Crisis over oil hedging deals

  • CPC delays payments to Standard Chartered Bank, CitiBank

Two separate oil hedging deals between the Ceylon Petroleum Corporation (CPC) and Standard Chartered Bank (SCB) and CitiBank have gone wrong and about US$ 30 million was not paid by the CPC when the deadline (for the October payment) ended on Friday, informed sources said.

The Sunday Times reliably understands that the two banks were scheduled to meet their ambassadors (Britain and the United States) to put pressure on the CPC to pay, citing it as a sovereign bond, in the two hedging deals where the CPC was either misled or not properly advised, according to Central Bank rules, on the risks involved in this kind of instrument.

Banking sources said the Colombo branches of these banks were putting pressure on the CPC to make the payments since any accumulation of these losses could reach millions of dollars in the coming months, given that fuel prices were unlikely to rise sharply above the US$ 58-80 levels.
“If that happens, the local branches of these foreign banks may be under pressure to close,” one banker said.

The CPC also has, somewhat smaller, oil hedging contracts with Deutsche Bank and the Commercial Bank. Another local bank which was requested by a foreign investment bank to get involved in a similar type of instrument (with the CPC) mid this year turned down the offer on the basis that the risk (to the CPC) was too high.

The biggest problem in the current hedging deals is that liability on the upside (SCB/CitiBank pays CPC) is limited while liability on the downside (when fuel prices fall and the CPC pays banks) is unlimited. (See details on the deals in The Sunday Times FT section). This risk has not been clearly understood by CPC officials and also Petroleum Minister A.H.M. Fowzie who was also approached by SCB before the deal was finalized.

Every month a payment is made, a few days after the last day of the month, and October’s due date was Friday but the payments to the two banks were not made. The sources said that during a meeting between CPC Chairman Asantha de Mel and SCB Country Head Clive Haswell on Friday, the SCB had offered a new, alternative (hedging) instrument saying under this instrument, last month’s liability ($16 million) could be reduced by half. The CPC, it is learnt, did not respond positively to this offer. The CitiBank Colombo CEO was also believed to have met the CPC chairman Asantha de Mel.

Mr. de Mel told The Sunday Times there was a delay in the payments to CitiBank, but on Monday the CPC planned to pay US $ 7 million to CitiBank. He also claimed that there were no problems with the Standard Chartered Bank.

When asked, SCB’s Haswell told The Sunday Times that it was the bank's policy to refrain from discussing dealings with its clients. However, he said the Bank had a 'very good and long-standing relationship with the CPC.' He said that the bank was supportive of the CPC's activities and is working closely with them.

Under the hedging mechanism, either party has to pay the other when the oil prices fluctuate but in practice, the CPC has been doing all the paying as the downside risk was not properly calculated or the state petroleum distributor was not properly advised. Central Bank rules clearly state that authorized dealers must get an undertaking from customers that they clearly understand the nature of the product and ‘inherent risks.’

“While the CPC has made a serious mistake in not assessing the downside risk, 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," one market trader said.

However The Sunday Times learns that the CPC had during late last year expressed concern to this bank that any hedging mechanism should sufficiently protect the CPC and provide an exit clause in case prices fall sharply, as they subsequently did. While the SCB is learnt to have acknowledged this concern, no attempt was made to alter the contracts to make sure the risk to the CPC was minimal.
Some bankers also raised the issue of whether the CPC making risk-related foreign payments was a violation of exchange control regulations. “This has never happened before as this is a negative payment unlike the normal foreign exchange that goes out for imports, etc. I wonder whether there is any violation here,” a city banker noted. The deal was announced in January 2007 and prices were low at the time. However oil rose sharply to a high of $134 per barrel in July 2008 and subsequently crashed to a low of $58 throughout last week.

The Central Bank in recent times is particular about the risks involved in these instruments. In its latest directions on Financial Derivative Products issued in July 2008, it is stated that, “All dealers should ensure that Board of Directors of corporations clearly understand the risks of the instruments and draw up/lay down adequate plans … to mitigate the risks.”

Under the 2007 deal, the oil price was capped at US$ 130 a barrel and the floor price was at US$ 100 a barrel. If the price rose 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 was below US$ 100, the agreement terminates only after 12 months during which Sri Lanka is committed to buy 200,000 barrels per month.

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