World’s Largest Oil Hedge Set to Make Billions for Mexican State

(Bloomberg) -- Mexico is on track to receive billions of dollars from its 2016 sovereign oil hedge, the first time it will reap the windfall two years in a row, according to data compiled by Bloomberg.

The potential payout -- after Mexico already got a record $6.4 billion in 2015 -- is likely to sharpen the market’s attention to the Latin American nation’s effort to lock in prices for 2017. Mexico usually hedges in midsummer against a drop in oil through a series of deals with banks that in the past have included Goldman Sachs Group Inc. and JPMorgan Chase & Co. 

The oil price crash has spurred President Enrique Pena Nieto’s administration to cut spending to preserve investor confidence in Latin America’s second-largest economy, behind Brazil. While the oil hedge helps cushion public finances, analysts believe the government can’t count on it forever.

“The Mexican government has done a good job at buying these put options because they have helped to smooth the transition of public finances towards lower oil prices, but it’s just breathing room,” said Carlos Capistran, chief Mexico economist at Bank of America Corp. “This buys the government time to think about the best way to go about expenditure cuts.”

Last year, Mexico locked in prices for 2016 at $49 a barrel, buying put options which give the country the right, but not the obligation, to sell at a predetermined price. The banks that sell the options to the government typically also hedge themselves in the futures market.

Since Mexico started covering its exposure to crude prices through Wall Street in 1990, the Latin American country has never collected two years in a row. Last year’s payout surpassed the $5.1 billion of 2009 in the aftermath of the global financial crisis. The country also made money in 1991 when prices fell after the start of the first Gulf War.

The hedge, which runs from Dec. 1 to Nov. 30, covered 212 million barrels, according to government statements. Since Dec. 1, the Mexican oil “basket,” an index including various grades of crude such as Maya, Olmeca and Isthmus, has averaged $32.40 a barrel.

Mexico’s Finance Ministry said in an e-mailed response that it wouldn’t comment on the potential hedging profit before the program is settled at the end of November.

Making Money

Unless the basket more than doubles to average almost $80 a barrel from now until the end of November, Mexico would make money. Even if oil averages $50 over the next four months, the country would still receive a payout of $2.3 billion. If prices remain around $36 a barrel for the basket, Mexico would get about $3.3 billion.

The price of West Texas Intermediate crude, the U.S. benchmark, has fallen back into a bear market, with a drop of 22 percent since early June to below $40.

The final figure could vary from the Bloomberg estimate as some details of the hedge aren’t public and oil prices will change until the end of November.

Mexico paid $1.09 billion in 2015 to lock in prices for this year, the government said last August. The country’s annual hedge, which is closely watched by the oil market and often moves prices, is the largest undertaken by a national government.

Despite the success of Mexico, few other commodity-rich countries have followed suit with similar hedging programs. Ecuador locked in oil sales in 1993 and after losses triggered a political storm, never tried it again. Colombia, Algeria and even Texas have experimented with locking in prices. More recently, oil importers including Morocco, Uruguay and Jamaica have bought protection against rising energy costs.

--With assistance from Michael Roschnotti To contact the reporters on this story: Javier Blas in London at jblas3@bloomberg.net, Eric Martin in Mexico City at emartin21@bloomberg.net. To contact the editors responsible for this story: Will Kennedy at wkennedy3@bloomberg.net, David Marino, Dan Stets