Mitigating the risk

Crude oil prices have been falling sharply on the international petroleum market since July 2014. For Ghana, this poses a serious threat as it could lead to a significant reduction in oil revenue, worsen the projected fiscal deficit in 2015, and have serious negative implications for macroeconomic stability and economic growth.

This article looks at the implications of the falling international oil prices for Ghana’s economy and the government’s approach to mitigating the associated risks.

Crude oil prices experienced significant volatility from 2004 due to high uncertainties driven by supply and demand factors, geopolitical considerations, and speculation. Prices rose from 2004 to historic highs in mid-2008, only to fall precipitously in the last four months of 2008. 

At the peak of the surge, nearly all developing countries intervened with price-based policies to mitigate the price increase on the world market. Ghana, which had liberalised fuel prices in February 2005 and set price ceilings in line with world prices, froze the ceilings between May and November 2008. 

As the oil price climbed, the government considered hedging but did not pursue it. The large fall in the price after August 2008 provided some breathing space, and consequently, in March 2009, the new administration lowered fuel taxes in response to` falling world prices and to ease the financial burden on consumers.           

One lesson that emerges from the previous oil price episodes is that both consumers and producers have to prepare for the unexpected. 

No one anticipated the speed at which oil prices rose in 2008, or the magnitude of the rise. And just when analysts predicted the price to surge to US$200 per barrel, it crashed even more suddenly, affecting oil projects and raising fears of supply shortages. This suggests that when producers and consumers are confronted with a regime of market-driven oil prices, they need a device to mitigate the impact of price volatility and potentially rising fuel cost. 

Hedging is one effective tool to deal with fuel price volatility risks. Through hedging, producers and consumers could enter into a contract to mitigate their exposure to future fuel prices and/or to establish a known fuel cost for budgeting purposes. 

This limits the risk of a country’s budget going out of control.

Petroleum price risk management in Ghana

Following the upsurge in oil prices in 2008 and most part of 2009, the Government of Ghana started exploring the possibility of hedging crude oil prices as part of measures to reduce the impact of the oil shock on the economy. On March 11, 2010, Cabinet approved a Commodity Price Risk Management Policy submitted jointly by the Minister of Finance and Economic Planning and the Minister of Energy. The primary objective of the programme was to contain the phenomenon of crude oil price volatility, achieve price stability and guarantee the availability of petroleum products on the domestic market. A nine-member Risk Management Committee was inaugurated to oversee the programme, with initial focus on petrol and diesel purchases. Hedging of crude oil exports was to be considered at a later date. The committee was later reconstituted as a National Risk Management Committee with representatives from the Ministries of Energy and Finance, Attorney-General’s Department, Bank of Ghana, Ghana National Petroleum Corporation, Cocoa Marketing Company, and Volta River Authority.

The hedging programme commenced in October 2010 and involved the purchase of both ‘call’ and ‘put’ options from counterparty banks. The call option specified a strike price which was a cap on the price of crude oil purchases over the duration of the option, thus insuring against price volatility around the cap, which was settled in cash by the counterparty banks in the country’s favour. The put option gave the country the right, but not the obligation, to sell crude oil at a set price over its duration.

Initially, the government hedged at a strike price of US$82.50 per barrel on monthly volumes of 1,000,000 barrels. Subsequently, as the market price of crude oil went up, the strike prices were adjusted upwards to contain the cost of the hedge. Despite forecasts by the World Bank and the IMF that the price of a barrel of crude oil would remain below US$80.00 in 2011, the government went ahead to hedge at US$82.50 per barrel. The government’s foresight was proven right when four months later the price of crude oil surged past US$115.00 per barrel. As a result of this success, the scope of the hedging programme was expanded to cover 100 per cent of the country’s oil imports beginning in July 2011. Up to the end of 2011, the government hedged on 2,000,000 barrels per month at an average strike price of US$115.00 per barrel. In January 2012, a decision was taken to hedge on a quarterly basis.

After Ghana started producing oil from the Jubilee Field, the scope of the hedging programme was expanded in May 2011 to include crude oil exports and thus protect the government’s projected oil revenues for the 2011 and 2012 fiscal years. The instrument used was a put option under which the country had the option to sell crude oil at a price of US$107.00 per barrel through to the end of 2011. The government was guaranteed this minimum price for its exports, which helped to stabilise the projected oil revenue in the 2011-2012 budgets.

The hedging programme was tremendously successful and, together with other prudent policy measures pursued by the government, it brought about one of the longest periods of monetary and fiscal stability in Ghana’s economic management history. In the first two months of the hedging programme, marginal losses were made, but thereafter the programme recorded net surpluses of US$70 million in April 2011, which rose to US$98.4 million (net of premium costs of $63.7 million) in August 2011. The key benefit, however, was the stabilisation of prices of petroleum products, which were partially protected even as crude oil prices soared from $78.00 per barrel in September 2010 to $125 per barrel in April 2011. The frequency of petroleum price adjustments was, therefore, reduced. 

It needs to be emphasised that Ghana’s hedging programme was not designed to make speculative profits, but was primarily an insurance programme to ensure a predictable maximum price for consumption and a minimum price for exports over a reasonable period.

3. Managing the Risks of the Current Falling Oil Prices

The success of the hedging programme in 2010-12 showed that with a structural plan and clear goals, hedging against fuel price risk can have a significantly positive effect on the national economy. But if this is the case, then one may ask why the hedging program was discontinued in 2013? 

At the time it was discontinued, oil was trading at around US$100 per barrel and rose to US$115 in July 2014. However, by the second week of January, the price had dropped dramatically to below US$50 per barrel. Meanwhile, a benchmark oil price of US$99.38 per barrel had been factored in the 2015 National Budget. There is no doubt, therefore, that the inaction of the government has dangerously exposed the country, and it is clear that the estimated oil revenue in 2015 cannot be realised. Indeed, the President of Ghana recently said that Ghana would lose US$700 million in oil revenue this year as a result of the falling crude oil price, with the expected revenue brought down sharply to US$500 million in 2015.

On August 19, 2014, the Deputy Minister of Energy in charge of Petroleum disclosed that the government was from September 2014 going to introduce quarterly hedging once Cabinet had approved a memorandum to that effect. This decision appears strange in view of the fact that a National Petroleum Risk Management Committee had been set up by Cabinet and approved by Parliament some four years back. In any case, nothing happened until mid-January 2015 when the Minister of Finance also announced that the government was to resume hedging of the country’s crude oil imports and exports. What is puzzling to many Ghanaians is why the government is dragging its feet on such an important matter and is holding back from resuming the hedging programme which was deemed to be very successful between 2010 and 2012.

4. Conclusion

For nearly seven months now since crude oil prices began to tumble on the international market, no concrete step has been taken by the government to mitigate the associated risks. The economy might, therefore, not be able to withstand the impact of the looming external shock, which could exacerbate macroeconomic instability and further slow down economic growth. The recent stability of the cedi may fall victim to the falling oil prices with evidential weak forex inflows and lower corporate tax receipts. This may have the potential to significantly affect the country’s balance of payments and foreign reserves. The effect on individuals and businesses may also be devastating.  

All is not lost yet, however. Given that some analysts expect oil to recover to between US$70.00 and US$80.00 before the end of 2015, Ghana can move quickly to resume the hedging programme to protect the government’s oil revenues and foster price stability. The government needs to undertake the required adjustments now to ensure that the fiscal consolidation objectives are not undermined. It should move quickly to resume the hedging programme, which helped to protect the economy against oil price volatility in the past. The government’s plans to review the Petroleum Revenue Management Act (PRMA) to incorporate a lower benchmark price and to set up a Mitigation Fund to hedge the pump price when oil prices start to rise are also good ideas which should be implemented now.

All enquiries and comments on this brief should be directed to the Executive Director, IFS, at info@ifsghana.org. Tel. +233302 786 991