Falling oil prices and their potential impact on mexico’s economy

By Cristina Kennedy

Falling oil prices and its impact on the world economy is making headlines literally in every country in the world. Low oil prices are of a great concern to oil producing countries - the “haves” who potentially face balance of trade and budgetary issues - and the “have nots” countries who now are importing their fuels at a lower cost per barrel. Oil broke the $100 per barrel in 2014 and since then has dropped to lows not seen in years. OPEC has decided to keep the oil lowing versus restricting shipments.
Mexico is about to open up its market to foreign oil companies which will coincide with these very low prices. The implications for Mexico’s of a long period of low crude prices may have a much broader impact on both its economy and the changes that Pena Nieto has been able to implement. If these are just short term low prices for Mexico’s oil then they will be an unwelcome hiccup. However, a longer term disruption could have a major economic impact and affect Mexico’s national policies. Like a family, Mexico will have to borrow to make up the shortfall, raise new sources of revenues (read taxes), and or cut spending.
Families and businesses who consume diesel and or gasoline in vehicles or machinery as part of their employment or business have seen tangible impacts of these lower fuel related costs. There is a beneit that is accruing to the consumers of petroleum products. The reduced fuel outlays by families and companies will be used for other budgetary needs.
However, at the macro level for Mexico as a governmental entity there is a potential larger problem. Mexico can ride out a short term period of low oil prices. However, Mexico as well as the other oil exporting countries will face the same budgetary problems so familiar to family units as oil climbed over the past years.

Oil Prices Background

All the big oil producing countries have seen oil drop 57% since last June of ’14 (see table below). Oil has slipped on the spot markets to below $50 for Brent crude in January. The US just this year began to export its first domestically produced oil since the Energy Policy and Conservation Act effectively banned crude oil exports (except in certain cases). The oil fracking boom over the last few years has greatly increased the US’s domestic oil and gas production.
Historically oil irst broke the $100 per barrel in February 2011. It has more or less stayed at that level through the irst 6 months of 2014. Planning by all those countries, companies, industries and others had centered around that price – plus or minus. The oil producing countries and the rest of the world had gotten used to this level.
Stable oil prices generally means that revenues and costs for both the oil producing countries and the oil consuming countries have been igured and planned into their goods and services and related iscal planning (currency exchange rates, budgets, deicits, borrowing et. al.). Six months into 2014 oil began dropping slowly….at irst. To those companies in the oil business the dip in prices was not unusual….until it began falling at a faster rate. A combination of lower oil demand due to worldwide economy slowdown and new production coming from the US fracking teamed up to push prices lower. However, there was more bad news coming.

OPEC, Oil Politics and Supply / Demand

Historically the OPEC cartel (Organization of the Petroleum Exporting Countries) has defended oil pricing which is why the cartel was formed in the irst place - to artificially control pricing. Recently there have been other inluences to the world oil market that have impacted the key law of “supply and demand”. First of all (1) the weak global economy has used less oil. This lower use has come from virtually all areas of the world’s economies. As an example China which is the second largest oil consuming country (as well as the largest consumer of copper) has cut back on both due to its slowing economic growth. Second (2) The US’s oil and gas production has surged due to fracking. Fracking as a technology can be used to bring oil and gas wells on line much faster than drilling traditional wells which typically take 2 – 3 years. The wells brought on line by fracking can also be shut down much faster than traditional wells. Additionally at a certain price (taking into account capital investments required et.al.) gas can be substituted for oil (harder to gauge when prices continue to change). Third (3) Libyan oil output has surged due to the internal political situation calming down.
OPEC currently accounts for approximately 33% of global oil output. The 12 members in OPEC have basically one thing in common and that is oil. Saudi Arabia is Sunni and Iran is Shiite. They don’t like each other. Neither Saudi Arabia nor Iran care in the least what happens to Venezuela or Nigeria. The only common tread is to try and control prices. Saudi Arabia is the largest producer with about 30% of OPEC production. The Saudis carry the biggest stick in OPEC and they are the richest. The unoficial attitude by the Saudis and a few of the other members is if they reduce their low of oil to the world they will only lose market share. They also believe the lower volume would have no impact on the price. Why? The other oil suppliers both OPEC and non- aligned producers would step in to ill any reduction by OPEC.
OPEC is made up of both rich and poor countries. The Saudi’s are the richest and have large monetary reserves and pump the most oil. They are the defacto OPEC leader and have run both surpluses and deicits because they can afford it. Within the 12 OPEC countries there are rich and poor countries. They also have very little in common. The Saudis are rich while the Iranians have struggled with their economy due to the nuclear sanctions which impacted and disrupted their sales (of oil and other goods/services) due to problems European and Western banking restrictions.
Oil’s New Normal and its Inluence on Mexico’s Future Economic Picture Mexico’s oil production began in 1901 and by 1910 prospectors had identiied 2 oil ields near the Gulf of Mexico’s central town of Tuxpan. In 1911 Mexico began to export oil. In the early 1970’s a Mexican isherman discovered the largest Mexican oil ield ever (up to that time) and was the world’s 3rd largest. During the early 1970’s time period Mexican oil production surpassed the peak output of 190 million barrels which had last been achieved in the early 1920s.
During Mexico’s iscal year of 2013 oil supplied approximately $65 billion to the federal government (54% of total sales revenue and 119% of operating income). According to a study done by the Council on Foreign Relations by a group of authors (Levi, Mauler-Haug, and Oneil) “during the last 40 years PEMEX (Petróleos Mexicanos) has contributed hundreds of billions of dollars to Mexico’s treasury”. The following analysis is based on excerpts of that study.
The U.S. government’s policy makers have had their classic thinking upset. Up to this time their thinking was that high prices are an unfavorable impact to an economy and low prices of course are good news to a country’s economy. In Mexico’s case high oil prices is good for their economy. Mexico produces a surplus of oil. However, countries who are net importers of oil look for stable prices to plan their own economies. Stable oil prices generally means that revenues and costs for both the producing countries and consuming countries are priced into their goods and services that are consumed by those nations. Volatile oil prices are currently sending shock waves into all the world’s economies.
Oil producing nations like Mexico depend on price and production volume to fund governmental spending. Decreasing production must be made up from other areas such as higher taxes or other goods and services being sold / exported. Alternatively Mexico’s government might have to reduce spending in order to make up a revenue shortfall based on the lower price per barrel and the revenues that would have been destined for Mexico’s sources of funds to run their government.
Problems Facing Mexico If Oil Remains Low. There are a number of options that Mexico must choose from should oil prices remain low for an extended period of time. They are: (1) Increase Debt (2) Raise Revenues, and or (3) Cut Spending. These are serious policy steps that are facing Mexico’s treasury should oil remains in the $60 +/- range. In addition to these problems, Mexico is about ready to open up its oil industry to competition. It has been closed since 1938.

The Alternatives:

1. Increase Debt To Fund Mexico’s Treasury. To the extent that it is possible, increasing debt will be the most attractive response to a revenue shortfall, as borrowing allows the Mexican government to avoid painful domestic policy changes and to spread the costs of absorbing the price shock over time. Mexico maintains an investment-grade rating of BBB+ from Standard and Poor’s. In recent years, Mexico has consistently been able to borrow in a range of currencies at attractive rates. It also has a $72 billion credit line with the IMF that has been reviewed and renewed annually, and that it has never drawn on. Nonetheless, overconidence in the ability and willingness of the Mexican government to borrow could blind policymakers to signiicant risks that Mexico might be forced to raise revenues or cut spending in the face of an oil price shock. An overly rapid rise in debt could worry international investors and limit Mexican ability to quickly increase its debt burden.
2. Raise Revenues. The next option available to Mexico would be to raise revenues. During 2009, faced with a weak budget balance due in substantial part to low oil prices, Mexico approved reforms that pushed the value-added tax (VAT) from 15% to 16% Recognizing its low tax intake and signiicant dependence upon Pemex’s payments, the government of Mexican President Enrique Peña Nieto reformed Mexico’s tax code in 2013. The new rules removed VAT border subsidies—where the value added tax rate had been 11 percent—standardizing the rate nationwide at 16 percent. These increases are already incorporated in market expectations for the Mexican budget and would not be available to respond to an oil price decline. Mexico could, however, raise its tax rates further over time. Options include raising personal or corporate income tax rates, increasing the VAT and/or expanding it to cover items such as food and medicines (currently excluded), introducing an estate tax, or increasing property taxes (which are minimal)
3. Cut Spending. The last option available to the Mexican government is to cut spending. This is perhaps the most politically difficult of the three possibilities. Cuts to programs are unpopular even in the best of times. Additionally, since a large portion of Mexico’s expenses are essentially ixed (at least unless policy makers have several years to anticipate changes), cuts would fall disproportionally on a small set of programs.
Mexico’s public-sector expenditures totaled $319 billion in 2013, with $253 billion for “programmable” expenses— comprising ongoing administrative and program costs—that can in principle be adjusted, and $66 billion in “nonprogrammable” outlays—including interest payments, transfers to Mexico’s states, or debt payments—for which there is no lexibility. Out of the programmable funds, some $44 billion went to education (mostly salaries), $42 billion to social programs, $34 billion to health care, and $9 billion to the military and public security, with the remaining $124 billion disbursed among a variety of other categories. Over the past seven years, the fraction allocated to the various categories has remained relatively stable.

Mexico’s Energy Oil Reform

In December 2013, the Mexican Congress passed a historic reform to end Pemex’s longstanding monopoly, opening up the country’s energy sector to private investment (both foreign and domestic) in exploration and development, as well as in reining, transport, storage, and distribution of oil, petroleum products, and natural gas. How might this affect the analysis here? Pemex will evolve from a state-owned enterprise to a “state-productive enterprise,” setting it up to compete with national and international energy companies in Mexico and potentially worldwide. In 2013, the Mexican government took 99 cents of every one of Pemex’s pretax dollars, essentially pouring all its earnings back into the Mexican Treasury.

Potential Economic Impacts for the United States

The scenarios that both the U.S. and Mexico are looking at including worst- case scenarios could have detrimental impacts for the United States. These scenarios plus a slow Mexican economy and a weak U.S. response could cause major problems. Trade with Mexico is large and important to the U.S.. A Mexican recession there may not impact aggregate GDP as much as it could but it certainly would hurt individual industries and their U.S. companies, workers, and their cities / communities. Exports to Mexico were $256 billion in 2013. Estimates for the number of U.S. jobs that depend on exports to Mexico range from 1 million to 6 million. A significant reduction in demand from Mexican households and businesses for American products would be especially damaging to the machinery, electrical machinery, vehicles, plastics, and agricultural products industries, each of which had exports to Mexico valued at over $15 billion in 2013. Reduced sales in Mexico could lead to layoffs of American workers and have a negative multiplier effect on their communities. An economic downturn in Mexico could also spur immigration to the United States. There are many factors behind the movement of people, but one is economic, including the differences in wages and opportunities. In the wake of Mexico’s past economic crises, there were large influxes, particularly of undocumented immigrants crossing the U.S. southern border. In the scenarios studied here, this could be compounded by constraints on the Mexican government’s ability to spend on social services, or by iscal pressure to hike taxes that might perversely weaken the Mexican economy in the short term. Large issuances of debt could also crowd out inancing for Mexican businesses, with broader economic consequences.

Summary

The drop in oil prices has caught most of the world by surprise. Similar to the surprising oil embargos of the 1970’s that brought in a new era of suddenly increasing prices for crude oil and their derivative products. There was generally a large jump in all the products that were crude oil based. Governments, businesses and consumers had to pay more for all those products. During those days of the 1970’s how did they pay for the higher prices of products? Some were forced to borrow the money (increase debt), and at the same time try and raise revenues from the purchasers of their goods and services. Many had to cut spending in other areas to pay for the increased costs.