Reading the Mexican Tea Leaves for 2019

On the eve of President elect López Obrador’s inauguration, we have some thoughts on what 2019 might hold.

 

Can Crude Stop the Slide?

President elect López Obrador (AMLO) has proclaimed one of the pillars of his energy policy is to return daily oil production from Pemex to 3 million barrels a day (mmbpd); levels not seen in over a decade. For September 2018, the national giant was only pumping 1.825 mmbpd, continuing a decade long downward slide.

The existence of reserves in Mexico has never been in doubt. But, as we know, the perpetual success of any exploration and production business is 100% contingent on maintaining investments for new production. Producers need new properties to develop, state of the art technologies to extract greater volumes at lower costs, well-trained employees and of course money (lots of money) to search for and find reserves buried thousands of feet if not miles below the Earth’s surface. 

To continue to produce, you must continue to spend.

As part of the Energy Reform enacted by outgoing President Peña Nieto, Mexico has awarded more than 100 contracts, both locally and to foreign investors, over the past 2 years through controlled auctions for the development of oil and gas. This farmed out production is “shared” with Mexico and with that a commitment to spend $160 billion. So far there have been encouraging announcements regarding new discoveries of large of quantities of reserves. This is all very positive for Mexico and advocates of the Energy Reform point to these facts as evidence of the effectiveness and necessity of the Reform.

The anti-Reformists scream corruption regarding the awarding of contracts and point to the seemingly ever downward spiraling production profile that the Reform has been a failure thus far and needs to be revised or repealed. 

So where will production go under AMLO?

Most of the government awarded tracts are located offshore in the Gulf of Mexico and deep-water offshore projects are typically 4-7 years in nature before initial production is realized. 

So, the reality is that we are probably still 1 to 2 years away from meaningful additions coming out of Mexico on the production front. For 2019, the best case is Mexico holds its head above 1.8 mmbpd but taking another couple percentage point hit indicates a realistic production estimate of close to 1.75 mmbpd. And anti-reformists will continue to shout until production reverses course.

 

Is Refining the Answer?

Pemex owns 6 refineries in Mexico with a combined throughput capacity of roughly 1.6 million barrels per day. Unlike their refining counterparts along the U.S. Gulf Coast, these refineries are struggling mightily and contribute negatively to the economic predicament Pemex and Mexico sits in today. There are a host of reasons for the underperformance of the refineries—namely perpetual lack of maintenance capital, underinvestment in current technologies, exceptionally high labor costs due to the very powerful unions, and poor crude slate management. When you add that all up, you get utilization rates well below 50%, high imbedded costs, and a bad product yield.

AMLO sees the problems in refining and has opted to take a bold (or controversial) position on the sector. He has made it a priority for Mexico to supply the Mexican demand for refined products, and his agenda includes massive plans for refurbishment of the existing refineries, but also billions of additional dollars for the construction of 1 or 2 new refining units.

This mentality and agenda are very in-line with the nationalistic “the people’s oil” philosophy that led to the creation of Pemex and the removal of all foreign participation within the energy sector in the first place. 

However, AMLO thinking that resolving the refining issue is the right focus as an agenda item is flawed reasoning. Mexico can meet current demand at competitive market prices without spending billions of dollars. The U.S. Gulf Coast is incredibly efficient, cost competitive, and happy to let Mexico drink from the trough all day long.

The reality is Mexican pesos are better spent elsewhere (E&P) where meaningful cash flows can be returned from investments. 

A more thorough and conscious review of the budget will steer AMLO away from pumping billions of dollars into a thin margin business while the country can economically be supplied by foreign sources. 

 

Investments in Infrastructure – Red Light!

There are more miles of pipeline in Texas than the entirety of Mexico. There are currently more barrels of crude oil being refined in Corpus Christi than in all of Mexico. Mexico has 21 million barrels of crude oil storage compared to 85 million barrels in Cushing, OK alone. You get the point. Mexico is vastly behind in building out the infrastructure required to produce, import, export, or distribute any molecule of energy.

In the last several years following the Energy Reform, there have been tens of billions of dollars of infrastructure projects announced in Mexico to resolve the shortfall, from pipelines delivering natural gas and refined products running from the U.S. to internal pipelines to coastal storage facilities capable of landing imports to rail facilities connecting Mexico to the United States and even Canada. But with all these announcements, only a few of the projects have actually received all the permits, permissions, regulatory clearance, environmental approvals and have been constructed and put into operation.

Since the results of the election back in July, the development of assets has been quiet. And right now, as we sit and wait for AMLO to take office, the infrastructure investors have gotten even more silent.

Last month, in a striking blow to the validity of government contracts that were awarded under President Peña Nieto, López Obrador called for a halt to a $13 billion project to expand and improve the Benito Juárez airport in Mexico City in favor of a project to add runways at a local military airbase. In reaction to the cancellation notice, the business community and foreign investors were spooked, and the financial markets shocked, with the peso sliding 3% and the stock market realizing a 4% dip.

There is definitely a ton of interest in constructing and owning new infrastructure in Mexico. But those projects will be cautious and slow until the new administration gives investors the confidence to resume spending.

The economics of billion-dollar projects are tied to long-term returns, and investors will only proceed with projects that have very fast returns on cash invested or outsized ROIs, require limited cash, have potential alternative uses, or are directly tied to contracts with Pemex or a government entity. 

Unless—and until—President AMLO can ensure investors that contracts will be respected, I anticipate the market to remain risk averse.

 

The Price Is Right?  Market Prices

While price talk sits somewhere on the back burner in the grand equation of trading products in Mexico, there’s not a more crucial variable than that in the ultimate success or failure of the refined fuels business in Mexico. 

Today, the Mexican market operates in a pseudo-free market environment. Pemex still produces, purchases and/or sells the overwhelming majority of all refined products in Mexico including gasoline, diesel, propane, and jet fuel. Even major oil companies opening retail stations across the country are being forced to source their gas and diesel from Pemex due to the lack of 3rd party infrastructures available to land, distribute, and market products. 

So, while prices are “open,” Pemex still plays such an influential role in setting the market price that competition is tough.

The other factor influencing (or manipulating) the price the consumer ultimately pays and the profitability of 3rd party marketers is the IEPS tax. Announced on a weekly basis, the deduction is a headache in the pricing model for marketers. Those in the trade are aware of the ups, downs, and unpredictable nature of the IEPS tax credit. In short, it is a government policy tool used to “smooth” market prices by reducing the tax on motor fuels. The credit is announced each Friday for the upcoming week. In a market with huge volumes, where pennies are the margin on gallons traded, having to manage the weekly fluctuation of a government tax is a considerable and much unwanted added layer of complexity.

As a proponent of “the people”, I believe López Obrador will continue to use the IEPS tax credit as a means of finessing product prices. As a grand gesture, I can envision the deductions under AMLO may even exceed the level of use under Peña Nieto to decrease prices at the pump. Influencing the IEPS tax is possibly the easiest lever to pull in favor of pleasing his constituency. However, greater pricing controls is bad for the overall market and a deterrent to participation and investment by outsiders. 

Eventually, prices must be determined on a cost-plus margin basis without subsidies.

 

Don’t Snooze on Regulation

Regardless, the Energy Reform act is here to stay. The stars aligned in getting the President, House, and Senate to write and pass such a monumental piece of legislation and undoing the constitutional amendment would take forces I don’t see lining up. And frankly as President, AMLO won’t need to rewrite history if he wants to return Mexico to a Pemex-centric universe. By manipulating prices, threatening investors, and increasing the political risk, he can simply deter the foreign market from participating in Mexico.

 

What Will 2019 Bear?

Strategic and investor parties have lined up to participate in bringing the Mexican energy market into the 21st century. The billions of dollars in projects are real. The solutions exist. If the market is right and the music starts, this party will get jumping. But if President AMLO eliminates the economic returns or levies too much political uncertainty to justify the risk adjusted returns, those dollars will walk, and the people of Mexico will be left without a chair when the music stops.

I expect President López Obrador to test the market’s resolve. His choices for key energy appointments and the language in his speeches strongly indicate granting as much power and influence to Pemex as possible. How much can he spend on production and refining? How quickly can he realize positive results?  In my view, not enough and not fast enough. AMLO didn’t create this problem but, as Executive in Chief, he will have to choose a path. Eventually that path must include foreign investment and participation.

 

Inspired to jump into the Mexican market? Click here to contact our international markets team.

Best,

Chad Smith
Senior Vice President of Terminal Services