(Thread on hedging: 1/n) Govt should avoid giving an impression that hedging against changes in oil prices will save money in future. It may or may not. Here is a quick thread on how hedging works & what the govt in #Pakistan should watch out for. dawn.com/news/1556226/p…
(2/n) Imagine, for example, that market expects the price of oil to be $30 a barrel in Dec 2020. You go to the market & sign a contract with person A who agrees to sell you X amount of oil for $30 per barrel in Dec 2020.
(3/n) Wen time comes, price of oil may be higher or lower than $30. But, whatever happens, u will get it for $30. If actual price in Dec-20 happens to be higher than $30, person A will make a loss. Y? Person A will hav to buy oil at a higher price & sell it to u at a lower price.
(4/n) Opposite happens when actual price happens to be lower than $30. Note that, in doing so, person A is taking all the risk. It should be obvious that you will have to pay person A some 'premium' for taking on this risk. The size of this premium depends on market volatility.
(5/n) So, going back, person A will not sign the contract at $30 but at a higher price. This is wat is happenin wen the article says, "the petroleum ministry is seeking purchase of oil at ... higher than the current low price." Since the future is very uncertain, premium is high.
(6/n) Now the most important point. There is nothing which say that the price of oil in Dec-20 will be higher or lower. If it is higher, u save money. But if it is lower, u loose money. Hedging is good bec u dont have to worry about changes in oil prices anymore. That's it!
(7/n) When the previous govt signed long-term LNG contracts, they thought future prices will be higher. But it did not turn out that way. Some in media & outside criticised the then govt for causing losses to taxpayers. But it wasn't the govt's fault. This is how 'hedging' works.
(8/n) The same can happen this time. If the effect of covid19 on world economy lasts much longer than what markets expect right now, oil prices may remain lower for longer. Or, if our economy does not recover sooner, we may have to buy more than wat we need.
(9/n) In such an environment, it is good that the petroleum ministry is only advocating "hedging some portion of exposure to Pakistan for import of petroleum products." Getting it wrong, even if for no fault of ur own, has a much higher cost in a low trust society like ours.
(n/n) Finally, it is equally imp. to get the story right. Govt shud not give the wrong impression that 'hedging' will save money. It can go either way. Rather, it shud be made clear tht hedging will insulate us from fluctuations in oil prices & help us plan for the future better.
