Hedging is good – CPC badly needs hedging
The purpose of this article is to remove serious misconceptions about hedging and to show all Sri Lankans that hedging is a very important tool to manage volatility of commodity prices. Sri Lanka should continuously use hedging strategies for the benefit of its people.
The hedging losses suffered by the Ceylon Petroleum Corporation (CPC) were more than the monetary loss – it was a commercial double tragedy in which people of Sri Lanka were victimised twice. Once due to wrong use of so called “hedging” promoted by foreign banks which led to huge financial loss and secondly, due to the fact that an important commercial tool – hedging – was branded a deadly tool for the wrong reasons and put into the dustbin. On the contrary to all misconceptions, the writer wishes to say hedging in its purest and simplest form is what Sri Lanka should use, especially when oil prices are as low as now, in order to secure those prices for another two to three years for the benefit of all Sri Lankans. Simple hedging is a commercial tool used by producers and buyers equally – all over the world to manage and to minimise risks. Therefore, how CPC lost money through “hedging” needs to be reinvestigated – not to victimise anybody but to ‘Learn Right From Wrong’ – at least to one benefit from the costly mistake.
What is hedging?
November 16, 2008 File pic: Officials briefing the media denying the CPC's hedging agreements were wrong. L to R: Clive Haswell – CEO Standard Chartered Bank, Dennis Hussey – CEO Citibank, Amitha Gooneratne – Managing Director Commercial Bank, Asantha De Mel – Chairman CPC.
There is no investment or business called risk free. There are different types of risks. The main risks are Business Risk, Financial – Commodity Risk and Operation Risks. The most important thing in Financial – Commodity risk management is to identify the risk, measure it and use the appropriate hedging tool. There are different types of hedging instruments available in the market. The most popular products are Futures, Options, Caps, Floors and Collars. They are called Derivatives. The buyer of a financial product or a commodity trying to protect himself against the upward movement of the prices and the seller is trying to protect himself against the downward movement of the price of a financial instrument or a commodity. The financial futures are traded in organised exchanges worldwide. Other products such as Options, Caps, Floors and Collars are traded in both organised exchanges and over the counter by banks and other derivatives houses. So hedging means protection and it also provides an insurance against volatility. A fee will be charged for any hedging product by the arranger or writer of an option product. What we have to keep in mind is that there is no free lunch with bankers.
Sri Lanka spends over US$5 billion annually on the import of crude oil and also refined products such as petrol, diesel and jet fuel. During the last seven years we have witnessed the volatility of crude oil prices from $45 to $155 per barrel. We, as a buyer of oil are always fearful of oil prices going up and if we want the current prices to hold firm for a defined period time in the future, we can hedge. Currently, oil prices are historically low and could go up in the near future. In other words we perceive a risk. So if we want these prices ($50 per barrel) to be maintained for our purchases in the future – for 12 to 60 months, we should hedge oil at current prices for a carefully selected period of time in the future. Then we are assured of oil at current prices irrespective of the market price of oil shooting up to the sky above or landing at the bottom of the sea. Isn’t that what we as a country would love to do? But one must also be aware of the disadvantage of hedging. The only disadvantage of hedging is that, if market prices come down further, we cannot take advantage of those low prices in the future since we would be locked to current prices for a particular period of time in the future. So it has to be a collective decision – our learned politicians and economists have to take. There should be a country policy on hedging of crude oil prices. The Central Bank has to pay a vital role on the formulation of this strategy and the CPC must have its Treasury Division in place to execute the hedging strategy with proper risk management framework and the right expertise in place. It’s sad to note that the biggest foreign exchange buyer of our country – the CPC – doesn’t have an in-house Treasury Division to manage the CPC’s financial risks to date.
Similarly, what do producers of oil fear? Naturally, they fear a price collapse. A few months ago oil prices were above $100 a barrel. And many oil producers in the US knew prices could come down due to the ever increasing shale oil production. Those oil producers who perceived a risk, did hedge oil at exchanges and today they must be reaping the benefits despite the fact that market prices have collapsed to $50 per barrel. This in fact is the real situation and many oil producers in the US had hedged oil at $80 or so and they are assured of $80 per barrel irrespective of the low market prices. Had the market prices shot up to $120 after hedging by the oil producers, they would not be able to make use of those increased prices. This is the downside of hedging. Remember, even then the oil producer is not a loser since he was happy with the price at which he hedged and on the contrary, if the prices came down the way it has happened now, he would have been forced to shut down his plant at least temporarily. This is the beauty of hedging – it is an insurance against a possible future event that could be disastrous if materialises.
Hedging – how it’s done
Hedging can be done in an organized exchange. The local manufacturers of cables hedge copper prices in the futures market in the London Metal Exchange (LME). Copper and aluminum are two metals widely traded at the LME. Let’s assume a cable manufacturer has accepted an order for the supply of copper cables using 1,000 tons of copper over the next 10 months at prices fixed today. The immediate risk the cable manufacturer perceives is what happens if the copper prices go up during the next 10 months. If so the currently profitable order could make him lose money heavily. Assuming the copper price today is $6,000 per ton, the cable manufacturer will BUY copper futures at the rate of 100 tons per month at $6,000 for the next 10 months. If the market price goes up next month to $7,000 per ton, he will SELL 100 tons of copper futures at $7,000, making a profit of $1,000 per ton at the LME. Since he has made a profit of $1,000 per ton, he can afford to buy physical copper at $7,000 and his net cost of copper remains at $6,000 per ton. The opposite happens if the price of copper goes down in the market but the net result is the cable manufacturer gets his copper at $6,000 per ton. This is simple hedging, one resorts to whether you are buying copper or oil.
On the other hand a person owning a mine of copper would like to see high enough prices to remain in the market for his stock of copper that can be extracted from his mine. So if copper prices rises to a level – say $8,000 per ton, he may decide that it is the right price for him and SELL copper futures at the rate of $8,000 ton per month for the next 24 months at the LME. If prices collapse to $6,000 per ton next month, he will BUY back his copper futures at $6,000 per ton to close his first transaction, making a profit of $2,000 per ton at the LME. Now if he releases his physical copper to the market he gets only $6,000 per ton. But to this he adds the profit of $2,000 he made at the exchange and his net recovery is $8,000 per ton. The opposite process happens if prices go up to say $9,000 per ton and he still ends up selling his copper at a net price of $8,000 per ton. Of course there is a disadvantage as well and it should be obvious to the reader – when copper prices go up to above $9,000, he cannot make an extra profit.
These are the advantages of BUYING copper futures by a cable manufacturer and SELLING copper futures by an owner of a copper mine. Both did HEDGING – the consumer of the commodity copper bought copper futures and the producer of the commodity copper sold copper futures to minimise perceived risk situations in the future. Both acted as HEDGERS – in order to minimise or eliminate perceived risk in the future.
Definition of Hedger and Speculator
According to the LME exchange a Hedger is someone who perceives a risk and takes a position in the futures market to minimize or eliminate the risk.
Hedger – Buy or sell futures to eliminate or minimise a perceived risk. Hedgers cannot lose money whether the price moves up or down. The Hedger starts with a perceived risk, enters the futures market to eliminate same and minimises losses. However there could be an opportunity cost.
On the other hand, a Speculator is one who acquires a Risk (Buy or Sell futures) in pursuit of profit. The Speculator makes money if prices move as per his wish but loses heavily if market prices move against his wish. He acquires a risk to earn profit.For example a person, who is neither a producer nor consumer of oil, buying or selling oil futures at an exchange, is a Speculator. If he buys oil futures, he acquires a risk position assuming prices would go up. If he sells oil futures at an exchange he acquires a risk assuming the price of oil to fall. If prices go against his wish he loses money.
CPC must buy oil futures
The CPC can buy oil futures up to 60 months or so at current futures prices it the organisation perceives that current oil prices are good and unlikely to go down. Then the CPC, the Government and the people of the country could be happy that they do not have to worry if oil prices go up in the World Market.
The CPC can unwind its hedging position if prices start tumbling for any reason.
The CPC cannot find a better time than now to hedge. The CPC moving in to oil futures must engage only in simple hedging. Depending on the market movement it must BUY oil futures. The CPC cannot find a better time to hedge as a buyer or as an agent on behalf of the consuming Sri Lankan public. This will give a tremendous boost to the national economy by saving billions of dollars which could be used for infrastructure development.
Many reasons why the CPC lost on “hedging” in 2008
Readers must be aware that the CPC could not have lost money if it did real hedging. The sudden market collapse in 2008 was not foreseen and the CPC cannot be found fault for not foreseeing the price collapse. The CPC was quite right if they had been BUYING oil futures when oil prices were rising. But one can now ask the question as to why the CPC did not unwind their positions when prices were tumbling and millions of dollars were being lost every day. Had they done that, the losses could have been minimised if not eliminated.
The reason for the CPC’s failure can be deduced from what I learnt from a cable manufacturing company which also lost Rs. 500 million during the same period.
Hedging or so called ‘hedging” was promoted at that time by foreign banks and not by brokers of an exchange. These banks were not promoting simple hedging. They were promoting “Hedging proposals” which were disastrously in favour of the banks and refrained from offering SELL opportunities when prices started falling. Had the banks acted in fairness to the companies engaged in “hedging” the losses could have been minimised.
The hedging opportunity offered to the cable company was structured so that if prices of copper went above a certain level, the company was paid the excess by the bank. This however, was terminated after paying the excess for two months. However, if prices went below a pre agreed level, then the company had to pay the bank as long as the prices remained below the agreed level. Was it hedging according to what we learned above? Did not the proposal violate the principle of hedging or minimising losses? Did the banks willfully mislead and acted unfairly by the company? Why did the banks fail to provide a Reserve hedge when the prices were continuously falling so that the company could have minimised losses? Didn’t the bank behave unfairly and refrained from providing good advice in good faith? Didn’t the banks violate the license given by the Central Bank by going beyond the mandate of hedging and persuading customers to transactions similar to Speculation? These have to be investigated by a set of qualified professionals and if banks had violated the mandate or the licence, should not the Government take appropriate action at least now?
The CPC should appoint a suitable foreign broker to advise it on hedging. But the process must be concluded very fast in order to take advantage of current prices. Since brokering firms are very well regulated in London, it is advisable to select a broker from London.
As I mentioned earlier there are no perfect hedge options available in any market. But hedging through derivatives provide a price stability to both the buyer and the seller of a product if the future. If future price movements are in favour of the buyer then the seller will have the opportunity cost.
Derivatives can be compared to a kitchen knife. It is a weapon that helps in cutting and chopping items on a daily basis. You could use the same knife to stab a person or you could commit suicide by the same knife. It is not the fault of the knife but how you use it. Likewise derivatives can be used for three purposes. Firstly for hedging, secondly for arbitrage and thirdly for speculation. It is important that we should use derivative products as a hedging tool but not for speculation as the CPC did in 2008.