Javier Blas at the Financial Times reports on the Mexican state’s new strategy for hedging the oil price. In recent years, the state had bought puts. But in the last couple of years, those puts expired out of the money. Whenever that happens, people start second guessing a strategy. The premium paid begins to look expensive. So this year the Mexican state has found a way to save on the premium. Instead of buying a simple put with an exercise price in the range of $80-85/barrel, it is buying a put spread with a second strike price around $60/barrel. If the price drops below the first strike around $85, then the put begins to payoff. But below the second strike of $60/barrel, the gains on the put are capped. The cost of the simple put on approximately $200 million barrels is said to be in the neighborhood of $1-1.5 billion. Using the put spread, the costs are halved, according to the Financial Times.
Of course, the cost is less because the Mexican state is buying less insurance. What is odd is that it is foregoing insurance exactly when the state will be in direst need.
The chart below tells the story using very approximate figures.
The black line running at approximately a 45° angle shows the Mexican state’s budget surplus or deficit on the 200 million barrels of production at issue as a function of the realized price of oil in 2013. It assumes an expected price of $100/barrel, so that the expected or budgeted revenue from the 200 million barrels of production is $20 billion. If the realized price turns out to be greater than $100/barrel, then there is a budget surplus relative to the original expectation. If the realized price turns out to be less than $100/barrel, then there is a budget deficit relative to the original expectation. And for every dollar that the price falls below $100/barrel, the deficit is increased by another $200 million. The maximum budget deficit on this 200 million barrels of production is $20 billion.
The green line shows the budget surplus or deficit after incorporating the payoff to a simple put with a strike price of $85/barrel. At the left of the chart the green line is flat, and at the right of the chart it runs at a 45° angle. The kink in the green line is at the strike price of $85/barrel. Below that price, the put pays off, while above that it doesn’t. And the put has a cost that is paid in all events. At the right of the chart, the green line is slightly below the black line, reflecting the assumed cost of the put of $5/barrel or $1 billion. At the left, the green line puts a floor on the budget deficit. The deficit is never greater than $4 billion. A simple put provides insurance. And the insurance pays off more just when its needed most: when the deficit is the greatest.
The red line shows the budget surplus or deficit after incorporating the payoff to a put spread like the one the Mexican state has reportedly chosen: with a first strike price of $85/barrel and a second one of $60/barrel. At the left of the chart the red line runs at a 45° angle, then, in the center it runs flat, and then, at the right of the chart it runs again at a 45° angle. There is one kink in the red line at the strike price of $60 barrel and a second kink at the strike price of $85/barrel. The put spread has an assumed cost of $500 million that is paid in all events. At the right of the chart, the red line is slightly below the black line, but above the green line. This reflects the fact that while a cost is paid, it is less than the cost of the simple put. At the left of the $85/barrel strike, the red line puts a floor on the budget deficit at $3.5 billion. But that floor disappears again when the price falls below $60/barrel. The deficit can grow to a maximum of $15.5 billion. The put spread provides some insurance. But it is only sufficient as long as the oil price is low, but not too low. As things get worse, the insurance is capped so that the state is subject to very large deficits.
It is hard to make a rational case for this type of hedging. In most cases, when a hedge is useful, it is most useful in the worst cases. That’s not always true. But on its face, one would expect that to be true here. Unfortunately, it is quite common to see hedgers adjust a strategy this way. It’s just another case of chasing past performance. Insurance always looks expensive after a run of years when it turned out the insurance was not needed. So why not cutback on coverage in order to pay a lower premium? The ministers will look good…until they don’t.
 This implicitly assumes that government expenditures are inelastic with respect to the oil price. Of course, that may not be exactly true. This would complicate the analysis.