Mexico's "Legendary" Oil Hedging Desk Is Quietly Preparing For The Next Plunge

While oil longs and Saudi Arabia are enjoying this week's latest, substantial short squeeze, prompted if not so much by the latest set of cheerful, if repetitive, IEA "rebalancing" forecasts, the fundamental reality as confirmed not only by a recent Morgan Stanley report which sees oil dropping to the mid-$30s, but also by the just released Baker Hughes oil rig count which reported a spike of 15 rigs in the past week, the most since 2015, suggests that there is more downside pressure in store for oil.

Some are already actively hedging for just that.

According to Bloomberg, Mexico has started "quietly" buying contracts to lock in 2017 oil prices when futures were near their peak in June, signaling the start of what has in prior years been the "world’s largest sovereign petroleum hedge." The Latin American country has been buying put options earlier than the usual period of late August to late September, according to Bloomberg sources, suggesting that at least according to one prominent trading desk, the oil peak has come sooner than expected this year. Specifically, Mexico is targeting the price of $49 as its breakeven, suggesting it does not expect oil to rise above this level.

Brent crude, the global benchmark, peaked at nearly $53 a barrel in early June. Since then, prices have declined about $10 a barrel as the outlook for the global economy soured and OPEC countries boosted production. Bloomberg did not report how much Mexico was able to hedge before prices fell back.

The Latin American country is notable in that it has spent an average of almost $1 billion a year over the past decade buying put from banks such as Goldman Sachsm Citigroup and JPMorgan Chase. Mexico’s annual hedge is the largest undertaken by a national government and "often roils the market."

Late in 2015 Mexico made waves in the oil market when similar bearish hedges were said to record massive payout of at least $6 billion.  In 2015, Mexico had guaranteed sales at almost $30 a barrel higher than average prices over the past year, thanks to its focused oil hedging process. The 2015 payment surpassed the previous record from 2009, when the Mexican government said it received $5.1 billion after prices plunged with the global financial crisis.  As Bloomberg reported at the time, the hedge covered 228 million barrels at $76.40 each for the Mexican oil basket, roughly $30 higher than where oil had averaged over the corresponding period, or roughly $46. Mexico's uncanny ability to hedge ahead of major price moves had prompted some oil traders to dub its oil trading desk skills "legendary."

The move to hedge 2017 oil prices comes as Mexico stands to take in about $3 billion from this year’s hedge, which was put on from June to August 2015, if prices remain around current levels. That follows last year’s record payout of $6.4 billion.

What is interesting is how, unlike in prior years, Mexico is covertly trying to hedge future prices. According to Bloomberg, "the rules forced U.S. banks to report some details of the deal through public swap data repositories. But this year not a single deal bearing the marks of the Mexican hedge has emerged, and two of the people familiar with the program said Mexico and its bankers were using non-U.S. branches of the banks to bypass the reporting rules."

In other words, Mexico does not want to be frontrun by other traders, since oil prices closer to its $49 bogey would make the puts cheaper.

As Bloomberg confirms, "Mexico and its bankers try to keep the hedge under wraps as long as possible, to avoid others front-running the trade and making the insurance more expensive. In the past two years, however, some details of the hedge emerged because of new regulations introduced in the U.S. with the Dodd-Frank Act."

Curiously, Mexico is alone in its hedging strategy. Despite Mexico’s hedging success few other commodity-rich countries have followed suit. Ecuador hedged oil sales in 1993, but losses triggered a political storm and the nation never tried again. More recently, oil importers Morocco, Jamaica and Uruguay have bought protection against rising energy prices.

One country that certainly does not appear to hedge is Saudi Arabia. Instead, as its oil minister openly admits, the Saudi strategy is merely to trigger short squeeze at time when shorts approach record levels, such as right now. This is what he told Reuters yesterday:

Falih said in the statement the market is on the right track towards rebalancing but "the process of clearing crude and products inventories will take time". "But the large short positioning in the market has caused the oil price to undershoot. However, this is unsustainable. To reverse the declines in investment and output, oil prices have to go up from the current levels," he added.

It remains to be seen if Mexico's magic "hedging touch" will be sufficient to get the market to try and frontrun its hedging efforts, in the process pushing the price of oil even lower.