Over the last two years, rapid fall in oil prices have given rise to significant budget deficits in the Gulf Cooperation Council (GCC) region. While there already have been a few large ticket foreign currency bond issuances by some of the states, there is considerable uncertainty around future rounds of external financing to meet further deficits. The possibility of a continued rise of interest rates in US dollar (to which GCC currencies are pegged) over the next year may not help their cases either. Against this backdrop, it is important to remember that bulk of the above uncertainty is still linked to volatility in oil prices which constitute major portion of export revenues for the states. Is there any way to align financing in an innovative way to work the above volatility in your favour as an issuer?
The answer may lie in oil linked bonds. These are bonds where face value as well as coupons are linked to price of specified barrels of oil (like face value at 2 barrels of oil). Various alternatives like a minimum/maximum coupon rate and face value enrich valuations of these bonds to investors. However, fundamental value of these bonds originates from the volatility of oil prices as it embeds the optionality of a higher payout when oil price rises and vice versa. Given the current complex interplay of various forces in energy markets, one can only expect volatility to remain higher for longer period of time.
From an issuer perspective, oil linked bonds help them pay lower financing cost relative to a conventional bond due to above oil price option. Additionally, it lets them hedge their oil export revenues through such structures. In good years with higher oil prices, the issuer payments are higher compared to other years where crude oil navigates in lower territories and issuers get a breather. From an investor perspective, any GCC related investment comes with an implied risk on oil prices. Such oil linked instruments make such correlations more explicit and possibly offers some hedging opportunities too.
Are there any examples from history on such issuances? In the late seventies, the Government of Mexico issued petrobonds/oil linked bonds through one of its development banks. Later in 1981, Petro Lewis Corporation of Denver issued some oil indexed notes. Apart from oil linked instruments, there also have been numerous issuances on other commodities like gold, silver, nickel, copper etc. While the overall market may not be very liquid, the efficacy of these instruments depends on right kind of issuers and investors coming together in the market place to transact. Current financing requirements from the GCC region may offer a very fruitful avenue in this regard. A large part of overall external financing through oil linked bonds may be able to reduce overall uncertainty in the funding challenges within GCC and even some other oil dependent emerging economies in Africa and Latin America. From an investor perspective, ever-increasing hunger for returns may be fulfilled by the possibility of upside scenarios from any rising oil price environment. An investor may even choose to look at such bonds from high grade government issuers just in the same way as inflation indexed bonds given that crude oil prices do often comprise a large part of price indexes globally.
Islamic variants of such underlying commodity backed products would be the next step.
— Samik Metia is a finance professional based in UAE. Views expressed are his own.
