Market braces for Mexico's annual oil hedge, trading surges: sources

NEW YORK/MEXICO CITY (Reuters) - Trading in crude oil options and futures surged last week as market participants prepared for Mexico’s annual oil hedging program, in which the country buys as much as $1 billion in contracts to protect its oil revenues.

FILE PHOTO: A chimney stands at the crude oil terminal Dos Bocas near a mangrove area in Paraiso, Mexico, December 10, 2018. REUTERS/Alexandre Meneghini/File Photo

The global oil derivatives market braces itself every year in late spring and summer for the hedge, the market’s largest and most secretive financial oil deal. This year, Mexico has faced several challenges in executing the hedge and timing has become a crucial factor.

Traders and brokers who monitor money flows told Reuters that activity in crude oil options and futures suggests that Wall Street has started to position itself for the trade, attempting to secure protection against further price volatility.

It was not clear whether Mexico has started executing the hedge. The Mexican Finance Ministry did not immediately respond to a Reuters request for comment. Traders have also had to react to weakening sentiment in oil markets.

Implied volatility, a gauge of options demand, for 2020 contracts has risen steadily over the past week, dealers said. Prices for 2020 options started to surge after a top Finance Ministry official told Reuters that Mexico had finished calibrating the formula used as a basis for the program, market sources said.

“Within minutes of that announcement, we saw a big pop in implied volatility,” one source at a bank said.

“It rallied in the December 2019-June 2020 range, which is typically where the hedges lie. That volatility has been well-bid the entire week,” the source added.

On Monday oil prices rose about 1% after Iran seized a British tanker late last week. Even though a major escalation appeared unlikely, the move stoked fears of potential supply disruptions in the Strait of Hormuz at the mouth of the Gulf, through which about one-fifth of the world’s oil supplies flows.

The longer-term outlook for oil, however, has soured as the threat of supply disruptions was eclipsed by worries about a slowdown in demand.

Mexico aims to protect itself through the use of put options it buys from a handful of Wall Street banks and oil majors in about 50 transactions usually executed between May and August.

By selling those options, those banks and oil companies - Mexico’s counterparts to the deal - leave themselves exposed to a possible downturn in the market themselves. They compensate by selling futures. The expectation of that selling made investors exit positions this week, sources said.

Oil futures across the forward curve weakened on Thursday, with average Brent crude prices for 2020 sliding to the weakest in a month. Options that Mexico usually buys outperformed last week, one broker said, noting trades in a series of put contracts that expire in 2020. Put options give holders the right to sell at a fixed price by a certain date and are widely used by producers to protect revenues against declining prices.

The sell-off intensified speculation among market participants that traders were getting ahead of the hedge and squeezing out premiums in options markets before prices drop.

“I wouldn’t be surprised if traders are already positioning themselves for this deal,” said Ryan Dusek, director at Opportune’s Commodity Risk Advisory. “The longer traders wait on this, the harder this becomes.”

Mexico’s 2019 sales were hedged at an average price of $55 per barrel in a deal worth $1.23 billion on put options. State oil company Pemex separately hedges its own sales.

Edgar Cruz, chief credit strategist at BBVA in Mexico City, who has covered Pemex and the broader oil sector for more than 15 years, said Mexico would probably seek a strike price of around $55 per barrel, close to what was set out in the 2019 budget, and hedge about half of its exports, most of which go to the United States.

Reporting by Devika Krishna Kumar in New York and Stefanie Eschenbacher in Mexico City; Editing by Leslie Adler