Whilst few predicted oil prices crashing or would dispute that hedging is necessary, it is the structure of the hedge entered into between CPC and the Banks that is at issue, according to hedge analysts.
Under a typical Zero-Cost Collar hedge, the importer sets the maximum price for oil, the High Collar. In response, the bank sets the floor price, the Low Collar. If the market price is above the high collar price, the Bank will pay the difference between the high collar price and the market price to the importer. If the market price is below the low collar price, the importer will pay the difference between the low collar price and the market price to the Bank. In this case no premium is involved.
The CPC decided around May 2008 to hedge for 12 months, after completing a few shorter- term hedges. A long one-year hedge is risky with volatile oil prices, inflated by speculators. Here is a typical hedge structure CPC entered into:
1. The High Collar or maximum price was set at $145 and the Low Collar or minimum price at $130. If prices ranged between these levels, neither party paid.
2. If prices are above the High Collar level $145/barrel, CPC is paid by the bank with a maximum payment of only $1.5 million per month for a total of two months only [maximum payout $3 million] and the transaction gets automatically cancelled [knocked off]. This protects the banks from large payouts. So the maximum ‘profit’ CPC can make is US$ 3 million for the contract.
3. If prices drop below the Low Collar $130, CPC has to pay the full difference between $130 and the actual price of oil (in this case $48) for double the quantity i.e 100,000 barrels x 2 = 200,000 barrels for the entire remaining duration of the contract (no auto cancellation like when prices go up). So, analysts say, the benefits are asymmetrical – limited, low risk for bank and high, unlimited risk for CPC.
Under this arrangement, total payments by banks to CPC since hedging started in 2007 was over $23 million. Then prices started falling. CPC has since paid almost $40 million to the banks. For October 2008 alone $27 million was paid. The payment for November is estimated at $45 million. For the duration of the current hedge with Standard Chartered Bank and others to May 2009, total payments could be as much as $400 million among all banks.
If global energy prices continue their downward spiral, the CPC hedging loss payments would increase even further. “If prices drop to levels that were seen a decade ago we will end up paying more for the hedge gone wrong than the actual oil,” one analyst said. |
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