1. 1.

Introduction. Hedging
Hedging is a tool of the risk management process. Doing nothing to manage risk is in itself a risk move. Hedging is a mechanism that protects buyers and sellers of commodities from adverse spot market price volatility by taking a position in the Derivatives Market. Hedging is not speculating. Speculating is taking risk but hedging is managing risk. Hedgers and speculators play a mutually exclusive role. The best way to understand hedging is to think of it as insurance. When people decide to hedge, they are insuring themselves against a negative event. This doesnt prevent a negative event from happening, but if it does happen and youre properly hedged, the impact of the event is reduced. So, hedging occurs almost everywhere, and we see it everyday. For example, if you buy house insurance, you are hedging yourself against fires, break-ins or other unforeseen disasters. Portfolio managers, individual investors and corporations use hedging techniques to reduce their exposure to various risks. In financial markets, however, hedging becomes more complicated than simply paying an insurance company a fee every year. Hedging against investment risk means strategically using instruments in the market to offset the risk of any adverse price movements. In other words, investors hedge one investment by making another.

1.2

Oil hedging
Crude prices are extremely difficult to predict and subject to rapid and significant changes. A comparison of crude and heating oil historical volatilities with those of metals or financial assets show that oil is one of the most volatile of all commodities. Oil is a highly inelastic commodity both on the supply side and on the demand side. Consumer cannot immediately cut or increase oil consumption and producers cannot immediately fine newer field or shutdown existing field with changers in prices given this nature of the commodity.

1.3

Oil hedging Strategies

There are many hedging strategies in the market. Considering the suitability of the prevailing situation of the economy we should identify exact strategy, otherwise we have to face unnecessary economic & social problems.

Most commonly used strategies are

Collars Fixed for Floating Swaps Participation Swaps Spread Swaps Caps and Floors Hybrid Strategies Ceylon Petroleum Corporation used zero collars hedging instrument but there are more hedging strategies in the market.

1.4

Background of the problem.

During 2003 to 2006 period Central Bank of Sri Lanka (CBSL) had seen the oil prices had been volatile and that was a sharp increase for the said period. In that period Expenses on Crude Oil Import are US$ 789, 837, 1210, 1655, 2186 million. Considering this increase the CBSL advised that a study would be undertaken by a committee of experts to consider a suitable method by resorting to hedging agreement to reduce the prices payable on Petroleum products in the event of such increase by the Corporation. The recommendation committee was appointed by the ministry and they submitted the cabinet memorandum dated 13th January 2007. 2

The recommendation committee advised the cabinet the below mentioned requirements are essential for the hedging agreement. 1. The Ceylon Petroleum Corporation to hedge purchase of petroleum products, both crude oil and refined products from the international market. 2. 3. 4. Use Zero Cost Collar as the hedging instrument with the upper bound based on market developments. Commence hedging with smaller quantities for a shorter period and gradually increase the quantity and duration. Grant authority to the Chairman of the Corporation to call for quotations for oil hedging, decide on future price and purchase hedging instrument from reputed banks. 5. Grant authority to the Chairman of the Corporation to change the instrument based on the development in the market Having agreed, in principal, that the oil hedging should be resorted to, the recommendation Committee submitted a Cabinet memorandum dated 13th January 2007 seeking the approval of the Cabinet of Ministers to implement the recommendations mentioned above and the approval was granted by the Cabinet to implement the same on or about 24th January 2007. There are different hedging options available in the market and the said committee had recommended the zero cost collar option which was admittedly proposed by the Deputy General Manager (Finance) and Chairmen/Managing Director of the CPC.

2.

Problem Statement
As per the advice of the Central Bank of Sri Lanka considering the sharp increase during the period from 2002 to 2005 and the recommendation of the committee appointed consisted with qualified professional experts and on the Cabinet approval the Chairman/Managing Director and DGM (Finance) 3

entered into the hedging agreement accordingly. People believe that it is a failure and it has affected to the economy of the country. Hence the public was directly arisen against the Government.

The research problem is Why this hedging mechanism was a failure in the Ceylon Petroleum Corporation and what is the most suitable hedging strategy in future for our country.

3.

Scope and Objectives

Ceylon Petroleum Corporation is fully government owned organization. It has been established by the Ceylon Petroleum Corporation Act No. 28 of 1961. This organization had a monopoly up to 2003. Lanka Indian Oil Corporation (LIOC). In November 2003 this organization was re-structured. In other word soled the 1/3 ownership to

1. To

examine

the

Oil

3.

To

analyze

the

Oil

hedging strategy of the Ceylon Corporation. Petroleum

consumption pattern of the country.

4. To analyze the available oil 2. To examine the deficiency and weakness of the Oil hedging strategy. hedging strategies of the market.

5.

To

identify Oil

most hedging

suitable strategy to Sri Lanka.

4.

Research Methodology Data Collection

In this research I will consider both primary and secondary data.

4.1

Primary data Primary data comes from the preliminary discussions, questionnaires and interviews.

Personally administed interview. I would be selecting key persons from the Ceylon Petroleum Corporation for the preliminary discussions and interviews.

4.2

Secondary Data Secondary data will come from documents, internet, journals, related studies, books, magazines and news papers on the hedging.

Following important documents to be studied to collect data for this research Hedging Agreement Advisory Committee Report Cabinet Paper Case Study Files Reports, case studies and relevant data through Internet Hedging Procedure introduced by the CBSL.

To analyze the oil hedging strategy used by the CPC the case study approach will be implemented.

To identify most suitable hedging strategy available instruments will be examined & analyzed appropriately.

5.

Significance of the Study

Oil Hedging is a risk management tool and it is most important to Ceylon Petroleum Corporation. There is hardly any research done on this oil strategy for CPC. The result of this research would be more benefited to the Ceylon Petroleum Corporation and as well as country in future hedging deals. Lack of knowledgeable person in hedging strategies in Ceylon Petroleum Corporation and so it is required to fulfill the gap. Since most of the officers in CPC want to know what is the real problem of the hedging deal, I believe that this research give a solution to that question. At the end of this research CPC can gain thorough knowledge about the hedging strategies.

6. Time Frame of the Study

The Activities Literature Review Design Research Proposal Design/Re cv. Questionn aire Data Collection Data Analysis Final Report xx x 200 8 Dec xxx 200 9 Jan. xxx Fe b. Xx x Mar . xxx Ap r xx x xx x xx x Ma y xx x Jun e xx x Jul y Au g Sep t. Oct .

xx x xx x

xx x xx x xx x xx x xx x xxx

Contingen cies

xx x

7.

Limitations
There are several limitations of this study. These limitations directly effect to the accuracy of the study. It is difficult to obtain secret documents relevant to the case. Obtaining relevant details from the key persons is restricted as most of them are busy with their work. A research on this subject has never been done before as this is new to organization as well as the country.

8.

Tentative Literature Survey

The literature sources available, Hedging your Bets: A Heads Up on Hedge Funds and Funds of Hedge Funds, U.S. Securities and Exchange Commission (SEC). Retrieved on 2006-04-11. Option futures and other delegates JONC HULE Financial Articles Financial Magazines Central Bank of Sri Lanka hedging critical Annual Reports of Central Bank of Sri Lanka Working Papers Unpublished Papers Newspaper Articles etc. 7

Previous Thesis written by some other students Through web sites-related articles, essays, comments

9.

Chapterization of the Thesis

This paper consists 5 major chapters and described as follows: Chapter 1: Introduction This chapter mainly consists with following areas and the overview of the each chapter is given below: Background Research problem Objectives of the research The scope of the study Conceptual frame work Significance of the study Limitation

Chapter 2: Literature Review This chapter reviews the main theoretical frameworks and similar researches related to the topic. Chapter 3 : Methodology This chapter briefly states overview of procedure and data collection for the research. Basically it contains data collection methods and analytical techniques utilized for research. Chapter 4: Data Analysis & Discussions 8

This chapter shows how analysis done through data collected by examining and discussing. Chapter 5 : Conclusion & Recommendation This is to briefly convince the reader about the main conclusion and the recommendation could be applied for the future hedging deals.

10.

List of Reference
This section consist list of references utilized for the research.

Philip Coggan, 2009, Guide to Hedge Funds,1 to 152 Scott Frush, 2008, hedge funds DeMYSiFieD,1 to 300 Richard Horwitz, 2009, HEDGE FUND RISK FUNDAMENTALS,1 to275 John C.Hull, 2008, OPTION, FUTURES, AND OTHER DERIVATIVES, 1 to 789 Hannon.S, December23, 2008, Hedging the Oil Sector, http://seekingalpha.com/article/111956-hedging-the-Oil-Sector,03/30/2009, Page 1 of 1 Vishwanathan. B , November 05,2008,Hedging the price of oil 2 comments, http://seekingalpha.com/article/104055-hedging-the-price-of-oil ,03/29/2009, page 1 of 10 Investopedia ULC , PerfectHedge , http://investopedia.com/terms/p/perfecthedge.asp , 03/29/2009,page 1 of 1. Investopedia ULC,Delta Hedging , http://investopedia.com/terms/d/deltahedging.asp , 03/29/2009,page 1 of 2 Investopedia ULC,Hedgelet, http://investopedia.com/term/h/hedgelets.asp, 03/29/2009,page1 of 1. Investopedia ULC,Hedge Ratio, http://investopedia.com/term/h/hedgeratio.asp, 03/29/2009,page 1 of 1 Investopedia,Zero Cost Collar, http://investopedia.com/term/z/zerocostcollar.asp, 03/31/2009, page 1 of 5 . Wahrenburg.M, Hedgeing Oil Price Risk, wahrenburg@wiso.uni/koein.de, 9

page 1 of 20 Herbst .M,May 07/2008,Hedging Against $200 Oil, http://www.businessweek.com/bwdaily/dnflash/content/may 2008/db2008056075377.html,03/30/2009,page 1 of 2 .

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