Last December, in a post titled Sovereign State Oil Hedging On The Rise, we highlighted the hedging initiatives of several sovereign oil and gas producers including Mexico, Qatar and Ecuador as well as several sovereign oil consumers including China, Panama, Ghana and Sri Lanka, several of which suffered from large "hedging" losses.

Since then, there have been a number of other sovereign owned/controlled entities in the news regarding their oil and/or fuel hedging including Indonesia, China and India, among others.

Taking it a step further are several countries which have both significant oil and gas production as well as significant fuel consumption, via their "flag carrier" airlines.  We say taking it a step further because, contrary to what many are led to believe, they are not relying on oil revenues to offset their airlines' (i.e. Qatar, Etihad and Emirates to name a few) exposure to fuel prices.  Further to this point, fuel hedging was a key issue discussed at the Middle East Airline Business Seminar, hosted by Embraer, where we delivered a presentation on the subject. 

As has been well reported by the media this past couple weeks, Mexico recently executed hedges for their 2013 crude oil production, albeit using a different strategy than they have employed in recent years.  According to the Financial Times, rather than hedging with stand-alone put options, as they did for 2012, Mexico is hedging it's 2013 production with put option spreads, which essentially provide them with a "limited" hedge against declining prices, albeit at a lower cost.  Limited because, while they are hedged in the $80-85 range, they are also exposed to WTI prices declining below $60/BBL. 

Per the FT article, “Mexico in effect is saying that oil prices could not drop for any sustained period below the $60 a barrel level because some producers would cut output,” a senior commodities banker said. “The hedge is more sophisticated than in the past.”

While it can can definitely be said that this strategy is more sophisticated than the strategies Mexico has employed in recent years, it certainly doesn't mean that it is an ideal way to hedge the country's exposure to oil price volatility.  In our opinion, it appears the decision to hedge with a put spread is based more on Mexico's desire to reduce the premium costs of their hedging program, which have been as high as $1.5 billion in recent years, than on the risk profile of the strategy itself.

That being said, all of these stories beg the question, why do sovereign states hedge their exposure to fuel and oil prices and are their strategies sound from a risk management perspective? 

As to the first question, some many are hedging in similar way as would a non-sovereign entity, which is to say that they are trying to limit their exposure to price volatility as a such it's impact on revenue, costs and/or cash flow.  For many it goes deeper than than the surface.  As an example, in most large oil producing countries in which the majority of the production is owned by NOCs (national oil companies), their oil derived revenues are the cornerstone of their economy and perhaps more importantly, their source of funds for infrastructure, health care, education, etc. In many of these countries, if oil prices collapse and remain low for an extended period of time, their infrastructure and social programs are likely to follow suit. 

Norway, which isn't believed to hedge their oil and gas revenue, at least in the traditional sense, takes an entirely different approach via The Government Pension Fund of Norway better known as "Oljefondet" which translates to "the oil fund."  The fund was set up in the 1990s with the idea of "saving" oil revenues for the future and to prevent too much capital from flowing into the Norwegian economy, generating excessive inflation.  The end goal is for Norway to maintain its oil wealth in perpetuity, by only using an average of returns from the fund, which itself invests in a diversified, global portfolio, rather than dipping into the principal of the fund.  

On the consumer side, most sovereigns that engage in oil hedging are doing so on behalf of state owned refineries and/or fuel suppliers, which often subsidize state-controlled, retail fuel prices.  In this sense, many in this situation are essentially "hedging" the economics of the fuel subsidies, which is topic that we simply don't have the time to properly address at the moment.

As to the second question, are sovereign oil hedging strategies, more often than not, sound hedging strategies?  Generally speaking, the hedging strategies of most sovereigns are often quite opaque, unless they experience significant gains or losses, so it's quite difficult to say.  Based on our experience, many of the large losses are can generally be attributed to the lack of hedging expertise, which could easily be obtained if the desire exists, but that's an entirely different topic for another day.

In summary, there are certainly many situations in which sovereign states can and do benefit from well managed energy hedging programs but when not well managed the results can be dire to say the least.

Update: On December 10, Mexico's Finance Minister, Luis Videgaray, said that the country has hedged 2013 crude oil exports at $85 per barrel.