Aug 23

In May 2009, CIMOGG wrote to the Press regarding several questionable features of the so-called “hedging” contracts entered into by the Ceylon Petroleum Corporation (CPC).  Whatever be the final outcome of the arbitrations and appeals that are involved, the public needs to look into this unsavoury episode from first principles, without being put off by the associated technical jargon.

The essence of CIMOGG’s May 2009 article titled Hedging Against Oil Price Changes is given in the next paragraph.  The full article may be found at www.cimogg-srilanka.org or at p145 of the CIMOGG book Good Governance and the Rule of Law.

What we said was that Minister A.H.M.Fowzie and certain officials of the CPC went abroad for a few days to learn about hedging in connection with petroleum purchases.  Despite price hedging being a skill which financial, economic and commodities specialists take years to master, the Minister and the CPC tried to create the impression that they would acquire during that short visit the necessary expertise to make an informed decision.  They conveniently ignored the inherent contradiction of getting the relevant training from the very banks that would obviously protect their own interests vis-a-vis the CPC.  It was entirely in keeping with the nature of this corrupt exercise that the cost of air fares, accommodation etc is reported to have been borne by the same banks.  Furthermore, the CPC officials concerned would have been well aware that many historical rapid oil price rises had been initially thought to be irreversible but that such increases were invariably followed by substantial drops to an intermediate level.  That so experienced an organisation expected prices to go up greatly but were most unlikely to drop significantly has all the appearance of having been a deliberate omission in favour of the banks.

It is known that, before Minister Fowzie and the CPC embarked upon the hedging exercise, a strong recommendation had been made to the Cabinet by Mr Ajith Nivard Cabraal, Governor of the Central Bank, to get the CPC to resort to price hedging when purchasing petroleum.  Whether this advice to go in for hedging was a prudent one merits examination. A good starting point for doing so would be to look first at lotteries and gambling, and then turn our attention to hedging.

All lotteries are run by organisations which retain a substantial percentage of the sales moneys to cover their administrative costs as well as a much larger percentage by way of profits or taxes.  Therefore, even if just one person buys all the tickets in a lottery and wins all the prizes, that person will get back only a part of the total investment made, whereas the organisation responsible for the lottery (which one might refer to as the “banker” for convenience) will always get a positive return from the retained part of the sales proceeds.  When a person buys only a few lottery tickets, he accepts the reality that the chances of winning are remote but, dreaming of the off chance that Lady Luck may award him a big prize, he does not mind taking the risk of losing his small investment.  By the inexorable laws of chance, regular bettors will, except in the rarest instances, lose money on the lotteries in the long term.  The fact that a percentage of the money the banker retains is usually diverted to a “good cause” helps to counteract one’s disappointment when there is no prize.  Moreover, the bettor risks only his own money, and this fact tends to keep his conscience clear.

Gambling in casinos is rather different.  Gamblers bet on an outcome they hope will be realised.  The frequency of occurrence of a favourable outcome is generally greater than in a lottery but the prizes are usually only a relatively small multiple of the value of the bet.  The odds of winning a bet vary from game to game but the methodology of the wagering process is so designed that the casino (“the banker”) always has a handsome profit over a period of time.  If there were no profit, the casino would go bankrupt pretty rapidly.  Unlike the self-discipline that one can easily exercise when buying a few lottery tickets, the atmosphere in a casino, combined with alcohol and many other attractions, makes chronic bettors reckless.  Thus, gambling in casinos is several degrees more damaging to one’s wallet than buying lottery tickets.  Although it may be argued that the gambler is risking only his own money, he may have many dependents whose lives are ruined by his losses.  To make things even less palatable, there is no “good cause” that is sponsored by the casino to solace one’s spirit.

We now turn to hedging.  When someone goes to a banker to help insulate himself against price rises of a commodity, what he really does is to gamble that his guesses or assessments of price rises and price drops will be superior to that of the banker, whatever the formula used to compute their respective liabilities.  The banker, on the other hand, would not remain solvent if he is going to be so generous as to ensure that his clients benefit every time.  In fact, he remains prosperous because his information on price trends, backed up by highly professional internal research and commercial intelligence units, is greatly superior to that of his clients.  However, just as much as the Goddess of Chance may occasionally help a lottery ticket buyer or a casino gambler, hedging clients may also be lucky once in a while. Nevertheless, it is the banker who will win more often than his clients.  Considering that the contribution of chance to the outcome in hedging is much less than the element of prior expert knowledge, it is an unequal battle of wits between a well-informed banker and a less-informed client.  In short, hedging is a form of speculation or gambling where the odds are badly stacked against the “bettor”.  For example, it has been revealed that, in two of the recent cases in dispute, the maximum that the CPC could have expected to gain was only US$3 Million, whereas the bank was able to make a claim for US$21 Million when prices started to drop – that is, excluding other consequential claims.

Everything about the CPC hedging exercise should give any rational person, with basic common sense, a sick feeling that the people of Sri Lanka have been taken for suckers yet again by our politicians and administrators.  One is forced to the conclusion that the Cabinet was not given a realistic briefing by the officials of the Central Bank and the Minister.  That this episode is not an isolated one is seen from the years of importing expired drugs and foods, polluted petrol and uncertified cement, undersized eggs and unmarketable chickens, not to mention Sri Lanka Cricket’s TV rights manipulations and any number of other foul rackets by politicians and public officials.

CIMOGG calls upon the Cabinet to insist on some degree of accountability being assigned to the various persons involved in this more than suspicious deal although, judging by past experience, we would be unwise to wager (sic!) even two cents on the likelihood that anybody important will be called upon to answer to their wrongdoings.