Wed, 14 Feb 2018 10:52:26 +0000
By PHILIP CHULU
IT is not a hidden fact that the volatility in fuel prices has adversely affected the cost of living in Zambia.
The rate a which the pump price of fuel is going up in the country is indeed a matter of concern.
The rise in fuel prices has affected the cost of doing business, and significantly reduced the amount of disposable income in the hands of Zambians.
In this article, I seek to explore possible solutions to this major issue affecting the lives of Zambians across all walks of life.
For us to come up with a solution, we must first identify the source of the problem we seek to address.
PRICE VOLATILITY
The term “price volatility” is used to describe price fluctuations of a commodity.
Volatility is measured by the day-to-day percentage difference in the price of the commodity. The degree of variation, not the level of prices, defines a volatile market.
Since price is a function of supply and demand, it follows that volatility is a result of the underlying supply and demand characteristics of the market.
Therefore, high levels of volatility reflect extraordinary characteristics of supply and/or demand.
Prices of basic energy (natural gas, electricity, heating oil) are generally more volatile than prices of other commodities. One reason that energy prices are so volatile is that many consumers are extremely limited in their ability to substitute other fuels when the price, of natural gas for example, fluctuates.
CAUSES OF VOLATILITY IN FUEL PRICES
According to research, crude oil prices make up 71 percent of the price of fuel. This makes it a major influencer of fuel prices. The remaining 29 percent comes from distribution, refining, and taxes, which are more stable.
Oil is a commodity, and as such, it tends to see larger fluctuations in price than more stable investments such as stocks and bonds. OPEC, or the Organisation of Petroleum Exporting Countries, is the main influencer of fluctuations in oil prices.
OPEC is a consortium made up of 13 countries – Algeria, Angola, Ecuador, Indonesia, Iran, Iraq, Kuwait, Libya, Nigeria, Qatar, Saudi Arabia, the United Arab Emirates and Venezuela.
OPEC controls 40 percent of the world’s supply of oil. The consortium sets production levels to meet global demand and can influence the price of oil and gas by increasing or decreasing production.
As with any commodity, stock or bond, the laws of demand and supply cause oil prices to change. When supply exceeds demand, prices fall and the opposite is also true.
The fall in oil prices can be attributed to a lower demand for oil in Europe and China, coupled with a steady supply of oil from OPEC. The excess supply of oil caused oil prices to fall sharply.
Therefore, the price of fuel in Zambia is greatly influenced by the performance of crude oil on the global markets.
Another fact that may greatly influence the price of fuel in Zambia is the performance of the local currency against major currencies.
Zambia heavily relies on imported fuel as it is not an oil producing country.
Crude oil on the global markets is priced in dollars. Hence an adverse performance of the Kwacha makes it expensive to buy imports denominated in a foreign currency.
The issue of volatility in crude oil and hence fuel prices is not just a matter of concern to Zambia but to many other nations, companies and industries that are heavily reliant on usage of fuel.
THE SOLUTION
Over the years, some large fuel consuming companies, such as airlines, cruise lines and trucking companies have developed strategies to manage and mitigate the huge risk faced by the volatility in the crude oil prices.
HEDGING
A fuel hedge contract is a futures contract that allows a fuel-consuming company to establish a fixed or capped cost, via a commodity swap or option.
The companies enter into hedging contracts to mitigate their exposure to future fuel prices that may be higher than current prices and/or to establish a known fuel cost for budgeting purposes.
If such a company buys a fuel swap and the price of fuel declines, the company will effectively be forced to pay an above-market rate for fuel.
If the company buys a fuel call option and the price of fuel increases, the company will receive a return on the option that offsets their actual cost of fuel.
If the company buys a fuel call option, which requires an upfront premium cost, much like insurance, and the price of fuel decreases, the company will not receive a return on the option but they will benefit from buying fuel at the then-lower cost.
TYPES OF HEDGES
- Purchasing Current Oil Contracts
In this hedging scenario, an airline would have to believe that prices will rise in the future. To mitigate these rising prices, the airline buys large amounts of current oil contracts for its future needs.
This is similar to a person who knows that the price of gas will increase over the next 12 months and that he will need 100 gallons of gas for his car over the next 12 months.
Instead of buying gas as needed, he decides to buy all 100 gallons at the current price, which he expects to be lower than the gas prices in the future.
- Purchasing Call Options
When a company buys a call option, it allows the company to buy a stock or commodity at a specific price within a certain date range. This means that airline companies are able to hedge against rising fuel prices by buying the right to buy oil in the future at a price that is agreed on today.
For example, if the current price per barrel is $100, but an airline company believes that the prices will increase, that airline company can purchase a call option for $5 that gives it the right to buy a barrel of oil for $110 within a 120-day period.
If the price per barrel of oil increases to above $115 within 120 days, the airline will end up saving money.
- Implementing a Collar Hedge Similar to a call option strategy, airlines can also implement a collar hedge, which requires a company to buy both a call option and a put option.
Where a call option allows an investor to buy a stock or commodity at a future date for a price that’s agreed upon today, a put option allows an investor to do the opposite: sell a stock or commodity at a future date for a price that’s agreed on today.
A collar hedge uses a put option to protect an airline from a decline in the price of oil if that airline expects oil prices to increase. In the example given, if fuel prices increase, the airline would lose $5 per call option contract. A collar hedge protects the airline against this loss.
- Purchasing Swap
Contracts
Finally, an airline can implement a swap strategy to hedge against the potential of rising fuel costs. A swap is similar to a call option, but with more stringent guidelines. While a call option gives an airline the right to buy oil in the future at a certain price, it doesn’t require the company to do so. A swap, on the other hand, locks in the purchase of oil at a future price at a specified date. If fuel prices decline instead, the airline company has the potential to lose much more than it would with a call option strategy.
These strategies have been successfully implemented by corporations throughout the world. Surely countries cannot be an exception.
A CASE STUDY OF
MOROCCO
Source: Financial Times
Morocco has become the first oil-importing country to turn to Wall Street banks to protect itself against high oil prices.
The move highlights the challenges faced by governments in Africa and the Middle East grappling with social discontent because of rising fuel costs. Morocco has entered into derivative contracts to hedge any unexpected rise in the cost of imported fuel, the Financial Times said, citing two people familiar with the deal.
The rare hedge transactions, made last month, come as Morocco starts to wind down a costly subsidies programme under pressure from the International Monetary Fund. Morocco is the only oil importing nation known to be hedging its consumption through derivatives arranged by the government, the Financial Times said.
Ghana, an oil exporter, has previously taken out hedges on oil imports and exports at the same time. The Moroccan government initially hedged its imports with local bank Banque Marocaine du Commerce Exterieur (BMCE), and BMCE then paid premiums to Barclays, Citi and Morgan Stanley to take on the risk.
The transactions covered a large chunk of Morocco’s expected fuel consumption for the rest of the year, and cost the government roughly $50-60 million, the Financial Times said, citing a person familiar with the deal. The government bought so-called call options for European diesel, which give Morocco the right to buy fuel at a predetermined price for the rest of the year. Morocco’s move comes as countries across the world balance the cost of fuel subsidy regimes with the threat of social unrest if they unwind them.
CONCLUSION
I therefore would recommend the Energy Regulation Board and the Zambian government to implement hedging strategies to mitigate risk in price movements of crude oil.
