MEXICO CITY/NEW YORK (Reuters) - Mexico is playing a risky game of hide and seek with the oil market.

FILE PHOTO: Tanks holding fuel of state-owned company Petroleos Mexicanos (PEMEX) are seen at a storage facility, in Ciudad Juarez, Mexico October 4, 2017. REUTERS/Jose Luis Gonzalez/File Photo

To frustrate speculators and contain an annual bill of more than $1 billion, Mexico is going to new lengths to mask its attempts to insure its revenue from oil sales against falling prices - no mean feat for a hedging program known as Wall Street’s biggest oil trade.

Getting the hedge right is crucial for Mexico as it offers stability at a time the government is planning to boost social welfare and security spending, the economy is stagnating and the country’s credit-worthiness is under intense scrutiny.

Once an enigmatic agreement between a handful of finance industry officials and Wall Street banks, the hedge is now the most anticipated deal in the oil futures market, making it harder, and more costly, for Mexico to arrange.

For its 2020 hedge, however, Mexico has adopted a different strategy than in previous years, according to a Wall Street source with direct knowledge of the deal.

This time, an estimated two-thirds of the options Mexico bought in financial markets were indexed to the international Brent crude benchmark, shifting away from the Maya oil Mexico mainly produces, according to the source.

By using such a heavily traded contract as Brent, Mexico should have been able to cut costs by getting lower quotes for its trades and to place bets more unobtrusively to avoid prices shifting ahead of its moves, market sources said.

But critics say the strategy creates new risks. By using international oil contracts based on a different kind of oil, the structure of the hedge may not fully reflect Mexico’s export mix dominated by Maya, which is typically cheaper than Brent.

SWEET OR SOUR

"I would expect a divergence of prices over the long term. This pressure on Maya could move prices down faster than its hedge. This would cause a loss on the physical sale of Maya and minimal-to-possibly no benefit of the hedge," said Ryan Dusek, director at consulting firm Opportune LLP opportune.com based in Houston, who added that the trade could end up being "worthless."

The Mexican finance ministry declined to comment on the structure of the hedge.

The Wall Street source said the proportion of Maya crude hedged for 2020 was significantly lower than in previous years.

For the 2009 deal, for example, Barclays, Deutsche Bank, Goldman Sachs and Morgan Stanley hedged 305 million barrels of crude using Maya and only 25 million with Brent, data obtained by Reuters through a freedom of information request showed.

The Wall Street source said for 2020, Mexico had bought put options on Brent on the Intercontinental Exchange (ICE) at $54-$56 a barrel and hedged Maya at $42.

Brent LCOc1 is trading at around $63 a barrel while Maya's official selling price for deliveries to the U.S. Gulf Coast is about $55, according to S&P Global Platts pricing data.

The options give Mexico the right to sell oil at the predetermined price, so if the actual market price is lower, the options pay out and make up the difference - acting effectively as an insurance policy.

But if the price of Maya, a heavy sour crude, falls faster than Brent, a light sweet crude - or Maya drops and Brent rises - Mexico could miss out on oil revenues without the hedge kicking in, analysts and market sources said.

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Mexico has had to contend with the potential divergence in Maya and Brent crude prices before but the risk is now greater as demand for heavy crudes globally is expected to slump.

Reuters was unable to determine whether Mexico has taken additional steps to bridge any gaps between Maya and Brent.

‘HACIENDA HEDGE’

Mere rumors of Mexico’s “Hacienda hedge,” which gets its name from the country’s finance ministry, can shift prices ahead of its anticipated deals and the government fears participants push up premiums when they suspect Mexico is about to trade.

“Banks have become much better at accumulating information about it,” said Victor Gomez, a former Mexican finance ministry official involved in the hedge until 2018.

In part due to this, the hedge’s cost has increased 10-fold in peso terms since 2001, even though the number of barrels hedged has barely changed, the data obtained from the freedom of information request showed.

Mexico spent the equivalent of $212 million to hedge 200 million barrels in 2001 but in 2016, hedging 212 million barrels cost $956 million. In 2017, Mexico stopped disclosing the number of barrels it has hedged.

Now, for the first time in at least 19 years, finance ministry officials have declined to reveal how much they’re spending to protect 2020 revenue, saying the information would give speculators insight into their strategy and raise costs.

“What we don’t want is that they identify the moments that Mexico goes to the market, because that raises the costs of the premium,” Gabriel Yorio, one of the main architects of the hedge under President Andres Manuel Lopez Obrador, who took office a year ago, told reporters this month.

The cost of the hedge has also risen because the peso has declined versus the U.S. dollar and because options have become more expensive since many commodity-oriented funds, which were natural counterparties to the deal, have closed.

Officials have also declined to say how much of the 1.73 million barrels a day it produces they’re protecting, nor to what extent they’re using put options or a budget stabilization fund to guarantee government revenue.

All they have disclosed is that the 2020 hedge guarantees an average price for Maya of $49 a barrel.

(Graphic: Mexico oil hedge - )

Since 2001, Mexico has received three payouts up until the end of last year: in 2009, 2015 and 2016, the data showed.

Nevertheless, those three payments were so large the finance ministry could argue it was still ahead - at least before including the cost of the 2020 program.

Mexico has also taken other steps to cover its tracks. In response to further questions in Reuters’ records request, Mexico’s transparency institute said additional information about the hedge had been sealed for five years.

It cited the finance ministry as saying revealing details could increase costs, affect Mexico’s monetary policy and financial stability and create systemic financial risk.

“This is part of Mexico’s strategy to leave banks and oil majors in the dark about what they are buying and how much they are paying,” said Gomez.

Asked about specifics at a news conference on Jan. 9, Mexican official Yorio highlighted the importance of the overhaul of the crude oil pricing formulas that underpin Mexico’s oil exports.

Last year, Mexico changed the pricing formula for Maya sales to the U.S. Gulf Coast to be based 65% on U.S. West Texas Intermediate in Houston - a light sweet crude which is the most traded U.S. Gulf Coast grade - and 35% on Brent futures.

Before, it had been derived from West Texas Sour, Dated Brent and other grades that have become less traded markets. The formula also previously included fuel oil rich in sulphur, which has been hit by new rules requiring ships to use cleaner fuel.

FUND OR OPTIONS

Mexican officials involved in the hedge in the past said the government may be considering increasing its use of the stabilization fund to guarantee oil prices as a supplement to financial instruments.

From the mid-2010s, Mexico started to lock in part of its target oil price with the fund to contain the costs of the options it buys from banks and major oil companies.

For example, Mexico locked in a price of $79 for its 2015 hedge, with $76.40 guaranteed by options and the remaining $2.60 backed by the fund. In 2017, the last time the ministry released such information, $4 of its $42 hedge was covered by the fund.

Gomez and Julio Ruiz, another former official involved in the hedge until 2018, said Mexico was expected to expand this strategy in the coming years but cautioned it would struggle to keep enough money in the fund to hedge oil exports fully.

“They would have to accumulate a larger amount of resources in this fund,” Gomez said.

Nevertheless, those changes would do little to ease the concerns of some who believe Mexico spends too much on the hedge, said Ruiz, adding that guaranteeing oil revenue was still necessary given the pressures on Mexico and state-owned Pemex, the world’s most heavily indebted oil company.

“In congress, many will say they don’t agree with how this money is spent, and that it shouldn’t be spent on the oil hedging program,” Ruiz said.

“But Mexico’s finances would become a lot more volatile without it.”