Let’s get down to the answer right away: yes, they should. There are a number of factors that make hedging ideal, but the most important thing is to understand and determine the reason behind the hedge.
Governments hedge their oil prices not to benefit from a change in price, but rather to lock in a price for several months, enabling them to plan and budget the year ahead. Unfortunately, with such a sharp decline in oil prices, the true purpose of hedging oil has currently been forgotten.
When arguing about hedging, one should not target the change in price but rather question the type of hedging that is being used.
In the long-term, hedging pays off as it creates stability, which in turn improves the economic system. However, it needs to be well planned and organised.
One should also question the types of instruments used by governments when it comes to hedging as this is of the utmost importance, especially when it comes to cost and flexibility.
Judging or being judged with hindsight does not make sense in the hedging industry. If the hedge is out-of-the-money – that is, it would have been better (with hindsight) if the government had done nothing – then society may complain because the cost of fuel would be relatively higher than the cost of fuel in most foreign countries.
On the other hand, if the government’s hedging ends up in-the-money, then society will probably neither complain nor congratulate the government. After all, it is perceived as being the government’s duty to get the best price available.
Lack of knowledge about hedging may also be an issue as some sectors of society may not fully understand its true purpose. This leads to the dilemma faced by many governments: whether to hedge or not. In order to overcome this dilemma we need to go back to the true reason for hedging – that is, to remove uncertainty and get price stability for a period of time – irrespective of whether the hedge results in a profit or loss.
Furthermore, one may look at hedging with a different perspective. As human beings we tend to give more weighting to negative results. But we should also note what happens to an economy if the cost of fuel increases without a hedge in place.
We are currently looking at an opportunity cost since the price of fuel decreased when a hedge was in place. But what if it were the other way round?
Is the government robbing society? This is a tricky question. Politics aside, in order to answer such a question one needs to have at hand all the necessary information – which is not realistically available to the public. One would need to see the hedging agreement, the cost of hedging, reasons why that agreement was chosen, the length of the agreement, the company used, and so on.
As long as fuel prices reflect the price outcome from the hedge, this on its own does not make a government anti-social. However, the type of hedging instruments used and the studies behind the hedge would be an important factor to answer this question.
Looking forward, I believe it would be more expensive in the long-term if governments moved away from oil hedging. This is backed up by a number of studies done throughout the years, although some research does not provide the same outcome. Perhaps further studies need to be conducted on more recent scenarios.
Furthermore, in domestic discussions, we are forgetting one important factor which goes side by side with oil hedging: foreign exchange hedging. Since oil is priced in dollars and our taxes are collected in euro, there is an exposure to the euro/dollar exchange rate when purchasing oil.
One should also note the inverse relationship which normally occurs between the value of oil and the US dollar. However, this is beyond the scope of this article.
The euro/dollar rate dropped sharply in the past months, resulting in considerable pain for those who did not hedge this currency pair, even if they did not hedge oil. This is because the government now needs to pay more euros to get the same equivalent of US dollars. Hence, the cost of oil in euro terms will be more expensive due to a weaker euro. Worst case scenario is for those governments that hedged the price of oil at higher prices and did not hedge the euro/dollar exchange rate.
John Mark Caruana is a senior trader with FX market maker Domino Europe Ltd.