A Hedged Oil Producer: A Floor Price May Help This Country's Currency

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Includes: BNO, CRUD, DBMX, DBO, DNO, DTO, DWTI, EWW, MXNS, OIL, OLEM, OLO, QMEX, SCO, SMK, SZO, TWTI, UCO, UMX, USL, USO, UWTI
by: Andrew Hecht

Summary

Oil prices continue to tank.

Mexico is the ninth-largest producer of crude.

Prices locked in at $76.40.

A floor under an already weak peso?

Like most other currencies versus the US dollar, the Mexican peso has moved lower since May. The US dollar index bottomed at 79.24 in early May, closing Friday at 88.595 - a gain of 11.8%. Meanwhile, the Mexican peso has moved from 12.8 to the dollar in May to a close Friday of around 14.8, a decrease of more than 15%. The peso made new six-year lows of 15-1 and closed slightly above that level.

The monthly chart of the Mexican peso futures illustrates the recent slide in the peso, which has picked up steam since the end of November. A falling peso is the result of many factors. Chief among them, according to many analysts, is the price of oil. Mexico is a major oil-producing nation. The peso fell quickly last week forcing the Mexican Central Bank to intervene in an attempt to prop up the currency, which has been under siege.

Oil prices continue to tank

The move in oil has been nothing short of breath-taking. After trading at $107.73 on the active month futures contract in June, January NYMEX crude oil futures settled on Friday, December 12 at $57.81 - a drop of 46.3% in six months. Oil moved lower throughout the summer but picked up downside steam in late November when OPEC decided not to cut production. Since the OPEC meeting, oil has been freefalling and the Mexican peso has fallen in lockstep with crude.

Mexico is a major crude oil producer

While Mexico is not a member of the oil cartel, it is a major producer of crude. In fact, Mexico is currently the ninth-largest producer of oil in the world. The country produces just under 3 million barrels a day - slightly less than the United Arab Emirates and more than Kuwait, both OPEC members.

Given the selling frenzy in crude oil, it comes as no surprise that the value of the peso has tanked. After all, Mexico depends on sales of crude oil to support the country's economy. All oil-producing countries are dealing with prospects of a drastic cut in revenues after a four-year period of prices above $75 per barrel. During the majority of the past four years, prices were actually much higher than that. Now all of a sudden these producers are staring at sub-$60 oil and the rout has not ended yet. Some producers are suffering more than others are. For example, Russia, Venezuela, Iran and Nigeria are feeling the pinch more than most given the weakness of their economies. The Mexican economy is generally in a volatile state; however, this time things might not be so bad down south of the US border.

Prices locked at $76.40

Back in 2009, Mexico avoided disaster when crude oil fell from over $147 to $32.48 in a six-month period. Mexico locked in prices during that period and was able to avoid a major budget crisis as crude oil prices sank. This year, Mexico did the same thing. The country knows that oil, a commodity it depends on for around a third of its federal budget, is volatile and subject to massive price moves like the one we are witnessing.

Last Thursday, Mexican Finance Minister Luis Videgaray said that Mexico insured its oil exports at $76.40 per barrel for 2015. Mexico used derivatives to cover 228 million barrels to protect its public finances "fully" from unexpected oil shocks and that is what is going on right now - an oil shock. Mexico's hedging program is one of the biggest sovereign hedging programs in oil. Mexico negotiates its hedging each year in secrecy to minimize the costs for the government and avoid speculators taking advantage of the country's program. Mr. Videgaray said, "We're in a context in which the oil price is one of the risk factors for public finances, given the negative evolution of prices." The details of the hedge are that the Mexican Congress set the oil price at $79 for the 2015 budget, which is the lowest estimate since 2011. If oil trades below $79 but above $76.40, Mexico pays the difference with a reserve of 7.9 billion pesos or $588 million that has been set aside as a stabilization fund. Mexico then buys options to insure a minimum price for its crude, which gives it the right to sell at any time. That floor price amounts to $76.40. The Finance Minister said that the government contracted the hedge with seven international financial institutions. With Mexican crude production hedged, the risk now lies with lower production. In 2014, Mexican oil production suffered some shortfalls.

It is likely that Mexico has sacrificed some upside potential in crude prices to transact the hedge. However, with crude oil prices closing below $58 per barrel on Friday, the risk of opportunity loss on the upside is well worth the cost of the hedge.

A floor under an already weak peso?

Although the Mexican price protection became public on Thursday, December 11, the peso continued its downward spiral on Friday. Granted, there are many issues going on in Mexico; however, with the oil price risk in check, this should give some comfort to the country's currency. The insurance policy on Mexican crude production only lasts through 2015. One year is a long time in markets, particularly in commodity markets.

It is quite possible that the floor price Mexico arranged on their crude production could translate into a floor for the peso as well. Mexico insured revenue flows from crude, which is a positive for the peso. No matter how low crude goes, the Mexicans know exactly how much they will receive for their oil production in 2015. Not many crude-producing nations can make the same statement. Given the hedge and certainty in a sea of uncertainty in markets, perhaps the peso is overdone and will recover in coming months.

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