The Economic Coordination Committee (ECC) of the Cabinet is scheduled to discuss proposals for oil hedging, submitted by the Deutsche Bank as the appointed advisor. Given the unprecedented fluctuations in international oil prices that peaked in July 2008 at around 148 dollars per barrel and plummeted to around 41 dollars per barrel in May 2009, the need for oil hedging must be acknowledged by all bulk users of oil including state owned organisations (SOEs), like Pakistan State Oil and Pakistan International Airlines.
Exposure to the risk of exceptional volatility in prices - as has been evident in the price of crude oil for the past year and a quarter - costs rise while profits fall dramatically. Therefore, the need to efficiently manage exposure to fluctuating oil prices is a challenge that needs to be addressed by all, including Pakistan whose oil import bill alone reached 13 billion dollars last year.
Hedging would, it is hoped, stabilise cash flows, reduce cost of capital, secure company objectives and enable the management to measure performance. Thus, there is no question about the urgent need for Pakistan's bulk consumers of oil, including oil refineries, PSO and PIA to, with appropriate government backing, consider undertaking oil hedging. Be that as it may, the government would be well-advised to tread carefully into this arena.
A careful look at what happened in Sri Lanka with respect to oil price hedging would provide some useful benchmarks to our government, already much-maligned for lack of transparency and corruption, about what not to do with respect to oil price hedging. In 2007, the state-owned Ceylon Petroleum Corporation (CPC) entered into contracts with five banks led, by Standard Chartered Bank (SCB), to protect itself against oil price fluctuations.
The agreement allowed oil price to be capped at 130 dollars a barrel and the floor price was set at 100 dollars a barrel. As the oil price went over 135 dollars per barrel, the CPC benefited, as it had sought protection on the upside. However, once prices began falling, crude oil per barrel hit 41 dollars in May 2009, the CPC ended up owing banks up to 1 billion dollars.
In response to petitions alleging fraud and corruption, the Sri Lankan Supreme Court stopped CPC payment to banks temporarily, which had repercussions on Sri Lanka's image as a defaulter. It also suspended the CPC chairman and directed President Rajapaksa to consider replacing the petroleum minister, accused of not properly supervising the CPC on the hedging deals.
Consequently, the Cabinet appointed a risk management committee to review all hedging contracts and minimise the losses but this, so claim its detractors, was shutting the stable door after the horse had bolted. The Federal Ministry of Finance did float a proper RFP to leading banks. And, after a three-step approach, sent its recommendation to the ECC for consideration for appointment of an Advisor.
The ECC needs to assess the need from a budgetary point of view. In 2007-08, the government was caught on the wrong foot in relation to its budgetary assumptions and the international prices of imported crude and POL products. Pakistan needs to keep the structure simple unlike the Sri Lankan structure, which was heavily leveraged. Our POL requirements have to be properly assessed. We import under a long-term contract with suppliers from Middle East on a floating rate.
The advisor is needed to mitigate and address potential upward spike in prices. This requires hedging of future imports in a time and price band. Hedging is like insurance. It has a cost just like an insurance premium. The job of the advising institution on hedging is to provide the expertise to do the job, in the right manner, with the right structure and identify banks willing to compete for the hedge and bring them together with bulk importers-cum-users of oil in a contractual arrangement.
In addition, there is a need to ensure that the process is transparent and for this purpose, the Cabinet must establish a risk management committee now and ensure that none of its members have a conflict of interest that would be possible if they are allowed to wear two hats.