Oil hedging questioned as diesel prices seen rising

Experts say good start but few gains

By Natasha Gunaratne

Diesel prices are seen rising despite the Ceylon Petroleum Corporation (CPC)’s oil hedging pact in February to cushion volatility in the global market, raising questions as to whether the government secured the most suitable option. Mangala Boyagoda, a well-known oil hedging expert, told The Sunday Times FT even though the government is on the right path with oil hedging, this particular hedging will not result in any significant change. "It's a good start but if you want to manage petrol prices, petrol being the biggest foreign exchange buyer in the market, the government has to put their house in order."

Boyagoda, also Managing Director and Chief Executive Officer of Wealth Lanka Management (Pvt) Ltd, said it is essential to manage the dollar rupee price and that a centralised treasury must be appointed to manage all the risks that come with hedging. "There is nothing called risk free business. Everything has to be managed."

After petrol prices were raised last week, CPC Chairman Asantha De Mel warned that diesel prices might also be increased in the near future. Petrol prices rose by Rs.7 per litre while diesel is seen rising by Rs.4 per litre, which could raise costs of goods during the Avurudhu season.

On Thursday De Mel, speaking to the Sunday Times FT, reiterated that diesel prices might well have to be increased. "We have given all the facts and figures and we are waiting for the Minister's (A.H.M Fowzie’s) approval. The Minister will discuss the matter with the President. We still haven't gotten the approval from the Minister and the President so we are waiting." De Mel added that currently, the CPC is selling diesel below cost. "We have hedged only 300,000 barrels and are only compensated Rs.2 per barrel. There is a five rupee difference between the selling price and the cost."

However hedging was meant to reduce prices and cushion the impact on the consumer. Minister of Petroleum and Petroleum Resources, Fowzie said back in February 2007 that 'oil hedging is a good option because when prices go up, the government will not have to pass it onto the consumer.' According to Boyagoda, two main factors crucial to pricing is the commodity price and dollar rupee value. Since the rupee has depreciated, there is a lot of volatility in commodity prices and in this case, crude oil prices. “The point at which you hedge is also important.”

The oil hedging was handled by Standard Chartered Bank whose Head of Corporate Sales Chanaka Peiris said this week that the CPC had entered into a 'zero cost collar with a three way price' hedging option with the Bank. With the zero cost collar, Peiris said the CPC is 'limiting the upside.' He explained that the CPC is buying and selling a cap and selling a floor. "When you buy a cap, you are protected at that particular level."

Peiris further explained that the market rate or in this case, the method at which the rate is calculated is according to a pre-defined manner in calculating the average price. Boyagoda said CPC's hedge with Standard Chartered put the floor price at US$67.50, the cap at US$72 and a strike price of US$70. This means that for anything over US$70 up to US$72, the CPC is getting a two dollar advantage. Similarly for anything over US$72, the CPC also gets a two dollar advantage. For anything between US$67.50 and US$70, the CPC has to buy oil at the market price and does not get compensated. If the price is below the floor price, the CPC still has to purchase oil at US$67.50.

However, Boyagoda said that 'for the two dollar gain, we sacrifice the total downside by 100%' and this is the disadvantage of the hedging option. "We have only taken the view that everything is going up when really the CPC should have gone only for a cap and not a floor." Boyagoda said that considering the fact that the CPC has only hedged 300,000 barrels for three months from March, it tallies into savings of only US$600,000, a relatively small amount considering Sri Lanka paid over US$2 billion on oil imports for 2006. Furthermore, Sri Lanka imports between 30 to 35 million barrels of petrol a year and requires around 8000 barrels of diesel per month. Hedging 300,000 barrels is not enough to control the price.

De Mel, when asked if more can be done by the CPC to curtail rising costs, said they are doing everything possible in that regard. "We are looking at bringing down our costs. We have to reduce the purchase price. We are looking at a one-year contract andit will make a significant difference."

De Mel said the CPC has already called for tenders but due to the fact that this is the first time Sri Lanka has done anything of this nature, there are several procedures and protocols that have to be observed and barriers that have to be broken. "Cost reduction is happening. We are controlling waste and the pilfering of oil. The thing is that the price has gone up so much and that's the reason we have to revise the price."