Following the initial oil output cut that was announced by OPEC and its allies, Mexico rejected the terms of the deal. This was much to the surprise of many stakeholders around the world. The North American country’s decision to reject the deal literally held other top oil-producing countries (including G-20 countries) to ransom.
Mexico’s secret: Some analysts have since been wondering about the secret behind Mexico’s negotiating power. Well, Nairametrics understands that Mexico has a massive Wall Street hedge which protects it from the impact of low prices.
Definition of hedging: Hedging is just a way of protecting one’s self against financial losses or adverse circumstances. It is also an investment intended to reduce the risk of adverse price movements in an asset. Crude oil producers can, therefore, hedge against crashes in oil prices by taking a position in the crude oil futures market.
(READ MORE: Crude oil prices fall to $30 as COVID-19 erases gains from oil production cuts)
Benefit of hedging: The major benefit of hedging in the oil industry is the ability of producers to reduce the impact of anticipated (and unforeseen) price slumps on its revenue.
Mexico has a sovereign oil hedge that insures it against low prices. This is a critical factor that might have made the country less inclined to accept the deal from OPEC+. This gave the Latin American country the right to sell its oil at a predetermined price. This is generally referred to as an equivalent of an insurance policy.
More details about Mexico’s hedge: Although the hedge comes at a $1 billion annual cost to buy the option, it has shielded Mexico from market shock over the last 20 years, helping it to make $5.1 billion when prices crashed in 2009 during the global financial crisis, $6.4 billion in 2015, and another $2.7 billion in 2016 after Saudi Arabia’s price war.
A different story from Nigeria: However, Africa’s largest crude oil producer, Nigeria, does not have any crude oil hedging programme in place. Instead, it sells its crude oil on spot prices. These have made Nigeria exposed to oil market price swings, which in turn cause the country’s oil earnings to fluctuate.
In an emailed response to Nairametrics, Temitope Busari (CFA), the Head of Treasury in a leading financial firm in Lagos, commented on the situation thus:
“As exciting and impressive as the Mexican crude oil hedging is, it is an insurance policy that costs a small fortune. With circa 200,000 bpd of crude oil production ahead of Nigeria’s, the Latin American country has been known to spend upwards of $1billion per annum on the purchase of put options that allows her sell oil at a guaranteed future price that is agreed upfront.
“On why Nigeria does not hedge crude oil revenues in the international markets, I would say that this is because hedging costs are prohibitive. It may be worthy to critically appraise this structure going forward.
“The Nigerian economy takes a direct hit from oil price fluctuations and the hedge (the buffer that the payout provides when the option is in the money) could be one way to limit the impact from the uncertainty of global market events.
“With this in place, future cash flows would be more predictable and the entire budgeting process more efficient, which would be something of a much-needed silver bullet.”
(READ MORE: OPEC+ Deal: Crude oil prices rise amid volatile trading session)
In addition, Nigeria’s oil derivative markets are relatively underdeveloped. This makes the cost of hedging oil in the country to be higher than the cost of hedging in Mexico. Mexico has a developed, efficient derivative industry.
Mexico also has good relationships with some of the biggest banks in the world like JP Morgan Chase and Goldman Sachs. These banks help to structure and sell these oil derivative contracts to investors, speculators, and knowledgeable policy stakeholders, thereby taking advantage of executing hedging into its crude oil production programme. According to Silas Ozoya, the President/CEO of Suba Capital:
“Nigeria does not have a crude oil hedging program because those in the front line of such policies and decisions believe the crude oil and the market will always be there.
“Hedging in all ramifications means to protect your investment against a future occurrence in the market, whether bullish or bearish.
“What we need are crude market analysts with anticipation of the market to be able to convince these policies and decision makers to make such policies compulsory to hedge out crude revenue against market movements.
“The excess crude reserves we currently have and operate are like savings accounts; we go there to dip our hands every time we have a need. That’s not a good financial plan for a huge country like Nigeria.
However, sometimes hedging crude oil can be unnecessary and counterproductive. For instance, when crude oil prices dropped sharply in 2014 and 2015, American airlines that had hedged against their future fuel costs did not help as much as those that were unhedged.”
(READ MORE: Nigeria faces breaking point as India’s global crude oil demand drops by 70%)
Bode Abolade, an Investment Professional at Africa50 Infrastructure Investments, also sent an email to Nairametrics, pointing out the difficulties Nigeria would face if it partook in crude oil hedging. He said:
“The practical reason is that there is no hedging policy or strategy in place at the NNPC (Nigerian National Petroleum Corporation). And if you think of it, it is counterintuitive if you are part of a trade organization like OPEC (Organization of the Petroleum Exporting Countries) and you are buying hedges; Nigeria being part of OPEC (supplier of c.50% of global supply).
“If you approach the market to buy oil hedge, it sends panic to the market and hedge premiums go up. I do not think any OPEC member will want that to happen.”