1 MANAGING GOVERNMENT BUDGETS IN AN ENVIRONMENT OF UNPREDICTABLE OIL PRICES By Rachid Amui Energy Analyst, UNCTAD NOT AN OFFICIAL UNCTAD RECORD

2 OVERVIEW OIL PRICES AND GOVERNMENT BUDGETS PREDICTABILITY OF OIL PRICES IMPACTS OF VOLATILE OIL PRICES LIVING WITH VOLATILITY – RISK MITIGATING STRATEGIES THE WAY FORWARD

3 OIL REVENUE AS % OF GOVERNMENT REVENUE COUNTRY 1998 – 1999 AVE ESTIMATE NIGERIA75.7%83% ANGOLA78.8%90% EQUATORIAL GUINEA XX XX61% GABON49.9%60% CAMEROON23.3%20% Source: Catholic Relief Services

4 IMPORTERS AND EXPENDITURE GHANA – (USD 333.8m IN $18– USD 520.1m IN $30.8) COMMON MARKET FOR EASTERN AND SOUTHERN AFRICA – ( USD 9 bn in 2003 – USD 15 bn IN 2004) SOUTH AFRICA IMPORTS APPROX 270,000/DAY – AT$30 = $3.5bn; AT $50 = $5.0 bn ZAMBIA OIL IMPORTS ABOUT ONE-FIFTH OF THE TOTAL IMPORT BILL

5 PREDICTABILITY OF OIL PRICES He who lives by the crystal ball soon learns to eat ground glass. Edgar R. Fiedler OIL PRICES ARE UNPREDICTABLE AND RELYING ON FORECASTS IS VERY RISKY.

6 Relying on forecasts is not a way to manage risk The herd instinct among forecasters makes sheep look like independent thinkers. Edgar R. Fiedler

7 RELYING ON FORECASTED « AVERAGE » RETURNS IS HIGH-RISK. YOU NEED TO BE ABLE TO MANAGE DOWNSWINGS.

8 MOVEMENT OF OIL PRICES

9 WHAT DRIVES VOLATILITY LACK OF ACCURATE INFORMATION ON SUPPLY/DEMAND BALANCE LOW SPARE OIL PRODUCTION CAPACITY TO MEET STRONG DEMAND LOW STOCKS AS AN EFFICIENCY DRIVE GEOPOLITICAL TENSIONS INSUFFICIENT US REFINING CAPACITY FREAK WEATHER TRANSPORTATION PROBLEMS SPECULATORSDEMONSTRATIONS

10 IMPACTS OF HIGHER OIL PRICES HIGHER INFLATION & INTEREST RATES BALANCE OF PAYMENTS PROBLEMS BUDGET PROBLEMS DECLINE IN ECONOMIC GROWTH EXCHANGE RATE APPRECIATION HIGHER TRANSPORT COSTS ECONOMIC INSTABILITY (E.G. DUE TO POWER CUTS) SOCIAL UNREST MACRO MICRO

11 Widespread protests against fuel increases in Zimbabwe By our correspondent 23 June 2001 May 25, 2004 California truckers protest high fuel prices INDONESIA: Fuel price rises spark protests - Jakarta, 3 October 2000 Protests by tens of thousands of workers and students have rocked Indonesia since the government of President Abdurrahman Wahid and Megawati Sukarnoputri, under pressure from international creditors, decreed an average 12% increase in the price of domestic fuel on October 1. Nigeria's fuel protests gather support By our correspondent 23 March 2001 For local consumers, fuel prices are often of critical importance

12 LIVING WITH VOLATILITY: OPTIONS AVAILABLE DO NOTHING AND HOPE FOR THE BEST STABILISATION FUNDS HEDGING USING MARKET BASED INSTRUMENTS – DERIVATIVES COMMODITY LINKED BONDS Risks can be managed with foresight. Damage can be controlled with hindsight. Your choice. Coopers and Lybrand, L.P. Advertisement in The Wall Street Journal, December 7, 1995

13 STABILISATION FUND FUNDBUDGET OIL REVENUES >TARGET LEVEL TRANSFER TO BUDGET EXPENDITURE NON OIL REVENUES + OIL REVENUES BALANCED

14 HEDGING CONTRACTS HEDGING PRINCIPLE IS GOVERNED BY SIMPLE FORMULA: HEDGING PRINCIPLE IS GOVERNED BY SIMPLE FORMULA: GAINS/LOSSES IN PHYSICAL MARKET + GAINS/LOSSES IN FINANCIAL MARKET = PRICE OBJECTIVE GAINS/LOSSES IN PHYSICAL MARKET + GAINS/LOSSES IN FINANCIAL MARKET = PRICE OBJECTIVE

15 CONTRACT TYPES: OPTIONS OPTIONS: AGREEMENT GIVES HOLDER THE RIGHT TO BUY OR SELL AN UNDERLYING ASSET – CALL/PUT SIMILAR TO INSURANCE

16 CONTRACT TYPES (cont’d) FUTURES: STANDARDIZED CONTRACT ALLOWING HOLDER, BUYER OR SELLER, TO ACCEPT OR DELIVER A GIVEN QUANTITY OF ASSET AT A SPECIFIED PLACE, PRICE AND TIME IN THE FUTURE DEPOSIT OF GOOD FAITH REQUIRED (5- 10%) MARGIN CALLS

17SWAPS EXCHANGE OF CASH FLOW AT REGULAR INTERVALS TO ANOTHER PARTY OVER PREDERTIMINED TIME PERIOD PRODUCING COUNTRY IMPORTING COUNTRY SPOT MARKET PAYS <$40 PAYS >$40 SPOT PRICE COUNTRY AEND USERS FINANCIAL INSTITUTION RECEIVES DIFFERENCERECEIVES MKT. PRICE SELLS CRUDE AT MKT. PRICEPAYS DIFFERENCE TO A

18 COMMODITY BONDS USEFUL AS DEBT SERVICING INSTRUMENT – ATTRACTIVE TO BUDGET PLANNERS FORWARD TYPE BONDS OPTION TYPE BONDS

19 RISKS IN USING FINANCIAL INSTRUMENTS ARISE WHEN THERE IS NO CONTROL DIRECTION OF PRICES ARE GROSSLY MISJUDGED AND CASH CALLS – FUTURES FORGO EXTRA INCOME EXCHANGE TRADED PRODUCTS DO NOT NECESSARILY CORRESPOND TO HEDGER’S ASSET BASIS RISK – GOOD PRICE CORRELATION IMPORTANT TO MINIMISE BASIS RISK POOR UNDERSTANDING OF INSTRUMENTS

20 ADVANTAGES OF RISK MANAGEMENT ABLE TO EXCEUTE BUDGET PLANS WITHOUT RECOURSE TO ADDITIONAL FUNDING EXPORTERS HAVE AN OPPORTUNITY OF A STEADY INCOME BUT FORGO EXTRA INCOME WHEN PRICES ARE HIGH MACROECONOMY IS GENERALLY UNAFFCETED

21 IMPLEMENTING THE USE OF FINANCIAL INSTRUMENTS MUST BE DONE WHEN UNIVERSALLY ACCEPTED TIMING IMPORTANT – HIGH VOLATILITY GOOD FOR PRODUCER ADAPT TO THE SKILLS AND LEVEL OF UNDERSTANDING PRESENT IN COUNTRY PLAN FOR POSSSIBLE SCENARIOS BE TRANSPARENT

22 THE WAY FORWARD MAKE DEBT SERVICING BE DEPENDENT ON COMMODITY PRICES USE FINANCIAL INSTRUMENTS TO SHIFT RISK STABILISATION FUNDS ARE DIFFICULT TO ARE DIFFICULT TO MANAGE BUT CAN MANAGE BUT CAN WORK. WORK.

23 It’s never easy… To quote from a presenter at one of our African Oil&Gas Trade and Finance Conferences “It was the morning after we started bombing I., world oil prices had dropped $10 per barrel overnight, the B. Administration announced that it would start a sale of oil…..The Secretary of Energy had convened a meeting with all his assistant secretaries…. He observed with the group that he had been cornered by John S., the President’s chief of staff… Why, he asked, didn’t the Energy Department sell in the futures markets when prices were high so we could have gotten much more…. The Secretary’s question: “What was he talking about?” A 10 minute discussion ensured in which every assistant secretary had his or her chance to explain to the Secretary, and it became quickly clear that not a single one of them understood the question either. I suggested my Director that we answered the Secretary’s question. He whispered back “Bob, I don’t believe we can provide anything these people can use.” Later, I suggested we send a short paper to the Secretary. My boss responded “Don’t worry about it: no one will be thinking about this by tomorrow.” Unfortunately, he was exactly right.”

24 LAST WORD « THE BIGGEST POLITICAL CHALLENGE IS THE WIDESPREAD LACK OF UNDERSTANDING OF THE COSTS OF DOING NOTHING, AND THE LACK OF KNOWLEDGE AMONGST POLICY MAKERS ABOUT THE MERITS OF APPROPRIATE POLICY REMEDIES » RANDALL DODD (DIRECTOR – FINANCIAL POLICY FORUM 21 SEPT 2004) RANDALL DODD (DIRECTOR – FINANCIAL POLICY FORUM 21 SEPT 2004)