Protecting Nigeria’s Revenue Through Crude Oil Hedging

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Crude oil accounts for about 80 percent of Nigeria’s export earnings. It may therefore be surmised that any drop in the international price would have a significantly negative impact on the Nigerian economy and create a massive budget deficit. A budget deficit would lead to drawdown in our foreign reserves.

Nigeria’s foreign reserves currently stand at about $36.5billion as at April 2012. The foreign reserves figure is anticipated to continue to grow under the current democratically elected government of President Goodluck Ebele Jonathan together with proper management by the trio, the Central Bank of Nigeria Governor Mallam Lamido Sanusi Lamido, Honourable Minister of Petroleum Dieizani Alison-Madueke and Honourable Minister of Finance Dr. Ngozi Okonjo Iweala.

2011 Production, Revenue and Excess crude oil revenue

In the 2011 budget, $62per barrel (pb) was provided for in the 2011 Appropriation Bill. In simple terms, this means our crude oil budget benchmark is put at $62 pb and if the international crude oil price falls below $62pb our budget will go into deficit. At $62 benchmark and a production output of 2.3m barrel per day in 2011 that gave an annual production of over 839million barrel and revenue of $52 billion per year. At $100pb Nigeria earned $83.9billion in 2011 (NGN 12.6 trillion naira).The excess crude oil earned for 2011 should be approximately $31.9 billion (approximately NGN4.8 trillion excess crude oil revenue in 2011).

However, we should not forget that Nigeria operate joint venture (JV) agreement with the major international oil company at 55% to 45% JV agreement. This means Nigeria earned 55% of $31.9billion excess crude oil which came to about $17.5 billion (NGN2.6 trillion naira) in 2011.

2012 Production, Revenue and Excess crude oil revenue

The Federal Government has set an oil production target of 2.48 million barrel per day and oil price of $72 per barrel benchmark for the purposes of revenue projections in the 2012 budget

Crude oil revenue at current international crude oil prices of over $100 (which is above the benchmark of $72 for 2012) is about $248million per day (assuming $100 average daily price). This would come to about $90.5billion at the end of 2012. Excess Crude Oil revenue in 2012 assuming oil continues to trade at over $100, will be over $25bn (NGN3.8 trillion naira)

Also we should always remember the 55%-45% joint venture agreement. This means Nigeria is projected to earn $13.9 billion (NGN2 trillion) in excess crude oil revenue in 2012. ( This is more than enough to take care of Nigeria infrastructure problem and still have enough saving for the Nigeria Sovereign Wealth Fund account).

Oil Price Shock in 2008

It is highly optimistic to assume that the government will continue to earn this excess crude oil revenue though. However, the oil market is very volatile and dangerously unpredictable, as was witnessed in 2008 when crude oil peaked at about $140 and yet fell to $30 in the same year. This sudden price drop saw a number of oil-producing nations suffer substantial losses and massive budget deficit, which is why hedging against such occurrences, has become extremely important.

The best way to guarantee Nigeria’s oil revenue, based on our budget benchmark of $75pb for 2012, is for the government to hedge our crude oil production at the budget benchmark as strike price using the money we derive from the excess to buy a put option at 75 strike- protection on our production against a fall in the international crude oil price below $75. This has to be done urgently given the current downward trend in the global commodity price .

Benefits of Hedging

Below are the benefits of Hedging to Nigeria government:

• increasing accuracy of budgeting

• guaranteeing a minimum price the Government will receive for its crude oil sales.

• reassuring the Federal Ministry of Finance and Central Bank that it will be able to meet its budget obligations to ensure satisfactory funds are available for National development.

• promoting transparency, accountability and consistency of foreign exchange earnings as hedges can be benchmarked against international Oil prices in US dollars $

• reducing uncertainty of the future international market events

• supporting long-term financial planning and cost control

• creating greater certainty of cash flows;

• It will also guard against any production shortfall and

• resulting in a favourable Credit Rating for the Nation by international rating agencies

Hedging Instruments

Hedging is done using financial contracts (put options or call options), which gives the right but not the obligation to buy or sell an asset against another at a pre-determined rate (“strike”), and at a pre-determined time. Buying an option gives full hedge and unlimited participation if the price move is favourable and should guide against budget deficit/shock due to any fall in the international crude oil prices below our budget benchmark price. It will also guard against any production shortfall.

The Cost of Hedging

This is dependent on the trading price of crude oil at the time of hedging. If it is trading close to our strike (budget benchmark) it will be costlier than if it is further away from the benchmark. For example if Nigeria decided to hedge now using the Nigerian budget benchmark at strike price $72 and with oil trading at over $100, it would be cheaper than if oil were below $100 and close to the benchmark

Mexico as a Case Study

(Lesson from Mexico)

Mexico is one of the major crude oil producing countries and has over the years been involved in hedging of their crude oil productions using options. Mexico’s oil hedging program is one of the biggest from a single entity in the derivatives market.

In 2009, Mexico spent a total $1.5bn to hedge a total of 330m barrels at a budget benchmark of $75 strike. When oil dropped to as low as $28pb in 2008, Mexico made more than $5bn on those hedges. As they were fully hedge and was able to sell at the strike price of $75 even though oil was trading at $28

In 2010, seeing the advantages, Mexico spent a total $1.17billion to hedge a total of 230million barrels at a budget benchmark of $57 strike in 2010, and $812m to hedge a total of 222million barrels at a budget benchmark of $63 strike in 2011. Mexico has already taking care of her 2012 crude oil through hedging.

The Way Forward for Nigeria Government

Given the current market price of over $100, there is need for the Nigerian government to act swiftly and consider starting a hedging program for our crude oil production. At the current price, we can get the hedging done much cheaper than we would if the price were to fall. The Nigeria government can also consider hedging in parts – for example 40% to 50% of daily productions like some other oil producing countries.

Advisor Role to the Federal Government on Crude Oil Hedging

Nissi-Lloyds Capital & Investments LLC is available to provide advisory services to the Federal Government of Nigeria on Crude oil hedging. Currently an industry leader in deal origination, execution and distribution, Nissi-Lloyds Capital has advised on many transactions across several sectors and assets as well as demonstrated market leadership capabilities in derivatives structuring and advisory.

Adebayo is MD/CEO of Nissi-Lloyds Capital & Investment LLC, Lagos.


In : Finance

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