Islamabad - To take maximum benefit from the lowering international oil prices, the petroleum division has recommended the government to hedge the prices of 15 million barrels of oil for up to two years.

In a summary moved to the Economic Coordination Committee (ECC) the Petroleum Division has recommended various options for hedging the prices of Petroleum Products.

According a summary available with The Nation, the Ministry of Energy (Petroleum Division) recommended Call Options for 15 million barrels of oil for one year, divided in 12 monthly accounts, with a strike price of $8 above current Brent as long as the fee is within acceptable range. Similarly it was also proposed that a Call Options 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 the fee is within acceptable range. As per the summary PSO was approved as the call option holder and Ministry of Finance was to give a guarantee of performance by PSO.

Fuel price hedging through call option, which is a contractual tool being used to reduce exposure to volatile and potentially rising fuel costs, is being used by Pakistan for the first time.

The energy ministry proposed that a committee be notified, led by Secretary Finance and comprising of Secretary Petroleum, Secretary Law, Secretary Planning and MD PSO, to finalize the Call options with the selected banks.

OGRA be given policy direction to include the monthly price of the options in the cost of LNG (or any other oil products chosen) in announcing the monthly prices.

It was further noted that the international market for oil and petroleum products has been in a major turmoil for the last few months. Starting from a price was led by Saudi Arabia and Russia (two largest oil producers, who perhaps have a common goal of forcing out American Shale oil producers) to the collapse in demand due to Covid-19 related lockdown around the globe, the market has seen price lows that nobody expected. With the recent agreement on production cuts, the Brent price 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 include crude oil, Motor Gasoline, HSD as well as LNG. In this process, several discussions were held with Standard Chartered Bank, Citibank and a consortium of Habib Bank with JPMorgan to understand the options available and the pricing mechanisms.

The advice from all three institutions was that since Pakistan was considering oil price hedging the first time, it should start with covering 15 percent to 20 percent 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 and the cost of a hedging program goes up in a volatile market, therefore, the collective view was to try to time the bottom of the market, and wait for some level of stability so that the option premium, which has to be paid by the option holder, might come down.

Considering all the possible hedging instruments, two seemed practical to evaluate. First, was a straight swap, where a variable price was to be converted to a fixed price for a defined volume and a defined period of time. This fixed price will of course be higher than the current price and will keep increasing the longer the swap. Second was 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 swap was rejected because while it gives certainty of fixed price, it takes away any benefit of lower market prices if the prices decline further. The call option was selected because it acts as an insurance policy with a price ceiling, while the option holder stays in the position of getting the benefit of lower market prices than the ceiling.

The total imports of crude is 68 million barrel per annum that of HSD is 19 Million barrel per annum, while that of PMG is 45 million barrel Per annum and term contracts of LNG is 6 million tons.

This total is equivalent is approximately 175 million barrel per annum. If we target approximately 9 percent per year for 2 years of this volume be hedged, it translates to approximately 30 million bbl of call options.

The call option is a financial instrument and we 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 entity are involved, while private companies are involved 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, it is recommended that we buy two Cell Options (a) a call option for 15 million barrels, for one year at a spread above current market price of Brent, and (b) a Call options 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 range of $3million/month Option 1 with a strike price of $45 and $5 million/month for Option 2 for a strike price of $50, if paid upfront fully. If we intend to stagger them into monthly payments, there will be a small financing cost in the instalments, but it is 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 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 to 25/bbl. Since the prices of the 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 Option prices, 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 relevant as the market moves.