London, September 2010

The Financial Times has identified PEMEX as the major oil producer executing a hedging programme with oil options that has increased implied volatility and the cost of downside strikes in recent weeks.

Goldman Sachs, Barclays Capital, Deutsche Bank and JP Morgan were named by the newspaper as arranging the programme. The banks have already hedged an estimated 100-150 million barrels, according to brokers, with the total programme expected to be less than 200 million for calendar 2011, down from 230 million in 2010.

The programme's competitive terms illustrate the pressure on banks and investors to take more risk in order to generate returns in a range-bound market. Assuming the details are correct, PEMEX has paid for downside protection much closer to current prices than it did last year. The resulting increase in cost appears to have been shared between the producer (in the form of a smaller hedging volume) and the banks (in terms of taking greater risk for the same amount of reward).

According to the Financial Times, the producer has reportedly hedged at around $65-70 per barrel (WTI basis). These are the strikes for which BNP Paribas noted that there was producer hedging interest in a strategy note published last week.

But they represent a discount of only $5-10 to current spot prices and $15 below average forward prices for calendar 2011. In contrast, PEMEX last year hedged all its 2010 net exports at $57 per barrel, which was then about $12-20 per barrel below the spot market, depending on when exactly the hedges were executed, and $16-25 below the prevailing forward prices for 2010.

Moreover, in contrast to late 2009, when the market was bullish about further price gains and PEMEX was buying insurance against a double dip, forecasters and investors are now more cautious about the prospect of further gains, downgrading their projections for 2011, after the rally in oil prices fizzled out earlier this year.

Other things being equal, the hedges will have been more expensive. Range-bound prices and lower implied volatility will have mitigated the impact. But moving the strikes closer to the current and forward prices is still likely to have increased both the risk of exercise and the resulting cost.

PEMEX has responded by cutting the volume covered by the programme from 230 million barrels to less than 200 million. But it is likely the banks had to trim their risk adjusted prices in order to secure the business, which looks potentially higher risk and less profitable than last year. In a market going nowhere, both traders and investors are being forced to take on more risk if they want to sustain revenues.

Assuming the current contango structure persists next year and spot prices remain trapped in a $70-80 range, futures prices for Jan-Dec 2011 will gradually fall back towards $75 as they approach expiry, leaving the downside strikes only $5-10 out of the money. It would only require a small further setback to bring the options into play.

For the sellers, these options are a gamble that spot prices will rise next year and the contango structure will narrow as the economic expansion matures and excess inventories of crude oil and refined products are drawn down. But it is a gamble. By granting options so close to the current market price, the options themselves introduce a new source of fragility on the downside. Any extended or unusually sharp drop in prices below $70 would tend to become self-reinforcing as banks and other sellers of these options start hedging their exposure.

So while it is still probably true that the effective floor for crude oil prices, based on fundamentals, lies in the $65-70 range, that floor is becoming more brittle.

Ends --

By John Kemp, Reuters market analyst - for Commodities Now.

The views expressed are his own.