Central Bank advises Govt. to hedge oil prices

COLOMBO: Sri Lanka should hedge oil prices to mitigate negative effects on the economy, by entering into contracts with foreign banks, the country's Central Bank said in a statement. The Central Bank said it had made a presentation in early September to the President and Cabinet of Ministers to explain schemes available in the global market to hedge oil prices.
"Such forward contracts or hedging arrangements would have to be entered into with international banks of high reputation, who have the experience and ability to manage risks of this nature," the Central Bank's Economic Research Department said in a statement Thursday.
Crude oil is imported in Sri Lanka by the Ceylon Petroleum Corporation, which is a state-owned enterprise, while a subsidiary of the Indian Oil Corporation which has a third share of the market, only imports refined products.
The Bank said it had made the presentation to the government because, 'in the view of the Central Bank, it would be imprudent for any organisation or a government not to pursue an insurance scheme such as a hedging mechanism, when dealing with a highly volatile market, which if left unchecked, could result in a high foreign exchange drain that could even destabilise the entire economy.'
The Central Bank said Sri Lanka's oil bill went up by 37 percent in 2005 to 1,655 million dollars on top of a 45 per cent in crease in 2005.
In 2006, the Bank is projecting the oil bill to rise to 2,200 million dollars, which was equal to 31 per cent of export earnings compared to 17 per cent in 2002.
As percentage of imports, the share of oil is expected to rise to 21 per cent in 2006 (13 per cent in 2002).
Economists have pointed out that Sri Lanka's policy of heavily subsidising oil since 2004 has boosted demand and blunted the incentive make better use of energy by sending the wrong price signals.
Central Bank said Sri Lanka could either pay a premium and buy futures contracts, getting a cap for oil imports; or go for other hedging mechanisms that gives protection within a price band or a 'collar'.
"For example, under this mechanism, if Sri Lanka purchases a cap at (say) US$ 60 per barrel, the country need not to pay a higher price even if world market prices reach US$ 100 per barrel or beyond," the Bank said.
"In such a situation, Sri Lanka would be free to purchase oil at the prevailing market price if prices fall below US$ 60 per barrel. Another mechanism is a "Zero-cost Collar" that can provide similar protection without Sri Lanka having to pay a premium."
Collars can be built by selling an option at one price and using the proceeds to buy an option at a different price.
"However, in this method, Sri Lanka would have to commit to a minimum price, below which Sri Lanka would not benefit by the reduction," the Bank said.
The Bank said oil prices have risen with high demand from China, India and USA, capacity limitations in refineries, supply disruptions in some oil exporting countries and general geopolitical unrest.
"With the easing of certain pockets of geopolitical unrest, oil prices seem to have declined but several other factors, which could raise oil prices, are still present," the bank said.
"In that background, it would be prudent for Sri Lanka to contract for oil at a reasonable price with a protection from future increases, as that would lead to greater economic stability."

Add to: del.icio.us | Digg | | | | | | | | | | | | |