Financial Times

Crude oil prices reaching US $ 75.90 p/b and US $ 90.00pb are on the horizon. We have seen many theories been discussed to address the rising energy prices one more time.

Solutions range from “policy changes” to introducing “technical changes”.

One end of the spectrum is the introduction of a “car pooling” program to curtail the consumption of fuel. On the other end of the spectrum is the use of alternative energy: Introduction of fuel cells, and renewable energy. On paper they all look excellent solutions to address record energy price levels. A closer look reveals that from a Sri Lankan perspective, none of the above is feasible on the short term.

We all know the time sensitive nature of the problem. Problems need to be solved immediately. Doing nothing about the problem in the hope of a self-corrective mechanism is not an option.

Creating an awareness of the concept of car-pooling is a formidable task. Not many will support such an initiative given practical problems they will potentially face in Sri Lanka. In other countries the concept of car-pooling has been a success.

Whether we can achieve the same success rate in Sri Lanka is yet to be determined. Even in the event it is going to be a success; it will be on a long-term basis. Bringing about a shift in technology is a capital-intensive proposition. While fuel cells are a viable alternative, it will be a few years before we can actively get into fuel cell technology programme.

Sri Lanka as an agricultural based economy should actively look into the possibility of developing the use of Ethanol as an alternative energy source. This too is a long-term proposition.

Alternatively, we may increase the retail prices to reflect the spot market prices and pass on the price increases to the consumer. As well, the retail prices can be subsidized using the tax revenue to mitigate the record oil prices. Higher energy prices will contribute to higher inflation. Higher inflation will put pressure on higher interest rates. The vicious cycle will continue.

When the government is focussed on reducing the cost of living, and encouraging investments, further increases in the fuel prices to reflect the spot market prices only runs counter to the government’s initiatives to reduce cost of living and stimulate further investments.

Given the limitations we have to work with, introduction of a commodity price risk management program referred to, as hedging is the prudent and practical approach to the high-energy prices in Sri Lanka. Buying at the spot market price with no price stabilization mechanism is a very primitive process.

Hedging has become an integral part of all energy trading operations. Concept of energy hedging is relatively new. Given the increased volatility in crude oil, NYMEX introduced the first crude oil Futures contract in 1974.

South Western Airways Jet fuel hedging program is a success story. SWA has successfully hedged 85% fuel requirements up to 2007 at a capped rate of US $ 35pb.

The objective of hedging is to avoid major financial losses caused by a volatile spot market. Hedging is a mechanism that insulates the buyers and sellers of assets and liabilities from adverse price movements in a volatile spot market.

Derivative instrument facilitates the hedging process. There are two main types of Derivatives. Exchange traded and Over the Counter traded Derivatives. Exchange traded Derivatives are Futures and Options. OTC Derivatives are SWAPS.

Exchange traded Derivatives are standardized trades providing transparency and guarantee the performance of the trades.

OTC Derivatives are customized trades that are tailored to meet specific needs of the parties to the trades. Essentially, hedging is similar to an auto insurance policy. One buys protection paying a premium to the insurance provider. As long as the policyholder does not get into an accident situation, the premium payment is seen as an expense. However, in the event of an accident the insurance policy will protect you. Premium payment is therefore not an expense.

The premium payment must be seen as a loss of profit or a capitalized expense. By the same token, hedging will protect the buyer of a commodity from price increases.

The protection seeker will pay a premium to the hedge provider to buy the underlying commodity at a pre-determined price (Capped price) in the future. If the price of the underlying product is higher than the capped price, the hedge provider will pay the variance (market price - capped price) to the counter part.

(The writer could be contacted on -- uarunajith@can.rogers.com)