Sri Lanka: Over The Hedge?


Sri Lanka went through a historical milestone in the financial markets when they first used a tailor-made oil hedge for purchasing crude oil. However, the instrument that was supposed to save Sri Lanka millions of dollars on the import bill became a burden when the markets took a downward turn. Since then hedging has become the worst nightmare of Ceylon Petroleum Corporation (CPC) and associated ministries fuelling the nation. Lahiru Mudunkotuwa outlines the ins and outs of the deal.

Risk mitigation

In order to find out how this blunder materialized we need to first understand what hedging is all about and how hedging can be used effectively for financial gain from a transaction. Whilst this type of financial instrument has been around in our local markets for a long time, the actual use of hedging for oil imports by the CPC took place in 2007.

Commodities have always been subjected to price fluctuations due to whatever prevailing market conditions determine supply and demand. Oil is a product which is highly volatile and this is mainly due to various additional political-economy and security factors which affect the market price. To reduce the amount of exposure to volatile market conditions hedging is used widely amongst the oil importing nations of the world.

Corporations are exposed or subject to various types of fluctuations of prices due to the interest rate changes, exchange rate variations and / or commodity price fluctuations. There are a variety of risks involved in future transactions of any commodity such as micro-economic exposure, macro-economic exposure, political stability exposure and transaction exposure.

Hedging is the mechanism for covering risk and derivatives are the instruments that are used to do this. Unless these factors are managed efficiently and effectively companies are exposed to the risk of huge losses and / or solvency. Therefore most firms have a treasury department with highly qualified personnel to manage this risk which is a much specialised area of corporate management. In layman’s terms, hedging is a way of covering your self from market fluctuations. Governments and multinational companies use different types of tools or derivatives to hedge themselves or to minimise their risk in their future positions and transactions. The question that arises is whether this has been practiced adequately at the national level in Sri Lanka.

In order to have any chance of getting to the bottom of what happened in the Sri Lankan oil hedge bungle, we need to refresh ourselves on some of the key financial instruments that are central to the practice of risk minimization;

Risky jargon

Swaps: A swap is a transaction whereby one party buys at a shorter date and sells at a forward date in the same transaction or vice versa. These can be as interest rate swaps or currency swaps. Swaps are used almost all over the world for minimising exchange or interest rate related risks.

Forwards: When a party agrees to buy or sell at a future price and enters into a contract with another party the transaction is referred to as a forward. Standard market dealings are usually valued as spot deals (there and then) or valued for two working days from the time of transaction. So any transaction beyond this is considered as a forward transaction. A forward can be dealt on any odd dates as well as on any standard dates of trading.
Futures: These defer from forwards in two ways. Futures are only traded in financial exchanges and are also a forward contract for a future date. They are traded only on standard durations - one month, three months, six months and one year.

Options: Options are contractual arrangements giving the owner the right to buy or sell an asset or a commodity at a fixed pre-agreed price on or before the given date. It is a right of the owner to buy or sell and they are not obliged to exercise the transaction if they feel the market is against them. For being able to do this the owner of the option pays a premium to the party underwriting the option similar to an insurance policy. There is a huge risk involved for the company undertaking to provide the facility because they may be subject to any type of market volatility. Still if they are willing to take a calculated risk they will charge the risk premium from the party taking the option. From the very basic definition of options, it is accepted that the buyer pays the premium and keeps the right to buy or not to buy with themselves.

Miss-calculation

So what went wrong with the Sri Lankan deal? We went for a zero cost option which was tailor made for our very own transaction of purchasing oil for Ceylon Petroleum Corporation. But considering the huge premium involved, we have not opted for the simpler version of the option and by using this tailor made complex package of zero option we have exposed or gambled heavily on oil prices remaining at their highest levels ever and a continuous rise in the prises.
This would have been ok had Sri Lanka inked the deal some five years before when the oil price hike was gathering momentum especially following the US invasion of Iraq. However, the geo-political factors were either not considered or totally miss-calculated. Moreover, for oil prices to continue on its record spike several other geo-political factors would have had to come into play such as some type of US led conflict with Iran or Venezuela, the world’s second and third largest oil producers coupled with perhaps further trouble in the Nigeria’s oil producing Delta region.

Fortunately, or unfortunately for the CPC, the nightmare global scenarios did not take place. Moreover, with the election of Barak Obama as US President, the world has a chance of entering into a more stable phase which will serve to calm the markets. Moreover, these markets are already depressed by the global down turn that has witnessed all commodities across the board falling due to stifled demand.

If anyone has been following commodity prices for even a short period of time, it is clear that all prices fluctuate. There is no steady trend of rise or decline in any of the available exchanges around the world. So how it was assumed by our decision makers that oil prices will only be faced with a scenario of continuous rise is yet unknown.

As consumers of fuel in Sri Lanka, we are all in the same boat as all across the board are affected by these decisions. When the oil prices were high we have received a payment of over $20 million from the facilitator of the oil hedge. But when these prices declined we are to pay a huge sum and we have to purchase double our requirement as part of the agreement. We will not only have to buy high priced oil, but due to this error it will also influence our foreign exchange reserves which are already declining as a result of controlled intervention of the (pegged) rupee.

What happened will be a bitter lesson for all Sri Lankan’s using crude oil products. But it was part of a learning curve for Sri Lanka and we need to rectify our costly mistakes and need to introduce a more efficient and reliable system. The solution is not to blame the hedge but to use correct instruments for the hedge so that costly mistakes like this would not be repeated in future. We also have a right as citizens of Sri Lanka to ask those truly responsible for this miss-calculation to be held to account.