I want to try and clarify certain issues related to the current discussions on hedging our oil purchases.
First, reference is often made to futures and other forward contracts for oil which involve contracting today for future deliveries of a certain specified quantity and quality of oil. These futures contracts expire during different months in the future and are used by both consumers of oil and traders or speculators.
An oil consumer would take delivery of the oil at a specified seaport, for example in Cushing, Oklahoma or from a specified pipeline. A trader or speculator, in contrast, would want to avoid taking delivery and just terminate the position or transfer it into a contract which expires further away.
Normally, futures with longer maturities are more expensive than those with nearer maturities because of the storage, financing and insurance costs which the holder of the physical oil has to incur. Farther futures, therefore, are generally more expensive than nearer ones and this even if the market believes that the spot price today is about equal to the expected spot price at the future date. The spot price can be taken to mean the price for instant delivery against cash.
However, it sometimes happens that the market expects supply and demand conditions in future to be substantially different than they are today. This may be because of seasonality or new supply capacity coming into the market or greater future demand or what have you. If the market expects the spot price in future (including incidental costs) to be lower than it is today then the price of the farther future contract would be lower than that of the nearer one. The market goes into what is called "backwardation".
As I write, for example, the spot price of light, sweet crude oil is around $61 but the expected long-term price is in the mid-$40s. This is the price which is implied in the valuation of publicly traded oil companies. It is also close to the indicative range given by Lord Browne, of BP, to Bloomberg this week.
Reflecting this, therefore, Crude Oil futures are trading at $62.35 for the December 2005 contract, $60.40 for the December 2007 contract, $56.70 for the December 2009 contract, and $55.65 for the December 2011 contract. The prices quoted are for futures on the New York Mercantile Exchange(NYMEX).
Malta, as a consumer of end oil products, is likely to be more interested in futures for refined oil products, such as unleaded gasoline and fuel oil, rather than for crude oil itself. One has to examine prices across the different energy contracts and for different months into the future.
Futures for gasoline and other refined oil products, for example, are following similar patterns, although trading in the standard contracts (i.e. the contracts as specified by the relevant futures exchange) far into the future tends to be a little thin and many use forward contracts arranged via intermediaries. For such refined oil products, also, futures prices tend to go into backwardation in later months.
The futures prices, of course, reflect the existing and likely future fundamentals and the different circumstances surrounding crude and refined oil products, such as gasoline and fuel oil.
Opec recently argued, for example, that take-up of crude oil was very slow and that, while its members stood ready to increase production if necessary, actually increasing production now could lead to a glut. It is the shortage of refining capacity, rather, which is pushing prices up, and fuelling speculation. It is feared that production would not be enough to keep up with the new demand coming from China and India.
During the last 30 years or so, no new refineries were built. Indeed, in the second half of the 1990s, in the US alone, there were 24 refinery closures. This situation is being redressed and it is said that the order books for new refineries are now full and a number of other refineries are being upgraded.
A refinery with a capacity of 500,000 barrels per day costs around $10 billion to build. As the additional capacity comes on-stream, the supply of refined oil would put downward pressure on prices to mitigate the upward pressures coming from emerging economies.
Nobody knows tomorrow's news, of course and that means nobody can forecast accurately. The best one can do is elicit the best informed opinions. These opinions are reflected in the market since the market consists of people who back forecasts with their own money.
Every action is a bet but doing nothing is also a bet. Describing hedging as a bet, therefore, does not take you to the heart of the problem. A bet, in itself, is neither a good thing nor a bad thing. Whether you win or lose depends on the odds. What one needs to ascertain is the benefit one is trying to derive from the hedge, or the bet.
The benefit of hedging is not primarily a low price but a known price. You hedge not necessarily to capture what you think is a low price but to know beforehand what the price is going to be so that you can plan. The edge of the hedge is that it buys you certainty.
Hedging is a two-edged blade and decisions as to the average level of hedging which ought to be in place is a policy decision since there is a trade-off between the benefits of certainty and the gain/loss in the price.
Paul V. Azzopardi is managing director of Azzopardi Investment Management Limited (www.azzopardi.com) which is licensed by the MFSA to provide investment services, including stockbroking. Mr Azzopardi or related parties, including the company and their clients, have an interest in securities mentioned.
This article is only meant to provide information, which the writer believes to be accurate at the time of writing and is not intended to give investment advice and its contents should not be construed as such.
The value of securities and the currencies in which they are denominated, may go down as well as up. Readers are requested to seek professional financial advice tailored to their own personal circumstances.