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Hedging: Untangling The Web

Feb 12, 2011 1:53:12 PM - thesundayleader.lk

By Abdul H. Azeez

The Central Bank encouraged the move

Hedging deals are double edged, and even though they reduce risk, they do not completely eliminate it. If hedging deals are entered into without proper foresight, they can cut down and amputate like a sweeping butcher’s knife.
Sri Lanka, in its rush to rid itself of the burden of high fuel prices, entered into a ‘hedging’ deal with several international banks to try and dodge the petrol bullet. But something unexpected happened. Fuel prices actually plummeted. Whereas our hedging deal protected us against high fuel prices, it had somehow forgotten to offer us protection if the opposite happened.
Everyone knows how it turned out for the Sri Lanka Petroleum Corporation. Oil prices fell, and the lack of sufficient protection meant that we were potentially liable to pay billions of dollars to foreign banks. The government refused to do this, insinuating that the hedging deal was not on the level. So currently the GOSL and the foreign banks are in arbitration in Singapore to settle the matter once and for all.
After many months of talks, it looks like a solution is finally in sight. Many false alarms have already been sounded, and authorities deny that the hedging scenario has been decided. But the arbitration is not going to last forever. Eventually a decision will have to be made. Question is, how friendly is that decision going to be for Sri Lanka?

What is Hedging?
The word ‘hedge’ comes from the old English word ‘hecg’ which originally meant any type of fence, living or artificial.  These days it is fashionable to talk about it like it is some newfangled financial innovation. Well it is, but its purpose is pretty straightforward. A financial hedge operates just like a regular garden hedge. It protects and gives you security. Of course a real hedge may only protect you from prying neighbours, and not really offer any shoring up against say, a drunken lorry driver or a fire. A real hedge can even be a disadvantage. In my old neighborhood, garden hedges were used by local brewers to hide bottles of illicit liquor or kasippu, unbeknownst to their owners. The question is then, who put the kasippu in Sri Lanka’s oil hedge, rendering us completely at the mercy of price volatility?
A hedge in the world of finance then, is just like a real world hedge, but in this case we protect ourselves against financial risk. It is a method of reducing uncertainty in your financial future. And we have all probably used some means of hedging to dodge or evade future risk. Insurance is the most common.
What the Sri Lankan government adopted was a fuel hedge. During the high point of the global financial crisis, the falling confidence in investors led them to seek out sure-fire means of increasing their returns. So they turned to commodities like oil. Interest in oil increased the price of oil. Investors expected oil prices to rise because of the higher interest level. This type of vicious cycle is also known as ‘speculation’. Anyway, this increase in fuel, needless to say, put a lot of pressure on the people who needed to buy it, and countries such as ours were desperate to find means of procuring cheaper (or at least fixed price) oil in an environment that projected an eventual price of $200 per barrel.

How it all started
It was the Central Bank that encouraged the move. In a statement released after the whole thing blew up the Central Bank said that it had initially come up with a proposal for hedging fuel when it realised that petroleum prices, rising sharply towards the latter part of 2006, were on the verge of causing a balance of payments crisis.
A report released subsequently said that “Sri Lanka’s expenditure on petroleum imports (were) to rise from US $ 837 million in 2003 to an estimated US $ 2.1 billion in 2006”. The Central Bank then appealed to the cabinet and then to the Ceylon Petroleum Corporation itself urging for a hedging deal to be made with ‘international banks’ of ‘high reputation’. Two basic hedging methods were suggested.
The first method was ‘Crude Oil Cap’. CPC sets the maximum price: i.e., the cap. If the market price rises above the cap, the hedging bank will pay the difference to the CPC. If the market price drops below the cap, CPC is free to buy from the open market. As consideration, CPC needs to pay a premium for each barrel.
The second suggestion was ‘Zero-cost Collar’. CPC would set the maximum price: i.e. the Higher Collar. In response, the bank sets the floor price: Lower Collar. If the market price is above the higher collar price, the hedging bank will pay the CPC, the difference between the higher collar price and the market price. If the market price is below the lower collar price, the CPC will pay the hedging bank, the difference between the lower collar price and the market price. No premium is involved.

How it all fell apart
What happened after that is anyone’s guess really. Oil prices plummeted after the speculation bubble burst and suddenly the only thing that many Sri Lankans knew was that the government had seriously mucked up a hedging deal that would see us still paying high prices for oil even though global prices had dropped.
The problem appears to be a lack of a proper price floor when it comes to setting the hedge. Perhaps the deal makers, confronted with what appeared to be ever increasing oil prices, and deluded by rumors about depleting oil reserves, increased global demand for oil, didn’t give much thought to the unlikely event that prices would drop. So they just worried about a suitable price ceiling, and forgot about the floor.
The government has been playing a unique game of cloak and dagger ever since they broke the deal with the international banks involved (Standard Chartered, City Bank and Deutsche Bank). No clear information is available as to what precise hedging method was used, what price levels were chosen or how much money is owed to the banks.
Arbitration kicked off between the banks and the GOSL last October and are still underway despite having been scheduled to end by November last year. Recent newspaper reports stating that the government had lost the arbitration with a liability of USD 360 million were denied by the Petroleum Corporation, who insist that proceedings are still underway. Economist and Parliamentarian Harsha De Silva told The Sunday Leader that the liability could be somewhere closer to USD 500 million but no definite figures were available due to the lack of transparency; Governor Nivard Cabraal when contacted merely referred us to the Central Bank report detailed above.
As far as the arbitration proceedings are concerned, the GOSL is still hanging on, and perhaps they have a valid case. But denying the public information about exactly what is going on is not comforting, and is unbecoming of a democratic government. The arbitration will soon have to be over and we may likely have to pay a thumping fine, or we may not. But as far as the finer details of the mystery surrounding Sri Lanka’s oil hedge is concerned, the public maybe left in the dark for a good while yet.