Mexico’s oil hedges for 2016
October 2015 | Leo Drollas
On June 9th of this year, according to Argus Media, Mexico started hedging some of its 2016 oil output, ending the operation on August 14th.
The hedging program was undertaken by the Ministry of Finance in order to safeguard the oil revenues that accrue to the government. Mexico’s hedge is said to have taken place through purchases of options to sell its Maya crude and Brent, the global crude oil benchmark, at a strike price of $49/bbl and at a cost of $1.09 billion in options premiums. Bloomberg reported on July 29th this year that some large options deals being executed in the market in the previous ten days were probably related to the Mexican program, which suggests that Mexico’s hedging would have started earlier than its usual months of August and September. Bloomberg said that last year Mexico paid $773 million to lock in prices of $76.4/bbl for 2015, which represents a very good deal, given that Maya crude had averaged $49.78/bbl by the time Bloomberg’s report was published in late July. Significantly, Bloomberg also pointed out that Mexico had received $5 billion from its hedges for 2009, due to the market’s collapse, which suggests that hedging can be extremely useful in the right circumstances and using the right hedging instruments.
The Mexican government’s draft budget for 2016 assumes an oil price of $50/bbl for the Mexican basket of crudes, unchanged from the revised $50/bbl price for this year, and assumes Mexico will produce 2.247 mbpd next year. In the past, the country’s oil revenues accounted for over a third of government income, but this year Mexico’s oil revenues are expected to decline to 29% of aggregate revenues and to fall further to 20% of governmental income in 2016. Nevertheless, oil revenues still represent an important source of income for the Mexican treasury and hedging a portion of the country’s oil production (Argus mentions 0.579 mbpd, i.e., 26% of expected output) continues to make sense, especially in view of Mexico’s weak tax base (60% of the workforce is not registered for tax payments). The question that springs to mind, however, is whether use of sell or ‘put’ options is the best way for Mexico’s Ministry of Finance to have hedged the oil price risk in 2016.
The purchase of so-called ‘put’ options, which give the buyer the right but – crucially – not the obligation to sell oil at a particular price (the strike price) up to(i) a certain date (the expiry date) for a fee (the premium), is certainly useful for an oil producing entity, because it provides protection from price falls and yet allows the entity to gain from increases in the price of oil. However, options are not cheap, especially if they are ‘in the money’ – that is, if in the case of puts the strike price is greater than the spot price prevailing at the time the option is being bought, thereby assigning ‘intrinsic value’ to the option (i.e., the value that can be realized immediately by exercising the option). Options that are bought ‘at the money’ do not have intrinsic value, but they have what is known as ‘time value’, because they may acquire ‘in the money’ status by the time they expire. It is possible to establish an option’s time value by subtracting the intrinsic value (which is zero or positive for American-style options) from the option’s premium. Unfortunately, we have no detailed information about Mexico’s purchase of put options to hedge part of its 2016 output, since the banks thought to be involved (Morgan Stanley, JP Morgan Chase, Citigroup and Goldman Sachs among others, according to Bloomberg) have declined to comment. However, there is enough general information available to help us form a view as to whether Mexico’s purchase of puts was advisable at the time, although it must be said that a final assessment of Mexico’s hedging program must obviously wait for the options to expire – and even then it might well be impossible to deliver a verdict, because the options might be exercised prior to expiry, should they be ‘in the money’.
The first point to make is that Mexico is unique among oil-producing countries in persevering year after year with a substantial hedging program. Ecuador hedged its output in 1993, but losses led to a political crisis, and Colombia and Algeria have experimented with hedging on the producer side, while Morocco and Jamaica have hedged against rising oil prices as oil consumers, but one can safely say that, apart from Mexico, most sovereign states do not hedge. The second point concerns Mexico’s 2016 strike price of $49/bbl, which we shall assume refers to the basket of Mexican crudes of which Maya is representative. During the period when the Finance Ministry was engaged in purchasing its put options Maya’s spot price averaged $50.54/bbl, implying that Mexico’s strike price was out of the money by $1.54 a barrel, which of course made the put options relatively cheap, but how inexpensive – with a time value of $5.16 per barrel – is a matter for conjecture. For Mexico’s hedge to show a profit in 2016, Maya’s average would need to be below $43.84/bbl, which is of course possible but is it likely?
Thus far in 2015, Brent’s mean value is $55.90/bbl with a standard deviation of $6.35 a barrel. Now, on the assumption that the differential between Brent and Maya crudes remains at $6.08/bbl (the average differential over the period 9/6/15 to 14/8/15) and that Maya’s standard deviation is proportional to Brent’s, the implication is that 95% of Maya’s prices in 2016 are likely to range between $39/bbl and $61/bbl, with an expected value of $49.82/bbl(ii), a mere 18 cents below the oil price predicted for 2016 in the federal budget. Put in a different way, there is a 15% probability that the price of Maya crude will be below the options’ break-even price of $43.84/bbl in 2016. Thus, the Mexican Ministry of Finance is paying 10.5% of the strike price (or 11.8% of the break-even price) as a premium, hoping to benefit from a 15% probability that the price of Maya crude will be less than $43.84/bbl. Evidently, the Ministry has decided that this is an acceptable cost for the country to bear.
Could Mexico have acted differently? What other hedging possibilities are generally available? Selling options to buy oil (known as call options) at a strike price that generates sufficient premium income to pay for the purchase of Mexico’s $49-a-barrel put options (this operation is termed a zero-cost collar) would have covered the $1.09bn cost of capping the downside price risk, but the call options would have also put a limit on Mexico’s upside price gain from selling 579,000 barrels per day of its crude output. What about hedging Mexican crude by selling crude oil futures on a monthly basis either on NYMEX (for WTI) or on ICE (for Brent)? After all, to take ICE’s Brent as an example, on June 19th this year the futures prices for the standard Brent contract at a monthly frequency from November 2015 to November 2016 (apparently the end-month for Mexico’s hedging program) averaged out at $60.89/bbl, i.e. $5 a barrel more than the expected value of Brent crude next year based on this year’s Brent prices till the 14 th of September.
One of the problems of using an exchange-traded proxy crude like WTI or Brent for hedging purposes is the so-called ‘basis risk’ – in Mexico’s case it entails the differential movement of Maya prices with respect to Brent or WTI. If the price correlation between Maya and the proxy crude is high, hedging using futures carries little basis risk and is a lot cheaper than using naked put options. However, if the correlation is low, the proxy crude is not a good hedging instrument and could involve the hedger in losses that are unrelated to the specific type of crude being hedged. The other – and more significant – problem with using futures to hedge production is that – unlike options – the price upside is unavailable to the hedger, who gets the futures price come what may: once an oil producing entity has sold futures contracts, these can only be bought back (and thereby cancelled) at a loss in a rising market, in which successive spot prices exceed the already fixed sequence of futures prices. In light of the above, Mexico’s policy of using put options that are slightly out of the money(iii) to hedge part of the country’s oil production next year seems preferable to selling oil futures at prices that might appear favorable, but that would prevent Mexico from enjoying higher spot prices, should they materialize.
(i) American options can be exercised on or at any time before expiry, whereas European options can only be exercised on the expiry date; so-called Bermudan options can be exercised on specific dates prior to expiry (e.g., at the end of each month). In Mexico’s case the presumption is that we are dealing with American-style options.
(ii) Assuming that the distribution of prices in 2016 is normal, with the same central tendency and dispersion characteristics as those observed for Brent in 2015 (until September 14th).
(iii) The use of put options that are in the money becomes progressively more expensive as the strike price increases. For example, on September 15th this year, Dec-16 Brent futures on ICE settled at $55.26/bbl, while on that same day a $55/bbl Dec-16 put option on the exchange cost $7.15/bbl, or 13% of the strike price; on September 15th, a $60/bbl Dec-16 put option cost 16.7% of the strike price and a $70/bbl Dec-16 put option attracted a premium that was almost a quarter of the strike price.
About the author
Leo Drollas is a senior adviser for Energy Insights