Financial Times

CPC energy hedge: Anatomy of a crisis

By Upul Arunajith

A fuel attendant takes a quick snooze while waiting for customers at a local shed.

As the architect of this trailblazer project, I consider it my responsibility to provide an explanation as to what this “CPC Hedge” is all about given due regards to media reports during this entire saga in the recent past. Provided below is a succinct account of what really transpired and how a solution to a problem has led into a much more serious problem and placed the CPC in a vulnerable and yet another unprecedented crisis.

This unprecedented crisis obviously contests the validity of the concept of hedging. Notwithstanding its wide use with varying degrees of success internationally, Minister A.H.M. Fowzie has gone on record saying that in the future he will opt to keep out of hedging. He was not in favour of hedging at all from the very start. In this connection my task is to prove the validity of hedging and protect the project initiative for the greater benefit of the national economy. It will not be prudent for them to discard the entire concept of hedging given one bad experience.

I have read multiple interpretations to this word “Hedging”. A former chairman of the CPC interpreted hedging as a process to control the world market spot price! Recently I heard that hedging facilitates earning foreign exchange. If that be the case, I am sure CPC is in the wrong path for it’s losing foreign exchange due to a wrong hedge. I also hear that “Hedging” is “Speculating” a widely held belief. So we have seen all the definitions to this mystic word “Hedging” and not well understood.

What is hedging?

Hedging is a mechanism that protects buyers and sellers of commodities from adverse spot market price volatility by taking an opposite position in the Derivatives Market. Hedging is not speculating. On the contrary speculators add liquidity to the markets and facilitate the hedging process. Without speculators there will be no liquidity. Hence, hedging is not speculation. Hedgers and speculators play a mutual exclusive role.

Hedging is akin to an auto insurance programme. From a laymen interpretation, the same way the insurance policy protects the owner in the even of a contingency, so does the hedging programme insulates the buyers and sellers of commodities from adverse price movements. Derivatives facilitate the hedging process. Derivatives are traded in an organised Exchange or Over The Counter (OTC). Exchange traded instruments are futures and option while OTC are SWAPS and Options.

In the case of exchange traded derivatives, all trades are transparent and the performance is guaranteed. In the case of OTC derivatives, these are for the most part tailor-made to suit counter-party requirements and governed by International Swaps and Derivatives Association (ISDA). One of the cardinal rules associated with Derivatives trades is that these trades should be kept simple. The moment it gets too complicated and deals are structured, the risk associated with the instrument becomes hard to monitor.

The current sub prime mortgage is mostly driven by the excessive use of Credit Derivatives that traded in the OTC market and controlled by ISDA. This Credit Derivative instrument is a Credit Default Swap.
The success of any hedging programme is entirely dependant upon the use of the: correct instrument – Option, Futures correct strategy. – Call, Strips,
Southwest Airlines Jet Fuel Hedging Programe: Success Story.

2005 Hedged at US $ 26.00 bbl
2006 Hedged at US $ 32.00 bbl
2007 Hedged at US $ 31.00 bbl
2008 /09 Hedged at US $ 35.00 bbl

Southwest Airlines was able to make profits in the billions as it took a proactive role way back in 2001 when oil was trading under US$20. For the record, I first made the proposal to the Sri Lankan government at the end of 2002 to introduce hedging.

If the wrong instrument is used, the hedge will sooner or later go in the wrong direction and will lead into a crisis. A case in point is the Orange County issue. Mettalgesellschaft Refining Hedge Programme – “Stack Hedge”

The Mettalgesellschaft Refining Hedge provides a good example of a hedge that went bad and the refiner losses totalling a billion. The refiner used a “Stack Hedge” strategy using futures contracts.
The refiner had an agreement to sell a certain quantity of petroleum products at a fixed price on a long term supply contract. This exposure was hedged with short term futures contracts and when the market spot market price dropped, the refiner got margin calls and faced a funding gaps. This forced the refiner to close the position taking a massive loss of over US$ 1 billion.

This is a classic example of not being able to use the right instrument and failure to watch for warning signal of the market price movement. Tool and Strategy selection is critical to the success of any hedging programme. Failure to understand the tools and the strategies will sure lead to disaster.

CPC Hedging Programme – “Zero Cost Collar”

In the case of the CPC hedge failure can be directly mapped out to the strategy implemented by the CPC. The tool selection was driven by cash flow constrain to some extent but this is not the only reason why CPC got into this crisis. There were warning signals that the Zero Cost Collar was the wrong strategy. I had personally informed them of the impending disaster to no avail. Nonchalance to the warning signals and failure to heed to advice was the key to the CPC. Thus the hedge went in the wrong direction.

The cabinet would have approved what the CPC concept paper recommended. Both parties lack the skills for a critical review. Hence pointing fingers at the cabinet is of no use for it was the CPC-prepared cabinet paper that promoted the Zero Cost Collar.
Had they pursued the simple plain vanilla instuments, the risk is limited and can be monitored. In structured deals as stated earlier, the instrument risk cannot be monitored.

Basket Hedge Model – Final product development

We developed the world’s first Basket Hedge model for the CPC in February 2007 locking in the price of Crude oil + Freight at US $ 61.50pb for 24 months, using a cash settled Call Option to Cap the price of crude oil + freight for a period of 24 months structured through the world’s fourth largest energy trading firm based in Geneva facilitated through a broker based in Singapore, as per discussion held at the Treasury in Colombo.

Hedge Structure Analysis:

During the term of the hedge, CPC pays only a maximum of US$61.50 for the commodity + freight, if the oil + freight cost remains above US$61.50pb, while having the flexibility of participating (in the open market) if the world market price drops below US$61.50pb.

If the market price drops to $50 the CPC purchases the commodity at the lower market price. If the market price is US$135 the CPC purchases the commodity at US$ 61.50 (the pre-agreed Call Option Cap Price). For having this benefit, to Cap the price and also to participate the event of a price drop, CPC has to pay an Option Premium akin to an auto insurance premium.

Hedging the “commodity” and “freight”

We provided unlimited upside protection above US$61.50pb. If the price moved above 61.50pb, to US $ 100pb the hedge provider paid the variance between $100 and $61.50 = US $ 38.50 per barrel to the CPC. If the price dropped to $55 the CPC had flexibility to participate in the price drop.

Basket Hedge Model rejected by the CPC

Regrettably though, this hedge model was rejected by the CPC. In violation of the agreement we had at the Treasury meeting, the CPC went to two commercial banks in Colombo, Citibank and Standard Chartered Bank (SCB) and asked them to develop hedge models. In this context it has to be stated that neither of the two banks are specialized energy traders nor did they have the wherewithal to provide a hedge to the CPC for a huge exposure of US$2 billion.

Taking my idea and asking for counter proposals is an act of plagiarism by CPC. This is a departure from the agreement we had at the Treasury discussions to work with dedicated commodity hedge providers based overseas.

Local banks

Local banks did not have the financial stamina to provide the required coverage due to high volatility of oil and taking into account the CPC’s exposure. This later proved to be the case when the Citibank made a strategic exit after making a US$4 million “knock-out payment” to the CPC when the hedge went in favour of CPC citing that there was a “single client limitation”. Following this development, CPC went back to the SCB to seek hedging. Given that SCB first sold a wrong hedge model to the CPC and also lost US$2 million going back to SCB is leading to financial suicide and definitely will not be in the interest of the CPC. Citibank did a good job of misleading the CPC but did a poor job in calculating the risk and ended up with a huge unexpected payment to the CPC.

This situation where the local banks are unable to provide coverage to the CPC given its exposure was discussed at the preliminary Treasury meeting and that was the reason why we all decided to work with foreign based hedge providers who were specialized in commodity trading and hedging.

SCB “Zero Cost Collar” Hedge Strategy:

Responding to the CPC’s call to develop Hedge models, SCB developed a Hedge model using a strategy referred to as a “Zero Cost Collar” which is a wrong strategy. SCB developed this model in such a way that the CPC will end up paying the SCB as opposed to the SCB making a payment to the CPC. Unfortunately, the calculations of the SCB backfired and the Bank eventually ended up paying the CPC.

Added to this there was an instance when the SCB sold a “Crack Spread” to the CPC and the CPC lost US$2 million. These financial losses are passed on to the average gullible consumers.

Citibank “Leverage SWAP”:

Having advised the CPC that the Zero Cost Collar as developed by the SCB was the wrong strategy, and the CPC Chairman having agreed that it was the wrong strategy in view of the vulnerability of the CPC to this strategy, CPC went to Citibank and signed an agreement to get an oil hedge at US$73 pb on a trial basis for a period of three months. Again this too was wrong and costly strategy.

Due respect given where it’s due, it was the current CPC chief Asantha De Mel who took the bold step to get into unchartered waters by implementing the concept of hedging. However it has to be stated where he went wrong was implementing the wrong strategy from the very inception. This could have been averted for he was given signals that it was wrong.

As a parting remark, this failure is only a teething problem associated with hedging and it is imperative that we continue with the hedging programme for that is the only salvation CPC will have against high spot market price volatility.

(The writer, involved earlier in the hospitality trade in Sri Lanka, has been residing in Canada since the early 1990s. He has been involved in banking, risk management, commodity futures and derivaties trading. He could be reached at

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