China & Russia oil deal

China just made a deal with Russian on $25bn oil purchase for over 20 years. That solves a chunk of China’s long term supply problem.

In return for its $25bn worth of loans, China will get a total of about 2.2bn barrels of oil over 20 years. Including interest at 5%, that equates to a price of $17.40 per barrel over the period, a bargain when the longest NYMEX futures contract, for December 2017, sells at $73.22.

The contract covers about 8% of China’s current oil imports, which are expected to increase sharply in coming years. The Chinese authorities regard long-term oil supplies as a key matter of national security, and are not prepared to rely more than modestly on the international spot market. Hence in recent years, Chinese oil companies have invested in a number of African countries to line up supplies, and have lengthy discussion with the other oil-rich countries.

Given its energy concerns, a 20-year contract with the erratically governed Russia could be regarded as only moderately risky. Russian oil companies may be less likely to default on a deal with China, which takes a strong stance in most international matters, than they would be on an equivalent obligation to the more passive EU, for example.

On the other hand, Russia gets the capital needed to upgrade its oil industry and established a long-term relationship with a large and growing customer. And even the low price of this contract probably represents a profit given Russia’s low extraction costs. It also provides guaranteed demand in the event of an oil glut.

This looks like a win-win deal for both sides.

Mexico hedges all of its oil export

We have witnessed a bunch of crisis here: subprime-mortgage crisis, hedge fund redemption crisis, derivatives crisis and of course, commodity crisis. Oil prices hit an all-time high of $147.27 a barrel in July but have since fallen to less than $65 as the global economy cools. Some economies largely depending on oil have been hard hit. Some countries have taken actions to protect themselves from the falling oil price.

Mexico, the world’s sixth biggest oil producer hedged almost all of next year’s oil exports at prices ranging from $70 to $100 at a cost of about $1.5bn through derivatives contracts. This is the sign showing the concerns of concerns of producer countries at the impact of the global economic slowdown on their revenues, as Mexico relies on oil for up to 40 percent of government revenue. Last year, Mexico only hedged about 20-30 percent of its oil exports.

These trades appeared to have occurred in late August and early September, at that time the oil was traded within $90-$110. So the hedge seems a good move and a presumed cost of some $1.5bn is immaterial relative to risks. Without the hedge, the recent price falls would have been a serious concern for Mexico.

Actually there were already signs that a big producer was hedging over this summer as traders in New York noted a significant surge in options for December 2009. Mexico’s action could have added some downward pressure to spot oil prices as some banks including Barclays Capital and Goldman Sachs, who predicting the oil price would be remain at $150 by the end of year, offloaded some of their risk, selling futures.