Oil risk radar: Detection and protection strategies for Bangladesh's energy landscape

Photo: Reuters

Crude oil holds strategic importance for all nations, especially for economies reliant on crude oil imports. The world has witnessed various events, such as the Iraq, Yemen and Ukraine-Russia wars, which have introduced risks for oil-importing nations, resulting in higher oil prices. The challenges associated with rising oil prices pose a significant burden for any government of an oil-importing nation. 

Without financing opportunities, governments must reduce spending in other sectors or generate additional revenue when prices increase. Achieving this quickly and efficiently is also a daunting task. It will likely result in procyclical fiscal policies, imposing a significant burden on the private sector and the impoverished, contributing to macroeconomic instability, e.g., monetary financing, currency rate volatility, debt rescheduling and uneven economic growth and causing social and political discontent. 

Furthermore, oil price volatility complicates budget planning, as incorrect oil price assumptions can undermine fiscal plans. Higher oil prices and volatility can also lead to an inflationary environment and increased production costs. Exposure to rising oil prices can undermine the investment environment and delay existing projects, hindering economic growth from reaching the expected rate. Therefore, addressing the issue of ensuring oil price stability in the economy is crucial.

Oil import Scenario, sector-wise allocation and economic impact

The growth rate per barrel of crude oil from 2011 to 2022 has been a CAGR of 8.6%, while GDP has grown at an average rate of 6.5% during the same period. Research demonstrates that fluctuations in oil prices have a substantial impact on GDP growth in emerging oil-importing countries.

Since energy is a price-sensitive commodity, the government should exercise caution regarding costs. Bangladesh Petroleum typically issues two tenders each year, one between January and June and another between July and December. 

Additionally, it negotiates rates with selected suppliers at least four months in advance. Therefore, it takes some time for prices to adjust to reflect the state of the international market. As a result, consumers have no choice but to purchase fuel at government-set uniform prices.

As a non-sovereign currency country like Bangladesh, its foreign exchange reserves heavily influence the nation's fate. Crude petroleum and petroleum, oil and lubricants (POL) comprise an average of 11.4% of total imports from 2007 to 2022, reaching a 15-year high. The impact of exchange rate fluctuations on the trade balance becomes more apparent when considering this composition.

The transportation sector accounts for the majority, representing 62.9% of total petroleum product usage. Therefore, if oil prices rise, it will mainly affect low-income and low-middle-income individuals. 

Production costs in industries and agriculture increase with higher oil prices, leading to cost-push inflation and higher food prices. Moreover, the increase in transportation costs affects middle-income individuals in multiple ways. 

Bangladesh is the world's 120th largest importer of crude petroleum. Importing oil at a high price increases the import cost. The demand for the dollar increases, leading to a trade deficit. 

This trade deficit contributes to the current account deficit; fortunately, we have remittances to offset it. As an import-dependent country, the negative trade balance dropped to Tk286,965 crore in 2021-2022 from Tk149,966 crore in 2017-2018. 

An increasing negative trade balance influences currency depreciation due to higher pressure on foreign exchange. Therefore, the import cost of industries increases, which passes on to the cost of products, leading to inflation. In the long run, foreign currency reserves will decrease, currency instability will increase and the external debt burden will haunt the economy.

Covid-19, Russia-Ukraine war and global oil shortage: A gloomy period for Bangladesh

Due to the second wave of the pandemic, 3.24 crore people, or 19.54% of the nation's population, fell below the poverty line, according to a poll by the BRAC Institute of Governance and Development (BIGD) and the Power and Participation Research Centre (PPRC) in August 2021. This figure increased to 2% in March and 7% in August.

Despite the many challenges, Bangladesh's economy appears to be expanding at an impressive rate, but it cannot conceal the country's widening income disparity.

When the acute coronavirus pandemic emerged after March 2020, the price of oil on the global market plummeted to an all-time low of $19.33 per barrel, and BPC accumulated substantial profits. In December 2021, Brent crude fluctuated between $77 and $79 per barrel. America's embargo on Russia's fuel caused prices to soar to US$100 and reach a record high of US$139.13 in 2008 after Russia invaded Ukraine.

According to a senior BPC official, due to lower forex reserves, the state-run BPC would import up to 1.585 million tons of refined petroleum products in the second half of 2023, from July through December, which is around 4.0% lower than the second half of 2022, despite a 34% increase in oil imports during the same period in 2021 to 2022. 

Furthermore, as of May 16, 2023, BPC owes various suppliers of refined gasoline products over $297.49 million. Foreign exchange reserves have faced pressure due to significant exchange rate depreciation. To manage this critical situation, the International Islamic Trade Finance Corporation (ITFC), which previously authorised a $1.4 billion loan to the BPC, will lend the Energy and Mineral Resources Division an additional $900 million to cover the bills for the import of crude oil for the fiscal years 2023–2024.

Current scenario

Recently, the government has undergone a significant policy shift, relinquishing its monopoly position and welcoming the private sector to import, refine and sell products in the market under the name of "Policy on Storage, Import, Export, Storage and Retailing of Recyclable Fuel in the Private Sector-2023." 

The private sector can sell 60% of its total oil production to the Bangladesh Petroleum Corporation (BPC) for the first three years at a government-determined price and then the remaining 40% through their channels. Another significant achievement is establishing a Single Point Mooring (SPM) over a 110km pipeline on the Maheshkhali coast, a first in Bangladesh. 

This will reduce the unloading time from 10-11 days to 2-3 days and cut costs by Tk800 crore annually. However, despite all these improvements, oil price risk management remains critical because, without sustainable and fair policies, the suffering among the people will continue to spread into new areas.

Potential strategy for oil price risk management

Oil price risk management solutions come in various forms, each designed to address specific components of risk exposure. Here are some typical tactics and how they work –

The two primary categories are physical and financial subcategories of price risk management tools. Physical instruments include long-term contracts with fixed or variable prices, minimum/maximum price forward contracts, price-to-be-fixed contracts, and strategic timing of physical purchases and sales (such as "back-to-back" trading). 

Financial instruments include collars, commodity-linked bonds, trade financing agreements, exchange-traded futures and options and over-the-counter options and swaps. These strategies can mitigate the potential negative effects on economic stability, budget planning, strategic reserves and stockpiling methods to counteract the consequences of unexpected price shocks or supply interruptions.

Market-based risk management tools

Risk management tools for market changes are often called "market-based risk management tools" or "market-based risk management strategies." While future hedging can help control short-term price risk, it may not be as effective for dealing with the long-term secular rise in oil prices. 

Over-the-counter market contracts or risk-hedging instruments sold on financial markets can be utilised to reduce a nation's exposure to oil price risk. Since the first Gulf War, countries like Mexico, Brazil and Chile have actively participated in the oil derivatives markets. According to the New York Mercantile Exchange (NYMEX), developing nations now account for a greater share of open interest in crude oil futures, presenting opportunities for international exchanges.

Governmental entities can use futures contracts as a risk management tool to mitigate their vulnerability to fluctuations in oil prices. For instance, if the government anticipates an increase in oil prices, it can engage in a futures contract at a fixed rate for future delivery. This allows the government to safeguard itself against potential price escalations.

In a forward physical contract, the importer and the exporter will agree on a predetermined crude oil delivery date, a defined price, and a volume of crude oil. The agreement will remain intact even if they become embroiled in a dispute at the designated delivery date. If the volume hedged is insufficient, the importer may purchase crude oil on the spot market but not from exporters engaged in disputes.

Dr Mohammad Enamul Hoque is an Assistant Professor at Brac Business School, Brac University. Email: [email protected].

Ashfaque Reza is an MBA student at Brac Business School, Brac University. Email: [email protected].

Disclaimer: The views and opinions expressed in this article are those of the author and do not necessarily reflect the opinions and views of The Business Standard.