Delroy Hunter | Debate on oil hedging needs less heat and more light

Recent public discourse on Jamaica’s attempt to manage oil price risk suggests that there are major issues and misconceptions about how and why the Government manages this risk. For instance, there is a concern that a previous government might have engaged in the wrong hedging transaction, which, if true, would have magnified, rather than mitigated, Jamaica’s financial risk.

Further, public statements by opposing political interests on whether we have obtained value for the premium paid to procure the hedge indicate that the Government’s objective as a hedger is conflated with that of a speculator in the oil market. The purpose of this article is to provide clarity to the ongoing debate.

Hedging is a technical term for managing risk. In the current situation, the Government wishes to maintain a relatively low at-the-pump price of gas in periods of high global oil prices. Consequently, it hedges to reduce or eliminate the risk of paying too high a price for oil that it intends to purchase within a given future period.

The Government could hedge by engaging in an appropriate derivatives-based transaction with a counterparty like Citibank or an established exchange such as the CME Group. Derivative securities are so called because they derive their values from the price of an underlying asset, in this case oil, or the level of an index, interest rate, or other measurable outcomes. Various derivatives, including options, forwards, and futures, may be utilised in hedging oil price risk. They differ from each other in their implications for Government’s financial liquidity, settlement risk, and flexibility in crafting the desired hedging contract.

HEDGING WITH CALL OPTIONS

The Government could hedge by purchasing call options on crude oil. Upon purchasing the call options, the Government obtains the right, but not an obligation, to buy oil at a price that it determines at the time of contracting (strike price), and the oil can be bought at the strike price up to some given point in the future (expiration date). For this right, the Government pays the counterparty a fee (option premium). Purchasing call options guarantees the Government a maximum price at which oil can be bought during the life and up to the expiration date of the options, even if oil price increases significantly during that period.

Assume that oil is currently priced at US$40 per barrel, and the Government forecasts that if price exceeds US$60 and remains elevated, it could have significant negative consequences for the Budget and consumers. Suppose the Government purchases the call options, giving it the right to buy oil at any point over the life of the option at a strike price of US$55 per barrel. Assume that for this right, the counterparty charges the Government a premium of US$5 per barrel. While the Government pays that premium immediately, it does not have an obligation, only a right, to purchase oil at $55. Hence, if oil remains below US$55 over the life of the option, say, at US$48, the Government does not exercise that right to buy oil at US$55.

Instead, the Government would buy oil for US$48 on the spot market. The effective cost of oil to the Government would be the spot price of US$48 plus the option premium of US$5, a total of US$53. Given the Government’s concern about price exceeding US$60 per barrel, this would be a favorable outcome.

Now suppose that oil price jumps to US$90 and is expected to remain elevated for an extended period of time. If it had not hedged, the Government would have had to buy oil at the budget-busting price of US$90 or higher. However, since the Government procured the right to purchase oil at a strike price of US$55, it would exercise that right as oil price exceeds the strike price. The effective price of oil to the Government would then be US$55 plus the premium of US$5, a total of US$60. Hence, by spending the premium of US$5, the Government has guaranteed itself a maximum price of US$60 per barrel for oil.

JAMAICA’S OIL PRICE RISK

Purchasing put options would confer the right to sell oil in the future at a strike price that is set at the time of contracting. This contract would be appropriate for an oil supplier that intends to sell oil in the future and wishes to lock in the minimum price it would obtain when the sale is made in the future even if oil price falls significantly in the spot oil market.

For the Jamaican Government to satisfy its demand for oil at a reasonable price, it needs to purchase call, not put, options. Purchasing put options is inconsistent with risk management as it does not provide any protection from an upswing in global oil price. In fact, in this scenario, purchasing put options would exacerbate the oil price risk as the Government could lose the entire put premium and obtain no protection if oil price increased above the strike price of the put option. If pursued by design and not in error, then a put strategy would be purely speculative.

Any entity tasked with procuring oil in the future would purchase puts only if it has a strong belief that oil price will fall in the future and it wishes to generate income from the purchased derivative. While it is perfectly fine for the Government to speculate for oil on our behalf, it is my strong opinion that speculating in the oil derivatives market is not the business of governments.

NOT DRIVEN BY PROFIT MOTIVE

Risk management is, in its essence, a ‘cost centre’ and is not to be perceived as a profit-generating activity. While I have not been privy to all the discussions and have not read all articles pertaining to oil price hedging in Jamaica, some public discussions create the impression that the expenditure of the premium to hedge should generate a profit. This is unfortunate and appears to be the core cause of the confusion in the current debate.

The “profit” from paying the call option premium is the package of benefits that it confers on the Government. The direct benefits are a) the advance knowledge of the maximum price that the Government could pay for oil over the duration of the option contract, regardless of future oil price behaviour in the spot market;; and b) the right to benefit from lower oil price if oil price declines in the spot market before the option expires.

These features of the call option, in turn, imply that the Government can more efficiently plan and manage the expenditure side of the Budget, set targets for a primary surplus, forecast oil-induced inflation, estimate debt-payment capacity, and negotiate loan terms as its oil-related revenue risk is lower. It is worth highlighting that these benefits are not conditional on the eventual outturn of oil price, but instead, accrue to the option buyer immediately upon purchase. Therefore, characterising the success of the call options strategy on the basis of whether oil price eventually increased above the option’s strike price is either deliberately misleading or betrays a misunderstanding of the essence of risk management.

SHOULD THE GOVERNMENT HEDGE?

Successive governments have shown themselves unwilling to embrace oil price hedging. This is not surprising as there are clearly costs to hedging. The decision to pay out a substantial option premium at the time of the initiation of the option contract diminishes the Government’s liquidity, and, hence, its financial flexibility, as well as creates significant opportunity costs as those funds are no longer available to be deployed to alternative high-value-added projects. Moreover, as is currently evident in Jamaica, paying the option premium could create a political liability if, for example, voters are led to believe that if the spot market oil price does not exceed the call option’s strike price during the life of the option, then the hedging strategy was not beneficial to Jamaica.

So should the Government hedge oil price risk? This question is in sympathy with a long-standing question in financial economics: Should firms hedge? I believe it is fair to say that the preponderance of academic evidence now supports the view that hedging generates a net benefit. It is more likely than not that for some hedgeable risks, government hedging creates a net social benefit.

Notwithstanding the aforesaid, whether the Government should fully hedge oil price risk is neither unambiguous nor a trivial question. That is, in some circumstances, it may be optimal for partial hedging, where the government hedges only a portion of the total projected consumption of oil or fully hedges in some periods and not in others. If oil price declines subsequent to a decision to partially hedge, then the partial hedge results in lower costs relative to full hedging, but be aware that partial hedging leaves the hedger with significant exposure to the subject risk.

 Delroy M Hunter, Ph.D., is the Serge Bonanni Professor of International Finance at the University of South Florida. He is currently on a Fulbright Research Scholarship at the Mona School of Business and Management (UWI). Send feedback to dhunter2@usf.edu.