Saturday, September 25, 2010

Hedging- A Necessary Tool For Developing CountriesTo Stabilize Oil Prices

Developing countries like the Philippines have been hit hard by surging oil prices since the 70's and have hardly recovered from the successive oil price shocks since then. The most recent steep rise of crude oil prices forebodes of another similar scenario comparable to the 70's and the 80's.The Business Monitor International in its report entitled 'Philippine Oil and Gas Report Q4 2010' predicted a 2010 OPEC basket oil price level of US$83.00/bbl. It currently stands at US$73.00/bbl! If nothing is done to cushion the effect of the expected future oil price surges, this will definitely bring down the developing countries to their knees!
Richard Alcantara, Basic Author
So, what can done to avert such risks? These countries are so dependent on imported oil to keep their economies going. Through various ways and means, the governments of these developing countries tried to cushion the effects of the crude oil price surges in the past by legislating measures and/or imposing new taxes - in the end, ultimately passing the buck to their citizens. But, how much of these price increases can they take before they rise up in revolt!

It is amazing how the money managers and policy makers of these governments can craft stupid policies that are meant to protect the interests of and the continued existence of the big oil companies in their countries while at the same time passing the cost of the oil price increases to the consumers.
Take the Philippine experience as a case in point. When OPEC discarded the uniform pricing scheme for their oil products after the Iran revolution in the 70's which resulted in varying steep price surges, then Dictator Marcos concocted the Consumer Price Equalization Fund which was actually a levy incorporated into the price of every liter of petroleum product! The CPEF was meant to compensate the oil companies who source their imports from countries selling it at higher prices. After Marcos, the new government re-named the fund as Oil Products Stabilization fund. ( The same banana under a different name!) Like its predecessor, the OPSF was used, this time, to compensate the oil companies for losses incurred not because of oil price hikes ( the oil prices have slumped tremendously by then!)...but by sharp currency exchange fluctuations and purported inventory losses resulting from the sharp drop in oil prices. The OPSF have since been discarded and in its place came a new oil deregulation law. The new oil deregulation law allowed the oil companies to arbitrarily raise or cut down the prices of petroleum products according to prevailing international oil price benchmark. This new law was met with stiff condemnation from many quarters as it in effect gives the oil companies a free hand in pricing their products. What is more, the new law, just the same, passed on the burden of price increases to the consumers.
What many failed to notice and take advantage of (at that time when everyone else is reeling from the successive blows of sharp price increases on the 70's) was the fact that the runaway price hikes triggered the move to include crude oil as one of the commodities to be traded in the New York Mercantile Exchange in 1978. With oil futures now being traded at NYMEX, hedging the risks related to importing the product became possible!
(Sad to note though that even up to this time, very few have realized the value of hedging risks using the commodity futures exchange!)

Let us review the risks involved in importing crude oil and how crude oil futures can effectively minimize (if not totally eliminate these risks).
Normally, oil importers would place their orders 30 to 120 days prior to the desired delivery date. However, the contract price ill be based on the prevailing spot prices at the time the bill of lading is done (which is immediately prior to loading pf the goods on a carrier). Between these times, (e.g. from the time the order was placed to the time just prior to shipment) the spot prices may fluctuate in either direction significantly. Please note that if the spot prices of his import goes up prior to shipment, the importer will end up paying much higher price.He, therefore may lose money if he sells the imported goods at the original price (specially if he has made commitments at price)! With no other way of recovering the variance in price, the importer then passes the price difference to the consumers by way of a price increase! However, he risks getting the ire of his clientele and even lose them altogether should they find other cheaper sources of the goods. This is a risk inherent with all kinds of importation!
The risk of losing money due to sudden price increases by buying crude oil futures contract in a commodity futures exchange that trades the commodity (like NYMEX). The futures contract must be in the same quantity and/or of the same monetary value as the planned imports! The futures contract must be bought at the time the import orders are placed with the supplier. This is to make sure that the price of the futures contract is reflective of the spot prices at that time. The importer will hold on to the futures contract until the shipment of the imported goods commence. (At which time these are then liquidated!)
This practice is known as hedging. Consider it as a form of insurance to cover the cost of your losses in case the prices shoots up!  What happens here is when the spot prices of oil go up, the prices of the futures contracts would also relatively go up with it (specially the front contract months). And when the prices of your futures contract go up, you make money on it . Whatever it is you will potentially lose if the price of your imports go up will gained back through your profits in the futures market!
Inversely, if, instead, the spot prices goes on a slump , then the futures contract will be losing money. But this time,whatever losses the futures contract will entail is gained back through savings realized from the now cheaper imports.

To illustrate this, see the table below:

Crude Oil Price@ Order Placement
Final Price @ DeliveryYour Losses / bblYour Losses @ 100,000 bbl
Crude Oil Futures @ Order PlacementCrude Oil Futures @ LiquidationYour Profit / bblYour Profit @100,000 bbl

Of course, these are all on the assumption that the crude oil futures prices rise or fall in tandem with prices in the spot market. As per my own experience, there usually is a variance between spot and future prices. With the front and nearby futures contract which are more reflective of the spot prices, the differences are negligible. The  more distant contract months may reflect a different price direction since they show the perceived future prices of the commodity as gleaned by traders. These may be higher or lower than the front months depending on the prevailing  market outlook of those trading those months.

Hedging is a financial risk management tool that is simple and forthright implement. By it, you locked up the prices to that prevailing at the time the futures contract was executed.  From then on, where ever the prices go(up or down), it won't matter at all. Hedging the risks inherent with crude oil importations via buying into its equivalent futures contract is the most effective and the most efficient form of risk management. Besides, it doesn't cost much to buy into the futures contract since they only require minimal margin requirements (usually, a small percentage of the actual market value of the contracts).

For a government to implement such a risk management strategy would require policy changes. For one, to be effective, the government must have complete control over all imports (i.e. all oil imports must be coursed through it or through any of its agencies. Second, the hedging strategy must have both a short term objective (to cover the immediate purchases for the next 1 to 3 months) and a long term objective( to ride a bull trend and cover the risks for as long as the trend holds).

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