Trading Jenga: Canada-Mexico Swaps

The North American energy markets move forward in 2016 as almost integrated commodity markets. The legal issues remain in Mexico but are reduced as we move forward. Mexico deregulation will create a traceable set of contracts and commodity prices by 2019. Pipeline and transmission capacity ownership will determine the winners and losers in Mexico. As spot markets increases and transmission capacity is released or resold, swing markets develop. NAFTA did not build this marketplace.

Relationships have grown in the previous 20 years between Canada, Mexico, and the USA. Major pipeline capacity and transmission agreements form a substantial basis for import and export relationships for North America. Unfortunately, the best relationships in the world will not protect the sellers from volatile commodity markets.

The American government regulatory agencies which police capacity are FERC and NERC. In Canada, the NEB manages this logistics and transportation function. Mexico’s new wholesale electricity market (Mercado Eléctrico Mayorista) will be operated by the Centro Nacional de Control de Energía or CENACE. CENACE takes over as the independent system operator for Mexico’s electric transmission grid. It will have some functions similar to NERC. The Ministry of Energy and the Comisión Reguladora de Energía (CRE) will regulate and manage the new wholesale power market.

The President of Mexico recently appointed a new CEO for Pemex. This coincides with a falling oil price and falling Peso valuation. How much value has dissipated from the value chain in Mexico? The large fixed basis differential for Mexican crude creates a situation where Mexican crude is produced for less than production or replacement costs.

Inter-country profits must be protected in some manner by hedging the approximate amount in the bi-currency spread. Canadians working in Mexico must hedge the Canadian dollar against the Mexican Peso in order to retain their profits. This should be accommodated in contracts, Board presentations, and Excel spreadsheets. Failure to do so will impair the ability to manage cross country business relationships on a long-term basis. One may escape this pain in the short-term, but the long-term currency fluctuations in the Peso and Canadian dollar make or break spreads.

Each regulatory agency has different rule and policies for imbalances and applicable transmission system losses. It is crucial to understand these and deduct or net out this factor in cross country border energy swaps. This will not predict actual system interruption costs, which are almost impossible to forecast as systems deregulate. As these markets continue to integrate and strengthen, regulatory and governance issues will surface.

The primary issue for conflicts is which government agency prevails. The commodity regulatory group in America is NYMEX and the CFTC. Will their influence exceed that of the regulatory agencies such as NERC, NEB, and CRE? Complicated swaps between two or three countries have subtle undercurrents which may appear after the damage happens.

The best current example of this issue is Russia and its European natural gas customers. If Russia purchased natural gas from British Petroleum and delivered it as a swap, their pipeline capacity issues could be improved with significant reductions of fines accessed for under-deliveries. Proforma must include real-time supply deliveries and Russian customer loads for the best outcome. Three years of supply and load data should be back-tested to arrive at a predictive model. This is the best way to avert failure to deliver issues under longer term contracts.

Expect major supplier shifts in Mexico during the next four years. Mexico’s refineries in Hidalgo, Oaxaca, Nuevo Leon, Tamaulipas, Veracruz, and Guanajuato will benefit from $23 Billion on investment capital during the next thirty-six months. This increases their crude oil imports and impacts the refined products market. Increased natural gas across the border into Mexico arrive more quickly than the crude oil and refining infrastructure upgrades.

Natural gas production in the USA is high. The gas over-supply continues. The natural gas storage surplus exceeds 500 Bcf higher than last year. The shale gas established a new formation with strong reserves and deliverability. This will continue unless prices are low enough to bankrupt the gas producers. Will new gas pipelines and HUB into Mexico solve this US domestic imbalance? Could medium-term swaps be the answer?

Will America benefit from Mexico’s demand increase for electricity, oil, and gas? Cross-commodity swaps may become common between coal and Crude or coal and natural gas between the northeast USA or Canada with Mexico. Multilateral energy companies may include contractual clauses allowing commodity supply substitution or multiple delivery points. These will be driven by price rather than Force Majeure. Contract flexibility will be needed which contains maximum monthly variation restrictions.

A final note to those involved in cross-border swaps and trades: Constitutions for countries govern legally. This is imperative to examine in cases where countries have recently altered their constitutional rules. This case is Mexico. Cultural shifts in Mexico associated with changes in its Constitutional Amendment may not be fully rooted. Major shifts in supply and demand take the time to properly model.

©2016 ALL RIGHTS RESERVED Rebecca Stone SpeedyReads.com