(With apologies to Shakespeare)

Hedging is a gamble. To be successful, gambling or betting on racehorses requires knowledge and history of the animal, as well as an understanding of the race its best fit to run. Commodity hedging is no different.

Hedging provides a useful insurance against adverse oil price movements as experiences in several developing countries have demonstrated. The World Bank Policy Research Working paper 1667, published in October 1996, “Dealing with Commodity Price Uncertainty”, warned that, “The use of commodity derivative markets requires considerable knowledge and the existence of an appropriate institutional framework within which to carry out hedging operations. Hedging requires special attention from the user of commodity derivatives, it requires personnel to follow the positions in commodity markets as well as a system of controls to avoid abuses.”

IMF (International Monetary Fund) Working Paper Financial Instruments to Hedge Commodity Price Risk for Developing Countries, published in January 2008, examines the use of commodity options to hedge the vagaries of international commodity prices and also recommends alternative “hedging” options. Hedging is therefore a practice acceptable by both the World Bank and IMF.

It is important to understand that hedging will not hold the price of a commodity — in this case oil — but when properly applied, it will reduce the risk of exposure to oil price fluctuations. Hedging is risk reduction and not price stabilisation!

Investing in “hedges” necessitates an official hedging and risk management policy to formalise risk objectives, risk tolerance, a decision-making process and identifying individuals to carry out transactions. This requires risk analysis, experience in risk management as well as in the oil industry, coupled with diligent research. However, before the risks can be effectively managed, they must be identified and measured. While well-planned and well-executed hedges can be remarkably effective, a hedge can be disastrous when improperly implemented.

It was indeed an expensive (US$25 million) learning experience which may not have taught us much, as there is still talk about stabilising petroleum prices. Indeed, the Private Sector Organisation of Jamaica which supports the hedge understood that it was for risk reduction. Insofar as price stabilisation is concerned, we have forgotten the gas riots of December 1979 and what caused them.

In mid-1978 under an IMF programme, a series of monthly “mini-devaluations” of the Jamaican dollar vs the US dollar was imposed by Government. In that year and as part of Government’s five-year Development Plan, the Energy Plan envisaged “phasing-out of subsidies on petroleum products over a 12-month period to bring (petroleum) prices to reflect full effect of special exchange rate and OPEC price increases”. At that time, certain petroleum prices were held constant despite the monthly devaluations as well as the normal market price variations, as still occurs.

What this meant was that, on the one hand, Government’s policy was to stabilise petroleum price fluctuations, and on the other, to pass on to the consumer real price increases brought about by the devaluations. Naturally these two contradictory policies could not co-exist indefinitely, and hence, massive price increases were required in December 1979 when the petroleum price stabilisation fund was fully depleted. Large price increases were necessary, resulting in public outcry leading to riots.

Since hedging is risk management and not price stabilisation, perhaps one should ask the Government how they proposed to stabilise crude petroleum prices. Petrojam — the refinery — does not produce all the islands product needs and significant volumes of gasoline and diesel are imported. If, for example, the February 2015 hedge (bet) was successful and the price of the selected crude rose by US$20/bbl, then Government would have collected US$120 million on maturity. This gain would of course be reduced by the hedging costs, but still the question would be, how would this be used to stabilise prices?

It is certainly less complicated to hedge say JPSCo’s (Jamaica Public Service) fuel oil prices, but this would have to be the responsibility of JPS. Similarly, JPSCo can hedge diesel prices using the gain (if any) to offset losses when they occur.

The pricing of petroleum products is a complex business because some of the principles normally applied to the pricing of other commodities, for example those which take cognisance of raw material and manufacturing costs, are not directly applicable to the petroleum industry.

The petroleum market, especially insofar as international product prices are concerned, behaves more like an auction than any other commodity. On the production side, prices are heavily influenced by future crude price expectations and on the market side, by the need to ensure supply availability at a price which will secure these supplies.

Government’s involvement in the pricing of petroleum products had its genesis when the Esso Kingston refinery was commissioned in 1962. Prior to this, each marketing company — Esso, Shell, and Texaco — had their own import terminals in Kingston and Montego Bay and imported products from their own regional refineries. Since these imports were to be replaced with purchases from the refinery, a Heads of Agreement between Esso and the Government established a pricing mechanism which ensured that …. ”the selling price of each product manufactured in the refinery must be no greater than the selling price that would prevail had the product been imported from the cheapest source on the basis of an arm’s length transaction…”

The selling price of petroleum products produced in the three regional refineries, existing at that time, was published on a daily basis in the trade journal

Platt’s Oilgram. Esso Jamaica would use the average of these prices plus the published cost of freight from the Gulf to Jamaica as the basis for their ex-refinery pricing. To these prices and for each product the Government would add tax plus increments to cover (1) road haulage and (2) round island movement for shipping product from Kingston to Montego Bay, (3) marketers margin and (4) retailers’ margin. A fifth increment would also be added which was the (5) “Stabilisation Factor”.

The objective of this pricing system was to ensure that the price of transportation of fuels, gasoline and diesel would be the same at a Kingston retail station as any other station islandwide. Hence the Stab Factor could be negative or positive, depending on the product. Some products, like cooking gas (LPG), kerosene and diesel, used by rural transport buses were negative in order to subsidise these fuels. All increments were added together to represent the final product selling price. These figures were audited on a regular basis by the ministry responsible for energy.

Funds collected from the “Stabilisation factor” were deposited to a special account held by the Ministry of Finance, but administered by the ministry responsible for energy.

What is required is transparency, starting with what is the objective, management of risk or price stabilisation. Is a new petroleum pricing policy required?

Finally, there is another dimension to be considered and that is, what future is there for Petrojam? The refinery cannot process a barrel of crude without producing fuel oil. Depending on the type of crude, fuel oil represents almost 40 per cent of their production. When the JPSCo switches to LNG, Petrojam’s main market for fuel oil will disappear and crude processing will no longer be economical. Petrojam may then be faced with the possibility of only operating as an import terminal, unless the refinery is upgraded.

To bet or not to bet, what would have been your bet?

William “Bill” Saunders is a chemical engineer who specialises in the energy sector. He was the first director of energy, a founding director of Petroleum Corporation of Jamaica, Petrojam and Petcom as well as their first group managing director.