Petroleum is sold in the world market and priced in US dollars. RISCO in India must import petroleum to use it in its manufacturing. How are its profit affected when Indian rupee depreciates against the US dollar?

Understanding the Baseline Scenario

Initially, let's assume RISCO needs to import petroleum worth $100,000. If the exchange rate is INR 82 per USD, the cost in INR would be INR 8,200,000 ( $100,000 * 82). RISCO then uses this petroleum in its manufacturing process and sells its finished products, generating revenue. Its profit is calculated by subtracting the cost of petroleum (and other inputs) from its revenue. This represents the initial profit margin.

Impact of Rupee Depreciation

Now, consider a scenario where the Indian Rupee depreciates to INR 85 per USD. The same $100,000 worth of petroleum now costs RISCO INR 8,500,000 ($100,000 * 85). This represents an increase in the cost of raw materials by INR 300,000.

• Increased Input Costs: Depreciation directly increases the INR cost of imported petroleum.
• Reduced Profit Margins: If RISCO cannot immediately pass on this increased cost to consumers (due to market competition or price controls), its profit margins will shrink.
• Potential for Loss: If the increase in input costs is substantial and RISCO is unable to adjust its pricing or reduce other costs, it could even lead to losses.

Factors Influencing the Extent of Impact

The extent to which RISCO’s profits are affected depends on several factors:

• Price Elasticity of Demand: If demand for RISCO’s products is inelastic (meaning consumers are not very responsive to price changes), RISCO may be able to pass on the increased costs to consumers without significantly reducing sales volume.
• Competition: If RISCO operates in a highly competitive market, it may have limited pricing power and be forced to absorb the increased costs.
• Hedging Strategies: RISCO can employ financial instruments like forward contracts or currency options to hedge against exchange rate risk (explained below).
• Time Lag: The time between importing petroleum and selling finished goods matters. A shorter time lag minimizes the impact of exchange rate fluctuations.

Mitigation Strategies for RISCO

RISCO can employ several strategies to mitigate the impact of Rupee depreciation:

• Forward Contracts: RISCO can enter into forward contracts with banks to lock in a specific exchange rate for future petroleum purchases. This eliminates the uncertainty associated with exchange rate fluctuations.
• Currency Options: Currency options give RISCO the right, but not the obligation, to buy USD at a predetermined exchange rate. This provides flexibility while limiting potential losses.
• Natural Hedging: If RISCO has significant export revenues denominated in USD, it can use these revenues to offset the cost of importing petroleum.
• Import Substitution: Exploring alternative raw materials or increasing domestic sourcing can reduce reliance on imported petroleum.
• Cost Optimization: Improving operational efficiency and reducing other costs can help offset the increased cost of petroleum.

Government Policies and their Impact

Government policies can also influence the impact of depreciation. For example, the government might:

• Intervene in the Forex Market: The Reserve Bank of India (RBI) can intervene in the foreign exchange market to stabilize the Rupee.
• Adjust Import Duties: Reducing import duties on petroleum could partially offset the impact of depreciation.
• Promote Domestic Production: Policies to encourage domestic oil exploration and production can reduce import dependence.