Hedging of Oil Prices: Long-term vision vs Opportunism

One of the things that regularly hit the media is the price of crude oil. It is volatile and has a significant impact on the purchasing power of both families and businesses.

Recently, oil prices hit their highest levels in at least three years. It will probably continue to surge for a while. As a result, the cost of electricity in Europe is soaring. Prices had been rising steadily this year, as economic recoveries got under way. But they have spiked in the past few weeks. According to an article in the Economist published on the 15th September, since the start of September, wholesale power prices in Germany and France have climbed by 36% and 48%, respectively. They are now hovering at around €160 per megawatt hour, a record level. In Britain prices are at a whopping £385, up from £147 a few weeks ago.

Let’s move to Malta, a year and a half ago. During the first half of 2020, the price of oil has dropped to record low and the Nationalist Party immediately tried to capitalise on this fact. During a press conference on April1st, 2020, PN representatives urged the government to make sure that the electricity bills and fuel prices reflect the current international price of crude oil. This was a dangerous proposal which effectively meant a stand against hedging, implying that the utility prices need to be constantly revised, going up when the price of oil goes up.

Since the start of September, wholesale power prices in Germany and France have climbed by 36% and 48%, respectively.

In March 2015, a report by the Auditor General entitled ‘An Analysis of Enemalta Corporation’s Hedging Activity during 2014’ raised a number of observations. Among them, it concluded that “in 2014, Enemalta lost €8.6 million on hedges on crude oil and €5.5 million on unleaded petrol and diesel.” Again, the Opposition lost no time to air its stand against hedging. But here lies the crucial point of hedging.

What is hedging?

The term generally scares people due to the fact that a simple search on the internet points to complex financial instruments such as derivatives. But in reality, it can be compared to an insurance policy. You pay for an insurance, hoping you would not need to exercise it but if something bad happens, you are covered. It is an issue of risk-reward trade-off: reducing potential risk but at the same time giving away potential gains.

Governments hedge their fuel 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, when oil prices decline significantly as was the case during the first half of 2020, the purpose of hedging oil is forgotten, and the narrative starts to be around the price decline.

Not hedging is equivalent to not taking an insurance policy. In the long-term, hedging pays off as it creates stability, which in turn improves the economic system.

By looking at the chart which shows the prices of utilities (water, electricity, and fuel) of Malta and the EU as captured by the Harmonized Index of Consumer Prices (HICP) and the price of brent oil, it is immediately clear that over the course of the years, the overall results of hedging have been overwhelmingly positive.

First, despite the volatility in oil prices, the prices of utility in Malta remained stable. Thus, the first objective of hedging – to provide certainty – has been achieved. Secondly, apart from a short period in 2016, the price of utility in Malta remained below the EU average and below the corresponding period of price of oil. Meaning both Maltese families and businesses have benefitted from such agreement. Families and businesses were better off because of hedging.

This is another example of the difference between long-term vision and opportunism. 

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