The Sunday Times FT - Oil price fall

Finally, we have seen some relief in the price of oil. Unfortunately, the benefits of this long awaited drop in oil price, has not yet cascaded down to the average consumer who was hit with another price hike in spite of a marginal drop in the global spt market price.

Sure, the recent price drop, has given us reason to be happy. But this marginal drop is certainly no cause for celebration for the reasons given below. More importantly, we must bear in mind the very transient nature of the commodity price. In the recent past we have seen and read many theories being put forward. They range from “peak Oil theory”, “Asian robust economic growth”, to “American interest in the commodity”. The known fact is, Price of oil, is no longer determined by “supply or demand” alone. The basic market matrix has ceased to exist.

External forces drive prices
The price of oil can change in seconds, as we saw during hurricane Kathrina. There was no shortage of the commodity or there was no surge in demand prior to the devastating hurricane Kathrina. Yet, trading immediately following Kathrina took the commodity to record price levels overnight without any rhyme or reason. The unjustified $ 75pb did not reflect Department of Energy (DOE) analysis that usually tracks the energy commodity price based on inventory and demand forecast.

Light at the end of the tunnel
The recent price drop offers us an outstanding opportunity to lock in the price of future procurements. The CPC should now capitalize the opportunity to lock in the price for the next 15 months by introducing linear hedging / strip trading.

Missed opportunities
The CPC has consistently missed on opportunities to lock in lower prices since 2002.
If the CPC had introduced commodity hedging in 2002, today the CPC would have paid under $40 for a barrel of oil providing a great relief to the consumers and saving valuable foreign exchange.

The present high prices are mainly due to lack of proper judgement at a policy making levels.

While high prices in the global market can be one reason it is not the one and the only reason. Prices were gradually increasing since 2002 and proper counter measures should have been implemented at that point in time.

In 2003 empirical data showed that oil imports cost only US$ 600 million. Today, it costs more than US$ 1.5 billon. This is a significant increase. While it adds to our inflation, it also is a major strain on our foreign exchange reserves.

Policy makers should use this opportunity to get the benefit of relatively lower prices by locking in the price of future purchases. Failure to do so will be a costly error and we will see a repeat performance of what we have see in the recent past -- more price increases at the pump.

Price inelasticity
As we have seen in the past one year, even with record price increases the demand for oil has been increasing globally. Oil demand is price inelastic. As long as there are no alternatives to oil as an energy source, oil consumption will be increasing annually.

As the consumption keeps increasing, the price would move in tandem with consumption. Until the price hits a record price of US$ 100pb the barrier point, consumers will be insensitive to small price increases. It is not by choice but simply because they have no alternative. This is a theory bolstered by economists and oil traders.

With a strong likelihood of oil reaching record levels, despite the recent price drop mainly due to good weather conditions, time is right to make the move to lock in a lower price for future procurements.

Conclusion
Hedging is an integral part of all energy trading operations. Introduction of hedging is not optional. Having a customized Hedge model in place is imperative given the market volatility.