Financial Times

“Didn’t go for best hedging option” – CPC

De Mel says Cabinet recommended the current option

The Ceylon Petroleum Corporation (CPC) this week rejected reports that it may default on payments to commercial banks on hedging contracts but said the hedging option was not the best one – a point raised in The Sunday Times stories last week.


The panel at Monday's media briefing on the CPC's hedging agreements. L to R: Clive Haswell – CEO Standard Chartered Bank, Dennis Hussey – CEO Citibank, Amitha Gooneratne (Hidden) – Managing Director Commercial Bank, Asantha De Mel – Chairman CPC, Lalith Karunaratne – DGM Finance CPC. Pic by J. Weerasekera

CPC Chairman Asantha de Mel told The Sunday Times FT in an interview that they have not defaulted on any payments owed to banks on any of its oil hedging agreements while noting that this was not the best option for the CPC.

The CPC made a payment to Citibank of US$6.5 million on November 10 – a slight delay from the payment due date of November 7 – and also made another payment to Standard Chartered Bank (SCB) of US$27 million on Friday (14). This is in addition to the US$5 million payment to SCB for September 2008.

Mr. De Mel said the 'zero cost collar' hedging instrument which was used was not the best option and noted he was directed by the Cabinet to hedge using that option after it approved a concept paper put forward by a Committee of experts. However CPC’s Deputy General Manager (Finance) Lalith Karunaratne - also present at the same interview – said that it was his proposal for a zero collar option made in a concept paper on behalf of CPC that was tabled before the committee. "We told the Cabinet the best way to do this is to purchase an option but the cabinet and people were not agreeable because you have to pay upfront." Mr. De Mel added that the ideal decision would have been to go for a part zero cost collar option and part option but that premiums are very high. However, he said politicians and the government still do not understand hedging although the CPC has briefed the President, the Central Bank (CB) Governor, the Minister and the Treasury.

"They think it's gambling," he said.The CPC hurridly called a press conference on Monday after The Sunday Times in last week’s issue raised concerns over the hedging contracts and that the Corporation would be at a serious loss due to falling oil prices. Mr De Mel, flanked by CEO’s from SCB, Citibank and Commercial Bank who separately issued a joint statement saying the CPC had been fully informed of the risks, insisted that the CPC had benefited from the deal but conceded a mixed option should have been resorted to. In the interview which Mr. De Mel gave to ‘clarify’ further issues on The Sunday Times reports, he said at the end of the six months (when these contracts end), the CPC will be able to renegotiate its hedging agreements. If the current world oil prices prevail, the worst case scenario is that the CPC will owe the banks US$300 million over the next six months, another point stressed in our reports.

However through renegotiations, the CPC might be able to stretch out that payment of the next 18 months, he said. According to Central Bank figures, oil prices have been rapidly falling in recent months and on Thursday was pegged at $52 per barrel – compared to …. in January 2007 when the first hedging contracts were signed.

The Cabinet Memorandum submitted by the Minister of Petroleum and Petroleum Resources Development A.H.M. Fowzie dated January 3, 2007 states that as per a decision made on September 6, 2006 consequent to the presentation made by the Governor of the Central Bank (CB), a committee comprising the officials from the CB, Bank of Ceylon, People's Bank, Ministry of Finance & Planning, Ministry of Petroleum & Petroleum Resources Development and the
CPC was appointed by Treasury Secretary to further study the subject and present a report to the Cabinet.

Accordingly, the Committee studied the subject and presented a report to Treasury Secretary. The Memorandum states that the Committee has recommended the following:

1. CPC to hedge purchase of petroleum products, both crude oil and
refined products in the international market.

2. Use Zero-Cost Collar as the hedging instrument with the upper bound
based on market developments.

3. Commence hedging with smaller quantities for a shorter period and
gradually increase the quantity and duration.

4. Grant authority to the CPC to call for quotations for oil hedging,
decide on future prices and purchase hedging instruments from reputed banks.

5. Grant authority to the CPC to change instruments based on the
developments in the market.

The Memorandum signed by Mr. Fowzie states that he agrees with the above
recommendations and would seek the approval of the Cabinet of Ministers to
implement the same.

The zero cost collar means there are no upfront payments and is only used for buying call options, not selling ‘puts’. Mr. De Mel said it can safeguard against the upside but not against the downside. "The Cabinet discussed options but I can only act on the instructions given by Cabinet," he said. "The concept paper recommended the zero cost collar and the cabinet also recommended the same thing."

The CPC wanted to earn money on the upside because the government does not allow it to increase prices as world prices escalate. "We lost Rs.23 billion in the first nine months of the year (2008) because we sold below cost," Mr. De Mel said. "We made money in the end because the refinery made profits."

Mr. De Mel said experts around the world believed that oil prices would be around US$120 by the end of the year (2008). He added that the lowest the CPC thought oil would move down to was US$85. "We never thought it would come to this price and not in tht short period," he explained. Due to the hedging agreements which are only for 35% of oil imports while the remaining 65% is free floating, Mr. De Mel said the CPC and the country has come out in a good situation. "We are in the oil business. The dollar has to be controlled by the CB, not the CPC. There are no dollars to buy today and that is the reason we were asked to hedge and the Governor of the CB even thanked us for hedging. February 2007 was the first oil hedge and we were given an award for the best innovative hedge by the Standard Chartered Bank (SCB)."

Mr. De Mel said that those who say the price of oil cannot be brought down further is due to hedging are wrong. He said it is taxes imposed by the government which is keeping prices from decreasing. "The government is charging Rs.72 tax on petrol and Rs.17 tax on diesel." He added that he has been hedging for the last 18 months. "We were managing the CPC without having a negative loss after giving subsidies. We didn't trouble the government. We gave a concession to the people but the country had a US$3.5 billion oil bill. We got an Iranian credit line for seven months and a credit line from Singapore. We are standing on our own because the banks are not helping us. If we don't hedge, how do we cover that loss?"

Oil prices have crashed due to the credit crisis, Mr. De Mel said and not the supply and demand for oil. World oil prices are controlled by four exchanges in Singapore, Dubai, London and New York, not by the producers. Banks are in a financial crisis and not able to lend to people and the markets are volatile. The credit crisis has hammered everyone and is affecting unemployment, growth, and consumer spending. Retail businesses and construction have come to a grinding halt.

If oil prices had not fallen, the country wouldn't have paid anything out but the CPC would have been earning, he said. Mr. De Mel reiterated that the best option would have been to go in for a certain percentage in options and a certain percentage in zero cost. "We have never gone into oil hedging in Sri Lanka and we have never seen markets like this where the volatility is so high."

Mr. De Mel also said that after the hedging agreements are up in six months, he and Mr. Karunaratne will not be involved in any more hedging. He said he will get others to handle it because he does not want the negative media scrutiny when he is trying to do something good for the country.

Role of the banks

Mr. De Mel said banks are only mediators, also called 'hedge providers' and do not take the hedge. The banks find buyers and get a small trading commission in the middle. However, they end up making money either way but they take on the risk if the producer or the buyer defaults. Banks have to honour the contracts irrespective of which party defaults.

Mr. De Mel added that oil producers don't want prices to come down so they safeguard those prices by downward hedging. He predicted that oil prices will go up but said this will be good for hedging but bad for the country. "If oil prices go up, it's good for the hedge but the country will fall to pieces. I think today we have the best situation because the prices are low and we will have a bill of less than US$2 billion. If prices go up, we will have a bill of US$3 billion and we can't afford it." He added that the CPC
has hedged only a small portion. "This is a start of it," he said. "When
the prices are rising, it's not prudent to hedge."

Mr. De Mel said the CPC sat with the banks and went through everything in detail. "It wasn't a haphazard hedge." He explained that over the last two year, he has gone all over the world to all the exchanges and has been educated by every expert in this field. He said Mr Karunaratne and himself have the most hedging experience in Sri Lanka today. To this effect, the CPC has followed CB guidelines for hedging which states that an undertaking has to be given from the bank that the client understands all the risks. "We understand them all. There is no risk to us on the downside because all we are doing is paying less for oil."

Opposition protest

Mr. De Mel said the opposition UNP has no right to complain that the CPC is unable to reduce prices due to hedging. "The government taxes have to do with not being able to reduce prices," he said. "The government also needs money. The UNP were taxing 44% on petroleum products during their time and they made large profits in the CPC by fleecing the people. We are consumer friendly now. The UNP has no right to talk. They are angry because we have all the facts and figures."

According to figures tabled by the CPC in parliament, the percentage of taxes on fuel were 44 % (2002), 41 % (2003), 14% (2004), 11% (2005), 13 % (2006), 14.6% (2007) and 9.8% till June 2008.


 
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