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How to Guarantee Success - Why Mexico Hedged it’s 2010 Oil Production at $57 per barrel

A lot has been made this week of news that Mexico hedged the bulk of its 2010 oil production at $57 per barrel.

Several analysts chalked this up to a vote of non-confidence in the oil market. And wondered why Mexico would be so bearish when 2010 futures are trading between $70 and $80.

This analysis misses a few key points. Which go to the heart of the philosophy behind hedging.

By hedging at $57, Mexico's leaders are not betting that oil will drop in price. They are making a decision that protecting against downside below $57 is more important than maximizing upside if oil prices go higher.

In other words, the message is: we can live with our situation if oil goes to $100 and we have to sell at $57. But the situation is unworkable if oil drops below $57 and we're forced to sell at $40 or $30.

(In actuality, Mexico will not be selling at $57 if oil goes to $100. The government has purchased options that give them the right but not the obligation to sell at $57. These options are costing the country $1.172 billion to cover 230 million barrels of oil, which amounts to $5 per barrel. If prices go to $100, they will simply not exercise the options, losing that $5 on each barrel. So at $100 oil, they'd effectively be selling at $95.)

From this perspective hedging makes a lot of sense. Mexico's move suggests (hopefully) that the government has analyzed its fiscal needs and decided that at $57, oil revenues will cover necessary expenditures. This is a price they can live with. Whereas at $40, finances might be stretched to the breaking point.

Smart developers of resource projects use the same strategy. If you understand your project, you know what sale price you need in order to make an acceptable return on capital. You also know at what price the project turns into a money-losing black hole.

Let's look at a quick example. Suppose we're planning to drill a development well on an oil project. We know from other wells in the area that the cost to drill will be about $3 million. We also know that at usual initial production and decline rates, we're likely to pump about 200,000 barrels of crude over a ten-year period.

Looking at the decline curve (and assuming that our well behaves similarly), we can predict what yearly cash flows will be at various oil prices. And by discounting these cash flows (a dollar next year is worth more than a dollar ten years from now), we can come up with a net present value (NPV) for the well. And calculate a return on investment.

I've been looking at decline curves for a well very similar to the one described above this week. At today's oil price of $70, the well's NPV would be $5.5 million (assuming 13% royalty and $20 per barrel operating costs). Meaning we would pay back our $3 million drilling cost, and make an additional $2.5 million. Giving us an 85% return on our investment ($2.5 million profit divided by $3 million capital investment).

These are good numbers. However, we don't know if oil will be $70 over the entire ten-year life of the well. What if the crude price falls?

The economics change. At $50 oil, the NPV of the well drops to $3 million. We would cover our drilling cost, but make no additional profit. Obviously not an attractive situation.

Armed with these numbers, we can make some decisions about hedging. We know that we need to lock in a price higher than $50 in order to make a profit. So what do we choose? $70 is nice (remember, 85% return on investment), but buying a hedge program at this price would be expensive (hedge options with "strike prices" close to the current spot price cost more).

This is where we need to decide: what return on investment do we need to make this project worthwhile? Is 10% enough? If we're a large company with lots of drilling prospects, it might be. After all, if you can invest $3 billion in drilling 1,000 wells (at $3 million each), you'd make $300 million at 10%. That's a lot of money.

If we're a small private group, however, we might want more than 10%. I might be able to make 10% on my money day-trading or buying corporate bonds. Which is a lot less work than drilling and managing on oil well. In this situation, we might decide that 30% is the minimum return at which the project is worthwhile for us.

After deciding what our minimum desired return is, it's simply a matter of running the model to figure out what sale price gives us this threshold. For the above example, $53 per barrel gives us 10%. If we want 30%, we need to go up to $58. And we may have to give up a few percentage points on our desired return, in order to account for the cost of purchasing the hedge program. We're paying for certainty.

After doing this analysis and implementing a corresponding hedge program, we could rest easy. No matter what the market does, we're going to have an economic project that (roughly) meets our requirements for return on capital. True, we'll miss out on some money if oil prices rise. But, like Mexico, our financial needs will be covered.
This is a very sensible way to develop a project. Make money by not losing money. In many cases, protecting against your downside is more important than chasing the upside.

Bottom line: decide what you need to make a project work and then make sure you get it. That's what hedging is all about.

By. Dave Forest of Notela Resources




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