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.