MUSHTAQ GHUMMAN & ZAHEER ABBASI
ISLAMABAD: The Petroleum Division has prepared call option-based oil hedging plan for one year or two years through some selected banks. It will be submitting hedging plan to Economic Coordination Committee (ECC) of cabinet anytime soon, well-informed sources told Business Recorder.
The international market for oil and petroleum products has been in major turmoil for the last few months. Starting from a price war led by Saudi Arabia and Russia (two of the largest oil producers, who perhaps have a common goal for forcing out American shale oil producers) to the collapse in demand due to Covid-19 related lockdowns around the globe, the market has seen price lows that nobody has ever expected. With the recent agreement on production cuts, the Brent prior seems to have stabilized somewhat.
The Ministry of Energy (Petroleum Division) has been working with the Ministry of Finance for the last one month to evaluate the possibilities of hedging some portion of the exposure to Pakistan for import of petroleum products that are directly or indirectly linked to crude prices. This includes crude oil, motor gasoline, high speed diesel as well as LNG. In this process several discussion were held with Standard Chartered Bank, Citibank and a consortium of Habib Bank Ltd with JP Morgan to understand the options available and the pricing mechanism.
The advice from all three institutions was that since Pakistan was considering oil price hedging the first time, it should start with covering 15 or 20 per cent exposure to start with. Once this program is operational, it can consider increasing the coverage and making it an ongoing program. While price indications were also given, it was clearly advised by all that since the prices change hour to hour, the cost of hedging program goes up in a volatile market. Thereafter, the collective view was (a) not to try to time the bottom of the market and (b) wait for some level price stability.
Petroleum Division is of the view that considering all the possible hedging instruments, two seemed practical to evaluate. First, was a straight swap, where a variable price is converted to fixed price or a defined volume and a defined period. The fixed price will be course be higher than the current price and will keep increasing the longer the swap. Second, a call option where a price cap is bought for a defined volume and a defined period of time. This call option has a price which depends on the length and the level at which the call is set up. After initial discussion, the first structure was rejected because while it gives certainty of fixed price, it takes away any benefit of low market prices if they decline further. The second structure was selected because it acts as an insurance policy with a price ceiling, while Pakistan keep getting the benefit of market prices as long as they are lower than the ceiling.
The total imports of crude is 68 million barrel per annum, that of HSD is 19 million barrels per annum, PMG 45 million barrels per annum and term of contracts of LNG is 6 million tons. This total crude, HSD, MS to approximately 175 million barrels per annum equivalent.
“ If we target approximately 9 per cent per year, for two years, of this volume to be hedged, it translates to approximately 30 million bbl of call options,” the sources added.
The call option is a financial instrument and if Pakistan exercise it( when the price goes above the call level), then the amount received can be allocated to any particular product to keep its pricing fixed at the ceiling for the hedged period. However, since in the LNG sector, only government entities are involved, while private companies are in refineries and OMCs, it would be better to allocate it to LNG. This will also help in synthetically fixing the LNG price at the manageable level.
With this background, Petroleum Division has recommended that Pakistan should buy two call options (i) a call option for 15 million barrels for 1 year at a spread above current market of Brent, and (ii) a call option for 15 million barrels for two years at a spread above current market price of Brent.
“Primarily when we priced the call option when Brent was around $ 35/ bbl, they were in the average of $ 3 million/ month for option 1 with a strike price of $ 45 and $ 55 million/ month for option 2 for a strike price of % 50, if paid upfront fully,” the sources maintained.
However, if Pakistan intend to stagger them into monthly payments, there will be a small financing cost in the installments, but Petroleum Division has recommended to undertake the course. In addition to not having to pay upfront, this also allows OGRA to pass this option cost in the monthly fuel procurement whether LNG or oil products, when determining the prices. However, in this instance, the agreement between the banks will either be directly with the Ministry of Finance or with PSO but guaranteed by Ministry of Finance, in either case the actual cost can be paid by PSO since it will able to recover in the product pricing.
Currently, Brent is in the range of $ 20-25/ bbl. Since the prices of call options are varying every day with the prices of Brent, it is essential that the approval granted by ECC is for a range of call options price, in order for the Finance Ministry to lock it the day an acceptable offer is put on the table by the relevant banks. A fixed price approval will become irrelevant the next day as the market moves.
Petroleum Division has recommended the following options ;(i) call option for 15 million barrels of oil for one year, divided in12 equal monthly amounts, for a strike price of $ 8 above current Brent as long as fee is within acceptable range ;(ii) call option for 15 million barrels of oil for two years, divided in equal 12 monthly amounts, for a strike price of $ 15 above current Brent as long as fee is within acceptable rang;(iii) PSO to be approved as the counterparty and Ministry of Finance to give a guarantee of performance by PSO;(iv) a committee be notified, led by Secretary Finance and comprising of Secretary Petroleum, Secretary Law and Secretary Planning, plus Managing Director PSO to finalise the call options with the selected banks. Final approve will require ECC approval on a short notice and ;(v) OGRA be given a policy direction to include monthly price of the option in the cost of LNG (or any other oil product chosen ) in announcing the monthly prices.