Mexico Accelerated Global Oil Slump Through Derivative Deals

  • 'Hedging program was under-appreciated negative for prices'
  • Banks acting on behalf of Mexico had to sell futures to cover

When oil collapsed to a six-year low this month, weak demand from China and extra barrels from Iran and Saudi Arabia were marked as the prime suspects. Another country, less central to global energy markets, had a big part to play: Mexico.

The Latin American nation didn’t affect physical oil flows -- instead, its role was financial. Every year, Mexico locks in the price of oil for the following year in a series of derivatives deals. While the hedges didn’t trigger the slump, they accelerated the downward trend.

“Mexico’s hedging program was an under-appreciated negative for prices in recent months,” Adam Longson, an oil analyst at Morgan Stanley in New York, said in a note to clients, echoing a view widely held in the energy market.

Mexico buys put options -- contracts that give it the right to sell at a predetermined price and time -- from several Wall Street banks, which in turn often sell futures in the open market to cover their own positions. The selling pressure from the banks has often roiled markets since the hedge’s first introduction in the early 1990s.

The country traditionally implements its hedge in the second half of the year, often finishing as late as mid-November. This year, however, it started much earlier, buying put options in early June and ending Aug. 14. The end of what Longson described as the “biggest sovereign oil derivatives trade in the world” removes a “bearish overhang for oil.”

On its own, the hedging program doesn’t usually affect prices. But in a falling market it can accelerate the bearish trend, according to two people who in the past worked on the deal but are no longer involved. That’s because banks acting on behalf of Mexico have to sell more and more futures to cover their own positions, creating a downward spiral that drives prices lower.

Price Spiral

Oil brokers and traders, who asked not to be named because of their ongoing relationship with Mexico and the banks involved in the hedge, said that was the case this year, in 2014 and also in 2008, when Mexico hedged during a bearish market.

Brent crude, the global oil benchmark, traded at $64.88 a barrel when Mexico started hedging in June and was quoted at $49.03 by the time it ended, a 24 percent decline in 10 weeks. The grade traded at $44.68 at 2:11 p.m. on the London-based ICE Futures Europe exchange Thursday.

Oil options activity suggests Mexico was forced to chase down the market from late June onwards. Several put-options transactions that brokers said are related to Mexico’s hedge reveal deals as high as $53 a barrel in mid-June and as low as $42 a barrel in early August. The deals were made public because of new regulations introduced in the U.S. with the Dodd-Frank Act. The disclosures don’t reveal the final buyer but brokers can pinpoint the Mexico trades because of the large size of the options and their distinctive expiration date.

Measuring Impact

Measuring the real impact of the hedge isn’t possible because most of its details -- including how the banks cover themselves -- are confidential.

To be sure, Mexico wasn’t the only force at play -- perhaps not even the most important one. China reported weaker-than-expected economic data, triggering fears about global oil demand and a sell-off in emerging markets. Iran signed a deal to remove nuclear-related sanctions and subsequently said it would increase its production at “any cost” this year or in early 2016. Meanwhile, Saudi Arabia and Iraq kept flooding the oil market with record production rates.

Mexico said it spent $1.09 billion to hedge 212 million barrels for 2016 -- equal to about 580,000 barrels a day, or more than the daily production of Ecuador, the second-smallest member of the Organization of Petroleum Exporting Countries.

Before it's here, it's on the Bloomberg Terminal.