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COMMENTARY | Oil hedge was a good decision

Published:Friday | February 5, 2016 | 2:00 AM
William Mahfood, president of PSOJ.

On Monday, February 1, 2016, the Private Sector Organisation of Jamaica issued a statement in continued support of Jamaica's oil hedge purchase. This is the statement in full.

The Private Sector Organisation of Jamaica has noted commentary over the past couple of weeks regarding the oil hedge strategy Jamaica effected last year by purchasing an option to buy eight million barrels of oil - representing about half of the country's annual requirement - at a price of US$66 per barrel.

The total cost of the option was approximately US$20 million. It is the exercise of this option which would effect the hedge.

One argument is that the hedge was a waste of money, as oil prices have fallen to US$30 per barrel, and the strike price where we would have started to benefit from the hedge is at US$66 per barrel. Therefore, the reasoning goes, a bad decision was made to purchase the hedge, and that poor decision has cost the country US$20 million ($2.4 billion at current exchange rates).

It is important to understand the reasoning behind the hedge strategy, and why the PSOJ still supports the decision.

At that time, all projections were for oil prices to recover in 2016, with most expecting oil to go past US$66 per barrel and settling off at around US$80 per barrel, which at 17 million barrels per year, would have had an annual cost above the strike price of US$234 million.

If this had happened then we would have saved US$214 million, net of the option cost of US$20 million. So for us to even have broken even on the cost of the option, oil prices would have had to go to US$67.20 per barrel (an additional US$20 million based on our usage above the strike price).

Note that the hedge is not a contract for supply at the strike price of US$66, but rather an option to purchase at that price, so that the only cost is the US$20 million fee.

It is also important to note that the amount applied to pay for the hedge was applied while prices were falling, so it was not an additional cost, which was important as it did not reduce already existing consumption spending. This, therefore, made the risk even more acceptable versus the risk of oil prices rising to over US$70 per barrel.

At the time also, there were still restrictions on Iran, China's economy was stronger than it is today, and ISIS was in control of more oil resources than they are today. This is the nature of geopolitics, which changes every day and as governors, we have to be able to adapt to the changing environment while considering the associated risks.

So in fact, the cost risk associated with not purchasing the option - based on the market information at the time - would have been far more hurtful to the economy than the risk associated with the price of oil not going above US$66 and us not benefiting from the hedge.

The only way that we can be sure of an event is after it has happened. In other words, much of the commentary today is being made from hindsight, which is 20/20. Buying a stock after the price has increased will not give you the benefit of the price rise, or what is the sense of buying insurance after a catastrophic event? And because an event might not happen, would you then not insure against it?

The fact is that we could ill afford oil moving back to US$80 per barrel, and the cost of US$20 million to mitigate a US$200 million risk, like insurance, makes good business sense.

This is the same argument that we apply to the need to lower the tax rate, and move towards indirect over direct taxation. The fact is that if we are to see sustainable development, to move to that next level of progress, we must make bold decisions based on rational projections, and not make decisions based on the fear of failure.

The PSOJ would also support further hedges, if a reasonable strike price can be obtained, because one of the most important factors of economic planning is certainty, which is what the hedge provides.

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