The principal goal of hedging is not to make money but to prevent losses. The two primary instruments used to hedge are futures and options.
Futures: when one sells a commodity in advance to lock in a price and, in exchange, gives up the opportunity to make more money, if prices rise. This is achieved either through active or passive hedging.
Passive hedging is used by highly risk-averse companies that would like to be completely certain of their future cash flows through hedging of their entire risk exposures. This is done by locking a specific price either through (i) long- term contracts between supplier and buyer, or (ii) through a derivatives contract such as futures, forward or swaps, available on most leading commodity exchanges or (iii) as over-the-counter (OTC) bilateral contracts
Active hedging is an approach by which a company seeks to achieve a balance between hedging risk and the cost of hedging by hedging only part of its overall exposure either through a long-term contract or a derivative instrument, and keeping the remainder of the exposure un-hedged so as to benefit from favourable market movements, either through exercise of options or deals in the spot market.
Options: Companies can include the benefits of price changes in hedge contracts by resorting to option contracts, which allow them to either buy or sell in the spot market without necessarily being committed to hedge contract. But such a method imposes a heavy hedging cost in the form of option premium which has to be paid up front at the time of hedging.
Why hedge oil? Crude oil prices have become more volatile than the prices of other commodities:
Oil price risk is of course extremely important to those involved in the oil industry: producers, refiners and end users. The volatility of crude oil prices has a significant impact on the planning decisions, budgets and cash flows of producing and consuming companies.
The nature of risk exposure of an organisation to fluctuations in oil prices depends considerably on its position in the oil value chain. For instance, an E&P company is perennially exposed to the risk of any decrease in oil prices. By contrast an oil refining company would be largely concerned about protecting the spread between crude oil and refined products (motor spirit, diesel, naphtha, etc.); and oil marketing company would be concerned about the variation in the retail margin, i.e. the difference between import or ex -refinery price and the sale price to customer or consumer.
Considering the extensive reliance on budgetary revenue from oil products and the trickle-down effect of oil prices on national economies, price risk management of oil is a critical requirement for governments, particularly in import-dependent, energy-deficient countries. It makes sense for public sector stakeholders to develop some sort of hedging programme to insure that they are protected against a collapse or a run-up in oil prices.
While companies are of course free to choose hedging with options to make money, entities such as public utilities or governments should refrain from hedging as a source of extra profits. Rather, their policymakers should only look upon hedging as a means to stay within budget forecasts, to ensure certainty of cash flow and, by stabilising energy prices, protect the economy from shocks.
Hedging vs speculation: It is important to distinguish between hedging and hedge funds. While corporations and governments hedge to reduce volatility, exchanges that make hedging possible also accommodate speculators who use the same instruments in an effort to make money.
Hedge funds, or speculative commodity pools, are made up of institutional investors or groups of investors that shift large sums of “hot money” between different markets at the first sign of a possible higher rate of return elsewhere.
In this sense, the term “speculators” usually refers to investors who trade oil futures with a view to profiting from the rise or fall of prices; they have no exposure to the physical oil commodity.
By contrast, hedgers have sizable spot or forward market commitments and trade futures contracts in order to minimise their exposure to price fluctuations. There is almost always an underlying physical contract behind a hedging trade.
Pakistan: A country’s ability to cope with prolonged high oil prices is said to depend on four key factors – how economically (and politically) resilient it is to start with, how much dependent upon oil imports, how intensively it uses energy, and how heavily it subsidises fuel prices.
In a recent Australian survey of the region, on a scale of 0-7 (zero being best), Pakistan scored 6 for its ability to cope with oil price risk. By way of comparison, Taiwan scored 1, China 2, Malaysia 2, India 3, Vietnam 5, Indonesia 5, Sri Lanka 5, Bangladesh 6, and Myanmar and Nepal 7 each.
Oil price volatility in 2006 has hit hard some of Pakistan’s best-known corporations, plunging several into loss and wiping out the profitability of others. The most publicised example is that of PIA, which saw its fuel bill rise by Rs17 billion, and which would have turned a profit of Rs 3.5 billion if it had ensured stability in its oil purchase prices.
In the oil sector, the gross profits of PSO and Shell declined by 50 per cent, the loss of income being caused principally by imports of HSD and furnace oil that were not hedged against adverse price risk. By contrast, Attock Petroleum, which does not carry import price risk, reported an increase of 28 per cent in its GP for the same period.
The four listed refineries made a loss of Rs0.5 billion in H1 2007-08 compared to a profit of Rs2.9 billion the corresponding year-ago period due to higher input prices of crude oil.
The woes of KESC and Wapda due to high furnace oil prices and the cost to government for subsidising these entities are all well documented. Not so well-documented is the cost to companies such as PNSC and Air Blue, both major purchasers of oil products or budget dislocations to public sector entities such as Pakistan Railways and the Defence services, but these can be estimated to be substantial.
The prognosis for 2007 is not encouraging. Furnace oil imports are expected to increase in FY2007-08, due to demand from electricity generating companies and industrial consumers facing shortage of natural gas supplies.
Future planning: Pakistan’s oil imports, which are projected at $7.5 billion for FY 2007-08, are not expected to decline in monetary terms, even if oil prices move down, because of the annual 12 per cent growth rate in energy demand.
If the on-going LNG, piped gas and electricity imports plans do mature into fruition, the country’s level of risk to oil and energy price volatility will rise correspondingly.
This suggests a need for (i) capacity-building in hedging among the oil industry, oil-consuming corporations in the public and private sector, financial sector companies and regulatory agencies; and (ii) development of a framework by which hedging of energy (oil, gas, electricity) can be regulated.
The losses already suffered and the possibility of further losses, in view of the known geo-political factors influencing oil and energy price stability, indicate there is little reason for stakeholders to procrastinate.
Like any other risk mitigation instrument, hedging has its upside and downside, The downside is managed through professional competence, knowledge of the overall market and the complexities of the transactions, and proper regulation and reporting of hedge trades.
Policymakers need to develop a proper regulatory environment based on experiences of other countries and avoid the mistakes made by other nations in their learning curves.