Labour's hedging bets

In January 1998, during the last year of the short-lived Sant administration, Enemalta entered a contract to buy fuel oil, diesel and Jet A1 at pre-agreed prices. They lost the bet and, as a result, between February and December 1998, they racked up losses totalling Lm9.1 million on their hedge. In August 1998, ever the gluttons for self-inflicted punishment, they signed another contract covering all of 1999. They racked further losses of Lm3.7 million in the first five months of 1999, before spot oil prices changed course.

In the oil-importing countries, the general public is palpably angry at the explosion in oil prices, and politicians generally take the blame. In the United States, the oil companies have come in for some severe criticism and the dip in President George W. Bush's popularity has to do - in part - with high fuel prices. In the US, it may make sense to expect the President to do something about the problem, even though there are limits, even to what the US government can do.

The situation in Malta is somewhat weird. The Opposition is trying to give the impression that the high prices we are paying for fuel and electricity are entirely the government's fault... as if it has little to do with conflicts involving oil-producing countries, soaring demand from China and India, or the geopolitics of oil prices. Rather it is all a matter of our government's incompetence.

The Leader of the Opposition keeps rubbing salt into the wound, as he did in a recent Wednesday 'PR' column in The Times: "International oil prices are not set by the Gonzi administration. They knew that this year there would be a consistent upward pressure on oil prices. They failed to take corrective action to stabilise internal prices through hedging."

So the current administration is supposed to have known ahead of time that there would be consistent upward pressure on oil prices. The question that Alfred Sant must answer is: in the face of such certainties where would one find traders who would be stupid enough to commit themselves to keep selling oil to Malta at low prices? Are these counterparts (for example, those who sell the futures contacts) so dim as to be willing to undertake transactions that guarantee them a loss, and keep doing so repeatedly? If the Gonzi administration is expected to be prescient, then how come those on the other side of the hedging strategy don't know the same things?

Hearing Malta's hedging aficionados on this issue, one gets the distinct impression that they are not shooting straight. When they speak of a stable price, they actually want people to understand a stable and low price. The truth is that guaranteeing a price is possible, but guaranteeing a price that is lower than the spot price is impossible.

In effect Dr Sant is claiming that he or his experts know how to keep buying oil on the cheap. By implication, if we had a Labour government, we would be paying 20c for a litre of petrol and electricity would cost a fraction of today's rates. Energy and fuel users in Malta would never have to face market realities. If Labour is so smart now, how come it was so stupid in 1998?

Hedging may make sense if the intention is for Enemalta to lock in an oil price that would permit a particular level of the electricity surcharge. For example if a surcharge of 70 per cent is consistent with an oil price of say $60, and Enemalta hates the thought of having to face the public at some time in the future with an even higher surcharge, then Enemalta should perhaps contract forward at $60. That way, for say the next year, the surcharge can be left constant at 70 per cent, and Enemalta management can sleep well at night.

That's the good news. The bad news is that if the spot price drops to $50, then Enemalta is still bound by its futures contract, and obliged to pay $60 for its oil, and the surcharge cannot be reduced.

If what one is after is certainty and price stability, then hedging is the way to go. However, hedging instruments can be used also for speculative purposes and I believe that what the critics are suggesting is in fact sheer speculation.

These are all zero-sum games. The gain made by one side is mirrored by the loss on the other side. If Enemalta succeeds in continually getting oil at below spot market prices, somebody somewhere keeps making equivalent losses. Who are these counterparts, those who end up absorbing the loss?

According to some of the proponents of hedging, the financial institutions who offer these attractive deals would themselves have made earlier deals with suppliers for cheap oil. So, the loss is absorbed not by the traders who sell the forward contract, but rather by some other fool higher up the supply chain. Hedging's proponents seem to think that there are businesses somewhere out there that thrive on self-inflicted losses.

There's a school of thought that believes that the Labour Party carries a strain that brings out a weakness for gambling. I have referred over and over again to what happened in 1985, when Labour's big name was allowed to speculate with the foreign assets of the Central Bank.

The story is told that he was sure the dollar would go in one direction. Instead it went in the opposite direction. The resulting loss amounted to Lm81 million. The Central Bank's accounts showed a smaller loss thanks to a convenient revaluation of gold holdings. Compounded at a modest interest rate, the Lm81 million meltdown would top Lm200 million in today's money.

Compared with such a big chunk of loss in our reserves, Enemalta's hedging losses in 1998 amount to a small bag of peanuts. Similarly, the current rise in oil prices looks modest in comparison.

But Labour keeps hedging its bets by assuming that it can keep blaming the government for the increase in oil prices that have directly led to the rise in fuel and energy charges. They are acting as if they are convinced that the 'hedging trick' will propel them to power, just as the 'VAT trick' did in 1996. They just can't resist a gamble!

micfal@maltanet.net