Hedging Natural Gas in Mexico Is a Must Today

All over the world, the futures market works round the clock making commodities predictable in an ever-changing environment. A vast majority of the energy market relies on this price assurance to deliver consistent numbers at the end of the year. Hedging is as important as any insurance policy for the assets or goods they trade.

In Mexico, hedging has not been a tradition mainly because the government has taken care of it via its oil sales by the now famous yearly PEMEX price hedge on the barrel of the Mexican mix. On the Fuel sales side, using the Special Tax on Production and Services (IEPS) quota as a subsidy has made the government the risk-taker for all vehicular fuel consumers, the most sensitive sector in the market.

Industrial markets that rely on fuel oil, natural gas among others, are mostly on the spot market without any price coverage by any means. In the natural gas market, price stability has come to an end after a decade of low volatility and low prices. The reality of the war in Ukraine and the production chains disruption have marked a new era, where Liquefied Natural Gas (LNG) is becoming the commodity of the moment. As of today, price volatility in North America is only limited to the production platform. Just this month, an LNG plant went offline, leaving 2 BCF available and making prices fall more than 150 cents per MMBtu in less than a week.

This reflects the market sentiment on any kind of altering event that may drive prices up or down overnight. When markets change this way, technical analysis become preponderant. On the last 10 years, fundamentals on natural gas (price, production, the success of shale gas, etc.) has been so solid that price jumps over 50 cents intraday were a rarity. Investors or consumers became comfortable in this then new scenario and quickly forgot about the shaky 2000s decade when prices hit as high as 13.00 USD /MMBtu and price jumps were a daily event. There were weaker fundamentals, mainly related to production deficit at the time, and technical analysis had a major role to play.

That time for Mexico is back and now, with oil also at high numbers, a more open market and an acute dependence on natural gas imported from the US, shows a scenario that needs to be taken seriously and very much hedged in the futures market. Being it Futures of any kind or an Option it means the stability for companies highly dependent on natural gas in their production process.

Some people might think that the price could hit a ceiling of about 10.00 USD /MMBtu, and then come back down. Sorry, but most fundamentals along with technical figures will make you think otherwise. New LNG plants, for example, will put more pressure on production that might go well over 100 BCF /day in the US to solve this demand, but producers are not as enthusiastic as the real market would like. They have suffered low prices due to excess production for many years now and may not be willing to go back down that road again.

Another kind of pressure comes from Mexico itself. With some commitment to switching to natural gas and new consumers in the electric sector, the LNG export sector (4 baseload facilities), CNG markets and new demand areas are coming into play, although very slowly. Mexico has not solved its E&P problems that have driven PEMEX natural gas extraction to less than 4 BCF/day from 6 BCF a decade before, although it has a huge reserve that could drive the country for over 60 years. We think that in the next five years, US exports to Mexico could hit more than 10 BCF/day.

Now, market sentiment is far from being unsettled and a new age of stability is not visible on the horizon. At least there might happen several events to slow down this trend. Meanwhile, having a good hedge program might prove to be the only way to predict margins.

To end this article let us go through an example based on real price figures from this same year on the Henry Hub Natural Gas futures index. In January, a month before the invasion of Ukraine started, April-Oct. 22 futures were at 3.986 USD /MMBtu. Forty days later when the invasion was already in the first two weeks, during the same time span the futures contract was at 4.628 USD /MMBtu. Today, after the LNG plant incident, we are talking about US$7.00, a price reduction of 2.00 USD/ MMBtu versus two weeks ago. Versus January, that is a difference of about 3.00 USD /MMBtu. With just one single 10,000 MMBtu contract (the typical demand of a CNG station in Mexico) you are talking of a net cash overpayment of US$30,000 a month, or US$180,000 for the six-month period.

You might think that this will be paid by the consumer and the CNG station owner will not have a real loss. In our experience, price elasticity in the emerging Mexican CNG market is not that graceful and the loss will go to everybody. If the example is extrapolated to other industries, it most probably will have the same effect.

Bottom Line: Volatility is here to stay, price prediction will be difficult, and you might consider insurance the same way as you cover your assets but this time via a hedge on your most important raw material: natural gas.

 [LP1]This is standard energy pricing nomenclature

 [LP2]Futures and Options are Hedge instruments.