Hedge now – in a proper way

by D. Kulasiri Ranaweera

(December 14, Colombo, Sri Lanka Guardain) Hats off to The Sunday Times for blowing the lid off the disastrous CPC hedging fiasco. Your paper has exposed the amateurish, unethical and sleazy nature of this deal and the subterfuge used to dupe the Nation and the dreadful drain it would be on our meagre foreign reserves. However, while the post-mortem is still going on, let me be the devils advocate and extol the virtues of hedging and disclose a window of great opportunity. It will not be prudent to discard the entire concept of hedging on one bad experience. Even the critics of the ‘dodgy-deal’ and the Central Bank, with their newly acquired wisdom - after closely witnessing the ‘phenomenon of hedging`- accept that hedging can be beneficially utilised to secure assurance against future price increases on oil, the most volatile of commodities. Most of the major airlines abroad have used hedging wisely for quite some time to successfully arrest the fluctuating volatility of oil prices.

The benefit of hedging is most heightened when a volatile commodity is ‘pegged’ at its lower-end. You reap the benefits when the price begins to climb. With oil at around 45 to 55 dollars a barrel at current rates, now is the time to hedge rather than wait until it rises again. We should be able to hedge oil at 60 to 65 dollars a barrel for two years with a renowned International Energy Trading firm (since local banks do not posses the potency or the financial ‘clout`) in Geneva or Amsterdam via a reliable broker probably from Singapore.

The hedging method used could be the now favoured ‘Option- Premium Model` or even the wrongly derided and vilified ‘Zero-cost-collar method` with proper ‘downside’ escape clauses in place. It is unfair to blame Zero-cost-collar method - which is cheaper to initiate - for the` debacle’ the CPC brought on itself by entering into an agreement heavily ‘loaded’ in favour of the banks and to the detriment of the nation. The agreement was so one-sided that even the two banks agreed unusually to renegotiate the `hedge’ halfway into the contract and opted to accept reduced payment. Even J.P.Morgen, the renowned international investment bank, intervened accepting the flaws in the agreement. It even violated our own Central Bank code of practice and kept CPC`s own board of directors in the dark. Given these mysterious circumstances some even profess that the Bribery Commissioner should have a say.

Although the recent surge in oil prices were halted abruptly by the world monetary crisis and the ensuing ‘meltdown`, the natural tendency for oil prices is up than down. Oil price behaviour for the last two years - bar the last three months - confirms this. In January 2007 the barrel price was just below $60 and climbed rapidly to around $95 by December and then to that unprecedented $147 by the end of July 2008 and remained around these levels until September. Within a few months, when financial rescue packages worldwide take effect and help to turn the tide, the oil price will begin its customary climb. Saudi Arabia recently demanded its ‘pound of flesh` by stating that it wants the oil price at $75 a barrel and opted to reduce production forthwith.

Although the temporary lack of demand is halting the surge, its only a matter of time that it will creep up again. Hence, I firmly believe that the new CPC leadership under the guidance of the Central Bank and consultation with competent advisors use this narrow window to its advantage and hedge now. The Southwest Airlines fuel hedging programme which it conducted when the oil price was down at 20 dollar a barrel in 2001 was a great example of this strategy. The ‘hedge’ helped them to peg the price of a barrel at $26 a barrel in 2005; $32 in 2006; $31 in 2007, and $35 in 2008/09. So hedge now or repent .

(The writer is a London-resident financial adviser who returned to Sri Lanka recently and witnessed the saga of hedging unfold). The article originally published on the Sunday Times, popular weekly paper based in Colombo.
- Sri Lanka Guardian