Can a hedge save an economy?


RECENT events in the oil market have sent the world’s oil producers reeling. The collapse in oil prices was due largely to the freezing of economic activities following the global lockdown.

Saudi Arabia’s price war with Russia for market share only made matters worse. So much worse that at one point, the West Texas Intermediate contract went into negative territory, albeit for only a day.

While the oil-dependent economies, the likes of Saudi Arabia, Russia, Nigeria, Algeria, the Gulf states and even Malaysia, are all staring at massive potential budget deficits and economic pain, one key player, Mexico, appears to be largely unhurt, thanks to its use of oil derivative contracts to hedge itself.

As with the other countries, revenue from oil accounts for a substantial part of the Mexican government budget. But unlike the others, Mexico had completely covered its expected 2020 output with a hedge programme.

The hedge involved the purchase by Mexico’s Finance Ministry of put options on oil from a number of Wall Street banks.

The fact that these were customised over-the-counter contracts meant that Mexico could get the size it wanted without moving markets and in total secrecy.

It now appears that Mexico has been doing such hedging for many years. According to World Oil, a trade magazine, the hedge programme has been a saviour for Mexico several times.

Apparently, Mexico made profits of US$5.1 billion (RM21.83 billion) in 2009 when oil prices crashed due to the global financial crisis and again in 2015 when it made US$6.4 billion and another US$2.7 billion in 2016 from the hedge.

The profit thus far this year is expected to be US$6.2 billion. The hedge in enabling Mexico to exercise the put would allow it to sell its oil at the exercise price of US$49 per barrel — far higher than the current spot price for Mexican crude, which now averages about US$15. By purchasing put options, Mexico was essentially buying insurance to protect itself from declines in the price of its key export — oil.

What is interesting about put options is that unlike other derivatives like forwards and futures, which lock-in the hedge price and protect only from unfavourable price movements, options enable the holder to benefit both ways. That is, a put option while protecting the holder against falling prices also allows for taking advantage of rising prices. This arises from the fact that options, unlike forwards and futures which are obligatory, need not be exercised.

So when oil prices fall, the put option holder gets to exercise and sell oil at the predetermined exercise price, but when oil prices rise, he does not exercise but simply sells the oil at the higher market price. Thus, benefitting both ways.

The put options essentially ensure that Mexico will receive at least US$49 per barrel for its oil, but possibly more if spot prices are higher. This flexibility, however, comes at a much higher cost.

Options have higher transaction costs relative to forwards and futures. Mexico appears to have been paying about US$1 billion per year on average for the put options.

The cost for 2020 was estimated to be US$1.37 billion, insurance that has paid off handsomely at a time of need.

The hedge programme, aside from protecting its oil revenue, has also provided Mexico with a huge strategic advantage in its dealings within OPEC.

The current OPEC deal would have required Mexico to cut its production by 400,000 barrels per day, but with the hedge in place, Mexico could push back and insist on cutting a mere 100,000 barrels per day.

Such leverage comes from the fact that Mexico knows that no matter how much oil prices fall, it is assured of its total hedged revenue.

For the other oil exporters, particularly those of the Muslim world, there is a huge lesson in this. It is one thing to be able to extract and export oil, but just as important is the ability to manage the price risk that comes with it.

Unlike Mexico, the other oil producers are scrambling for a solution. For them, it is truly a double whammy. Revenue has fallen drastically at a time when spending needs have risen sharply.

Yet, as the Mexican case shows, it wouldn’t have been difficult for a country like Malaysia — which produces lesser oil but is equally dependent — to have reduced its exposure and locked-in its revenue.

While there is no way to tell how much if any hedging was done by Malaysia’s Petroliam Nasional Bhd, policy reaction, thus far, implies little if any.

The flexibility that modern derivative instruments provide means that just about any price exposure, whether from oil, natural gas or other commodities, can be managed. The instruments are available, one, however, has to have the skill and appreciation for their use.

Prof Dr Obiyathulla Ismath Bacha is the professor of finance at the International Centre for Education in Islamic Finance. The views expressed are of the writer and do not necessarily reflect the stand of the newspaper’s owners and editorial board.