Still Time to Play the Muskrat 'Hedge'

We all like to avoid risk.  Whether purchasing insurance, making an investment or constructing an RRSP, we employ strategies to reduce risk.  What we have engaged in, is called a ‘hedge’.

The word hedge is from Old English, hecg, originally any fence, living or artificial. The use of the word in the sense of "dodge, evade" is first recorded in the 1590s;[1] so, the idea is not new.

Like insurance against fire, a hedge can be a simple concept; your portfolio manager may employ more complicated schemes from using derivatives, swaps, options or futures.  Depending on the level of protection sought, a multitude of hedge strategies are available to help everyone sleep at night.     

Can a hedge strategy be employed to protect us from the risks of the Muskrat Falls Project?

Indirectly, yes, by engaging one that offers protection from the threat of high oil prices. 

Forecasted increases in the price of oil constitute the chief justification for building MF. Offshore oil provides a direct link between world oil prices and NL's royality structure.  Hence, NL enjoys the benefit of an excellent natural hedge, one which a decision to sanction MF will immediately ruin .

Oil is used to generate electricity at the Holyrood Generating Station.  Critics of MF have suggested refurbishing Holyrood is a cheaper, less risky option.  Conservation programs, additional wind and some small hydro projects (if the demand is proven) could be added, when necessary. This is inherently a conservative strategy because it is ‘demand’ based, whereas MF is a purely speculative play.

Nalcor will acknowledge that the capital cost of renovating Holyrood is relatively inexpensive.  The largest expense is fuel; on this basis, it speculates that MF is the lowest cost option by $2.2 billion.

That said, our hedge will offer protection only if oil prices go up; if they go down, for a lengthy period, then Nalcor’s assumptions about Muskrat are wrong anyway.

How will our hedge strategy work?

To state the obvious, higher fuel costs at Holyrood also equates with more royalties for the NL Treasury via offshore production.

For the ‘hedge’ to work, the Government simply has to commit to the fiscal discipline necessary to ensure that the hedge is covered (paid ). And, it must decide the price, per barrel of oil, at which Holyrood generation is too expensive for the rate payer.  It would make this decision using the same price per barrel that might, otherwise, trigger MF sanction.  That price becomes the ‘benchmark’ and you will be shielded from the effects of any price that goes higher than that benchmark.

A little more information is necessary. 

The Province receives about $25 million revenue, annually, for each dollar the price of oil goes up (or loses when oil prices drop).  Based upon 2010 generation numbers, Holyrood costs $1.4 million, annually, every time oil increases by one dollar. Even when we start supplying Vale’s 80 megawatt requirement at Long Harbour, together with some domestic demand, Holyrood generation will no more than double. So, let’s say 3 million barrels is the maximum quantity Holyrood will require.  The figure allows us to conclude that Holyrood, at worse, will cost $3 million annually for each dollar the price of oil increases.

This is important to know; we need to be sure that a precipitous decline in offshore production will not imperil our strategy. That is not likely. In fact, total oil for Holyrood, to 2041, would represent less than 2% of our offshore oil resource, as Cabot Martin advised the PUB last November. 

What happens next? Royalties received by Gov’t, in excess of the benchmark price will be dedicated to what we might call “the Muskrat Hedge”. These funds will no longer be used for general government revenues, as they are now; instead, they will be segregated and used to subsidize your electrical bills.

You are participating in a hedge fund!  Consider it one of your smarter investments.

It's not complicated, either.  Government need only have the discipline not to use the money for another hockey rink.  If its motivation for MF is truly your financial protection, it will send you a cheque monthly from the "Muskrat Hedge" Fund, when oil prices warrant.  MF won't proceed.

What if the Government fails to offer the opportunity of a hedge program and proceeds with MF anyway?  This is a matter of grave concern. Why? Because, if MF proceeds and the price of oil falls, ratepayers will be stuck; firstly, with billions of dollars of additional debt.  Secondly, a decline in the cost of electricity, in more open markets, will make our economy less competitive. And, thirdly, falling oil prices will mean a poorer treasury; that won’t be good for you, either!

I like OUR ‘hedge’ strategy better.  And we won’t have an $8-10 billion boondoggle, at Muskrat Falls, keeping us awake nights.

Source: Wikipedia [1]