With high oil prices, as a developing nation where do we go from here seems to be the timely question?
As we started to smell the sweet success associated with the post-war economic development and as we were getting ready to bring back the glory days, there seems to be a dark cloud zooming in. Energy, being the front runner of the economy, we see yet another oil price increase during the last week.
The turn of the century when global crude oil spot price was around $20 a barrel, $100 a barrel for oil seemed a ludicrous thought. But here we are faced with the new reality. Whether we like it or not, let’s face it. High oil prices are here to stay and will not be going away.
Lo and behold, oil will reach $200 a barrel. As a nation let us be prepared to welcome the era of high oil prices and even higher spot price volatility associated with crude oil.
Geo-politics of oil and the conspiracy theory
All wars are fought for oil. Oil, is the driving force of the global economy and those who got access to oil call the shots while those who need access to these untapped resources manipulate the system so that they will one day be able to be at the controls of the oil well-head.
There are multiple theories around the concept of peak oil. Whatever said and done the peak oil theory has come and gone. It was said 2006 was the year of peak oil. Supporting this theory we saw the oil price reaching record levels. Some recent reviews suggest that in the Gulf of Mexico alone about 2/3 of the oil reserves are untapped.
The accent is on a very frightening thought that the world oil reserves are depleting at an alarming rate and faster than the original projection. Many books have been written and many a discussion taken place. But as they say, Stone Age did not end because of lack of stone and end of an oil era will not be caused by the lack of oil. Unfortunately though what is happening is the peak oil theory is being used as a tool to manipulate the spot price of oil.
The dilemma is, low spot prices will discourage new oil reserves being discovered while high oil price encourages such initiatives. Oil thus far discovered can support the base consumption demand but to support a demographical shift and population growth of estimated nine billion there certainly needs to be new oil reserves being brought into the market.
Hence, to support new discoveries, a spot price tag of $200 will be attached to the crude oil barrel.
Counter measures for high prices
We can pass on the price movements to the consumer in the hope that consumption will be curtailed. But oil as a commodity is inelastic to such price increases. Or, we can look into alternatives. But that is an undertaking that needs infrastructure development necessitating vast capital infusions. For alternatives to be made available commercially will need years of product refinements.
Viable and cost effective alternative that is at our disposal is effectively managing the commodity price risk exposure: Introduction of Hedging. The entire global energy industry has successfully got into dynamic hedging programmes to mitigate the volatility of the commodity spot price. In response to record high commodity prices the energy industry has seen in the recent years, there are numerous tools that are developed to effectively counter the price spikes. The world’s largest commodity / derivatives exchange the Chicago Mercantile Exchange (CME), is the hub for Energy Derivatives. Provided above(see table) is an analysis of the exponential growth in the daily trading volumes of the most liquid commodity futures contract (WTI) West Texas Intermediate - Sweet Light crude oil. These numbers validates the concept of hedging.
Recently, an analyst concluded that hedging is bad as it’s a double edge sword and discarded the validity of the hedging programme of the CPC. Hedging is not a double edge sword. If the right derivatives instrument and the proper hedge strategy is used, the hedge has to serve its intended purpose of mitigating the adverse effects of high spot market prices.
Controversial as it is, the entire concept of a universally valid mechanism cannot be discarded because of one bad experience. What really happened in the CPC hedge was, besides the banks giving a one sided leveraged structure to the CPC, all parties failed to understand the product and its inherent risk.
This is recipe for disaster and it will not do any justice to point fingers at the concept of hedging. Hedging though a valid mechanism widely used by the energy industry, in Sri Lanka it’s implementation was flawed. Based on past performance if we continue to make decisions on wrong information i.e hedging a double edge sword we will compound the problem.
If the banks acted with diligence and provided the CPC the proper hedge today collectively the entire economy would have been benefited. Sri Lanka would have still bought oil at a much lower price under $100 a barrel with a hedge programme in place. Few individual’s hidden self interest unfortunately has impacted the entire national economy.
On a more serious note, the recent price increases will have a direct bearing on our tourism, bunkering, and exports.
Tourism is competitive and a price sensitive sector in the economy. The modern traveler, wants the ‘bang on the buck’. Effects of high oil prices cascading down to every sector of the tourism product, we will fail to serve the demands of the discerning traveler. As other destinations are pervious to changing dynamics of the energy sector and swift to positively adopt accordingly we in Sri Lanka take a lackadaisical approach. It was the same thinking that failed to market our unique tourism product to billions of cricket fans during the recent world cricket encounter.
Sri Lanka had a reputation as a bunkering hub in the region. From a strategic thrust, our position would have been re-enforced with the Hambantota port being developed. Unfortunately though, with India and other regional competing ports having proper exposure management mechanisms in place our comparative advantage will be lost. All good intentions to develop the Hambantota port as a shipping hub will be lost if we fail to manage the energy prices properly.
As an export dependant economy, Sri Lanka cannot afford such haphazard oil price increases. High oil prices will increase the base cost and we’ll out-price our export products.
Last but not least, the most significant element is that as we borrow foreign exchange for our oil imports that in turn will strain our exchange rates and this will make other essentials that much more expensive driving inflation.
Whether we like it or not we have to recognize one basic fact: The era of cheap oil is a thing in the past. It will not be a prudent approach to await price reductions. Sri Lanka as a fast developing economy must not resist this basic fact and the sooner it is identified the better it is for then we can develop proper counter measures.
The incumbent petroleum minister was a strong advocate of introducing the concept of hedging to protect the CPC from adverse price movement. I conclude that the only counter measure around high oil prices is having a properly structured hedging programme. I am a strong advocate of a national hedge policy being developed and introduced to insulate us from adverse price movement of essential commodities - crude oil, liquid petroleum, fertilizer and other imports i.e sugar, milk powder, and flour. This will be yet another trailblazer initiative that must be given serious thought if we are to remain competitive and be a regional economic power, to reckon with.
(The writer is a derivatives specialist based in Canada. He can be reached at firstname.lastname@example.org).