Saudis Declare OPEC+ ‘Up And Alive’ After Mexican Standoff, But Demand Still ‘Down And Dead’

“We have demonstrated that OPEC+ is up and alive”, Saudi Energy Minister Prince Abdulaziz bin Salman declared, in an interview with Bloomberg Sunday.

After four agonizing days, the cartel and allied producers made official an agreement to curb production by a combined 9.7 million barrels per day, a shade less than the 10 million barrels tipped over the past week.

Amusingly, Mexico never relented. The country will contribute just 100,000 barrels per day to the overall cut, far less than its “fair” share. President Andres Manuel Lopez Obrador was obstinate throughout. His recalcitrance threatened to derail the entire deal, forcing Donald Trump to intervene and effectively guarantee a portion of Mexico’s pro-rated share.

Read more: Trump’s Latest Mexican Standoff And Big Banks’ Plan To Seize Oil And Gas Fields

The deal – which Prince Abdulaziz said the Saudis are “more than happy with” – includes a commitment from the US, Brazil and Canada to cut a combined 3.7 million barrels. Other G20 countries will pitch in 1.3 million.

That commitment doesn’t appear to be “real”, though. Rather, it’s basically a projection of expected cuts imposed on producers by plunging prices and the new economic reality.

The actual cuts from OPEC and the alliance will go into effect in May and last through June. After that, they’ll be tapered to 7.6 million barrels per day until year-end and to 5.6 million through 2021, although it goes without saying that nobody has any idea what the landscape will look like by then.

Either way, this is a relief for a nervous market which was staring down the prospect of the new week beginning without a final accord thanks to Mexico’s refusal to bow to pressure from the Saudis. AMLO was keen to score political points at home by avoiding deeper cuts which may have jeopardized his domestic agenda and was likely emboldened by the country’s legendary hedging program (the “Hacienda hedge”) which protects the budget from price collapses like that witnessed in the first quarter.

Mexico spends around $1 billion annually for the insurance, but it paid off handsomely in 2009, 2015 and 2016, to the tune of $5.1 billion, $6.4 billion and $2.7 billion, respectively. Pemex itself has a hedging program too.

The sovereign hedge usually entails insuring some 250 million barrels via puts purchased from the likes of Goldman and even the trading operations of oil companies like Royal Dutch Shell. In addition to Goldman, Morgan Stanley, Barclays, JPMorgan, Deutsche, Citi, HSBC and BNP, have all been recruited over the years to participate in the massive deal, the most coveted oil trade on the street and, in some cases, an outsized portion of banks’ oil business.

The hedge is profitable over time. As Bloomberg wrote in a feature piece three years ago, “from 2001 to 2017, the country made a profit of $2.4 billion [as] its hedges raked in $14.1 billion in gains and paid out $11.7 billion in fees to banks and brokers”.

There are risks on both sides. For a government, shelling out hundreds of millions in fees annually to banks for a hedging program is bad optics when you end up not needing the protection. For banks, the downside is obvious – it’s highly profitable as long as crude prices don’t crash. The post-crisis regulatory regime complicated matters for participating banks by making it more difficult to “hedge the hedge”, so to speak. That’s crucial because, when things get particularly dicey, the mark-to-market on this monstrosity can be daunting – at one point in 2009, for example, banks reportedly owed the Mexican Treasury nearly $10 billion.

Banks’ efforts to keep their own positions squared in the face of massive hedging programs have been blamed for accelerating downside moves in crude on multiple occasions over the past several years.

Previously, Mexico made public the strike, the cost of the program, the number of barrels involved, the price it locked in and the incremental amount of protection provided by a separate stabilization fund. So, ultimately, you’d have a hedged price and then an additional several dollars per barrel insured through reserves in the stabilization fund. Based on that level ($42 in 2017, for instance), Mexico makes budget decisions.

Recently, things became more opaque as the government moved to designate some data a state secret, and according to reports, Mexico materially altered the structure of the hedge for this year. But what’s clear is that having the program in his back pocket made AMLO more comfortable in his negotiating position which, as noted, he never relinquished over four days of wrangling.

For 2020, the Mexican government said its budget was shielded from prices lower than $49 per barrel. This year’s hedging program cost $1.37 billion. “The hedge is usually not cheap, it is expensive, but it is for occasions just like this”, Mexico’s finance chief said last month. “The income part is covered, we will not have a direct impact on the budget”, he added, referencing plunging crude prices. “But it is still a worrying situation”.

Ostensibly, the “situation” is less “worrying” now that there’s officially a deal to curb production, but because it doesn’t go into effect until May, an already oversupplied market will likely have to cope with another three weeks of flooding before the spigots are dialed back.

On the demand side, the story remains the same. The unprecedented scope of demand destruction associated with virus containment protocols implemented across the globe means any production cuts will fall short of balancing the market – at least in the near term.

Sell the news? We’ll see.