How to Solve Pemex? López Obrador Tries.
Mexico’s mighty state oil company, Petroleos Mexicanos (Pemex), has long been front and center as a subject of government policymaking during its 80-year history. In 2013, the Mexican government won Congressional approval for a bold energy-sector reform package – the first in its history – to create a new business model for Pemex. The reforms were designed to attract foreign and private investment, enabling production-sharing contracts with global companies to boost declining oil production, even as polls at the time indicated that the majority of Mexicans were wary of allowing much foreign participation in Pemex.

Today, however, Mexico’s new left-wing populist President Andrés Manuel López Obrador, commonly known as AMLO, who was inaugurated in December 2018, has instead a new pitch to go it alone: he is reviving the idea of Pemex the state champion. We have been waiting for the details.

The issue is complicated, as Pemex cannot stand by itself. Unless, say, the government revokes all its taxes. But then, Mexico’s credit rating risks approaching junk. And AMLO has promised fiscal responsibility.

So AMLO and his economic team have a problem: Pemex is broke, no less because the government needs its high taxes.

The administration understands Pemex needs support, but it also has a new path for the energy sector, with a greater role for the state. Pemex has negative equity including pension liabilities, large financing needs every year, and it needs to reduce its balance sheet while it may actually increase it by building a new oil refinery. While refining is a lower margin business compared to exporting, the new refinery is dear to AMLO. He plans to build it in his home state in the less-developed southern region of the country, and in his view it will boost Mexico’s gasoline self-sufficiency and allow for lower prices.

Fiscal Accounts and Impact on Mexico’s Ratings

Pemex’s financial condition, because it is a government-owned entity, has implications for Mexico’s sovereign debt ratings.1 A good approximation is that Pemex has annual financing needs equivalent to about 2% of Mexico’s GDP, and Mexico’s yearly tax intake from the company is also equivalent to about 2% of GDP. Mexico is limited in its support for Pemex, and it needs its tax contributions, because it needs to keep its own finances in check in order to be fiscally responsible and meet promised targets. Pemex has large needs for investment – its oil production has been declining for 15 years and needs to be at least stabilised (requiring approximately $15 billion annually) – and for debt obligations.

In past times of financial stress, the solution has been a combination of some tax relief for Pemex and some liquidity injection. It was no different this time around.

On Feb. 15, it was finally unveiled that Pemex will have approximately $5.5 billion, including a recurring annual $0.75 billion tax relief and a $1.3 billion capital injection that was already budgeted. (The other line items are $1.8 billion in cashing out pension promissory notes, and $1.7 billion from hoped-for fuel theft recovery.)

While, in our view, Mexico can accommodate some fiscal deterioration – a small deterioration in its debt load will not necessarily bring its credit ratings down – losing all of Pemex’s tax revenue will likely push Mexico’s ratings down several notches and closer to junk.2

In the best case, capital expenditures will be large enough to increase oil production so that Pemex’s financing needs can be significantly reduced to a point of not requiring ongoing sovereign support. This is where we would like to arrive. But Mexico is not ready. In our view, the Feb. 15 announcement was bound to fall short of expectations, given Mexico’s commitment to fiscal responsibility. In this sense, the consensus view will likely continue to be that more funds are needed for Pemex to use for capex (capital expenditure) and debt service obligations.

Overall, the government offered some relief to Pemex while protecting its fiscal accounts. For now, this may be sufficient to postpone cash shortfalls, but there are debt maturities to finance and no long-term plan beyond this year was presented. This type of support buys time. It isn’t sustainable or structural because it does not solve the problem of severe underinvestment to turn around oil production. The space for further capitalisations is tighter. Credit rating actions pressure are likely to persist and time may run out. The need for a bolder solution such as a fiscal reform, which is not expected in the first three years (the half time) of the administration, will also persist. The good news has been the recurrent support the government also announced: they offered tax relief that will increase every year by $0.75 billion to $4.5 billion in six years.

Mexico’s Growth Problem

Of lesser urgency than the Pemex situation but no less important is that Mexico seems to have a growth problem, and it may get worse. It is an issue of the quality of growth. To the extent that growth going forward will be driven by consumption and public expenditure, Mexico will be moving towards a lower-quality of growth over the medium term.

Last year Mexico’s GDP growth was 2.1%, in line with the approximately 2% level of the past five years, driven by exports and private consumption. This year, Mexico is facing a different external and domestic economic environment, with slower growth in the U.S. – its main trading partner – and the mixed messages being delivered at home on issues such as the cancellation of a $13 billion airport construction project and a proposal to cut banking fees. The domestic issues, in particular, heighten policy risks and threaten a recovery in private investment.

This background brings downside risks to growth, as both exports and consumption may lose steam; we will be monitoring both carefully. On the upside, public expenditure will likely fill the gaps, especially looking ahead into next year.

New Presidency: Outlook Evolving but Constructive

Our economic outlook for Mexico will evolve alongside the shifting political landscape led by AMLO. Coupled with what we see as an adherence to fiscal discipline and sound economic fundamentals, we remain constructive on Mexico, maintaining overweight local currency bond positions in our portfolios. We are, at the same time, underweight hard currency bonds due to the pressure on credit ratings and rich valuations facing the sovereign Mexico and the quasi-sovereign Pemex credits.

AMLO and team are committed to supporting Pemex one way or another, while maintaining fiscal responsibility and delivering on campaign promises. The new government wants more equal opportunities, less corruption, and more security. Conciliating those objectives is a tough call. Campaign promises are episodic and will represent AMLO’s effort to deliver and to stamp his vision on the economy; nevertheless, they may be market-unfriendly, as evidenced by the airport construction cancellation, which soured market sentiment.

There will be additional risks independent of AMLO, no less from his own party in Congress, if the latest proposal to limit banking fees is any guide. (The Morena party introduced the bill late last year without consulting AMLO, who promptly opposed the banking legislation.)

This is a fundamentally different political and institutional environment for Mexico. Overall, while we are watching political risks carefully, we believe AMLO will be able to broadly achieve his campaign promises and drive Congress to his positions, given his popularity and the support for his domestic agenda.

Strong Fundamentals Supportive of Asset Prices

If we take a big picture perspective, we see that Mexico’s starting position of strong fundamentals is favourable, and relatively low debt levels allow for some fiscal deterioration to accommodate the new administration’s policy agenda. Even if Mexico may be moving towards lower-quality growth, we do not envisage a scenario in which its fiscal condition will deteriorate to the point that forces Mexico’s sovereign debt rating below investment grade.

Pemex is inevitably intertwined with Mexico’s finances and will be for years to come. In facing this understandably challenging situation for the need of substantial recurring support for the company, without hurting the budget and credit metrics, Mexico’s government must walk a tightrope.

While observing the policy environment, we believe the fiscal discipline espoused by the new AMLO administration, and economic fundamentals-driven policies implemented by Mexico’s highly-regarded central bank – including high real interest rates that may allow it to cut interest rates later this year – are supportive of asset prices in Mexico.

 
  1. ^Sovereign debt is a central government’s debt. It is debt issued by the national government in a foreign currency in order to finance the issuing country’s growth and development. The stability of the issuing government can be provided by the country’s sovereign credit ratings, which help investors weigh risks when assessing sovereign debt investments. Sovereign debt is also called government debt, public debt, and national debt. A sovereign credit rating is the credit rating of a country or sovereign entity. Sovereign credit ratings give investors insight into the level of risk associated with investing in a particular country, including its political risk. At the request of the country, a credit rating agency will evaluate the country’s economic and political environment to determine a representative credit rating. Obtaining a good sovereign credit rating is usually essential for developing countries in order to access funding in international bond markets. Mexico’s long-term foreign currency credit ratings as of 2/22/19 are: A3, Stable Outlook, Moody’s; BBB+, Stable Outlook, Standard & Poor’s; BBB+, Negative Outlook, Fitch. In the case of Pemex, in late January 2019, Fitch lowered its debt rating two notches to BBB- from BBB+, negative outlook. (In addition, for Pemex, Moody’s rating is Baa3 and S&P’s is BBB+, both with stable outlooks, unchanged for 10 months or more.)
  2. ^A junk bond is a fixed-income instrument that refers to a high-yield or non-investment-grade bond. Junk bonds carry a credit rating of BB, Ba, or lower, as assigned by a Nationally Recognized Statistical Rating Organization (“NRSRO”) such as S&P Global Ratings, Moody's, Fitch, etc.). Junk bonds are so called because of their higher default risk in relation to investment-grade bonds.