A committee of experts analysing the recent oil hedging debacle says in its report that the zero collar hedge, recommended by the Central Bank (CB) has been adopted recklessly by the Ceylon Petroleum Corporation (CPC), not understanding the limitations and not including safeguards to protect the CPC's interests.
Here are extracts of the report that was compiled and edited by Mr.Daham Wimalasena :
The CPC signed eight hedging transaction contracts, totalling 14,160,000 barrels of oil, covering 12 calendar months with Standard Chartered Bank (SCB), CitiBank, Deutsche Bank, People’s Bank and Commercial Bank. The traded cost of oil on transaction dates are estimated at over $2,000 million. The transactions have exposed the CPC to financial obligations that could range from a low of $700 million to as high as $1,000 million if the decline of crude oil prices to $25 per barrel were to occur as now projected by Merrill Lynch Energy Research.
The group examined the steps and processes leading to the potential debacles and likely remedies.
Rising prices
In September 2006, faced with the rapidly increasing price of crude oil and petroleum products, the Governor of the Central Bank (CB) made a presentation to the Cabinet of Ministers to identify strategies to 'Maintain Stability in a Volatile Global Oil Market.' Oil-costs hedging instruments were proposed. Commodities hedging is a useful tool in the commodities trade but should be engaged in with great caution.
On 13th January 2007, the Minister submitted a Cabinet paper requesting approval for the following:
- CPC to hedge purchase of petroleum products both crude oil and products in the international market.
- Use zero-cost collar as the hedging instrument with the upper bound based on market developments (the floor prices are set by the Banks-please see definition of floor price below)
- Commence hedging with smaller quantities and gradually increase the quantity and duration.
- Grant authority to the CPC to call for quotations for oil hedging, decide on future prices and purchase hedging instruments from reputed banks based on market developments.
- Grant authority to the CPC to change instruments based on the developments in the market.
The Cabinet approved the Ministers request on January 24th 2007. The Minister and CPC Chairman thereupon arrogated the procurement of hedges and circumvented established procedures on the basis of authority granted to the CPC to call for quotations for oil hedging, decide on future prices and purchase hedging instruments from reputed banks based on market developments.
Strategy
The option recommended by the CB was to adopt a strategy referred to as a "Zero-Cost Collar" hedge. Under this strategy the CPC would set a maximum price and if the market price were to exceed this ceiling, the Banks would pay the difference in price multiplied by the quantities hedged.
With regard to the lower limit, the Banks would set the price, referred to as the floor price and if prices were to fall below the floor price the CPC would pay the difference in prices multiplied by the quantities hedge to the Banks.
There is no crystal ball to set either price but this is generally based on knowledge of global conditions such as economic, political and petroleum supply and demand.
There is much uncertainty in the oil markets due to ongoing wars in Iraq and Afghanistan and political tensions in the Middle East. The CB suggested the zero collar hedging but the details were left to the CPC to develop.
Under normal and required procedures the CPC, since it did not have the necessary expertise, should have engaged consultants to develop the terms of reference and establish the ceiling and floor prices and review contracts.
The CPC Chairman apparently decided this was not necessary and he and the Deputy General Manager (Finance) trained themselves as 'experts' by attending seminars and meetings with representatives of the very banks who were potential sellers of hedge instruments and claimed that he and his DGM have become the foremost experts in the company on hedging instruments.
Upper limit
The CPC Chairman set the upper price limit. The Banks stipulated the maximum dollar risk they would bear and also specified a contract life time limit of three months if events were not to favour the banks' position. The Banks set the floor price and other conditions also specified that the quantities hedged would double if it is in their favour without a dollar limit.
The contract periods in all transactions were 12 months. The potential loss on current prices because of the structuring of contracts is over $1,000 million based on December 5, 2008 prices. None of the risks was explained to the Cabinet, the CPC Board or any other party or approved by the Cabinet. The CATB (Cabinet Appointed Tender Board) was totally ignored.
Mandatory Procurement Procedures
The authority granted by the Cabinet was to the CPC and not to the CPC Chairman. The CPC is required to follow cabinet approved procedures for procurement of crude oils and products for which purposes a permanent CATB which comprises the Deputy Secretary to the Treasury, Secretary Petroleum and an Assistant Governor of the Central Bank, is established to be convened when required. The CATB also has to consult the TEC (Technical Evaluation Committee) before making a decision after which the decision is sent to the Cabinet for approval.
The CPC Chairman dispensed with these procedures relying on the Cabinet decision wherein the CPC was authorized to negotiate hedging contracts. The mistake here was that the Chairman's apparent interpretation that CPC is synonymous with Chairman and the authority was granted to him. In the light of the procedures described in the preceding paragraph, how could the CPC Chairman who is not even a member of the CATB, undertake hedging instrument purchases on crude oil and gas oil which are enormously higher in value and riskier than those considered by the relevant CATB without the final approval of the Minister and the Cabinet? The Minister had no authority to do so and also did not seek Cabinet approval of the terms negotiated by the CPC Chairman outside accepted purchase procedures.
It would appear that the exposure now faced by the CPC is a result of lack of experience and knowledge on the part of the Chairman and the Chairman identifying himself as the CPC. Decisions were taken by the Chairman unilaterally, presumably with the blessings of the Minister, who has defended every action of the Chairman. The Minister and Chairman have hence to bear sole responsibility for the hedging debacle and not shift the blame for recommendations to hedge to either the Cabinet or the Central Bank. It is not hedging that is at fault but what was in the hedging contracts – the terms and conditions. The Chairman entered into eight contracts unilaterally, without the approval of the Cabinet, the CPC Board and the Attorney General.
CATB/TEC
The Chairman is not synonymous with the CPC. The CPC could make decisions as listed in cabinet resolution but the decisions have to be consistent with CPC procedures and limits of financial responsibility vested in the corporation and hence should have followed established procurement procedures, which the Chairman did not. As far as the Chairman was concerned it appeared that the CATB and the TEC did not exist.
The permanent CATB is to procure crude oil and products and the TEC is to provide transparency and the necessary checks and balances to safeguard the public interest. The hedging instruments ultimately totaled 14.16 million barrels of oil with an intrinsic value between $1,500 million and $2,000 million. How could the Chairman have unilaterally signed contracts aggregating over $1,500 million? The transactions should have been processed through the CATB and the TEC.
The CPC team worked directly with the Minister of Petroleum and the Banks, made decisions without informing the CATB and did not obtain Cabinet approval. The Minister became a one-man Cabinet. As pointed out by the Chief Justice, there was no supervision by the Minister of the activities of the CPC Chairman. Belatedly, when the hedging debacles made headlines on November 18th 2008, eleven months after the purposed approval in principle by the Cabinet of the hedging concept proposal, the Minister of Petroleum submitted a memorandum seeking approval for the appointment of a Hedging Risk Management Committee – please note that eight hedging contracts with five banks had by this time been signed between April 2008 and completed November 2008.
Costly mistake
Not working with the CATB and the TEC was a costly mistake both in financial terms and propriety. It is a well known fact that hedge funds compensate their managers based on performance. Bonuses on large transactions run to millions of dollars. On the CPC transactions, if the Banks were to prevail and the CPC has to pay, bonuses to hedge fund managers could range from $50 million to $100 million or more depending on the quantities to which the CPC has foolishly committed and market prices. Fund Managers are known to wine and dine their clients. Spreading part of their bonuses around also is not uncommon. Considerations such as these should have weighed heavily for the protection of the officials, the CPC, the Minister and the transactions' integrity. The Minister should have followed accepted procedures and directed the Chairman to work with the CATB.
In summary the financial claims facing the CPC result primarily from the following reasons:
- Circumventing the CATB and the TEC
- Unrealistic Floor Prices in Hedging Contracts that safeguarded and enhanced the profits to the Banks.
- The total lack of appreciation of market developments by the CPC team and the Minister who acted as a one-man Cabinet.
- Understanding the nature of oil markets and that oil is one of the most volatile of any commodity.
- Signing relatively long term contracts for a highly volatile commodity –oil. Lack of an affordable exit strategy.
- Approval for hedging was given primarily for the purpose of 'Maintaining - - Stability in a Volatile Global Oil Market' as explained by the CB. Volatility is measured by how rapidly crude oil and product prices change.
In order to monitor volatility and take preventive action the following precautions should have been taken:
-Contracts should have been short term, not more than 3 months and certainly not 12 months for a product that is the most volatile of all commodities.
-Developments in the oil markets globally and price perturbations should have been continuously and rigorously monitored – not even the CPC Commercial Manager was consulted.
Lessons to be learnt:
The CPC appears to have over the past three years systematically dismantled established procurement procedures, judging from the several instances of malpractices that have been reported in the media. The hedging disasters have exposed the deft circumventing of procedures that may never have been revealed if not for media vigilance. There are two other reported cases of likely improper procurement already committed or in the process of being hatched. These are rumoured to be a proposed refinery project and a bunkering deal.
With a vigilant press misdeeds cannot be supported for too long. In the interest of the President’s good name and for the country's sake, a major cleansing of the CPC may be needed from the top down.
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