A Short Note on Sovereign Commodity Risk Management*

by Frank Lehrbass

Working Paper, January 2015

JEL: C00, D7, F5, H3, H7, N4

Key words

Sovereign risk management, rationalist explanations, expected utility maximization, commodity risk management, hedging

Abstract

I investigate sovereign risk management using expected utility theory. A proposition is derived under which conditions which degree of hedging is optimal. An application to the case of Russia shows that a risk-acceptant attitude can serve as an explanation of the decisions to bail out Rosneft and to leave some oil exposure unhedged.

*I wish to thank Bruce Bueno de Mesquita from New York University, NY, U.S.A., for helpful comments and suggestions.

A Short Note on Sovereign Commodity Risk Management Introduction Many countries in the world are exposed to commodity market price risk. It is an established element of corporate risk management to hedge these exposures using derivatives. Nonetheless the World Bank reports that "though well-established in the commercial sector, the use of market-based price risk management is not widespread in the public sector, particularly by sovereigns" (Dana and Sadler, 2012). However, there are some exceptions. "Sovereigns who have made public their hedging plans include Mexico, Panama, Ghana, and in the past Ecuador, for oil, and Chile for copper. The biggest oil exporter to publish its hedging program is Mexico, which gained acclaim in 2009 when its hedging program made a profit of approximately $ 5 billion" (Molloy, 2011). This example shows that the oil derivatives market is big enough to allow a sovereign to hedge its oil exposure – and that this can be a worthwhile action. However, recent research has elaborated that a group of sovereigns is currently running into problems with oil prices below $ 100 per barrel (bbl). The price of oil needed to balance their budgets is "one useful measure of their respective pain thresholds" (Deutsche Bank, 2014). The latest estimates per country are as follows: "Bahrain ($136bbl), Oman ($101bbl), Saudi Arabia ($99bbl), Nigeria ($126bbl), Russia ($100bbl), and Venezuela ($162bbl)" (Deutsche Bank, 2014). There is ample evidence that these countries are facing problems, which indicates that the oil production has not been hedged. Firstly, I will investigate the sovereign decision not to hegde on a general level by making use of expected utility theory as introduced by von Neumann and Morgenstern (1944). This presupposes that the sovereign is able to rank risky alternatives. But speaking of the risk preferences of a sovereign seems an unreasonable approach in light of the work by Arrow (1950). He has shown that – given only weak requirements for the ordering - there is no way to aggregate individual preferences into one single preference order. However, there are exceptions for countries which are ruled essentially by one or few, rather aligned individuals. The list of sovereigns in trouble might intersect to some degree with the exceptions. Secondly, for exposition I will apply the general model to the case of Russia to specify Russia's risk preferences. It will turn out that assuming a risk-acceptant attitude (i.e. a strictly convex utility function) conforms with the open position in oil and the bailout of Rosneft.

A Simple Model of Sovereign Risk Management The application of expected utility theory to hedging decisions has a long tradition. One of the early publications is Ethier (1973). The history of the application to international politics is a bit shorter and starts with De Mesquita (1980). I take two of his original assumptions and apply them to the case of sovereign decision making. Sovereign decisions can be viewed "(a) as if they are the product of a single, all important decision maker [i.e. the leader]; (b) decision makers are rational expected utility maximizers". Furthermore let me assume as in De Mesquita (1980) that the "leader's welfare" is the argument of the utility function u(.) to be maximized. Since future oil prices are uncertain, the leader maximizes expected utility. The leader's welfare is certainly a function of governmental tax income, which is again a function of the revenues from selling oil. To keep things simple I denote the amount of the sovereign's oil production by x in units of bbl and the uncertain oil price by p in units of $. The leader maximizes the following expected value over a certain time horizon: Eu(xp) (1) E[.] denotes the expectation operator using the subjective probability distribution as seen by the leader. For exposition I assume a horizon of one year, which makes x the annual oil production.

A Short Note on Sovereign Commodity Risk Management As a representative of the hedging instruments available I introduce a one-year futures contract, which can be bought or sold at today's known futures price level of f in units of $/bbl – for instance at the Intercontinental Exchange (ICE). The leader certainly does not have a 'crystal ball' to foresee future oil prices. Many studies have investigated how far oil-futures prices can be treated as expected spot oil prices and concluded that "treating oil-futures prices as the expected future spot price is a good first approximation" (Alquist and Arbatli, 2010). Hence, I assume that the futures price f is an unbiased estimator of the future oil price p, i.e.: f  Ep (2) The last bit of notation is the decision variable h, which is the amount of barrels sold forward at the current futures price f. For instance, if the leader chose to hedge fully, we would have x=h. What is chosen is the outcome of the following decision problem of the leader: max Eu(xp  h( f  p)) (3) h The only difference to equation (1) is the addition of the profit or loss term from hedging with futures. This simple model implies a proposition for leaders in general.

Proposition (i) The leader will hedge fully if he or she is risk-averse. (ii) If he or she is risk-acceptant a full hedge is the worst decision. Hence, he or she will leave the oil exposure unhedged. (iii) If he or she is risk-neutral it does not matter whether a hedge is in place.

Proof I start with (i). Risk-aversion means that the utility function is strictly concave. A full hedge reduces xp+x(f-p) to xf, which is non-random. Due to assumption (2) this is equal to xE[p]. With the help of Jensen's inequality from probability theory one sees that getting the expected welfare for sure is the best outcome for a risk-averse leader, because: Eu(xp) u(Exp) (4) The case of (ii) implies a strictly convex utility function. The inequality in (4) reverses. Thus getting the expected welfare for sure is the worst thing for a risk-acceptant leader, which is why he will avoid hedging. A risk-neutral decision maker maximizes E[xp+h(f-p)]. Insertion of (2) gives E[xp+h(E[p]-p)]. Since E is a linear operator the term following the control variable h vanishes. What remains is xE[p] for any choice of h. Hence, it does not matter. q.e.d.

A Short Note on Sovereign Commodity Risk Management Russia's Oil Exposure Management Sceptics might doubt whether the oil derivatives markets are liquid enough to allow Russia a sufficient degree of hedging. The answer is that hedging usually applies a whole range of instruments and that it is therefore insufficient to look only at the exchange traded futures markets. In the commercial sector exchange traded futures, OTC traded forwards and long term supply contracts are used in parallel. Hedges are built up over time and not on a single trading day. Hence, like Mexico or a commercial company, Russia could hedge its oil exposure if it wanted to1. The media report that there is a deep impact by the recent decrease in oil prices, which is reflected in falling Russian stock prices and a devaluing currency. More specifically the FT reports that Russia derived "more than half of its budget revenues from oil and gas extraction" in 2013 (Hille et al, 2014). Both commodities are closely related, because it is well-known that within Russian long term gas supply contracts gas is priced as a function of the oil price. If the oil price falls, so does the revenue from selling gas. "Falling oil prices were causing Russia economic damage of 'some $ 90 to $ 100 billion per year'” according to a statement from Russian Finance Minister Anton Siluanov (Khaleej Times, 2014). Obviously Russia has not hedged its oil price exposure to avoid these deep impacts.

Application of the Model With respect to Russia the "he" formulation of the Proposition is relevant. The fact that there is no full hedge of the oil exposure implies a risk-acceptant attitude or a violation of the unbiasedness assumption as expressed in equation (2). Under risk-aversion a less than perfect hedge would be chosen if the futures price is below the expected oil price, i.e. f

1 For 2014 the daily oil production of Russia is reported to be roughly 11 mn barrels. One can compare this for instance with the ICE Brent futures average daily volume, which is reported to be around 500,000 lots (each 1000 barrels). This shows that the daily volume at one exchange is already bigger than Russia's daily oil production.

A Short Note on Sovereign Commodity Risk Management Russia's bailout of Rosneft The media report that Russia's central bank is accepting corporate bonds issued by Russia's biggest oil company Rosneft as collateral from its debtors, i.e. commercial banks (Kuznetsov, 2014). Thereby the already big exposure of the Russian banking system to commodity related companies is increased. By assumption the central bank acts in alignment with the leader. So what does this bailout tell us about the risk attitude of the leader? Certainly, this decision cannot be reconciled with a risk-averse attitude, because this would call for diversification of credit risk and not for concentration. Risk-acceptant or risk-neutral attitudes appear as viable candidates. There are media reports on the specific conditions under which the central bank is taking the bonds as collateral. It is reported that they were taken at face value (Gallucci, 2014). This rules out a risk-neutral attitude. The reason is that "the interest that investors are charging Rosneft in these bonds is substantially below even that of Russian sovereign debt" (Guriev, 2014). In other words: The expected credit loss from holding these bonds is not compensated by the coupon - as would be required by a risk-neutral decision maker. Hence, the bailout of Rosneft can neither be explained by a risk-averse, nor a risk-neutral attitude of the leader. This leaves us with the risk-acceptant attitude as the best common explanation of not hedging the oil exposure and bailing out Rosneft.

Conclusion Sovereign risk management has been investigated using expected utility theory. A proposition has been derived under which conditions which degree of hedging is optimal. An application to the case of Russia has shown that a risk-acceptant attitude can serve as an explanation of the decisions to bail out Rosneft and to leave some oil exposure unhedged. As a final word I want to add a caveat: It might be tempting to apply this simple approach to the conflict in Ukraine or other similar crisis situations. But it is now generally understood that the fundamental questions of peace and war are far too complex2. Hence, this note is kept focussed on the simpler questions of sovereign commodity risk management.

Literature and Sources Alquist, R. and Arbatli, E. 2010, "Crude Oil Futures: A Crystal Ball?", Bank of Canada Review, Spring. Alquist, R. and Kilian L., 2010, “What Do We Learn from the Price of Crude Oil Futures?” Journal of Applied Econometrics 25: 539-573. Arrow, K.J., 1950, "A Difficulty in the Concept of Social Welfare", Journal of Political Economy, 58: 328–346. Dana, J. and Sadler, M., 2012, "Market-Based Approaches to Managing Commodity Price Risk", Contribution from the World Bank to the G20 Commodity Markets Sub Working Group. De Mesquita, B. B., 1980, "An Expected Utility Theory of International Conflict", American Political Science Review, 74: 917-931. Deutsche Bank, 2014, "EM oil producers: breakeven pain thresholds", Special Report, October.

2 One example is Powell's (2006) work concerning Fearon's model (1995). A recent overview of related literature can be found in Fearon (2013).

A Short Note on Sovereign Commodity Risk Management Ethier, W., 1973, "International Trade and the Forward Market", American Economic Review, 63, 494-503. Fearon, J. D., 1995, "Rationalist Explanations for War", International Organization, 49: 379- 414. Fearon, J. D., 2013, "Fighting rather than Bargaining", Department of Political Science, Stanford University, Working Paper, October. Gallucci, M., 2014, "Russian Oil Chief Denies Speculation That Rosneft Bond Sale Set Off Ruble Currency Collapse", International Business Times, 17 Dec. Guriev, S., 2014, "Russia is heading into an economic storm with no captain", FT, 17 Dec. Hille, K., Weaver, C., Strauss, D. and Moore, E., 2014, "Rouble rocked as oil price plunge turns up the pressure on Russia", FT, 2 Dec. Khaleej Times, 2014, "Russia loses $ 40 bn from sanctions but Putin says damage ‘not fatal’", 24 Nov. Kuznetsov, V., 2014, "Rosneft Gets Central Bank Help Refinancing $ 7 Billion Loan", Bloomberg, 12 Dec. Nabiullina, E. S., 2014, "Statement by Bank of Russia Governor Elvira S. Nabiullina in follow- up of Board of Directors meeting", 11 Dec. Powell, R., 2006. "War as a Commitment Problem", International Organization 60: 169-204. von Neumann, J. and Morgenstern, O., 1944, Theory of Games and Economic Behavior, Princeton University Press. Molloy, N., 2011, "The rise of sovereign commodity risk management", Energy Risk Journal, October.