The news that Mexico has locked in prices of at least $70 a barrel for 90% of next year’s oil exports has surprised many traders, and demonstrated the depth of the oil derivatives markets.
If reports are correct, Mexico has protected $37bn of revenue from oil sales, vital to its 2009 budget, at a cost of just $1.5bn. It is believed to have done so, far-sightedly, in late September and early October, while oil was falling from about $120 towards $90.
The government has already revised its budget, lowering its oil price target from $80 to $70.
With oil now dropping through $60, the country’s budget would have been devastated if it had not hedged so much of its production and if prices stay low. Oil revenues make up nearly 40% of public sector income.
By warding off this disaster, Mexico will likely have protected the public finances, its credit rating, its currency and its stockmarkets.
Moreover, Mexico used put options for the hedge, so that it will still be able to benefit if oil prices go high again, by choosing not to exercise its options.
News of the transaction appears to have broken in Reforma, a Mexican newspaper, on November 6.
The story was based on a footnote in the finance ministry’s quarterly report for the third quarter of 2008, saying that Ps15.5bn ($1.5bn) was spent from the country’s $10bn oil stabilisation fund on “financial investments, as part of the measures taken for risk management, and the payment of fees to the trustee and its auditors/advisors”.
It was then picked up by a team of UBS analysts in Mexico City, including strategist Tomás Lajous, who wrote a detailed and apparently well informed report on the deal the same day.
On November 11 the Financial Times reported the story, adding that Barclays Capital and Goldman Sachs had arranged the hedge.
Those banks have declined to comment, as has the Mexican Treasury. Deutsche Bank and Morgan Stanley are said to have participated in Mexico’s oil hedging programme in the past, but this could not be confirmed – nor is it clear why they were not involved this time.
Lajous believes the transaction was arranged privately in the over-the-counter market. The banks would then have hedged their own exposure in the open market.
Lajous estimates Mexico hedged about 90% of its annual production, expected to be 533m barrels, or 1.46m barrels per day (bpd).
He calculated the cost at $1.5bn, based on the Treasury report and the fact that in the past, Mexico has usually spent about $500m to hedge 20%-30% of its production.
That would mean the country bought put options for 480m barrels, which Lajous believes were at strike prices of $70-$100.
Based on options at $70 for a barrel of Mexican crude oil mix, equivalent to $82 for West Texas Intermediate, the hedge will be profitable for Mexico if WTI oil trades next year at any level below $80. In other words, the higher revenues Mexico obtains by selling through the options rather than in the open market will exceed the $1.5bn option cost.
Between $80 and $85 for WTI, the option cost will exceed any gain – above $85, the revenue from selling oil at higher prices again pays for the option cost and leaves a profit.
But this analysis clouds the real virtue of the hedge, which Lajous calculates is to lock in a maximum revenue shortfall, compared to budget, of $3bn, including the option cost, even if WTI oil falls to $40.
That cost is 7% of budgeted oil revenues. Without the hedge, at $40 a barrel for WTI, Mexico would lose 59% of its budgeted oil revenue.
Yet if oil goes back to $100 or $120, Mexico will still make $10bn-$20bn of extra revenue, and only give up $1.5bn of this.
The urgency of hedging is even more clear when one recognises that Mexico’s oil production – the sixth largest in the world – is falling steeply. In 2006 the country pumped 1.6m bpd. This dropped to 1.4m last year and is projected by some to fall to 0.9m in the coming years.
“A few years ago Mexico had more leverage to impact the market. But with demand rising and production on the low, after 2010 Mexico may no longer be an exporter of oil,” said Adam Sieminski, chief energy economist at Deutsche Bank. “It is no surprise that the Mexican government wants to see how much revenue it can get by selling oil, even just for forecasting purposes. It makes sense to do this.”
Food for thought
That Mexico was able to execute such a beneficial hedge on such a large scale may change the way other producers operate, and make market participants reconsider some of their assumptions.
If Goldman Sachs and Barclays Capital were indeed hedging their options during the last week of August and first half of September, that would coincide with a period of steeply falling oil prices.
Lajous analyses the six month out WTI future, which slid from about $118 to $91 in that time, before rebounding to nearly $110.
He argues this pattern of trading “supports the view that the hedge took place (and confirms oil market trading comments from the time, which suggested that a LatAm producer was involved in transactions that put pressure on the futures curve)”.
Raymond Carbone, president of Paramount Options in New York, told FOi: “There were clear signals that an oil producer was hedging over the summer. The December 2009 contract experienced a surge in volumes.”
Carbone believes Mexico’s hedging could have added some downward pressure to oil prices as the banks involved would have been pushed to sell the commodity in the derivatives markets to manage their risk.
But there is strong reason to believe that the mid-September bounce in the crude oil price was caused partly by US oil refiners being caught with an oil shortfall in the wake of Hurricanes Gustav and Ike (see the link below to Futures and Options Intelligence’s story on September 30).
And after the bounce, oil resumed its steady downward course until it sank below $70 in late October.
So there would seem to be little evidence that Mexico’s trading affected prices substantially.
The average daily trade in Nymex’s Light Sweet Crude Oil future was 504,000 contracts in August and 550,000 in September, representing about 500m barrels of oil a day for all delivery dates.
The corresponding option trades about one fifth as much: 111,000 in August and 146,000 in September, or roughly 100m barrels a day.
If the hedging was spread out over three weeks, it would therefore have constituted about 30% of daily trading in the WTI options markets, or 6% of the futures market – perhaps enough to move a placid market, but not one in which sentiment was being whipped by contrasting forces of economic gloom and hurricane damage.
However, stealth must have been an important part of the trade’s success. If the market had seen the two banks coming with $37bn of hedging to do for Mexico, it could not have got such good pricing.
“They have to be careful how they do this,” said Michael Wittner, global head of oil research at Société Générale. “They don’t want to sell too much or there will be too much downward pressure – they will end up shooting themselves in the foot.”
Mexico is said to be among the oil producing countries that is fairly transparent about its hedging strategy, while others are more secretive.
It will be a high priority for oil strategists to discover in the coming months how successful other nations and large oil companies have been at protecting themselves from what is already a savage fall in the oil price.