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BR Research

Oil hedging on the table: Take it!

The Ministry of energy (petroleum division) is proposing a bold decision to hedge imported oil in days of low prices
13 May, 2020

The Ministry of energy (petroleum division) is proposing a bold decision to hedge imported oil in days of low prices. Hedging is not a simple decision in a volatile market as the hedging cost is volatile too. The complications increase in a country where unnecessary politically motivated accountability is a norm. Credit goes to Nadeem Baber and team for coming up with a not-too-expensive call option.

The simple rationale of hedging is that the oil prices are too low due to COVID and once life goes back to normal, prices will go back up. It makes sense to lock in at an agreed price (option) for a defined volume in a defined period of time.

There were two possibilities of hedging. One is straight swap. In this, prices are fixed for a certain volume for a certain period. There is big risk in it. If the oil prices remained low, government will make straight loss. In private sector this possibility can work, but for government, it is too risky and was rejected.

The second possibility is of call option. In this, time and volumes are fixed, but there is an option to exercise the price. It works like insurance. You buy it and use it when and if required.  In this case, if the oil prices remain low, the government can enjoy the low prices. And in case the price goes up (beyond strike price), government can exercise the call option to become insulated from high oil prices. This is less risky, and is proposed by the ministry to the ECC.

It depends upon the call price whether the option is good or not (It is just like an insurance premium). Longer the time of call, higher is the option price. Higher the volatility in the spot market, higher is the option price. The case presented by the Ministry seems to be at a viable cost (for one year) and it makes sense to lock it.

Pakistan’s total oil and gas imports are calculated at 175 million barrels per year. That consists of 68 million barrels of crude oil, 19 million barrels of HSD and 45 million barrels of petrol. Apart from that, there are term contracts of 6 million tons LNG. Government is proposing 9 percent of imports to be hedged for one year and another 9 percent for two years. Since crude and oil products are handled by private sector in refining and selling, it is hard to come with arrangement of price and adjustment.

Ministry is asking for buying call options on LNG. It’s a G to G deal and easier to execute. In case of exercising the option, government can pass on the benefit to electricity consumers. Not to mention that electricity prices in Pakistan are too high. Plus, this can help reduce the import bill in case of higher prices.

The call price is worked to be at $3 million per month for strike price of $45 per barrel (when Brent price was $35 per barrel) for 15 million barrel per annum. The call price per barrel comes at $2.4. This implies, government has to pay $2.4 per barrel for 15 million barrels equivalent of LNG imports for one year irrespective of the price. If the prices remain below $45/barrel, government has to pay $2.4/barrel extra for no benefit. In case, price is above $45/barrel, government has to pay $47.4/barrel by exercising the call option irrespective of how high the prices go.

If oil prices remain on average higher than $47.4/barrel in next twelve months, government will have done well. Since the spot and option prices move every day, ECC approval for a price at a particular level is not likely. Hence, approval is sought for a range of call option prices.

The proposal is to have a strike price of $8 above current Brent for 15 million barrel of oil for one year. Pre-COVID, Brent price averaged at $63.6/barrel in Jan20 before falling to $55/barrel in Feb and nosedived to $23.3/barrel in April. Currently, the price is hovering between $25-30/barrel (and moving up). If the government can have a deal at strike price of $38/barrel, it is making money as long as oil prices remain higher than $40.4/barrel (assuming option cost is $3 million per annum for 15 mn barrels). It seems to be a good buy. Just go for it.

A similar proposal is offered for two years but at a higher premium. Remember, longer the time of option, higher is the cost. Here the call price would be around $5 million per month for 15 million barrel for two years at strike price of $15 above the current rate. The cost would be $4/barrel and if the oil prices remain higher than $49/barrel (assuming current at $30/barrel), this option will make money. It is a little riskyand the government can avoid it.

The best option is to buy one-year option for 30 million barrel. Let’s test the water with around 20 percent of oil import for one year. This can be rolled over after the termination of contract.

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