Khalid Faizi
OPEC plus spearheads, Saudi and
Russia could not agree to cuts
in oil production. Their spears moving from a decidedly western bent are now pointed toward one another, both sides appear intent on producing as much oil as possible – a scenario of mutually assured destruction. Goldman Sachs envisages under $ 20 Brent in the short term (2Q20) and a scenario where Brent oil prices could average below $ 30 throughout year 20’ with a rise to $ 40-50/ barrels (bbl) next year.
The daily global oil trade volume is around $ 7 billion (100 million bbl x $70) while the over-laid and derivative financial markets operate at a dollar volume of over 12 times to commodity at $ 80-90billion/day.
This shows the depth and strength of the oil derivative markets. The price of oil has fallen to some of lowest levels in since the first Gulf war in 1991. If the price stays at this level and Pakistan does nothing, it can still derive benefit from the Oil/LNG price differentials while the low price prevails. Fossil fuel international markets are erratic and there is risk of further price fluctuation.
Prices are predicted to range $ 25-35/bbl, with an upside of $ 50-70 contingent on a fall in supply due to exit of debt laden US shale producers. So, Pakistan must develop itself to be a more sophisticated player and take full advantage of the hedge, futures, swap and options markets to mitigate oil price risk.
A price risk mitigation and hedging strategy can be tailored to suit Pakistan’s specific requirements and conditions .This would most likely be through a combination of (a) “commodity swap arrangements” that would allow effective long-term price insurance and; (b) “futures contract with call option” to cap any price increase but reap the benefit of any price fall. The initial program would be for 2 years.
The benefit would be approx. $ 4-5 billion/year for oil purchases of 350,000 bbl/day; the approach should be intelligent and practical with a target to achieve saving of $ 4-5 billion per annum over 2 years.
Regulatory misconceptions need overcoming and hurdles which include apparent restriction on hedging by SBP must be quashed. The perceived risk of accountability due to loss making resulting from a failed hedging should be resolved. A sensible and thought out strategy executed in the normal course of business can minimize the risk.
The Government should promptly advertise and appoint a top International bank as financial advisor to structure and lead the hedging strategy; the World Bank and/or IMF would back such a programme and if required their technical assistance and support can be sought. The process can be cut short to directly solicit proposals which would be evaluated and ranked before award.
This should all be completed in 30 days. The windfall achieved should be utilised to pass benefit to the public in terms of lower prices at the pump, some can also be used to address ailments of the energy sector including the burgeoning circular debt which has the potential to bring the whole energy sector down. All this is in the public interest and will drive down prices.
In 2008 PIA hedged 425,000 bbls of oil at $ 120/bbl ($ 51 million trade) in a rising oil market. Unfortunately, the price of oil fell to $ 60/bbl, PIA was then forced to execute the contractual agreement at $ 120/bbl. Price predictions at the time were forecasting $ 300 to $ 400/bbl and error in judgement was attributed to political instability in places like Iraq and Venezuela. However, there is a major difference in hedging at peak prices and hedging at rock bottom prices, now, a much safer bet.
Pakistan’s price hedging is through long-term contracts such as 15-year Brent linked LNG import from Qatar. With Brent at $ 70 LNG was at $ 9.0/MMBtu while now with Brent at $ 35/bbl; LNG has fallen to around under $ 5/MMBtu; with a potential saving of over $ 4 per MMBtu. Amid Coronavirus, slack demand and higher than expected temperatures; the LNG spot price for February 2020 delivery is still lower at $ 2.5 per MMBtu; for March 2020 delivery around $ 2.7 per MMBtu and for April delivery $ 2.8/MMBtu; the rent linked LNG contract price paid by Pakistan, having fallen after Brent crash is still some 50%-70% higher than the prevailing LNG spot prices. Hedging is a sophisticated art and cannot be left to the novices.
However, hedging today at the low price around $ 30-35 is a no brainer and one does not need much intelligence to understand that it should be immediately done. Price risk mitigation can be achieved from one or a combination of the following methods: Crude oil futures: The profit on a futures contract in a rising market will offset the higher import price, while in a falling market the lower import price will offset the loss on the futures contract. Thus, the holder of a futures contract is assured his selected price level.
Crude oil futures contract and options: Hedging with options provides protection against upward price movements while still allowing the buyer to gain from a price fall secured through payment of an options premium.
Commodity swap arrangements: swaps are long-term price insurance arrangements without physical delivery arranged through commercial banks, involving a multi-year commodity swap arrangement whereby the buyer conducts spot purchases and is either compensated or pays the difference between the contracted price and the spot price.
The bank covers its position through futures transactions and makes a return through cash flows allowing it to make a return for bearing the credit risk. There is some confusion in Pakistan because it is claimed that SBP does not allow hedging of oil imports.
But most of all, we think that the hesitation is driven by “fear”- fear of the unknown because of lack of sophistication and experience and the fear “what if the bet goes wrong?”
A senior officer of PSO said “No one is going to stick his neck out for this. It’s almost impossible to predict oil prices even in the near future. And when the price drops below hedged value, there will be a loss. Someone would be made to pay for that,” So because of uncertainty and confusion Pakistan continues to bleed and no one wants to take the right decisions for the country.
Pakistan has a demand of about 350,000 bbls/day of crude and petroleum products. This has fallen from 475,000 bbl mainly due to sharp drop in furnace oil (FO) import and lower than usual HSD demand. Cost of $ 9 billion will fall to $ 4.5 billion giving a saving of $ 4.5 billion per annum, i.e. $ 9 billion over 2 years, will Pakistan be able to lock in this saving or will it slip away? Oil price risk markets seem a highly feasible solution, at least theoretically. The principle is quite simple.
The governments could either lock in the price of their future consumption now or insure against large oil price moves, or both. Total world oil consumption is around 100 million bbls per day and Pakistan consumes about 350,000 bbls per day; some 0.35 % of world consumption. It appears that those who generally have the most to gain, or lose, from hedging are not hedging. The answer could be to transfer this risk outside the country to those better able to bear it.
– (The writer is an energy expert and is engaged in consultancy in power sector for over 25 years.)
