Russia Is Contemplating the Wrong Oil Hedge

President Vladimir Putin has asked officials to dust off the idea of a hedging program to protect revenues in the event of an oil crash. Rock-bottom crude prices make insurance look appealing, but a host of practical reasons means it is unlikely to get off the ground. Moscow would instead be wise to invest in a different kind of hedge: preparing its fossil-fuel industry and wider $1.7 trillion economy for a greener future.

Oil hedges — usually put options or contracts that allow oil to be sold at a predetermined future price, thus “hedging” against price falls — are tempting for producers. They are also uncommon, because of the hefty cost and the associated risk of expensive insurance going to waste: Just ask airlines. A rare exception is Mexico, whose so-called Hacienda hedge is Wall Street's biggest oil trade. From 2001 to 2017, the country paid $11.7 billion in fees, but made $14.1 billion in gains. Why shouldn’t Russia follow Mexico’s example?

Despite low-cost production, Moscow has been hit hard by this year’s crude crash, when the collapse of a deal among major exporters coincided with a pandemic-induced contraction in appetite for the black stuff. It’s a crisis Putin can ill-afford to repeat. With the worrying prospect of lower prices ahead — thanks to rising supply and a sputtering recovery in demand, as my colleague Julian Lee writes — it’s not surprising that his team is reaching for a solution that has been considered but rejected before. 

Unfortunately, the Russian hedge still looks more appealing in theory than in practice. 

For a start, Moscow already has significant protection. Russia salts away excess oil and gas revenue in the National Wealth Fund when prices are above roughly $40 a barrel, and the government can draw on this when prices are below that figure. This has helped Russia accumulate the world’s fourth-largest foreign exchange reserves. Russia also has a shock absorber in the shape of a floating currency that tends to weaken when oil does, helping exporters.

So it’s hard to disagree with central bank governor Elvira Nabiullina, who says using the NWF to finance extra insurance is unlikely to be worth the expense — especially if the cost rises, as it surely will, when the world’s second-largest oil exporter steps into the market and drives up demand for these hedges. Mexico has already said that erratic movements in the market were raising the cost of its annual cover. 

According to calculations from Putin advisor Maxim Oreshkin, at strike prices similar to Mexico’s for 2019 and 2020, Russia would have spent $3.6 billion on hedging for 2019 and $4.3 billion for 2020, but this protection would have yielded almost $20 billion in the first half of this year alone. However, the past is no guarantee of future performance in a fast-changing industry, not least if the price of that insurance spikes. It also matters that at least some of the benefit to Mexico has come in the form of lower borrowing costs, as the hedge smooths out the budget impact of oil falls — something that would not be as helpful to less indebted Russia.

Even if Russia wanted to replicate Mexico’s gambit, it’s unclear that it could. That is partly because of scale: Whereas Mexico produced 1.7 million barrels a day in May, Russia produced about 9.4 million. Even if Russia hedges only a portion of its output, it would still be a sizable deal for the market to digest.

More significant is the issue of counterparty risk. For international banks, trading houses and producers on the other side of this derivative deal, the repercussions for the rest of their trading book would be huge — and the threat of getting tangled in U.S. sanctions against Russia is unappealing. 

Having said all this, Moscow is right to consider its future in a world where fossil fuels are ebbing and markets are increasingly turbulent. But the $4 billion or more that Russia would pay up annually for a hedge would yield more if spent elsewhere. 

In an ideal world, that NWF cash could go toward diversifying an economy that remains far too dependent on hydrocarbon exports, by supporting innovative, small businesses that have been badly hit by the pandemic, as well as science, education and tourism. But as Evghenia Sleptsova of Oxford Economics points out, Putin’s Russia needs stability above all, even if that means rigidity. Preserving control is paramount.

A more realistic, but still beneficial, approach could be to earmark that sum for the fossil fuel sector — not to shield the future earnings of Rosneft and others with derivatives, but to aid investments in technology to turn Russia’s oil and gas giants a shade greener. The cash could be used to help reduce methane leaks and flaring — the burning of unwanted gas; to increase the use of renewable energy to power oil and gas production; or even to advance carbon capture and storage.

State-controlled producers do not face the same environmental pressures as the likes of Royal Dutch Shell, but the largest buyers of Russian oil and gas are becoming increasingly concerned with the carbon-intensity of their purchases, as seen with gas in Europe’s historic rescue plan. Moving closer to those aims would be more reliable protection against an unpredictable future.

This column does not necessarily reflect the opinion of the editorial board or Bloomberg LP and its owners.

Clara Ferreira Marques is a Bloomberg Opinion columnist covering commodities and environmental, social and governance issues. Previously, she was an associate editor for Reuters Breakingviews, and editor and correspondent for Reuters in Singapore, India, the U.K., Italy and Russia.

©2020 Bloomberg L.P.

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