The Fuse

Oil Prices Fall, Along With Dreams for a Mexican Energy Revival

by Nick Cunningham | September 10, 2015

In a move that raised eyebrows, the Mexican government hedged 212 million barrels of oil to be sold next year at a price of just $49 per barrel. This price point is shockingly low.

With oil prices remaining low, Mexico is seeing economic and financial strain that is expected to last into next year, affecting the country’s crude output. The government is taking measures to soften the impact of low prices on the economy, and the Mexican finance ministry recently revealed that the government spent $1 billion in order to secure hedges on oil prices in 2016. In a move that raised eyebrows, the government hedged 212 million barrels of oil to be sold next year at a price of just $49 per barrel. The level is shockingly low, and down by more than 36 percent from this year’s hedges at $76.40 per barrel.

Too Pessimistic, or Simply Realistic?

The hedge represents a rather pessimistic view of where oil prices are headed, especially given the ongoing rebalancing in global markets. Higher cost sources of oil supply are taking a hit. U.S. crude oil production has been lower this year than previously expected and is expected to fall further, while demand continues to grow quickly on the back of lower prices. The IEA estimates that oil consumption will expand by 1.6 million barrels per day in 2015, and by another 1.4 mbd in 2016. With supply falling and demand rising, it appears likely that oil prices may rise next year. Against that backdrop, Mexico’s move to lock in a portion of its oil at just $49 per barrel looks like a curious one.

On the flip side, plenty of analysts predict that oil prices will remain subdued through 2016. The EIA, in its latest Short-Term Energy Outlook, estimates that WTI will average $53.57 in 2016, and Brent will average $58.57. Vitol, the world’s largest independent energy trader, predicts that oil prices will remain between $40 and $60 through next year and possibly into 2017.

Moreover, Mexico’s heavier crude trades at a discount to WTI. In June, for example, Mexico’s Maya Crude Oil sold for an average of $3 less than WTI. In that context, Mexico is merely playing it safe by hedging at $49. In fact, the government is expecting that it will sell its oil for just $50 on average in 2016, a harsh realization for a major oil-exporting country, but perhaps a prudent move.

Mexico Braces for More Pain

More importantly, the government is looking for some stability and assurances by locking in some oil sales, even if it forgoes the opportunity to benefit from an oil price rise. The collapse in oil prices over the past year has ravaged the government’s budget and inflicted serious damage on the country’s economy.

The government is looking for some stability by locking in some oil sales, even if it forgoes the chance to benefit from an oil price rise, as the collapse in prices over the past year has ravaged the government’s budget and inflicted serious damage on the economy.

Besides persistently low oil prices, the volatility in the peso and the tepid economic growth rate have forced the government to slash spending. The low price hedge, in turn, will only create more anxiety for the Mexican public, already dealing with a bout of intense pessimism not seen in years. On September 8, Mexican President Enrique Peña Nieto sent the government’s 2016 budget to Congress, an austerity budget that acknowledges the steep drop in revenues from the collapse in oil prices. The 4.75 trillion peso budget (US$282 billion) is 221 billion pesos (US$13.1 billion) lower than the 2015 budget. The pullback in government spending is intended to “preserve the economic stability of the country,” Finance Minister Luis Videgaray emphasized, as lower oil prices have left government coffers much emptier than anticipated.

Revenues brought in by state-owned oil company Pemex typically account for about one-third of the government’s budget, but that share fell to just one-fifth of revenues in 2015, in part due to lower oil prices.

The economy overall is also not doing as well as once hoped. The government expects the economy to grow just 2.3 percent this year, down from previous estimates of between 2.5 and 3.5 percent. To make matters worse, Mexico’s currency has tumbled since oil prices crashed. The peso has lost nearly 30 percent of its value since oil prices began falling in the fall of 2014, raising the cost of imports for Mexican consumers. The global commodity bust over the past year has put pressure on emerging market currencies, and the August devaluation by China ignited a currency selloff. The Mexican central bank has had to step in to keep the peso from falling further, as the government hopes that the peso will regain some lost ground with a target of 15.9 pesos per 1 U.S. dollar next year compared to the current 16.8 per dollar.

Oil Auctions

The Iranian oil minister Bijan Zanganeh made headlines on September 8 when he said that Mexico was poised to cooperate with OPEC if the oil cartel decides to take action to stabilize oil markets. The comments suggested that Mexico’s oil industry would be willing to cut production along with OPEC in order prop up prices.

However, Zanganeh’s counterpart in Mexico quickly threw cold water on such a scenario. “Mexico is not influencing overproduction because Mexico’s oil output has been steadily declining,” Mexico’s energy minister Pedro Joaquin Coldwell told Reuters on September 8. “It would be unacceptable for us to have to cut when our output is already declining,” he added. “It is not an option.”

Coldwell is right. After peaking in 2004 above 3.8 mbd, Mexico’s oil production has declined significantly. In its latest budget, the government also revised its projection for oil production downwards to 2.25 mbd for 2016, a glaring revision from a March estimate of 2.4 mb/d. Simply put, not only is Mexico suffering from lower oil prices; it is selling fewer barrels, too.

mexico's oil prodcution

Mexico production revival?

There are hopes of an economic and production revival, however. The Mexican government passed historic energy reform, amending the constitution in 2013 to open up its energy sector to private investment for the first time in over seven decades. The signature achievement of President Peña Nieto promised to usher in a wave of capital from international oil companies, bringing in cutting edge technology and drilling expertise that Pemex lacked. This opening would allow the country to reverse its decade-long decline in production.

To that end, Mexico held its first auction for shallow water blocks in the southern Gulf of Mexico in mid-July 2015. However, the results were disappointing. Only two bids were awarded among the 14 blocks offered by the government. Several of the blocks received no bids at all.

Of course, the timing was abysmal. Mexico held its first auction when oil prices were hovering near six-year lows. Obviously, the government could not have predicted the low oil prices when it began the process of opening up its energy sector, but nevertheless, weak oil prices have scared away producers.

Even if Mexico is successful in the next phase of Round One, it will take years for companies to achieve significant production levels from the blocks on offer.

The next phase of the Round One auction is set to take place at the end of September and the government plans on offering five shallow water blocks, also in the southern Gulf of Mexico. The Mexican energy regulator CNH has taken steps to sweetened the terms in an effort to spark more interest. It lowered the “corporate guarantee,” which is a certain level of capital that private companies have to put up front to cover the costs of a hypothetical accident, and it will also publish the minimum level that companies must bid in order to be awarded a contract, details that had been lacking in the July auction.

The changes by CNH are not revolutionary, but they could help draw more bids in the next phase. Still, with oil prices still so low, it may be difficult to avoid another repeat of the July auction.

A long road ahead

Even if Mexico is successful, it will take years for companies to achieve significant production levels from the blocks on offer. What was sold as a major economic stimulus by the government will have little impact in the short-term. Meanwhile, with no rebound in sight for oil prices, the government will have to continue down the road of austerity.