Market-risk hedging can reduce oil subsidy

Market-risk hedging can reduce oil subsidy

Gabriel Andris Thoumi, Yogyakarta

Here are some important global oil facts:
U.S. uses 25 percent of the world's daily oil production of 80
million barrels of oil. World oil supplies are at their historic
peak of maximum production due to depletion setting in. The
planet is operating at anywhere from 95 percent to 99 percent
capacity production. Since 1965 world trend is oil extraction
rates are declining. Over the next ten years China's and India's
2.3 billion humans will rapidly expand oil demand.

Indonesian oil facts are equally worrisome:

Indonesia's state run oil and gas company PT Pertamina
decreased its fuel reserves to 21 days. Indonesia's 2005
government fuel subsidy may be Rp 150 trillion which is 450
percent over forecast. The 2005 government fuel subsidy may be
275 percent greater than its education budget. Indonesia may have
to decrease its 2005 fuel subsidies by Sept. 30.

Indonesia's 2005 domestic auto and motorcycle sales are
expected to grow 38 percent and 26 percent respectively.
Indonesia's fuel subsidies are regressive because the poor and
middle class subsidize the rich. Indonesia's refining capacity
has decreased from 1.6 million to 1.1 million barrels per day
from 1995 to 2005.

Starting September 2004, Indonesia is the only OPEC country
to import oil. Average wealthy Indonesian uses about 39 barrels
of oil a year while average poor and middle class Indonesian uses
about six barrels of oil a year

However, the Indonesian government has no nationally-defined
financial market risk management plan for its fuel subsidy even
though it applies this technology to the banking sector.

Firms all over the world face a similar situation with regards
to financial market risk exposures as do governments. Since
hedging can have a material impact on a firm's ability to execute
their business strategy, firms use forecasting tools to determine
possible outcomes to attempt to hedge market risk.

Market risk is the risk that exchange rates and commodity
prices will move causing a firm an unexpected financial loss or
gain. Compared with companies, at the national level, the
consequences of a poorly designed hedging policy are much higher.

The key concept that many governments fail to understand is
that some of the macroeconomic financial market risks can be
transferred to the international financial markets by hedging.
Even though there may be a cost associated to hedging certain
risks, the benefits for the country, particularly in terms of
allowing the execution of the economic agenda, may heavily
outweigh the costs of inaction.

After having learned the lesson from the 2004 fuel subsidy
cost problem, the Indonesian government allocated Rp 76.5
trillion to subsidize domestic fuel for 2005. However, this
subsidy assumed an average global oil price of US$45 per barrel
oil, a Rp 9,300 exchange rate against the U.S. dollar, and a
domestic consumption rate of 59.6 million kiloliters oil.

To make matters worse, Indonesia's domestic fuel demand has
increased 10 percent over the first half of 2005 . This was
expected given that domestic automotive sales have increased 38
percent year-over-year June 2004 to June 2005 and domestic
motorcycle sales are expected to increase 26 percent in 2005
compared to 2004.

Early last March, the Indonesian government decreased its fuel
subsidy by 29 percent, but domestic oil fuel prices remain among
the lowest in the world. In comparison, this translates into
$0.70 per gallon premium gasoline and $0.68 per gallon automotive
diesel whereas current levels are above $2 in most U.S. states.

However, these savings from lower subsidies are offset by the
rupiah's depreciation and by the expected increase in national
oil consumption and international oil prices. According to Anton
Gunawan, Citibank's chief economist in Jakarta, every Rp 100 that
the Indonesian rupiah depreciates against the dollar has a Rp 1
trillion negative impact on a government deficit target of $2.2
billion.

Since Indonesia's government has to import oil to cover
increased national demand and it is having limited success with a
voluntary national fuel conservation plan, it has now delayed
cash transfers to the state run oil and gas company PT Pertamina
to force energy conservation. For example, on July 2, PT
Pertamina reduced daily fuel supplies to West Java Province and
Jakarta by 5 percent. Before this, each region received about
16,500 kiloliters fuel per day. Now roaming fuel shortages are
common, particularly on the weekends.

At current prices, economists estimate Indonesia's 2005 fuel
subsidy bill be between Rp 138 trillion and Rp 150 trillion based
on $60-$80 per barrel oil. About 25 percent-30 percent of
Indonesia's national budget is expected to be used for the 2005
oil subsidy.

The Indonesian government fears a decrease in fuel subsidies
will threaten stability and increase the possibility of street
violence.

The second national budget revision session of the Indonesian
House of Representatives is scheduled for late August with the
main agenda item being further decreases in fuel subsidies.

If Indonesia continues to base its national fuel subsidy
budget on single-point estimates, it is important for policy
makers to understand the potential variation of those estimates.

By using quantitative and qualitative market risk management
techniques, they will have some control over the Indonesia's
market risk exposures. A comprehensive evaluation of effective
financial market risk implementation strategies is needed in
order to make the final decisions.

With fuel prices at record levels and a falling rupiah,
inflation fears are being felt in Indonesia with the central bank
repeatedly warning that it will tackle inflation effectively.

If the Indonesian government starts moving towards a proactive
macroeconomic financial market risk hedging policy, it would be
able to forecast its fuel subsidy needs. This means moving from a
crisis management strategy to an effective financial market risk
management strategy by considering preemptive risk analysis tools
so that Indonesia can limit its dependency on its economic growth
to the fluctuations of international oil prices. Could an
effective financial risk management program in Indonesia reduce
poverty?

The writer studies international business development while at
the MBA program at the Ross School of Business University of
Michigan after a five year professional banking career. He is
currently researching Indonesian problems related to market risk
and oil subsidies.