This is how a hedge can work ..... hats off to Mexico.

Monday 23rd November 2015

This is how a hedge can work ..... hats off to Mexico.

Ref : "Oil Deal of the Year : Mexico Set for $6 Billion Hedging Windfall" , Bloomberg Online

This may not be "breaking" news exactly  --  the "Mexican Hedge" by which that country insures against downward moves in the value of its upcoming annual oil production is an annual event and one that's closely watched by the industry. But since Bloomberg have managed to put together some data that they hope will give an accurate picture of  what may have been achieved by the 2015 version, it's definitely worth another look.

Each year the Mexican government locks in a guaranteed price for its oil sales through a series of deals with top-name banks, largely and most simply by purchasing "Put" options.

** Note : for newcomers, a reminder that PUT options give the buyer the right to SELL the underlying instrument or commodity at a certain price (the strike price), in exchange for the payment of a premium. A purchaser of a CALL option would of course be buying the right to BUY an instrument or commodity at a certain price.

In this instance, Mexico's hedge transaction (which runs from Dec 1st  2014 - Nov 30th 2015) allows it the right to sell 228 million barrels at $76.40  --  and the actual average price over that period with one week to go is $46.61. The difference between the two numbers means that Mexico will receive a gross payment of about $6.8 billion, give or take. With the cost of the option premium being $773 million, that equates to a net profit of about $6 billion. Nice trade, eh?

But this is hardly rocket-science, so why don't more commodity-producing nations hedge their production in the same way ? It does happen, as with Ghana and its cocoa production for example, but not often and certainly not on such a scale. The main reason would be that though such a hedge strategy is designed to limit (if not entirely eliminate) downside risk, it can still come at a cost, some of it financial and a great deal of it political.

Remember that the cost premium of an option is paid away come what may .... so in this Mexican example, if the price had averaged more than $76.40 then obviously Mexico would not exercise its right to sell at that price. It would get a bit more for its oil but would have paid away $773 million for no apparent return. Now most traders would readily acknowledge that, depending on the price, paying a premium to protect your asset from sharp adverse price movements is not only a legitimate practice but a sensible one, even if you end up abandoning the option that you purchased. Volatile electorates however do not always take the same view of paying away the best part of a billion dollars say for no tangible result, particularly if it suggests that those in control misread the direction of the market.

Hedging downside risk to such an important part of your economy sounds like a no-brainer but it's not that easy, so Mexico deserves a good deal of credit for the way they've handled their 2015 production. It's probably not just their geographical proximity to a strong US economy that makes them one of the best performing of the so-called emerging nations. But what of 2016 ? Completing the process in August, three months earlier than usual and presumably to secure a higher price, Mexico has hedged its 2016 production at $49 per barrel, reportedly for accost of $1 billion. Like we said, this process is closely watched and even allowing for the fact that Mexico's heavier, sour crude trades at a discount to other benchmarks WTI and Brent, this doesn't sound over-bullish. Other producer nations may be hoping they've got it wrong this time.