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How oil hedging could allow Egypt to lift fuel subsidies despite rising international prices
 
 

Rises in international oil prices before the completion of Egypt’s fuel price liberalization program has put the Egyptian government in a quandary.

The significant negative impact of fuel price hikes on general prices, economic growth and people’s living standards in Egypt means that each price increase comes at a great cost. But the agreement Egypt brokered with the International Monetary Fund (IMF) gives the government a deadline to lift subsidies.

In hedging oil prices, however, the government has found a way to move forward with its austerity program without leaving the domestic market completely vulnerable to an uncertain international market.

The Finance Ministry is currently reviewing seven offers for hedging services from international banks and institutions. These services would allow the government to buy oil over a long period of time at a fixed price in order to avoid the uncertainty in the international market. It is expected to finish reviewing the offers in August, with the intention of taking on a three-year contract, official sources told Enterprise in June, speaking on condition of anonymity. One of the offers has been to cover any rise in prices above US$70 per barrel, according to these sources.

This move follows a June Cabinet decision to approve the formation of a committee from both the Petroleum Ministry and Finance Ministry, which has been tasked with reviewing the possible strategies for hedging against rising oil prices in international markets. The development is seen by three economists who spoke to Mada Masr as a necessary move that could protect the domestic market from the volatility of the international market if done properly, albeit with inherent complications and risks.

If the government does not hedge its oil contracts, a surge in oil prices would risk inflating the fuel subsidy bill in the Egyptian state budget, reversing four years of austerity measures that have aimed to reduce the budget deficit, despite the impact the measures have already had on the economy and people’s living standards.

International oil prices have soared in the past few weeks, and Brent crude oil came close to $80 per barrel in May, its highest price in four years. Although Brent is now hovering around $74 per barrel, the international oil market remains highly volatile.

How oil hedging works?

Hedging against rising international oil prices entails a contract between the government and a hedging services institution or bank or directly with a petroleum company. The contract covers an agreement on a fixed price for a fixed quantity of oil over a certain period of time, to overcome market uncertainty.

“In its simplest form, [hedging] is an agreement with a counterparty to buy or sell an object (in this case, barrels of oil) at a fixed price in the future. The buyer fears higher prices. The seller fears lower prices. They agree to buy and sell at a fixed price to protect them from these fluctuations,” Sherif Wadood, an expert in the economies of petroleum, tells Mada Masr in an email interview.

According to Wadood, what hedging brings to the table is certainty for the prices on which the budget is drafted. So for the government to predict oil prices a year ahead, it would have to face high risks of an uncertain international market. But in return for this certainty, the government gives up the future upside that prices could fall.

In hedging, the government would have two have at least two main choices: Egypt could either go for a futures contract or a call option contract. The contracts would have a counterparty, which could either be the petroleum company or a financial institution. But the details of the contract and the choice would depend on the government’s strategy, which both analysts recommend a consultant’s opinion on.

Fixing prices at $70 per barrel, for example, would mean that if international oil prices exceed $80 or $85, Egypt’s budget would not be impacted in the way it was during previous fiscal years, Omar al-Shenety, the managing director at the Cairo and Dubai-based investment bank Multiples Group, tells Mada Masr.

However, if it were the other way around and international prices fell below $70 per barrel, the government risks incurring costs higher than the market, in case it opted for a futures contract, which is the most commonly used contract type in the oil market, says Shenety. Alternatively, if the government opts for a call option, which is uncommon in the oil market, it could have the option of buying at the price stipulated in the contract if international prices rise and buy at the market price if they fall, avoiding any associated risks. But this would entail paying a premium in the form of a contract fee, explains Shenety, which, in the current context, could end up becoming very expensive.

“Depending on the structure of the hedge, the upfront costs will vary. I don’t think the government will enter into a structure that will have uncapped risk. This would be too dangerous and defies its objective,” notes Wadood.

A lost opportunity

This is the first time that the Egyptian government is looking to hedge in the oil contracts it enters into as a buyer. Over the years, the state budget has always been vulnerable to international price volatility. In one year, it would benefit from a plunge in prices, and in another, it would bear the brunt of an unanticipated surge.

A steep plunge in international oil prices in 2014 on the back of a supply glut allowed the government to lower its fuel subsidy bill with only one price hike on end consumers in two fiscal years. At the time, international oil prices tumbled to as low as $30 per barrel.

“This was a prefect hedge moment for the government. They would have secured low prices for 5 years or more. It would have taken off much of the burden,” says Wadood.

But the government did not hedge its contracts, and in fiscal year 2016/2017, the budget target for the fuel subsidy bill was LE35.4 billion, but the government ended up spending LE115 billion, as fuel prices rose more than predicted.

Source: Ministry of Finance
*LE115 billion is the preliminary spending estimates, according to the updated financial statement
**LE120 billion is the expected value for fuel subsidies in FY 2017/2018 financial statement according to a copy of the draft budget obtained by Mada Masr.

“Why did the government not do this before? I don’t know. It was an obvious thing to do, given the subsidy bill and the budget deficit. Maybe it was comfortable with the lower prices throughout the past three years or so, until it was surprised by the recent rise. Maybe there was a lack of resources, sophistication and competence,” says Wadood.

The government, like the petroleum sector, expected prices to remain low for longer than they did, financial economist Mohamed Sultan tells Mada Masr. The most obvious example of this, he says, is the move by most petroleum companies to suspend or lower their investments, indicating they anticipated prices to remain low for a long period and, hence, did not expect a good return on investments.

But going forward with hedging now is a complicated process that requires a strategy to be put forward by a party with experience in the hedging market, warns Shenety.

“The government should hire an independent hedge advisory firm first, before evaluating the hedging bids. They should not rely on banks or a counterparty for the design and evaluation of the hedge structure. This could be very costly, as there is an inherent conflict of interest — banks are focused on their fees,” says Wadood.

But despite these concerns, the Cabinet has tasked the move to the hedging market to two ministries with no previous experience in a market with high stakes for all parties involved.

Despite the lost opportunity and the complex market, the move was seen by the three economists as still relevant and necessary. The government “should hedge now, to protect themselves in the event that crude prices go higher, which would be devastating,” says Wadood.

What is at stake?

A scenario where the government does not hedge oil prices and where prices in the international market soar would be devastating for Egypt’s economy, government and population.

“If international oil prices surge [without hedging], it is unlikely that the government will completely lift subsidies. If this happens, the government faces two losses. The first entails the persistence of a high budget deficit on the back of a large fuel subsidy bill. A high budget deficit would, in turn, be financed by higher consumption taxes, leading to a rise in general prices,” says Sultan.

In this scenario, the government would need to simultaneously hike prices on end consumers, adding one more factor causing higher inflation rates, he adds.

Alternatively, “hedging against the rise in oil prices allows prices to be fixed in the budget. Subsequently, domestic fuel prices can be fixed in accordance to the hedging contract, while also reducing the subsidy bill,” says Shenety.

In this scenario, the government can transfer the cost of fuel completely to the consumer while maintaining fixed prices in the market for the period of the contract, guaranteeing price stability and simultaneously lifting subsidies.

Since the government began raising fuel prices in 2014, one month after President Abdel Fattah al-Sisi took office, and on the back of years of consultations with the IMF, fast-rising inflation rates took a toll on people’s living standards.

The plan was based on an assumption that oil prices would not increase significantly before the fuel subsidy bill was completely lifted, notes Sultan.

The plan — which the government later committed to in an international agreement with the IMF in exchange for a $12 billion loan over three years — involves lifting subsidies on all fuel types except liquefied petroleum gas by the end of the agreement’s time frame in November 2019.

In Egypt’s agreement with the IMF, the government is committed to implementing what is called “automatic fuel price indexation mechanism,” which entails a formula that allows the government to fix fuel prices for a set period of time, while simultaneously accounting for international market fluctuations, Shenety told Mada Masr in a previous interview.

“The introduction of an automatic price mechanism will ensure that domestic energy prices move in line with the costs to supply these products. This protects the budget from the risk of unexpected moves in variables such as the exchange rate or global oil prices, and helps preserve fiscal resources to increase social spending targeted to those who need it most,” IMF Mission Chief for Egypt, Subir Lall, told Mada Masr via email in April.

Hedging oil prices, Shenety says, is a move toward the implementation of this mechanism.

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