India is short crude oil, while Kerala is long the commodity. So it makes sense for the two entities (one of which is a subset of the other) to strike a long-term swap deal.
With oil prices being at a rather low level for the last couple of years (compared to the preceding decade or so), Kerala’s economy is in deep strife, as Mint reported. This is a consequence of a large amount of the Kerala economy being dependent on remittances from its expat workforce (35% of the state’s GDP, according to Mint), most of which is in the Gulf countries. With oil prices down, Gulf economies aren’t doing well, and being foreign workers, the expat Keralites, and consequently Kerala, is bearing the brunt of it.
With economic activity in the state reduced thanks to the withdrawal of legal tender of Rs. 500 and Rs. 1000 notes, the state is in deeper trouble, with doubts even cast on whether the state can pay salaries.
India on the whole, however, has benefited significantly from the fall in oil prices. With India a large net importer of crude oil, the drop in prices has resulted in significant easing of the pressure on the country’s current account deficit. The oil price drop has also helped in inflation dropping over the last couple of years, and since fuel is a transaction cost, has also helped in increasing economic activity.
After the oil prices dropped, experts advised the Union government to lock in the oil prices by signing long term forward agreements, in order to cushion the country’s economy against an oil price shock. The problem with striking this kind of a forward agreement is the need for a counterparty who faces the opposite risk. While investment banks can do such a deal, the margins can be high if a counterparty is not forthcoming.
With India benefiting from low oil prices and Kerala being hurt by them, the two entities should strike a long term oil swap. India can pay Kerala a fixed sum for the duration of the swap. Each month, Kerala will pay India an amount proportional to the extent by which the oil price (measured by indices such as Brent) exceeds a pre-agreed benchmark. In case oil remains below the benchmark, Kerala won’t need to pay India anything – the swap cash flows can be like an option.
This way, both parties will benefit. India will get hurt when prices increase but some of that will get compensated by the payments by Kerala. And while prices remain low, Kerala will get compensated for the loss in remittances by the payout by the government!
Wonder why no one’s thought of this so far!