Here's how Mexico's secret oil bet will pay out $6 billion while crude prices tumble

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Mexican President Andres Manuel Lopez Obrador said last week that the country’s oil hedging program would pay around $6 billion to the government, while oil prices continue a historic decline in the face of oversupply due to the coronavirus pandemic.

Mexico operates a sovereign oil-hedging program that works similarly to insurance – Mexico pays an undisclosed amount for contracts with buyers to sell its oil at a predetermined price. The exact details of the program are considered a state secret in Mexico, but it has insured Mexico against low oil prices as it means it can still sell its oil at a fixed price even when prices drop – including during this month’s unprecedented fall.

“This coverage gives us around 150 billion pesos [$6.27 billion],” the President said last week, Reuters reported. “That is, it compensates for income lost because of the oil price drop.”

The hedge has shielded the country from every major downturn in the oil markets for the last 20 years. Bloomberg has reported that it paid out $5.1 billion when prices crashed in 2009 during the global financial crisis, $6.4 billion in 2015, and $2.6 billion in 2016.

The policy however, does not come cheap, costing Mexico around $1 billion annually, and is considered the largest oil deal on Wall Street.

“The insurance policy isn’t cheap … But it’s insurance for times like now. Our fiscal budget isn’t going to be hit,” Mexican Finance Minister Arturo Herrera told broadcaster Televisa on March 10, Bloomberg reported.

In return for its investment, Mexico is able to sell an undisclosed amount of oil for $49 per barrel, according to the Finance Ministry, over three times more than the current price for Mexican crude of around $15 per barrel.

The put options - contracts in which the buyer agrees to buy the oil at a pre-determined price – are bought from Wall Street banks and major oil producers, but the number of barrels hedged and the signing counterparties are not disclosed.

The downside of oil hedging for the producer is if the price of oil rises above the pre-determined amount, as the producer would be forced to sell the agreed amount of oil at the pre-determined price to the buyer – which could be lower than it might fetch on the open market.

Oil hedging is not an uncommon practice. One common industry that relies on hedging the price of oil is airlines. An airline might lock an oil price in for a period of time to insure that it is paying a steady price for its expensive fuel use. Likewise some oil producers, in particular US shale companies, use hedges to ensure steady revenue.

These hedges, however, do not come close to matching Mexico’s giant yearly bet – one which seems to have paid off during an unstable period of unprecedentedly low oil prices.

With Reuters, Bloomberg

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