Cobertura! Or how Mexico became the unlikely OPEC+ deal winner, really cutting 50,000 bpd at most

The elephants in the digital room had reached a compromise. Russia had agreed, Saudi Arabia too, and with them almost all of the other oil producers of the OPEC+ alliance were ready to seal a deal that would translate into the largest-ever agreement by the group to reduce its oil output. However, a sole country resisted the pressure, dragged the meeting into the late hours and stood its ground, eventually succeeding in cutting what Rystad Energy estimates will in effect be at most 50,000 barrels per day(bpd).

Most did not expect it to block the deal and its stance may have come as a surprise, but Mexico joined the meeting with no plans to reduce oil production. And then OPEC+ asked it to slash its output by 400,000 bpd. A standoff was inevitable.

Mexico’s stance can be understood in the context of national oil revenues, which are protected by gigantic hedges, or what in Spanish is called “cobertura”. The exact hedge structure is unknown, but our estimates suggest a potential hedging gain of around $6 billion in 2020 given current oil prices.

In addition, the government strongly supports the revival of the state’s upstream and refining industry, which has finally managed to achieve positive operational momentum after a multi-year decline.

“If currently drilled wells come on line within schedule and no new wells are planned, Mexico would need to effectively reduce output by only 50,000 bpd in May and June to adhere to the OPEC+ agreement, either by partial shut-ins or flow restriction on less economic projects,“ says Rystad Energy senior analyst Alexandre Ramos Peon.

A key point in assessing the impact of OPEC-style production cuts is the definition of the “baseline” from which the cut applies. This has been set at October 2018 for most countries, including Mexico. Based on the latest reported production figures at the well level, it appears that as of February 2020, Mexico’s output is just below that baseline.

It should be noted that some reporting delay for February 2020 is still possible, but according to our analysis the impact is negligible.

If a 100,000 bpd cut from the 1.75 million bpd October 2018 level is enacted by May, and assuming no maintenance or extraordinary events take place, Rystad Energy’s analysis shows that Mexico would need to forcefully reduce output by 50,000 bpd in May and June only. The rest of the mandated cut will be delivered by base decline.

Of course, new drilling will probably be impacted if the country complies with the 100,000 bpd cut and we are likely to see more wells that were planned for the second quarter of 2020 being pushed into the second half of the year.

But there is another way that Mexico could technically cut even less than 50,000 bpd:

To begin with, we should remember that Mexico produces around 36,400 bpd of condensate, according to state data as of January-February 2020. While insignificant in absolute terms, on paper this corresponds to a material increase from less than 4,000 bpd of condensate produced in 2017.

Condensate production is exempt from OPEC+ production quotas, raising fundamental concerns about the incentives of different countries to reclassify some crude production into condensate to technically simplify the process of compliance. The challenge comes from the fact that there is no industry-wide standard definition of crude and condensate, with different versions varying in oil density, gas-oil-ratio and the composition of the stream.

While OPEC has a standard definition, other significant oil producing countries often use their own definitions. Moreover, the definitions might change over time and Mexico is not an exception.

In fact, apparent increases in Mexican condensate production in recent years actually came from similar crude-to-condensate reclassifications across several fields. In the current environment, it is not impossible that some countries will review their crude-condensate classification carefully to simplify the process of complying with crude quotas.

“It becomes clear that Mexico emerges as a big winner from the OPEC+ negotiations. It avoided the operational pressure of a 400,000 bpd output cut and will be well positioned for a gradual production ramp-up when demand recovers, given the country’s backlog of wells awaiting completions and the robust level of new activity,” concludes Ramos Peon.