Oil price hedging by governments can be a smart bet or a bad gamble - Action News
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Oil price hedging by governments can be a smart bet or a bad gamble

Provinces from Alberta to Newfoundland are no strangers to what big swings in oil prices do to their budgets, yet hedging still remains off the table. The reasons, as it turns out, are as much political as they are financial.

Every big drop in oil prices raises the question of why provinces don't hedge when they have the chance

A few extra billion from hedging oil prices would no doubt look good to provincial finance ministers, particularly Alberta's Joe Ceci, who is about to release a deficit budget expected to be around $10 billion. (Fred Chartrand/Canadian Press)

To hedge or not to hedge?

It's a question that teases governments from Alberta to Texas and beyond, especially at times when falling commodity prices leave budget makers wistful for what might have been.

What Alberta Finance Minister Joe Ceci who is set to reveal an ugly deficit number of around $10 billion later this week and his counterparts in Saskatchewan and Newfoundland and Labrador wouldn't give, no doubt, for the extra billions that would have come from locking in oil prices last year at more than $60 a barrel, rather than what they're fetching today around$40.

And they're not alone.

For reasons that are as much political as they are financial, most of the world's resource-reliant governments remain unwilling to step into the world of hedging, no matter how many times they're burned by the fickle nature of oil markets.

"It's like buying home insurance," said Constance Smith, an economics professor at the University of Alberta. "If your house burns down you look really good, but if your house doesn't burn down or the oil price doesn't fall really low you're spending all this money for this insurance thing that a lot of people don't understand."

Hedging vs. saving

Any conversation about sovereign-nation hedging typically begins with Mexico, which made at least $6billion US from its hedge book in 2015. The windfall wasnot the only such win for Mexico over the years. In 2009, a payout of $5.1 billionhelped the country avoid the serious budgetary pain promised by the plunge in oil prices linked to the financial crisis.

Despite such success, other governments seehedgingto offset the risk of falling oil prices as, well, just too risky.

Take Alberta, which has considered hedging many times over the years, with the most serious look coming in 2002 when the Finance Department worked with banks on a phantom trading program to simulate what real-world numbers might look like. Ultimately, the province decided against hedging in favour of putting money into a contingency fund, a type of savings account that could be tapped in leaner times.

It's a choice that's familiar to resource-dependent governments, most of which tend to see so-called stabilization funds as simpler and less expensive than running a hedging program.
Hedging might work to smooth volatile royalty revenues, but betting on the price of oil is neither cheap nor a lock to work. (Getty Images/STOCK4B-RF)

While strategies vary, a commodity price hedge would typically involve buying options in the futures market that offer the right to buy or sell oil contracts at a certain price. Depending on how these options are structured, a hedging program could, for example, set a price floor that would work as an insurance policy against a downturn in oil prices. Much like buying home insurance, however, hedging isn't free.

Mexico, for instance, spent $1.5 billion to hedge its production in 2009. The bet worked out, but if prices had gone up Mexico would have had nothing to show for its money other than the peace of mind offered by the hedge. While gaining certainty aboutfuturerevenues has value, it's easy to see how spending a billion-plus on speculative financial instruments would be a tough sell for a politician in any jurisdiction.

Regardless of the party in charge, just imagine how much hay the opposition could make if a provincial government spent a billion dollars on hedges that ultimately didn't pay off. Sound economic theory or otherwise, the idea that money that could go to schools, roads or hospitals was instead used to enrich Bay Street traders is a political disaster just waiting to happen.

As a study on government hedging by the International Monetary Fund surmised, "probably the most important constraint on government hedging is political. For an individual finance minister (or head of a state oil producer), the political costs of hedging may outweigh the benefits, even if the economic case is clear."

The government of Ecuador found this out first-hand in 1993 after a series of oil market hedges cost the country millions. A special committee was eventually appointed to investigate allegations of corruption against those in charge of the program.

Compared to hedging, tucking money into a stabilization fund, which amounts to a giant piggy bank, is less risky, easier to explain to voters and avoids worries about whether oil prices will rise or fall. Of course, such funds do have drawbacks. If crude prices stay low for a sustained period, they can be drained before prices turn higher. A lack of government spending discipline also means the savings may get spent before times even get tough.

Leaving money on the table

Despite such imperfections, most governments continue to prefer stabilization funds to hedging. While that's unlikely to change, the idea isn't entirely off the table.

"We're always looking at ways to manage the budget," said Lowell Epp,assistant deputy minister at Alberta's Finance Department. "We've thrown hedging up the line a number of times over the last 10 or 12 years and we've gotten varying levels of support. At some point, it would be the public service's job to throw it back up the line."

The inherent political downside to hedging certainlystacks the oddsagainst a province pursuing a hedgingstrategy. What's more, riding the river with commodity prices is now such an accepted part of living in a resource-producing province that little pressure exists to change the status quo.

In Alberta, for instance, the idea of capping the potential upside of a rising oil price environment fits poorly with the province's go-go image of itself. When commodity prices are booming, the economy is rolling and billions are funnelling into provincial coffers, a defensive strategy like hedging may not only seemunnecessary, but itcan actually feellike giving money away.

Economists, for their part, remain divided about whether hedging is a better way to smoothvolatile royalty revenues than a stabilization fund. And, of course, when oil prices are scuffling as they are now, debating what to do with non-existent money can feel neither practical nor pressing.

All of that meanshedging isn't top of mind for provinces at the moment, but if there ever were a timefortheconversationto gain traction it would be now, when the pain of a downturn is sharp and the motivation not to squander any future price rebound is at its highest.