While consumers and markets cheer the fall in fuel prices as a budget proposal, the government is seriously considering defaulting on the costly payment under the controversial oil hedging deal with Standard Chartered Bank – because the Ceylon Petroleum Corporation (CPC) can’t afford it anymore, informed sources said.
Market analysts are also pushing this strategy saying the Bank didn’t advise the CPC sufficiently on the risks involved in the deal announced in January 2007 at a time when fuel prices were around $56 per barrel. After rising to a high of $134 per barrel in July 2008, the price has crashed to a low of $58 last week and now trading at the $60 level.
The sources said the government stands to lose millions of dollars under this deal in a move experts have said was ill advised and misguided and is the reason why the CPC is unable to lower fuel prices – apart from a budget reduction. The amount the government is expected to pay Standard Chartered ranges from US$2 million up to a staggering US$20 million per month, with the monthly payment due last Friday. In the meantime, The Sunday Times FT also learns that the CPC is considering securing a loan from Standard Chartered Bank in Singapore to pay off the debt to its local branch.
Officials from either the CPC or Standard Chartered Bank were not available for comment as of late-afternoon on Friday. The need to properly understand hedging risk for the user is clearly stated in the Central Bank’s directions on Financial Derivative Products issued however on July 2008, a long time after the deal. It says traders should obtain an undertaking from customers that their total value of the hedges do not exceed the value of the risk that is being hedged. “All dealers should ensure that Board of Directors of corporates clearly understand the risks of the instruments and draw up/lay down adequate plans … to mitigate the risks,” it said. It also said that dealers should obtain an undertaking from customers interested in using these derivative products that they have clearly understood the nature of the products and their inherent risks.
A former CPC Chairman told The Sunday Times FT that hedging operations is the cause of the CPC problems and one of the main reasons they are unable to reduce fuel prices in Sri Lanka. He said hedging is speculation and a gamble and is one of the reasons behind the unusual high prices worldwide. "Hedging is not the answer to keeping oil prices down," he said. The former Chairman added that the CPC should not be hedging in a rising market. He added that there has been gross mismanagement in the CPC which has involved itself in hedging and futures without thorough knowledge of the crude oil market.
"The CPC is taking for granted what Standard Chartered is saying," he said.
The sources said the Sri Lanka petroleum hedge was based on the following details: The price was capped at US$130 a barrel and the floor price was put at US$100 a barrel. If the price is above US$130 for three months, the hedge agreement terminates. This means that during these three months, Sri Lanka can only buy 100,000 barrels per month.
If the price of petroleum is below US$100, the agreement terminates only after 12 months during which Sri Lanka is committed to buy 200,000 barrels per month. The hedge is only for a third of Sri Lanka's normal monthly consumption. According to the source, in respect of last month alone, Sri Lanka had to pay back US$20 million.
A hedging expert told The Sunday Times FT that in order to get involved in hedging operations, it is essential for the CPC to have a risk analysis department to analyze product price fluctuations. On crude oil, there is a daily market in which prices are increasing and decreasing. The official-published document is the Platts Oil Gram, also known as the Bible for oil prices which everyone refers to for current prices including origin prices and premiums.
What the CPC is currently engaging in every few weeks is to call for tenders and accept the lowest bid. "It is not a considered judgment," the expert said. "The CPC has been told that derivatives are highly risky and they must take precautions and understand what they are doing. They have to make sure they have to own department and train people to follow the market. They must get into the market with some education and background." Moreover, he said the CPC has lost enormous amounts of money through options but the exact amount is not known since details have not been released.
Another issue apart from hedging is the credit for crude oil Sri Lanka has obtained from the Iranians. This was done on a government to government basis as an interest free loan for six months. A few months back, the CPC Chairman and the former Treasury Secretary Dr. P.B. Jayasundera traveled to Iran to secure a six month extension. Despite the extension, an enormous amount of money will have to paid. "At the end of the day, there will be enormous capital flight."
Bank to blame
Several market players are urging the CPC not to pay to Standard Chartered Bank and accusing the Bank of unethical practices. A market expert said a risk management team should have been set up to make recommendations but added that he blames Standard Chartered for unethical banking. It is up to the Bank to protect the client and make sure they understand the risk involved when they are selling a product.
The mandate the government has given to the CPC is to hedge the upward movement of oil prices. As in any contract, the two parties are the buyer and the producer. The buyer will protect against upward movement while the producer will protect against downward movement. An expert said the Central Bank (CB) has not allowed for writing options but that is exactly what the CPC is doing.
The CPC went for the hedge with a cap at US$145 a barrel and a floor of US$130 a barrel. If the price goes up from the day of signing over US$145, the CPC will be able to buy only 100,000 barrels per month for a period of two months. Then the contract is terminated. If oil prices fall below US$130 in those two months, according to the leverage option, the CPC will have to buy 200,000 barrels each month for 12 months.
A market analyst said that the CPC must have assumed that prices will keep increasing because they have failed to protect the downside. "That is their mistake," he said. "However, I blame Standard Chartered Bank, they being the professionals. They have norms and they are not supposed to sell a product to a customer or country if they are not sophisticated enough to understand. The Bank has misled the country to make money."