State Bank blocks one-year ''''oil price hedging plan''''

State Bank of Pakistan (SBP) has reportedly blocked one-year "oil price hedging plan" tailored by the Deutsche Bank on the request of Finance Ministry, suggesting that the protection level should be in line with the budgetary constraints, official sources told Business Recorder.
"Currently the price of oil is already in the range of $65-70 per barrel. Any hedging structure which seeks protection at the prevailing price levels is likely to be very expensive. Our recommendation is that the protection level given in the proposal should be increased to an extent given the budgetary constraints," said, Muhammad Ali Malik, a Director in the SBP, in his comments on the proposal of the Finance Ministry.
Given the background of this "unfeasible" plan, Finance Ministry stated that the rapid increase in the price of oil during 2007-08 exerted severe pressure on Pakistan''''s external account with current account deficit rising to $13.7 billion equivalent to 8.2 percent of GDP in FY 2007-08.
However, in wake of the global economic recession and fall in demand, the oil prices witnessed a rapid decline in the later half of 2008. Since then oil prices have shown a fluctuating trend with the general market perception that prices are likely to rise in the later half of 2009 or early 2010. The current crude oil price level corroborates this perception.
Given the fact that increase in crude oil and POL products prices tend to escalate Pakistan''''s import bill, Finance Ministry said that it is considered advice to hedge against the likely increase in the prices of crude oil and POL products.
Accordingly, the major international banks and financial institutions, ie BNP Paribas, Citibank, Goldman Sachs/ BMA Capital, J.P. Morgan, Merrill Lynch/ KASB, Standard Chartered Bank and Deutsche Bank were requested to make presentations to the Ministry of Finance on the oil hedging solutions. There was a consensus amongst these banks that in view of the likely upward movement of oil prices, Pakistan should formulate an appropriate oil hedging strategy as early as possible.
An analysis of the presentations and evaluation of indicative term sheets submitted by the above referred banks reveals the following two major hedging solutions:
Call Option/ Cap Structure: The call option structure offers protection from oil prices rising above an agreed threshold in exchange for payment of a premium per barrel. By purchasing a cap, the government ensures protection if market price of oil moves above the specified cap. On the other hand, if the price of oil falls below the cap price, the government enjoys the full benefit of this downward movement by paying the lower market determined price.
Collar Structure: The government buys a ceiling (call option) and sells a floor (put option). The call strike serves as an upper limit of the collar, beyond which the government is fully protected against increase in price. The put strike is the lower limit of the collar. Even though the collar structure entails no payment of premium, there is an implicit cost in the shape of the government not benefiting from downward price movements (below put strike).
It may be noted that hedging always bears a cost regardless of structure. There is a trade-off between up-front cost and downside risk. Structures with no up-front cost pose significant downside risk, whereas structures that limit downside risk have an associated premium.
According to the Finance Ministry, the proposal would be managed by a hedging committee set up in the Finance Division with the underlying transactions of any of the refineries or PSO taken as a benchmark. The government would bear the costs, if any, and receive the gains, if any. The functions or the operations of the company providing the underlying transaction would not be affected in any way.
Given the above backdrop, approval of the ECC is solicited to the following proposals: (i) Ministry of Finance may be authorised to finalise hedging solutions on priority;(ii) Ministry of Petroleum may be directed to extend the requisite support in this regard;(iii) The size of the hedge may be approximately 30 percent of crude oil/ petroleum products;(iv) The protection level may be in the range of $65-70 per barrel;(v) Initially, the tenure of the hedging may be one year;(vi) the structure of the hedging may not be limited to one. Keeping in view the market conditions, a combination of cap and collar strategies can be used.
When the summary came under consideration in the ECC on August 18, it was explained that Deutsche Bank had been hired as consultant, in pursuance of ECC decision of June 15, 2009, to develop proposal and strategy for oil price hedging.
In their presentation, the consultant explained the concept of energy hedging in the prevailing global scenario and its relevance for Pakistan. Different hedge instruments relating to market dynamics were also presented. Scope of the consultant''''s job was also put up. Queries regarding oil price forecast, transportation of hedging and the extent of volatility were responded to.
It was noted that oil price hedging for Pakistan would neutralise risks and protect budgetary assumptions from volatility.
It was underlined that the consultants should not suffer from conflict of interest and should not be doing hedging for Pakistan. The sources said some of the ECC members also desired that ECC should be presented with more than one proposal so that selection of consultants on competitive basis could be made.