.Oil prices have touched zero and became even negative recently. A debate has ensued in Pakistan that we should have bought cheaper oil. It is a different matter that around the same time, there was news of diesel shortages. Petroleum Division, probably,
.Oil prices have touched zero and became even negative recently. A debate has ensued in Pakistan that we should have bought cheaper oil. It is a different matter that around the same time, there was news of diesel shortages. Petroleum Division, probably, projected lesser demand due to corona as it is we are always short of liquidity and foreign exchange and even storage. Buying more is not in our psyche or system. It was a unique situation. Prices do vary and there is a scope for saving money in buying or reducing price losses. After touching the lowest, the general perception is that prices would increase. Now, there are proposals for hedging crude oil, gasoline and diesel, etc. Assuming that it would be a safer bet as the general perception is of higher prices. We would like to make the reader understand as to what is involved in hedging and do not mean to support or oppose the hedging proposals that are circulating.
In recent history, oil prices peaked in the year 2008 at USD 145 per barrel and a low in the same year at USD 30. Subsequently, oil prices were higher than USD 100 in the years 2011, 2012, 2013 and 2014 when oil prices were respectively USD 113, 109, 111 and 108, while the lows in the same years respectively were relatively high, at USD 75, 78, 87 and 53, respectively. In the current year 2020, high was at 63.27 USD and the low was as low as negative prices. Pakistan oil imports around 2008 and onwards were of the tune of 20 billion USD as opposed to 12 billion USD average these days despite increase in the import volume.
Therefore, hedging is normal in oil both by the buyers and sellers and not in just oil but in other commodities as well. In the oil business, there is two-side hedging. Oil refineries hedge for crude oil and as well as finished products like gasoline and diesel, for both raw material and finished products prices may change and sometimes in the opposite directions due to inventory and other reasons. Thus raw material crude oil may become expensive and finished products gasoline and diesel may become cheap. In an extreme case, the price difference between raw material and finished products may become zero or less than the cost of production. Oil refineries, therefore, hedge on both sides for which a hedging product is available, called Crack. For example, in some exchanges in the US, gasoline crack spread for May 2020 has been quoted as 11.93 USD/barrel. For December 2020, it has been quoted at 4.98 USD only.
Airlines usually hedge jet fuel. This quarter, they could not have hedged, for example,10 USD or lower. Most hedged at 60 USD. The highest oil price within the year 2020 was 63.27 USD. Most successful airlines are in a bankruptcy situation looking for government bailout. There are two reasons: lack of business and hedging losses. Air France-KLM group is facing a hedging loss of more than 1 billion USD of hedging loss. Another smart airline, Singapore's SAL, suffered a hedge price loss of 198 million SD (Singapore dollars). There was additional loss due to lesser consumption than hedging contract amounting to S$ 710. Other airlines have similar stories to tell. So in hedging, one can lose and profit, although it was an extraordinary situation. Usually, hedging losses are manageable and enable avoiding catastrophic or unaffordable losses. In our case, for example, oil prices above USD 100 would be quite damaging, although we have borne such atrocious prices in the past.
Hedging is reducing the risk of loss and not making money. It is a risk management tool by which buyer and seller want to lock a price at which they would like to buy or sell at a future date. Buyer may buy a hedging instrument at lower prices but the prices become higher than his hedged price, in that case the buyer makes a profit and seller loses and vice versa. In case prices are lower than hedged price, buyer loses and seller earns a profit. In this particular situation which prevailed recently, both buyers and sellers lost. The price was below cost of production and even cost of storage, sellers lost. Nobody could have projected this kind of situation. Buyers who hedged lost money, but the buyers who did not hedge and had storage profited from the situation.
One would like to suggest that we examine other strategies like Forward and Swap with some of the Middle East oil countries and their nominated companies. We already have a diesel supply contract with Kuwait Petroleum but it is based on market prices without involving risk management. It may be explored with them on agreeing to some risk management arrangement. Reportedly, the UAE's ADNOC has started using risk management tools. Exchange-based contracts are more transparent and bilateral deals can be controversial, although may be cheaper.LNG contract with Qatar would not be a good example. All kinds of political controversies may develop, in case of losses as compared to spot prices.
All options would have to be examined. Such decisions cannot be based on generalities but would have to be based on concreted proposals which would have to be compared in terms of price-risk combinations and the costs and commissions.
In our case, there is no price risk to oil businesses, be it oil refineries or OMCs; it is a cost-plus regime here. Costs are passed on to the consumer and the government. However, finished products' prices are passed on with 5-7.5% taxes, apparently, there is no cover or protection against crude oil price fluctuations. However, time horizon is of 15 days, which reduces the risks. However, GoP budget and current account deficit may be affected by large variations in oil prices as has happened earlier. Also, people's standards of living and end-user business sectors are affected.
There are other policy issues related to passing on the cost, benefit and risk. There are three parties; consumer, government and the company (in this case PSO). OMCs may not need it as their parent offices should already be doing it irrespective of government of Pakistan's policy. However, oil refineries' issues appear to be open or PSO would be handling their trade as well. The beneficiary has to be the one who pays and assumes risks and gives guarantees. In this case, it appears to be the spread among the company, government and consumers. A clear delineation of shares of cost and benefit may have to be developed.
Hedging is useful but highly complicated issue and has quite a potential for political controversy. Transparency requires neutral and preferably non-commercial institutional advice. The World Bank has recently assisted Tunisia (and earlier Uruguay) which is an oil importer and has similar problems as Pakistan has. The World Bank helped build technical and managerial capacity in risk management and also helped develop risk management strategy. A competitive process was used to select the minimum price offers. Hedging is new for Pakistan. The local know-how is limited and is not institutionalized. We should do the same and involve the World Bank on the same lines. Doing otherwise may prove to be controversial and less cost-effective.
(The writer is former Member Energy, Planning Commission)