How commodity derivatives mitigate physical price volatility
The average person may not be able to recite the hundreds of economic figures announced daily in newspapers, on TV and online. But there’s one exception to that rule: It seems almost everyone knows how much he has to pay for a litre or a gallon of gasoline. This price, like the price of a barrel of oil, seems central to many people’s lives.
Indeed, in 2008, when the G20 began addressing commodity prices, oil was on everyone’s mind. The price of a barrel of Brent had run from $98 in January to $158 in July, and then plummeted to $35 in December, all in the same year. The July peak provoked significant increases in local fuel prices, particularly in countries where taxation on fuel is low.
The consequences of this shock were comparable to the energy crisis that occurred in the wake of Islamic revolution in Iran in 1979. When the Shah of Iran fled his country early that year, the subsequent disruption of Iranian oil supply (suspension of exports) caused panic in Western countries, even though the other OPEC nations tried to mitigate the effects through increasing their own production. In reaction, the US effected a phased deregulation of oil prices starting on April 5, 1979, when the average price of crude oil was $15.85 per barrel. The price of crude oil rose to $39.50 per barrel over the next 12 months − the all-time highest real price until March 7, 2008.
Oil price shocks provoking economic and social crisis is not a new phenomenon, but countries can, and have, taken steps to alleviate the associated volatility.
In 2009, Mexico (an oil exporting country that depends on the commodity for 40 percent of government revenues) used derivatives to hedge against price decreases. At the time, the governor of the Central Bank of Mexico, Agustin Carstens, stated that derivatives, “when used responsibly,” are “very useful.” In 2013, Ghana, another exporter, used derivatives the same way as Mexico did in 2009.
Also this year, for the first time in history, as reported in the Financial Times this month, a sovereign oil importing country, Morocco, turned to the financial markets and to derivatives to hedge its consumption.
What the Moroccan government is pursuing is very simple: preventing an unexpected, uncontrolled rise in fuel costs. They are doing this by purchasing options for diesel that grant the right to buy fuel at a predetermined price for the rest of the year. If prices drop, Morocco can purchase diesel at lower prices in physical markets; if prices go up, the option enables Morocco to buy diesel at the option price which will be lower than the physical market price.
Corporates that consume oil in the ordinary course of their industrial activities have used options on a daily basis since the mid-eighties. But this is the first time that a sovereign state has entered into commodity derivatives transactions to limit price volatility for end-consumers, for the people in the street.
These people, who are so aware of the cost of gasoline, may be surprised to learn that the rising price of oil does not mean higher prices at the petrol pump. They deserve to know that in this case, commodity derivatives are being used to preserve affordable fuel for consumers.