Russia copies Mexico?
It may sound weird, but it could be that Russia will soon copy Mexico for best practice in managing government finances. Russia’s state-owned oil giant Rosneft has proposed to President Putin the introduction of a systematic hedging programme for its oil production. If implemented, Russia would follow in the footsteps of Mexico and become only the second country in the world to protect its oil revenues against price declines.
For those not familiar with the Mexican scheme here are the nuts and bolts:
Since 2001, Mexico is hedging its oil exports with Asian options that give the country the right to sell oil at the average price achieved over a predefined time. The options are purchased from a consortium of ten banks who then try to spread the risk across the market by hedging their positions.
Like most systematic put option buying the programme has on average cost the country money. The IMF estimates that the cost of the put options averaged 0.1% of Mexico’s GDP each year. However, in 2009, Mexico made a profit of c $5bn and in 2015 and 2016 a profit of c. $9bn. That’s about 0.5% of GDP in 2009 and c. 0.9% of GDP in 2015/2016.
However, while the long-term cost to the country exceeded its benefits, the country made a gain exactly when it needed the most and thus was under much less economic pressure in the crisis years than other oil exporters. The IMF estimates that this reduction in the volatility of government revenues has substantially reduced the borrowing costs for Mexico in international bond markets. If these benefits are included in the calculation the hedging scheme of Mexico has been beneficial for the country. In fact, the programme is considered so successful in Mexico that the exact terms of the put options have been made a state secret.
What Rosneft has proposed is not quite as sophisticated as the Mexican approach. It proposes to use funds from the Russian Sovereign Wealth Fund to purchase regular put options for the next two years of production. The company estimates that it could have earned c $120m in the first half of 2020 had the proposed scheme been in place.
The advantages for Russia would be several:
Russia’s economy would be protected against a sudden drop in oil prices and the government would have to make fewer cuts to social programmes in a recession.
Russia at the moment has almost no external debt, but with declining borrowing costs, the country could potentially tap into new sources of funding.
Russia’s political power would increase since it would be harder for OPEC to pressure Russia into coordinating its oil production with the cartel.
Of course, the last point is probably the main attraction to Putin who triggered a price war in March with his refusal to cut production in the light of the Covid crisis.
The risk is, however, that this hedging scheme becomes more popular with other oil producers as well. If every oil-producing country would launch a hedging scheme there would probably not be enough investors willing to take the other side of the trade and the options would either become prohibitively expensive or simply unavailable. Furthermore, the more countries follow this strategy, the more reckless their behaviour can become, and we should see more and deeper oil price crashes in the future. In the end, the temptation of increased domestic stability and international political influence would be bought at the price of rising international economic instability.