Sri Lankan expatriate says cheated out of initiative to help the country

Upul Arunajith, a Sri Lankan expatriate and commodity specialist based in Canada, says the Central Bank (CB) has usurped a proposal he made several years back and discussed it with many ministers.

The commodity specialist is very angry and accuses the CB of plagiarising his proposal which finally led him to write to President Mahinda Rajapaksa and offer his services while setting out the sequence of events that led to the appeal to the president.When Arunajith wrote to Treasury Secretary Dr P.B. Jayasundera in 2004 giving him the details of the proposal and how the country save money, there was little or no response. “Now the Treasury Secretary is saying 17 percent inflation is due to high oil prices. He ignored a request from Finance Minister Sarath Amunugama to discuss this matter. If he had taken due notice of my letters in 2004 and implemented the crude oil hedging proposal, today Sri Lanka would be paying under $ 40 per barrel of crude oil and inflation would have been single digit,” he said.He says the CB doesn’t even understand what hedging is all about.

For example Central Bank Economic Research Director Dr H.N. Thenuwara’s October 10 letter says, “As is well known, commodity hedging is a common derivative instrument prevailing worldwide and the Central Bank of Sri Lanka, has recently taken certain steps to educate the Government of Sri Lanka re. the advantages of embarking into such schemes. The recent proposal to activate the Ceylon Petroleum Corporation to use the hedging mechanism in its purchases of oil has been one such exercise of the Central Bank’’.

Arunajith’s response:
“Saying hedging is a derivative instrument is like calling a car the journey. The car is only a tool that is used in the journey. Likewise, Hedging is not derivatives. Derivative is a tool used in the Hedging process.”

Point by point, the Canada-based commodity specialist has picked holes in the CB proposal. “They all become experts when they plagiarise other people’s ideas and project proposals. The Central Bank apparently says it has experts in derivatives but see how many flaws there are in their proposal,” he said.

A CB press release on September 28 said a hedging mechanism is similar to an insurance cover where a comparatively smaller premium is paid in order to be indemnified against a large potential loss. In the oil future markets, an oil “cap” could provide a fixed maximum price for Sri Lanka’s oil purchases, for a premium. For example, under this mechanism, if Sri Lanka purchases a cap at (say) US$ 60 per barrel, the country need not to pay a higher price even if world market prices reach US$ 100 per barrel or beyond. In such a situation, Sri Lanka would be free to purchase oil at the prevailing market price if prices fall below US$ 60 per barrel.

Arunajith’s response:
The fundamentals of energy / commodity futures trading involve the locking in of future delivery price of the commodity and the performance of the trade guaranteed by the clearing house cooperation that only requires a margin deposit that is regarded as a deposit of good faith.

The critical element of a consummated oil futures trade is the future "delivery price guarantee" or "price cap". It is not possible for the price "protection seeker" to move away from the Futures contract during the term of the agreement in the event the spot market prices were to drop below the "cap price". As well, there is no premium payment involved in oil Futures trading.

The CB said:
“Another mechanism is a “Zero-cost Collar” that can provide similar protection without Sri Lanka having to pay a premium. However, in this method, Sri Lanka would have to commit to a minimum price, below which Sri Lanka would not benefit by the reduction. Such forward contracts or hedging arrangements would have to be entered into with international banks of high reputation, who have the experience and ability to manage risks of this nature.”

Arunajith says:
“Zero Cost Collars is an option trading strategy that involves two trades. This strategy involves; the sale of a Call Option on an asset we own and the proceeds of the sale will fund a Put Option with the same strike price and the same expiration date. This is a short - term strategy, common applications are to manage the risk of interest rate and foreign exchange and this is also referred to as an Interest Rate Collar. This is a strategy used when you own the underlying interest.

The objective of a zero cost collar is to seek protection from a drop in value of an asset. However, in the case of Sri Lanka (CPC), we don’t produce oil and we don’t own oil. We continue to buy oil in the spot market price and we are constantly exposed to spot market price volatility. We therefore, seek protection from increasing spot market prices.

A Split Strike Synthetic position (sale of a Put Option with high strike price and the purchase of a Call Option with a low strike price) provides protection from increasing spot market prices. The call option with a lower strike price (locks in lower purchase price of oil) will have a high premium. This strategy creates a synthetic Futures position and are useful primarily in the near term contracts. If applied to long term contracts it will loose hedge effectiveness due to market matrix (causing backwardation, and contango) will neutralize the benefits. Further, this strategy will not allow participating in the event the spot market price drops below the strike price of the put option.

A Zero cost collar and a Split Strike Synthetic Positions all involve two trades. The administration cost (commission) is duplicated therefore, and will wash off the potential benefits of the hedge if used over the long term to hedge the monthly purchase of crude oil.

Zero Cost Collar is not a dedicated strategy to hedge energy exposure that has an implied volatility of over 50 - 60%.”

Arunajith said these are the fundamentals of derivatives, not hedging. “Hedging is much more complex. Without getting the basics straight, how can one get into developing customized hedge models and manage such a program. Yet, they claim they are the experts in hedging,” he said.

The Sunday Times FT dated June 25, 2006 ran a lead-story headlined “Lankan offers to stabilise oil prices” where it was reported that Sri Lanka lost a golden opportunity of paying far-below world market rates for fuel and much below current rates of Rs 92 per litre of petrol all because of a frustrating four-year battle between state authorities and Upul Arunajith.

It said Arunajith, a Chartered Marketer and Derivates Markets Specialist based in Canada, had offered a sound proposal to the government on a combination of hedging, swap and futures options on oil contracts which could have resulted in the cost of fuel being only $40 a barrel now compared to the world market price of $70-72 per barrel.

If the proposal had been accepted and put into operation, Sri Lankans would have had to pay 2003 fuel prices now of Rs 50-55 per litre, some Rs 40 less than current prices – but it seems due to official apathy and indifference, the proposal has been on the back-burner for the past four years, the report said.

“Except for some action on my initiative last year when Mano Tittawela got cracking after the proposal was referred to him by Power Minister Susil Premjayanth, there hasn’t been movement on this issue. The consumer and the CPC would have immensely benefited if the plan was underway,” he was quoted as saying in The Sunday Times FT.