How Kenya can counter global oil price volatility

Kenya is grappling with substantial exposure to oil price volatility in what has seen its efforts to deal with price fluctuations challenging and expensive.

Conventional methods, such as stabilisation funds, have revealed notable areas for improvement to ensure efficiency.

A proposal of exploring Oil Risk Markets, alternatively known as oil futures or oil derivatives markets, as a potential solution.

The term “oil price risk” pertains to the possibility of abrupt, substantial, and unforeseen variations in prices. This risk can be chiefly managed in two ways locally.

Firstly, nations with extensive oil production, such as Saudi Arabia, rely heavily on the revenue generated from this resource. Consequently, any fluctuation in prices could significantly impact their income.

Secondly, governments that administratively determine the prices of oil-related products might experience financial strain, thus, occurring if the costs of their inputs rise and they need to adjust the prices of their outputs proportionally.

In both scenarios, the Kenyan Government is aware that such volatility can influence various facets of life.

Here are simple but practical strategies for managing government oil price risk.

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Oil price risk markets

Oil-dependent economies such as Kenya face a fundamental issue: they bear a significant oil price risk, which they must be better equipped to manage.

A potential solution could be to transfer this risk to international entities better positioned to handle it. This risk mitigation could be achieved through oil price risk markets.

Two primary risk transfer strategies for the Kenyan economy are buying oil later (forward buying) or purchasing insurance to protect against substantial price increases.

Such hedging could enhance the stability and predictability of the government’s cost expenditure and put less pressure on the dollar.

This strategy would reduce the variability in the government’s oil buying costs and provide ample time to anticipate changes and adjust its strategies smoothly.

A futures strategy would establish the oil price that the government will receive in the next financial year.

Hedging strategies

Hedging strategies can be customised to meet the unique requirements of the party implementing them, frequently leading to intricate agreements.

One uncomplicated example encompasses a strategy combining futures and spot purchases. Half of the output is procured via the futures market, and the remaining half is obtained from the spot market.

Compared to the options strategy, this combined approach continues to offer a degree of safeguard against a decline in spot prices, all without demanding a premium payment.

Compared to a strategy solely relying on futures, the combined approach enables the government to capitalise on possible future spot price rises.

However, this benefit does come with the risk of enduring some consequences if prices do indeed escalate.

A “no-cost collar” is another frequently employed hedging strategy that might attract Kenyan oil producers, especially when agreed upon by oil-producing nations.

This approach entails buying a premium as a protective measure against a considerable decline in future spot prices.

The expense of this premium is balanced by selling an option wherein the oil producer surrenders the gains from a substantial increase in future spot prices.

As a result, this constrains the range of prices the government would receive in the future to a bracket determined by the two strike prices.

Nevertheless, futures and options traded on an exchange might not be appropriate for managing governmental oil price risk, particularly for governments or State-owned oil companies with less advanced institutional capacity for executing such strategies.

A more suitable tool for these entities could be a custom-made agreement established directly with a financial intermediary.

Over-the-Counter (OTC) instruments emerge as another crucial solution. These instruments, characterised by various forms and structures, offer certain benefits.

Primarily, they eradicate basis risk, accommodate large volumes in single transactions, generally cover extended periods, and do not necessitate an initial deposit or margin calls.

However, OTC instruments are usually less transparent and liquid than their exchange-traded equivalents, which makes them less easily reversible.

Policy recommendations

Oil Risk Markets, which comprise futures and derivatives, pose a more promising solution for Kenya.

These markets offer the possibility to lock in future production or consumption prices, insure against significant price swings, and execute strategies to manage unpredictable costs.

In light of oil price instability, Kenya’s government should focus on several strategic areas.

It includes developing policies to enhance oil risk market operations, fostering regulatory frameworks supporting hedging strategies, and facilitating global market interactions.