By Feizal Samath
COLOMBO, Nov 24 2008 (IPS)

The Sri Lankan government is grappling with a costly 300 million dollar payout to Citibank and Standard Chartered Bank (SCB), following a disastrous oil futures contract between the banks and the state-owned Ceylon Petroleum Corporation (CPC).

Sri Lanka’s foreign reserves – worth around 2.7 billion dollars or the equivalent of more than two months worth of imports – is already under pressure from the global economic crisis.

SCB and Citibank have been accused of not properly informing the state petroleum supplier of the risks involved but vehemently deny any wrongdoing. Overseas officials from the two banks have been in Colombo over the past two weeks on ‘damage control’ visits.

Central Bank (CB) governor Nivard Cabraal said its guidelines in derivates trading had not been followed. Negotiations are now underway between the CPC and the banks to re-structure the contracts and reduce the burden on the fuel supplier.

Analysts recall that 15 years ago these two banks were implicated in a huge stock market scam following flagrant violation of the Reserve Bank of India guidelines on portfolio management services and ended up paying fines totalling 21 million dollars.

The Sri Lankan crisis came to the fore two weeks ago after newspaper reports hinted that the CPC may default on its October (monthly) payment to the banks due to a cash problem, and that the banks had not properly advised the CPC on the risks involved in the hedging contract.

After the SCB and Citibank got involved in the futures contracts, three others banks also followed suit – on a smaller scale however -– to get into oil futures contracts with the CPC.

The deals were made through a ‘zero cost collar’ instrument where no premium is paid by the customer and the risks shared with the banks. The CPC decision to hedge on oil as a protection against volatile oil prices came in January 2007 when there was speculation in the market that oil prices would rise to as much as 200 dollars a barrel in the coming months.

Under the zero cost collar option, whenever the price rises between 100 dollars and 135 dollars per barrel, the banks pay an agreed amount (upto a maximum of 1.5 million dollars a month) to the CPC. Any fall in prices below 100 dollars (without any restriction unlike on the topside) means the CPC pays the banks.

Since January the CPC gained 24 million dollars (payment from the two banks) but lost 38.5 million dollars – paid out just in two months – and is set to pay another 300 million dollars (if the oil prices remain in the 50-60 dollar per barrel range) or more if it falls further. De Mel admitted that payment at current prices would be over 300 million dollars.

On Friday, the benchmark Brent world crude price fell to 46.47 dollars per barrel, a stunning drop of almost 100 dollars per barrel from 143.33 dollars on Jul. 11 this year.

According to international news agency reports, crude oil prices are poised to fall by another 15 percent in the next week while recording its lowest price since May 2005. Even though OPEC is cutting down production to stem the sharp price fall, demand growth has fallen to its lowest in 23 years due to the world economic crisis, international market analysts say.

Dayasiri Jayasekera, Opposition legislator and member of the Parliamentary Committee on Public Enterprises (COPE), described the issue as serious. “Someone must be accountable for this huge loss to the country. We will be fully questioning Asantha de Mel (chief of CPC) on Thursday (at a COPE meeting) to get to the bottom of this,” he told IPS.

Newspapers and analysts have clearly indicated that the CPC went for the wrong hedging (futures) option where the payment on the downside (borne by the CPC) was unlimited while on the topside (liability for banks) was restricted and accuse the banks of selling the wrong option and not advising the CPC of the risks.

Upul Arunajith, a derivatives specialist based in Canada, told IPS over e-mail that if the wrong instrument is used, the hedge will sooner or later go in the wrong direction and will lead into a crisis. “This is what happened in this case.”

Arunajith, a Sri Lankan who initially made a proposal to the Sri Lankan government at the end of 2002 to introduce hedging, said that there were warning signals that the zero cost dollar instrument was the wrong strategy. “I had personally informed them of the impending disaster,’’ he said. ‘’Neither SCB nor Citibank are specialised energy traders nor do they have the wherewithal to provide a hedge to the CPC for a huge exposure of two billion dollars’’.

At de Mel’s press conference Citibank chief Dennis Hussey said the Sri Lankan government started the hedging process following a special cabinet approval, which has been carefully documented.

SCB’s Sri Lanka chief Clive Haswell said the bank had received a written undertaking from the CPC that the latter was aware of the risks.

But CPC’s board of directors said no such undertaking was given and are blaming de Mel, a political appointee and associate of President Mahinda Rajapaksa and Petroleum Resources Minister Mohamed Fowzie, for taking decisions without full board authority.

Issues of impropriety are also surfacing with claims that some CPC officials got ‘favours’ from the banks. Attorney General Priyadas Dep told The Sunday Times newspaper that his department – which normally scrutinises state contracts to check its legality – was not consulted.

As pressure mounted on the government, Rajapakse summoned de Mel for a meeting. A Parliamentary committee had also summoned de Mel for a hearing but the latter did not turn up, requesting time for proper preparation.

Political observers say while de Mel and the finance minister must take the rap for undertaking to use a hedging option where the downside risks were greater, the powerful CPC chairman’s political connections will come to his rescue.

This was clearly seen when CB officials, who had initially threatened to rap the banks for not following guidelines, seemed to relent later under pressure and are now guiding a re-negotiation of the payments.

As demands are being heard from some sections of the government to default payment on the basis that the banks misled the CPC, pressure has been mounting to pay up or face international repercussions.

Market analysts said that the two main foreign banks have hedged these instruments with the New York Mercantile Exchange (NYMEX). “Any default to the NYMEX by the banks will be perceived as default of a sovereign debt which will be disastrous to the country’s international rating and jeopardise Sri Lanka’s standing internationally to seek foreign commercial loans,” one analyst said.

The government has resorted to large scale borrowings in the international market over the past two years to fund state spending, including for costly war against separatist Tamil rebels in the island nation’s north.

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