, the carrying amount is reduced to its recoverable amount. The reduction is treated as an impairment loss and is recognized in profit and loss account. If at the balance sheet there is an indication that if the previously assessed impairment loss no longer exists the recoverable amount is reassessed and the asset is reflected at the recoverable amount. An impairment loss is reversed only to the extent that the carrying amount of the asset does not exceed the net book value that could have been determined if no impairment loss had been recognized. n) Leases Company is a lessee In respect of operating lease, rentals and other expenses are treated as revenue expenditure. 1.2 Micro, Small and Medium Enterprises development act 2006 The company has initiated the process of identification of suppliers registered under the Micro, Small and Medium Enterprises development act 2006, by obtaining confirmation from all the suppliers. Based on current information / confirmation available with the company there are no dues payable to suppliers, who are registered under the relevant act as at 31st March 2008. 1.3 Disclosure pursuant to Accounting Standard 15 (Revised) 'Employee Benefits’
Actuarial Assumptions For the year
Gratuity
(a) Discount Rate (per annum)
7.00%
(b) Rate of Return on Plan assets
7.00%
(c) Salary Escalation rate
4.00%
(d) Mortality
As per LIC (1975 – 79) Table of Mortality rates
(e) Employees’ turnover
Age related
For ABC Private Limited Director
For XYZ Associates Chartered Accountants
Director XXXXXX Partner Mem No. xxxxx
Place : Date :
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What are the real reasons for rise in oil prices? M.R. Venkatesh, FCA By now it is becoming too obvious that the United States is playing the oil game all over again. And this is the desperate gamble of a country whose economy is neck deep in trouble. Given this scenario, managing prices of oil is central to the US economic architecture. Expectedly, this gamble has been played in a great alliance between the US government, US financial sector and the media. I have earlier written about: The impending collapse of the US dollar on account of the inherent weakness in the US economy caused by its structural weakness as reflected in the sub-prime crisis; The repeated softening of the interest rates in the US that has the potency to kill the US dollar; and
approximately $5 trillion -- yes, $5 trillion! -- in the futures markets. It is estimated that half of these are bets placed on oil. Readers may note that oil is internationally traded in New York and London and denominated in US dollar only. Naturally, it has been opined by experts that since the advent of oil futures, oil prices are no longer controlled by OPEC (Organization of Petroleum Exporting Countries). Rather, it is now done by Wall Street. This tectonic shift in the determination of international oil prices from the hands of producers to the hands of speculators is crucial to understanding the oil price rise. Today's oil prices are believed to be determined by the four AngloEvery barrel they buy in the futures markets they sell back again before the contract ends. That may raise the price of 'paper barrels,' but not of the black stuff refiners turn into petrol.
How the fall in the US dollar suits the US corporate sector, especially its omnipotent financial sector. Naturally, since the past few years, the American financial companies-turnedUS financial sector has begun to turn oil traders, viz., Goldman Sachs, its attention from currency and stock Citigroup, J P Morgan Chase, and markets to commodity markets. Morgan Stanley. It is only they who According to The Economist, about have any idea about who is entering $260 billion has been invested into the into oil futures or derivative contracts. commodity market -- up nearly 20 It is also they who are placing bets on times from what it was in 2003. oil prices and in the process ensuring Coinciding with a weak dollar and this that the prices of oil futures go up by speculative interest of the US financial the day. sector, prices of commodities have But how does the increase in the price soared globally. of this oil in the futures market And most of these investments are bets determine the prices of oil in the spot placed by hedge and pension funds, markets? Crucially, does speculation in always on the lookout for risky but oil influence and determine the prices high-yielding investments. What is of oil in the spot markets? indeed interesting to note here is that Answering these questions as to unlike margin requirements for stocks whether speculation has supercharged which are as high as 50 per cent in the demand for oil The Economist, in m a n y m a r k e t s , t h e m a r g i n its recent issue, states: 'But that is plain requirements for commodities is a wrong. Such speculators do not own mere 5-7 per cent. real oil. Every barrel they buy in the This implies that with an outlay of a futures markets they sell back again mere $260 billion these speculators before the contract ends. That may would be able to take positions of raise the price of 'paper barrels,' but not 7
of the black stuff refiners turn into petrol. It is true that high futures prices could lead someone to hoard oil today in the hope of a higher price tomorrow. But inventories are not especially full just now and there are few signs of hoarding.' On both counts -- that speculation in oil is not pushing up oil prices, as well as on the issue of the build-up of inventories -- the venerable Economist is wrong. The finding of US Senate Committee in 2006 In June 2006, when the oil price in the futures markets was about $60 a barrel, a Senate Committee in the US probed the role of market speculation in oil and gas prices. The report points out that large purchase of crude oil futures contracts by speculators has, in effect, created additional demand for oil and in the process driven up the future prices of oil. The report further stated that it was 'difficult to quantify the effect of speculation on prices,' but concluded that 'there is substantial evidence that the large amount of speculation in the current market has significantly increased prices.' The report further estimated that speculative purchases of oil futures had added as much as $20-25 per barrel to the then prevailing price of $60 per barrel. In today's prices of approximately $130 per barrel, this means that approximately $100 per barrel could be attributed to speculation! But the report found a serious loophole in the US regulation of oil derivatives trading, which according to experts could allow even a 'herd of elephants to walk to through it.' The report pointed out that US energy futures were traded on regulated exchanges within the US and subjected to extensive oversight by the Commodities Future Trading Commission (CFTC) -- the US regulator for commodity futures market. In recent years, the report however pointed out to the tremendous growth Auditor May – June 2008
in the trading of contracts which were traded on unregulated OTC (over-thecounter) electronic markets. Interestingly, the report pointed out that the trading of energy commodities by large firms on OTC electronic exchanges was exempted from CFTC oversight by a provision inserted at the behest of Enron into the Commodity Futures Modernization Act in 2000. The report concludes that consequential impact on account of lack of market oversight has been 'substantial.' N Y M E X ( N e w Yo r k M e r c a n t i l e Exchange) traders are required to keep records of all trades and report large trades to the CFTC enabling it to gauge the extent of speculation in the markets and to detect, prevent, and prosecute price manipulation. In c o n t r a s t , h o w e v e r, t r a d e r s o n unregulated OTC electronic exchanges are not required to keep records or file any information with the CFTC as these trades are exempt from its oversight. C o n s e q u e n t l y, a s t h e r e i s n o monitoring of such trading by the oversight body, the committee believes that it allows speculators to indulge in price manipulation. Finally, the report concludes that to a certain extent, whether or not any level of speculation is 'excessive' lies entirely in the eye of the beholder. In the absence of data, however, it is impossible to begin the analysis or engage in an informed debate over w h e t h e r o u r e n e rg y m a r k e t s a r e functioning properly or are in the midst of a speculative bubble. That was two years back. And much water has flown in the Mississippi since then.
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The link to the spot markets Now to answer the second leg of the question: how speculators are able to translate the future prices into spot prices. The answer to this question is fairly simple. After all, oil price is highly inelastic -- i.e. even a substantial increase in price does not alter the consumption pattern. No wonder, a mere 3-4 per cent annual global growth has translated into more than a 40 per cent annual increase in prices for the past three or four years. But there is more to it. One may note that the world supply and demand is No wonder Goldman Sachs predicts that oil will touch $200 to a barrel shortly, knowing fully well that the US government will back its prediction. evenly matched at about 85 million barrels every day. Only if supplies exceed demand by a substantial margin can any downward pressure on oil prices be created. In contrast, if someone with deep pockets picks up even a small quantity of oil, it dramatically alters the delicate global demand-supply gap, creating enormous upward pressure on prices. What is interesting to note is that the US strategic oil reserves were at approximately 350 million barrels for a decade till 2006. However, for the past year and a half these reserves have doubled to more than 700 million barrels. Naturally, this build-up of strategic oil reserves by the US (of 350 million barrels) is adding enormous pressure on the oil demand and consequently its prices.
Do the oil speculators know of this reserves build-up by the US and are indulging in rampant speculation? Are they acting in tandem with the US government? Worse still, are they bordering on recklessness knowing fully well that if the oil prices fall the US government will be forced to a 'Bears Stearns' on them and bail them out? One is not sure. But who foots bill at such high prices? At an average price of even $100 per barrel, the entire cost for the purchase of this additional 350 million barrels by the US works out to a mere $35 billion. Needless to emphasise, this can be funded by the US by allowing it currency printing presses to work overtime. After all, it has a currency that is acceptable globally and people worldwide are willing to exchange it for precious oil. No wonder Goldman Sachs predicts that oil will touch $200 to a barrel shortly, knowing fully well that the US government will back its prediction. And, in the past three years alone the world has paid an estimated additional $3 trillion for its oil purchases. Oil speculators (and not oil producers) are the biggest beneficiaries of this price increase. In the process, the US has been able to keep the value of the US dollar afloat -- perhaps at an extra cost of a mere $35 billion to its exchequer! The global crude oil price rise is complex, sinister and beyond innocent economic theories of demand and supply. It is speculation, geopolitics and much more. Obviously, there is a symbiotic link between the US, the US dollar and the oil prices. And unless this truth is understood and the link broken, oil prices cannot be controlled. (Reproduced from Rediff.com with author's permission)
Mr S. Sankaran, President Mr Bheema Bhat, Vice President Mr R. Sivakumar, Vice President Mr S. Ramakrishnan, Secretary Mr B.K. Murthy, Joint Secretary Mr V. Swamynathan, Treasurer
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