In today’s Finshots, we explain how Mexico may come to affect the “future” price of oil
The Story
When you put together a list of the world’s biggest oil producers, you’ll probably include names like Saudi Arabia, Iran and the US. You are unlikely to include Mexico in this list.
But guess what? Mexico actually makes a list that includes the top 15 oil-producing countries in the world. Sure, it isn’t part of the 13-member Organization of Petroleum Exporting Countries (OPEC) — a cartel that’s largely responsible for dictating the production and supply of oil. But it is however an important member of OPEC+, a younger sibling of OPEC, that includes 10 other oil-producing nations who also have some say in the whole “should we cut oil supply or not’’ discussion.
Bottom line — Mexico has some clout here. And it’s not just any clout. They actually have the ability to influence oil prices on their own using something called the Hacienda Hedge. And that’s what we are going to be talking about today.
See, Mexico produces around 1.7 million barrels of oil a day. And it exports a lot of it. But as you probably already know, the oil market is pretty volatile. The cartels can try their best to temper supply and control prices, but demand can be tumultuous at times. Oil prices could rise tomorrow and tumble a month later. There’s always that risk.
So what does Mexico do? Every year, it signs off on a contract with some large investment banks. The deal is structured to give Mexico the right to sell its oil in the future at a predetermined price. In market parlance, it’s a “put” option.
So if the price of oil tumbles below a certain level, then the contract kicks in and the banks have to pay out the difference. In some ways, it's like buying insurance. Mexico expects to sell its oil at a certain price and if they can’t do it when the time arrives, the investment banks have to make up the difference. This is how they protect their export revenues when it comes to oil. And for the past two decades, they’ve been doing it with remarkable consistency.
In 2020 alone, the country is rumoured to have netted close to $2.5 billion. This was when the pandemic was in full swing. There were lockdowns. The economy was at a standstill and with personal transportation barely chugging along, demand for oil had all but collapsed. The price of the Mexican crude oil basket fell from $50 a barrel to less than $10 a barrel. The country’s economy would have gone for a toss if they had to sell their oil at such cheap prices. But with the Hacienda hedge, the government had a contingency plan in place. It was locked in a contract to sell oil at $49 a barrel through the “put” options and in many ways, this was a lifesaver.
But now, they may finally be moving on and if you’re wondering why, well, there are a couple of reasons.
For one, the contracts aren’t all that profitable. Sure the country netted close to $14 Billion between 2001 and 2017, but they only made profits to the tune of $2.4 Billion. Why? you ask. Well, these contracts don’t come cheap. Mexico has to pay a premium to buy the so-called insurance policy and they had to pay close $11.7 Billion in fee and commissions alone to facilitate the transactions.
And then there’s the fact that oil prices can rally too. In which case, the fees count for nothing. Mexico will sell the oil elsewhere at a higher price and the put option will be useless. Also, since the Hacienda hedge is an open secret now, it becomes more expensive to put together these contracts in the first place. If other investors are privy to these transactions, it becomes more expensive for Mexico to have such an arrangement. They’ll have to pay an even higher premium. So it’s not all that rosy.
And more importantly, Mexico wants to be self-sufficient. They want to reduce their dependence on oil exports. By 2022, they want to halve the total quantum of exports. And by 2023, they want to stop exporting it altogether. But how does all this matter? How can a country influence oil prices when they aren’t even going to be participating?
Well, the thing is — A lack of participation can have a distinct effect on the price of oil. Think about all those contracts we described earlier. When Mexico dabbles in this stuff, they are betting on the future price of oil. This bet in effect influences expectations across the board. And if Mexico isn’t supplying billions of dollars worth of oil in the “futures” market, then it could quite possibly push the “future” price of oil even further.
That’s kind of the gist here.
Hope you followed :)
Until then…
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