5.2.20 New Revenues to Fill the Fiscal Gap— Oil: Hedging
Oil revenues depend on the market price at the time the oil is sold so when the price is high, oil revenues are high, and when the price is low, oil revenues are low. Since it is impossible to know in advance what the future price of oil will be, oil revenues are inherently volatile. This makes state fiscal planning difficult because the state must maintain some type of "cushion" to compensate for when oil revenues are lower than average, and also must resist the temptation to spend everything when oil revenues are higher than average.
Hedging is one way to reduce the volatility of future oil revenues. Various hedging mechanisms could guarantee a future price for our oil. The Department of Revenue analyzed this method for reducing revenue volatility in 2002, and came to the conclusion that it is was not a good idea. Hedging costs money and carries political risks. In addition the Constitutional Budget Reserves already serves as a mechanism to minimize uncertainty in the budget process. Their analysis appears at the end of this section.
There is another argument sometimes made in favor of hedging. This is the idea that by hedging the state would be able to increase the total amount of future oil revenues. It would do this through mechanisms such as futures contracts which would guarantee that we would be able to sell our oil in the future at a higher price than the market price when the oil is produced.
Although this sounds like an easy way to increase oil revenues, particularly when the price of oil reflected in futures contracts is high, it would not work.
The idea that we can somehow take advantage of today's high prices (reflected in future markets) to assure ourselves of a high price for our oil from now until the end of time is bogus. If this were possible the oil industry would be doing it themselves but they are not.
Increasing oil revenues through hedging would require the state to consistently "beat the market"--basically like gambling. State bureaucrats might be able to do this for a while, but over time one would expect their guesses about future price to be too high about half the time and too low about half the time. In the long run one would not expect them to do any better through hedging than by accepting the market price.
In order for the state to come out ahead in the long run, there would have to be someone willing to offer the state a price guaraentee who would consistently lose money. In order hedge, there must be someone willing to accept the responsibility to pay the higher than market price.
Who would willingly and continuously take
a loss by agreeing to buy 1 million barrels of oil per day at a price
higher than they would be able to sell it in the market? No one.
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Oil Hedging (Alaska Department of Revenue, Fall 2002)
INTRODUCTION AND OVERVIEW From Alaska's perspective, locking in a predictable price for oil, even if it means giving up the opportunity to make more money if prices are higher than expected, is called trading in futures, or simply "hedging." Hedging essentially comes in two flavors: 1. Selling oil in advance to lock in a price and, in exchange, giving up the opportunity to make more money if prices rise (e.g., hedging with futures). 2. Paying a premium to ensure a minimum future price, while also retaining the opportunity to make more money if prices rise (e.g., hedging with options). Because of the upside benefits, this is more costly than hedging with futures. Alaska has not yet needed to pay the costs or take the risks of hedging its future oil revenues because our cushion against fluctuating oil prices for the past decade has been the Constitutional Budget Reserve Fund (CBRF). The fund was established a decade ago for exactly that purpose to fill the gap between a fluctuating revenue source and a constant need for public services. The Budget Reserve Fund is a marvelous tool when used properly. We have strayed, however, from its original intent. Instead of simply covering temporary revenue shortages as oil prices move up and down each year, we've been draining the account to cover a structural gap in Alaska's finances. As North Slope oil production declines, taking state revenues down with it, we're spending more than we take in each year and we're relying solely on the CBRF to fill that gap. Similar to an oil field, the Budget Reserve Fund is a non-renewable resource. The large oil and gas tax and royalty cases that filled the fund over the past decade have all been settled. Considering how important the CBRF is to Alaska's fiscal health, and how it can allow us to survive low oil prices, it would be irresponsible to empty the CBRF. But unless we do something soon, that is what will happen. A hedging program, however, could allow the state to know with more certainty when the CBRF will hit empty. By starting a hedging program immediately, the state could lock in some of its oil revenues for the next few years. This would provide the public and elected officials with a somewhat more predictable timetable for draining the CBRF. We would know much of our revenues each year and how much we would need to withdraw from the fund. The outcome would be essentially the same, only without the uncertainty of when. We do not recommend this option since we believe the certainty of knowing when the CBRF will run out isn't worth the cost.
HOW WOULD HEDGING WORK? The Department of Revenue expects that receipts from oil royalties and production taxes will provide two thirds of the state's unrestricted general purpose revenue for the next five years. These revenue sources depend directly on the price of oil. For each $1 per barrel change in the price of oil, the state's annual royalty and production tax revenue will rise or fall by $65 million. The question is how to protect those revenues and the public services they pay for from falling oil prices. Active oil futures and options markets provide the state an opportunity, during periods of high oil prices, to put a floor under or a range around that is to hedge its anticipated royalty and production tax revenue. Because these markets anticipate oil prices to remain above the historical average for the next two or three years, the state could take advantage and for a price secure a more stable revenue stream for the next few years. There are two primary instruments used to hedge: futures and options. Futures contracts provide for the future delivery of oil at a specified price. Any profit or loss from the agreed upon price vs. the actual market price on the delivery date is usually settled on the delivery date. For example, in mid April 2001, the state could have contracted to sell West Texas Intermediate oil at $23 a barrel for delivery in December 2003 (there is no futures market for Alaska North Slope crude). If the market price is below $23 a barrel in December 2003, the state would still receive its $23 because the buyer of the futures contract would pay the state the difference between the market price and $23. But if the price goes up and WTI is worth $25 a barrel in December 2003, the state would have to pay the difference between the market price and the $23 in its futures contract. Of course, if prices are up, the state could use its higher revenues to pay the bill. In summary, the state would be protected if prices fall but could lose out on extra revenue if prices rise. And while the up front cost for a futures contract is minimal, the state could be faced with a significant liability if prices rise above the contract price. Options are more like insurance policies, with an up-front premium. For a per-barrel fee paid in advance, an options contract gives the party on one side of the contract the opportunity but not the obligation to buy or sell oil to the other party at a prearranged price. For example, the state could pay the up-front options premium to sell WTI at $23 a barrel in December 2003, locking in that price. This would be buying an option to sell oil-called a "put" in the trade jargon. If the price is below $23 in December 2003, the state would exercise its option and the party that sold the put would have to make good to the state on the difference between the market price and $23 a barrel. And if the price in December 2003 is above $23, the state would gain the additional royalty and production tax revenue from the higher price. In summary, the state is guaranteed at least $23 a barrel either way, but that guarantee would come at the high up-front cost of the options contract. The up-front cost of buying put options is substantial, although there would be no downside risk or additional costs at the end of the contract.
WHY WOULD THE STATE WANT TO HEDGE? First, the volatility in state revenue could be reduced. Second, with a realistic long-range fiscal plan in place, the state could help ensure its ability to meet its public service obligations during short periods of low oil prices if it no longer had the CBRF to serve as a cushion. Hedging is not expected to increase royalty and production tax revenue over the long term but, at some cost, it can increase the year to year consistency of royalty and production tax revenue to the state. Most hedging is done to remove or reduce the uncertainty associated with a volatile revenue stream. The question becomes whether we are willing to pay that price to gain the benefits of hedging. That is, would the benefits of knowing how long the CBRF will last be worth the cost? We do not believe it would.
REASONS NOT TO HEDGE There are several reasons why state officials might be reluctant to initiate a hedging program. First, the state already has a means for paying for vital public services when oil prices are low the CBRF. But if the state continues its current fiscal habits, the CBRF will not last forever. When it is exhausted, the state will be forced to significantly restructure its public finances. Because oil prices are so volatile, using the CBRF as the state's insurance against low oil prices makes it impossible to precisely forecast when the CBRF will be exhausted. Second, a hedging program would cost money. When considered alone, the transaction costs for entering into futures contracts seem reasonable; they would cost something on the order of $0.10 per barrel for each barrel of WTI futures sold. To hedge all the state's royalty and production tax revenue using futures would require contracts to sell 180,000 barrels per day (5.4 million barrels per month) of WTI futures. At $0.10 per barrel, a three year futures program of this magnitude could cost $18 million to $20 million in up front transaction fees. But, if during a three year hedging program based on futures contracts, WTI futures prices increased significantly, the state would be required to fund a margin requirement that is, pay up to cover the higher price. Remember, in a futures contract, the state would be guaranteed a minimum price but would owe anything over that price to the contract's buyer. If, for example, WTI futures prices on average increased by $5 per barrel, the increased margin requirement for such a price change on a three year futures contract would be over $950 million. If oil prices actually stayed that high for the three year period, the state would recoup that amount through higher than anticipated oil revenue. Then, if the price of oil dropped back to the hedged price, the margin required would be reduced and the state's payment returned. If the state entered into a futures based program, it would need to be able to come up with sums of money of this magnitude or larger on relatively short notice. The per barrel, up front costs of an options based program would vary widely. For example, a $0.75 per barrel fee would put a floor under near term prices at a level about $1.00 per barrel under the futures prices for the upcoming month only. However, it wouldn't do the state that much good to lock in an oil price for just one month ahead. Like all insurance, the longer the protection you buy, the greater the cost. An option similar to the one above, covering a one month period three years from now would cost close to $3.00 a barrel. An options based hedging program covering three years would cost something like $300 million. While the up front cost would be more than a hedging program using futures, an options based program would allow the state to retain any additional revenue if oil prices move higher than the hedged level. Finally, some policy makers will be reluctant to take the political risks of a hedging program. If a program succeeded, it is unlikely the policy makers who took the initiative to create the program would be rewarded with public congratulations. On the other hand, if prices increased significantly and the state had sacrificed that upside to reduce or eliminate the volatility in its royalty and production tax revenue, the conventional wisdom is that public criticism would be harsh.
LEGISLATIVE AND CONSTITUTIONAL ISSUES Before the state could initiate an oil revenue hedging program, the legislature would have to pass a law that authorized and spelled out the program's parameters. Two states currently have oil revenue hedging programs on the books, although neither state does any hedging: Texas and Louisiana. Some aspects of a hedging program clearly would require specific appropriations. For example, if Alaska embarked upon a program that involved the purchase of options, it would need appropriated funds to purchase the options. We are not certain which elements of a futures based options program would require appropriations; certainly appropriations would be necessary for any fees or commissions associated with the program. If the state were required to put up large amounts from time to time to cover margin requirements in a futures based program and on occasion that could be hundreds of millions of dollars it is not clear if appropriations would be required. The same issue arises with respect to payments required when closing out futures contracts. The uncertainty about the need for appropriations for a futures-based program also raises questions about the constitutional prohibition of dedicated funds. Would contractual commitments to cover margin requirements or to close out contracts two or more years in the future violate that prohibition? We have discussed the appropriations question and the constitutional issue with the Department of Law, and they are not now prepared to provide definitive answers.
DEPARTMENT OF REVENUE RECOMMENDATIONS The department recommends against initiating a hedging program if the CBRF balance is expected to remain sufficient. There is no need to pay for a hedging program when an adequately funded CBRF does the same job. If it becomes apparent that state policy makers intend to spend substantially all of the CBRF before they restructure the state's finances eliminating our self insurance fund against low oil prices then we believe a state oil revenue hedging program may become necessary. However, even that will only work if the state has a long term fiscal plan to balance the budget in years of average oil prices. To ensure the success of such a hedging program, the state should initiate the program at least two years (and preferably three years) before it exhausts the CBRF. The principal benefit of an oil revenue hedging program would be to significantly reduce fluctuations in the state's year to year oil royalty and production tax revenue. With this reduction in revenue volatility, policy makers would know more closely when the state would exhaust its CBRF and how large the subsequent year to year revenue gap is likely to be. Would these benefits be worth the costs of a hedging program? Our judgment is that they would not, but it is just that a judgment call. Reasonable, prudent decision makers could easily conclude that the benefits of instituting such a program is worth the cost.
SUMMARY AND CONCLUSIONS Businesses and investors hedge to reduce volatility. The markets that make hedging possible also accommodate speculators who use the same instruments in an effort to make money. Some of these speculators make money but many do not. Business and entities like the State of Alaska should not hedge to make money. Rather, policy makers should only look upon hedging as a post CBRF option to stabilize the state budget and, by implication, the state economy. Right now, the state manages oil price volatility by relying upon the Constitutional Budget Reserve Fund to provide a buffer between a volatile revenue stream and a stable expenditure budget. The CBRF has worked extremely well so far to smooth out the bumpy path of oil prices. And unlike a hedging program that will likely cost money, the CBRF does not cost the state anything. In fact, the CBRF actually makes money. If we keep $2 billion in the fund, we can expect to earn $100 million or more annually. We would be foolish to not preserve the CBRF for the long run as our best insurance policy against sudden economic shock caused by low oil prices. However, if the state is going to exhaust the CBRF prior to implementing a long term fiscal plan, and especially if use of the earnings reserve of the Permanent Fund is restricted by the proposed constitutional amendment, hedging is something the state should consider.