To avoid the volatility of import prices of oil, the CPC has now decided to hedge at least a part of its oil imports against high and volatile prices. Like an insurance policy, hedging is used to protect against unexpected negative events. This does not prevent the negative event from occurring, but if it does happen and if it is properly hedged, the impact of the event is reduced.
Thus, the hedging is not aimed at generating profits, but mainly protecting from losses that could arise from adverse price fluctuations.
Some of the popular major hedging instruments, which are used worldwide, could be applied in hedging oil purchases are the following. Under Crude Oil Cap, a petroleum importer sets the maximum price, which is called the Cap.
If the market price rises above the Cap, the Hedging Organisation, usually a Bank will pay the difference to the oil company. If the market price drops below the Cap, the importer is free to buy from the open market. As consideration, the importer needs to pay a premium for each barrel. Under the Zero-Cost Collar arrangement, the importer sets the maximum price, 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 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.
Under Swap, a fixed price will be agreed upon. If the market price is above the fixed price the bank will pay the difference to the importer. If the market price is below the fixed price the importer will have to pay the difference to the contracting party. This instrument requires a premium (similar to insurance premium) to be paid by the the importer.
The cost of hedging could come either from direct cost of hedging such as premium paid or indirect cost from lost profit due to movement of market prices on the reverse direction (e.g., significant drop in oil prices). These costs are the cost of avoiding uncertainty and ensuing stability.