15 Nov 2008

Bubble, Schmubble: Mexico Shows Why Derivatives Are Still Cool

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The WSJ reports (HT2 Dan Simmons) that the Mexican government is worried that oil could really collapse, so it is hedging its exposure:

Mexico said it has hedged all of its oil exports for next year against a price of oil below $70 a barrel, in a sign of how some resource-rich nations are trying to protect themselves against slumping commodity prices amid a global economic slowdown.

Mexico’s Finance Ministry said Thursday that it bought $1.5 billion of put options that guarantee Mexico will get at least $70 a barrel for some 330 million barrels.

If the price is above $70, then Mexico can choose not to exercise the option and sell for the market price.

Mexico has been hedging against the price of oil for years, but normally the country covers only a fraction of total exports. But the steep fall in the price of oil from last year’s highs alarmed Mexican officials. The price corresponds to Mexico’s expectations of oil income for next year’s budget.

“We started this back in July, doing it very slowly to avoid affecting the market,” said Rodrigo Brand, a Finance Ministry spokesman.

With oil at Wednesday’s closing price, Mexico would have made $9.55 billion on the hedges, the Finance Ministry said.

Just to clarify a few things, because I’ve heard even some energy insiders misinterpreting the above:

(1) The Mexican government did not lock itself into $70 oil for 2009. That would have occurred if Mexico sold 330 million barrels worth of futures contracts, with a futures price of $70 per barrel. This move would not have cost anything upfront; no money changes hands when a producer issues (i.e. goes short) a futures contract to a party going long.

(2) The Mexican government is not “betting” that oil will average below $70 for 2009. They might think that, but strictly speaking they are buying insurance against this possibility. If you buy fire insurance for your house, it’s not because you are predicting it will burn down.

(3) The Mexican government will make more money if oil shoots up again. The last line about “making money” on the hedges is correct, but misleading. The $1.5 billion that the government spent on the put options is a sunk cost; that money is gone at this point. Now if oil is $70 or below, that’s how much the government makes on it per barrel. The difference between the actual price and the strike price of $70 shows up in the market value of the put options; the Mexican government “makes money” on them only because it is making less money from selling its oil. (If oil is at $50, then the puts are worth $20 per barrel; if oil is $40, then the puts rise in market value because they are worth $30 per notional barrel, etc.) If oil sells for above $70, then the put options are worthless, but the Mexican government is still better off.

All the put options do is allow the government to limit the downside to $70 per barrel; the government now has the ability to sell its oil for $70 or the market price, whichever is greater. And for that option, the government spent $1.5 billion in the present. Once you frame it like that, it is obvious the government is hoping for a high oil price. It’s true, the options would be worthless, and in retrospect they could have saved themselves the $1.5 billion expense. But given that that money is now a sunk cost, the government certainly doesn’t want to “make money” on the hedge. (Of course, if some policy makers fought hard for the purchases, while others said it was too much, then clearly group A might be hoping for $50 oil next year so they don’t look like idiots.)

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