Crude and petroleum oil constitute the largest share of 14 percent of our import wallet. Though the direct weight of oil is not as high in inflation basket, the indirect impact is much more as the trickle down impact of oil inflation virtually reaches, directly or indirectly, almost all avenues of modern life registering a multiplier effect. Moreover, since the "automatic price adjustment mechanism" for fuel is yet to be implemented in our country, Bangladesh Petroleum Corporation is exposed to losses every year. The Ministry of Finance has set aside an initial sum of Tk. 6 billion in the current budget (FY07) that can be used to cover losses of state-owned enterprises resulting from selling petroleum products, including oil, below formula prices. (The Daily Star, Nov 18, 2006). However, the actual losses may reach above the provisioned amount as global events may shake up the International Oil prices beyond forecast making the national fiscal planning difficult.

Though the world has moved a long way toward the "efficiency frontier" in consumption of oil and today it needs about two-thirds as much oil as it did in the 1970s for per unit output, LDCs like Bangladesh however are far behind in this regard. Such low oil efficiency combined with high dependence on oil import makes the economy vulnerable in a soaring oil price environment.

SURGING OIL PRICES ATTRACTED FOCUS IN RECENT PAST
Though different groups of commodities managed to draw attention in last few years, the major point of focus was undoubtedly the oil market. The oil market has always been very responsive to almost all streams of world events, starting from politics and violence to whims of nature.

2006 was a roller coaster experience for the crude oil market, creating a number of peaks and troughs along the way. From $60 level, the market set out with a sharp rise in the prices at the beginning of 2006 despite inventory build-up in the US, as fears of UN sanctions against Iran over uranium issues poured uncertainty over supply prospect. Geopolitical uncertainty and possible supply disruption arising from political conflicts, security threats, infra-structural problems in distribution etc overwhelmed the oil market for a major part of the year and pushed the oil price to reach record highs of close to $80 in August. But crude prices slid down sharply way below $60 as geopolitical tensions eased away, supply fears failed to materialise and US hurricane season elapsed without much incident. However, during the end 06, stronger seasonal demand, deterioration in US inventories, OPEC output restraint and a weaker USD had pushed the price back to above USD 60 per barrel.

SOFTER OUTLOOK, BUT VULNERABLE TO GLOBAL EVENTS
At the beginning of the year, oil prices were expected to exhibit greater stability in 2007, although it drifted lower by over 15 percent in early January driven by accumulation of stocks followed by unexpected mild weather in the US and an easing anxiety of supply. Geopolitical risks, while remained quiet for a while, always have the potential to shock and shake. OPEC's actions are once again a point to ponder in portraying the oil price outlook. The cartel's price aspirations are not clear; while some analysts viewed them to appear to be galvanised to cut production if WTI slips below USD 55 per barrel, reluctance of OPEC in recent past in reacting when prices came below $50 sprinkled uncertainty on their trigger level. The key upside risk to prices is, as always, a disruption to supply. Speculative non-commercial position in NYME for WTI contracts has turned long, indicating a strong view in the market. The recent rejuvenation of oil price to the level of near $70 per barrel driven by uncertainty surrounding Iran issue has indeed shaken those who were sitting too relaxed thinking that the drama might be over.

HEDGING IS A RESPONSIBLE BEHAVIOR
Since commodity prices have historically been notoriously volatile, concerns about the effects have led to efforts to stabilise commodity prices. There could be two broad approaches aiming to insulate the economy from price shocks either by stabilising international commodity prices or by transferring risks to the third parties. However, realistically it is not possible for developing countries to influence international prices. Hence, it leaves them with the alternative choice of transferring risk; or doing nothing. The most common way out for commodity importers to pass risk is the use of financial derivative instruments to offset their exposure of price risk via players having the appetite and expertise to house the risks, who are often the financial institutions. Besides direct hedging, different commodity linked investment alternatives are also receiving popularity as they provide indirect hedging by offsetting the direct impact of price changes through altering the return on investments.

The reliance on various commodity hedging instruments available in the international markets is increasing due to growing participation by speculative investors who can influence and aggravate volatility. There are numerous variations of on-the shelf and off-the-shelf commodity derivative structures offered in the markets to match the exact need of the customers depending on the exposure, risk appetite, individual views and price aspirations. Two broad categories are swaps and options. While commodity swaps are used as a price fixing mechanism, commodity options insures only against the worst case leaving the scope open to gain from favorable market movement.

For example, if oil price is fixed through a SWAP at $65 a barrel and the price goes up to $70, the hedger would be compensated by the difference amount of $5 a barrel which is a net saving for him. But if the price goes down to $60 at maturity, then also the hedger is obligated to pay $65 a barrel -- $5 higher than the market. A point to note that the hedger may effectively end up paying higher price in this situation, but has a certainty that his maximum cost would never cross $65 and hence can plan everything ahead. It may be pertinent to mention that, had a buyer of oil entered into a SWAP during the beginning of 2006 at around $60 level, he/she could have saved as much as $ 18 a barrel when oil price surged to $78. While there is some skepticism about SWAP because of rigidity, a bias is often observed toward options as a hedging tool for their flexibility. For instance, if an oil importer buys a vanilla "Cap" at $65 a barrel in exchange of a premium, it provides him the right to buy oil at $65 if the price goes above this level. But unlike SWAP, if the rate goes below $65 say at $60, the buyer is free to buy at $60. Thus it offers protection against up-side risk and simultaneously avoids any mark-to-market loss apart from the premium. Besides direct hedging, commodity linked investments are also earning popularity as a hedging mechanism. If a buyer of oil invests his fund in a deposit structure positively linked with oil price, instead of conventional index like LIBOR, it would generate a higher return if the oil price goes up. Hence, the impact of higher purchasing price of oil is offset to some extent by the higher return; and vice versa.

The beauty of derivatives is that they can be tailored to conform to any idea that the buyer adopts. It is extremely important to understand the difference between the ultimate objectives of speculators and hedgers. While speculators tend to play with the price curves, the commodity hedgers are not keen to use commodity options and swaps as a tool to make money from price volatility. They are using such products based on the logical reasoning that making speculative profit from volatility is not their core business. Rather the main objective is to make the future little more predictable, reign the risks within a conceivable band, avoid surprises that may pose threat to their core business and have a more sound and accurate financial planning thus ensuring a good night's sleep. It is encouraging that the government is concentrating to find ways to minimise the impact of price shocks by shifting to substitutes, for example from oil to natural gas to reduce net national cost. But such shifts may not deliver a complete solution. It is, therefore, important to manage the financial risk through alternative financial hedging options.

REGIONAL MARKETS GATHERING PACE
Though subsidy is used to counter the problem, the market regards subsidy as unsustainable. After Indonesia received a major hit from oil price surge with its heavy-subsidising policy, many Asian economies have scaled down their fuel subsidies. While this measure may stimulate the pace of inflation, the use of financial derivatives had helped these economies to mitigate the impact by limiting the actual increase in oil import cost to only about half the rise in international markets. Even the South Asian markets are also gradually embracing different ideas of commodity hedging. Indian market is already on the roll, while other neighboring countries are putting sincere effort to catch up. Sri Lankan Petroleum Corporation has recently closed first commodity derivative deal to hedge oil exposure with Standard Chartered Bank. These examples could be encouraging for Bangladesh to devise its mechanism. Few of the key enablers for these high-end solutions to be rolled out in our country should be onshore expertise in this specialised area and accessibility in the international markets. Only very few financial institutions like Standard Chartered Bank are equipped with the right local skill set, have strong regional presence to understand the local markets, a global platform to constantly migrate new developments around the world and a network accessing the important international hubs -- to accommodate financial derivatives. As the markets are becoming complex, it is probably worthy to know about and consider the alternative choices of commodity hedging that global markets are offering for our benefit to keep pace with the fast moving world.

The writer is associate director, Global Markets, Standard Chartered Bank