On June25, 2006, The Sunday Times FT ran an article headlined “Lankan offers to stabilize oil prices,” wherein a consultant stated that oil could have been capped around $40.00 /barrel compared to $ 70-72 /barrel , reigning at the time of the article, by using a combination of derivatives such as hedging, swaps and futures options. However through sheer curiosity I wrote a letter , which was published on 9th July 2006 , explaining inter alia -that the consultant’s proposals were “ irrational & misleading’ as option- contracts have a” time –period” and “premium factor” thus could not be “capped’ indefinitely. Also the proposal doesn’t convey the associated “ risk factors” the government would have been exposed to , had the oil prices dwindled or remained around the $ 40 mark
On Nov 9, 2008 The Sunday Times exposed the current status of CPC oil-hedging contracts with foreign banks in Sri Lanka. The banks claim that CPC was made aware fully of the risk factors which imply that the CPC had knowledge that it would lose millions of dollars (at least $300 million in this case) if oil touched around $70 per barrel, which was prevailing 18 months ago. Hence, did the CPC concept paper disclose this risk-exposure of the government, in the event oil prices reverted to $70/barrel or so, that prevailed few months ago, which was a high probability?
|All smiles. The other petitioners.
We are living in an information –age and if you link to Google-Web Browser, you would encounter numerous authoritative articles, confirming that nearly 60% of oil traded was speculator driven. Anybody could speculate on 1000 barrels valued at $67000 by merely depositing $ 3375, (20%) either on a “call option or put option” and thereafter, if the price fluctuates on the opposite direction, up to a maximum of 20% , the position would get automatically triggered, limiting the loss to $ 3375, with no “collaterals“ to fall back. In this gambling plan, the balance 80% is leveraged-funds, furnished by “Hugh-Speculator Funds & Investment Banks” which commands trillions of dollars, and who are the ultimate beneficiaries. As the bookmakers never go bankrupt, even the combined -colossal sovereign –wealth funds of OPEC would not be able to intervene, once the volatility is set in motion. OPEC‘s only option is to curtail production, anticipating that the price would prop-up through fundamentals of Supply/Demand, although it is a forlorn hope in the foreseeable future.
With nations taken as hostage by these speculators the regulatory authorities have lobbied to increase the “down- payment on oil futures contract” , to 50 % or so instead of 20%, as this would mitigate the wild volatility, by restricting players to genuine buyers, which would be immensely beneficial to global trade and domestic monetary equilibrium of countries.
It should be emphasized that there is no “ fool proof technique” of profiting from hedging or option trading, no matter what exotic jargon consultants/brokers may use such as zero cost collar hedging strategy, etc. Above all, to claim to be an expert in hedging – is blissful ignorance – particularly in a field even the mighty pension-funds and hedge funds had gone bust. In hindsight, we have a case where the captain of the Titanic blames the iceberg .
A good example is how Bank of Ceylon deals with its customers when negotiating a L/C particularly denominated in yen. With constant volatility of the yen, the bank would instantly ‘cover’ its position and pass the best “spot-rate “ to the client ensuring transparency and customer satisfaction. This is because the rules and regulations, (tested over a long period of time) are well defined and clearly in place, so that the dealers know their responsibilities towards the client as well as the bank, preventing any exposure to losses, consequent to volatility.
As a case study, the Port Authority has nearly $1 billion development loans from the Japanese government where the principle and interest are payable annually upto year 2035. It is common knowledge that the Yen had moved from $/y 250 to $/y 97 over the ears 1990-2008. During my tenure of service upto mid 2004, there had been many instances where the so called experts have suggested to hedge the yen against port authority Dollar Revenues. However in-depth studies of these proposals revealed that “ the huge up front premium factor” for hedging the currency, would negate any financial benefit to the institute.
There is nothing novel in what I have stated and in my experience, officials in authoritative places , whether Treasury, Central Bank, Ministries, Board Members or even Corporate Executives, are extremely conversant with the risk –factors of speculation. Hence these institutes are well insulated from consultants/experts, even though dismayed by the CPC episode. No wonder between 2002-2006 , the Sri Lankan expert from Canada had a frustrating experience in selling the instruments having met influential ministers as quoted in The Sunday Times of 25th June 2006. Further the articles that appeared in your paper had critically analyzed this fiasco in-detail hence there is nothing more to amplify. The $ 300 million that is earmarked for vaporization is awesome to comprehend, as the new breakwater of the port could be built, without donor funds. Finally, as an avid reader of your column may I extend a word of appreciation to The Sunday Times FT editor for enlightening the readers with his incisive journalistic skills.
(Rtd. Director Finance – SLPA)
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