Hush-hush hedge: Cabinet, CPC board in the dark - Investigation

By The Sunday Times FT Desk

Shocking evidence over the disastrous oil hedging deals emerged this week showing that cabinet approval and proper sanction by the Ceylon Petroleum Corporation board of directors, barring that of its chairman, were not obtained while the Attorney General’s view was also not sought, an investigation by The Sunday Times reveals.

Some cabinet ministers and CPC board members confirmed to the newspaper that the required approval (Cabinet and board) – in practice, by convention and by regulation for a costly deal of this nature -- were not received by either the Minister in charge (Petroleum Resources Minister A.H.M. Fowzie) or CPC Chairman Asantha de Mel.

Asantha de Mel

Acting Attorney General Priyasad Dep told The Sunday Times that as far as he was aware, their advice was not sought in hedging contracts. The Cabinet was presented a memorandum on hedging by Minister Fowzie but subsequent approval to go ahead with the mechanism was not obtained, a minister, who declined to be named, said.

CPC board sources said the go-ahead was given on oil hedging based on a document containing the broad framework of the arrangement but no proper explanation was made about other instruments except the zero cost collar instrument, which was also not clear to them (directors) at that time. “The Board was only informed about the gains achieved by the CPC and no details of hedging. If we were made aware of the downside risks (as it is emerging today), we wouldn’t have approved such transactions,” one source, close to the directors, said.

An even bigger revelation is that the board didn’t give a written undertaking to Standard Chartered Bank (SCB), as claimed by its CEO Clive Haswell, acknowledging that the CPC understood the risks involved in such transactions. ‘The board didn’t sign any such document unless of course the chairman independently sent such a letter to the SCB,” the source said.

Written acknowledgement of risk in this kind of transaction is compulsory under Central Bank (CB) guidelines in trading on commodity futures and other instruments. Central Bank sources say their investigation shows that these guidelines have been violated.

The issue at stake is that while the CPC has gained $24 million over the period in which these contracts were done (since January 2007), it has so far lost $38.5 million and is set to pay another $300 million (if the oil prices remain in the $50-60 per barrel range) or more if it falls further – till the current contract ends in May 2009. On Friday, world crude prices fell to $ 46.47 per barrel, a stunning drop of almost $100 per barrel from $143.33 on July 11 this year.

“If this (drop of $100) is not enough evidence that the CPC failed to properly consider the risk, what is? Someone must be made accountable for this huge loss to the country,” an industry analyst, familiar with oil hedging, said. According to international news agency reports, crude oil prices are poised to fall by another 15 percent in the next week while recording its lowest price since May 2005. Even though OPEC is cutting down production to stem the sharp price fall, demand growth has fallen to its lowest in 23 years due to the world economic crisis, international market analysts say.

The CPC liabilities lie with SCB and CitiBank while Commercial Bank and two other banks have smaller exposures. Despite the evidence stacked against the banks for not properly informing the risks to the CPC board, the government – while acknowledging that the wrong instrument was resorted to in hedging – was this week grappling with the dilemma of endorsing the huge foreign exchange payments by the CPC to foreign banks or face international repercussions.

Local industry analysts said the two main foreign banks had hedged these instruments with the New York Mercantile Exchange (NYMEX) – which is the normal practice like in insurance where re-insurance protection is obtained – and thus the NYMEX has to be paid. “Any default to the NYMEX by the banks will be perceived as default of a sovereign debt which will be disastrous to the country’s international rating and jeopardize Sri Lanka’s standing internationally to seek foreign commercial loans,” one analyst said.
The government, facilitated by the CB, has resorted to large scale borrowings in the international market. Currently a $300 million syndicated loan sought by the CB has drawn a proposal from an Islamic Bank under the Islamic Banking concept (no interest but sharing of profits’ concept) which is under negotiation, market analysts said.

Thus while the CB earlier this week appears determined to reprimand the banks for not following the ‘due process’, the position reversed later after a meeting on Wednesday between Governor Ajith Nivard Cabraal and bank CEOs. The subsequent meeting has led to a decision where re-negotiation is currently underway between the banks and the CPC. No details were available as to whether this re-negotiation will mean a lower liability to the CPC as against the contracted hedge price.

“There is re-negotiation going on to resolve this issue on payment,” Mr Cabraal said, without giving details as to whether the CB investigation is over. However CB officials visited the SCB on Thursday for the second time in a week.

During the week there was a flurry of activity when President Mahinda Rajapaksa summoned Mr de Mel to ascertain facts relating to this deal and where the President had expressed concern over the liability; where Minister Fowzie briefed the Cabinet on the issues with Mr de Mel also being present, and where the Parliamentary Committee on Public Enterprises (COPE) summoned the CPC Chairman and officials for a meeting on Wednesday.

However CPC officials didn’t attend the hearing and requested time. COPE member and UNP parliamentarian Dayasiri Jayasekera said that in line with this request another meeting had been scheduled for Thursday, November 27. Auditor General S. Swarnajothi told The Sunday Times that he had also been summoned by COPE (for this meeting) to seek his observations on the hedging contract.
At the cabinet meeting on the hedging deal, Mr Fowzie had said that the CPC would continue oil hedging but by paying a premium and not through the zero collar option which has failed – virtually agreeing with The Sunday Times and its analysts where it has been often pointed out in the past that the premium-based hedge was the best option. (See the FT for more details on the CPC crisis and what should have been).

The cabinet, it is learnt, had expressed its concern on the impact of fluctuating oil prices on Sri Lanka and noted that the public should not be burdened despite the heavy debt recovery difficulties faced by the CPC.

However market analysts say with the internal debt of the CPC rising, it is unlikely that local fuel prices can be reduced even though public pressure is mounting. “Any reduction in CPC prices would mean further losses to the Corporation or more borrowings to make up for reducing prices. That’s the reality,” one analyst said, adding: “The CPC is facing a huge crisis.”

The CPC payment is adding pressure to the country’s foreign reserves with another CPC bill for $300 million to pay the Iranian credit line due next month. Economists however say reserves, currently at $2.7 billion and equivalent to 2.8 months of imports, are unlikely to get affected. “If CPC bills including the monthly payments to SCB/Citibank are made through the commercial banking system then the reserves are not affected. The problem arises only if commercial banks are short of foreign cash and have to buy from the Central Bank and then the reserves will get drained,” one economist said.

Sources close to the CPC board said a more comprehensive proposal on hedging (which was not submitted) would have been referred to the Attorney General for advice in view of the huge, downside risks involved. They said while the chairman has the authority to make payments (in this case totaling $38.5 million) the procedure is to inform the board later which in this case has not been done so far.
The Sunday Times investigation shows that the CPC had hedged on an oil futures contract that neither the banks, CPC, Central Bank nor the cabinet and its Ministers had the competence and wherewithal to fully understand its fundamentals, implications and risks.

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