Energy Reforms Good for Mexico, even if not for Peso Immediately

The reforms proposed by Mexico's President Pena yesterday have the potential to be a game-changer, even if the peso does not immediately benefit. Indeed the US dollar is extending yesterday's gains against the peso, with last week's high near MXN12.75 coming into view.

Reform of Mexico's energy sector has been one of the promises of the Pena government. However, he is not the first Mexican president to try. Past attempts by Zedillo, Fox and Calderon were rebuffed. The constellation of political considerations seem to favor the Pena now. Although Pena's plan differs from the one the center-right PAN had proposed recently, the initial response from PAN officials indicate they are likely to support the government.

PAN has made good on its pledge to offer constructive opposition to the government, which means in practice, working with it. The agreement Pena hammered out last December (Pact for Mexico)has already changed the political climate. Already with PAN support a number of reforms have already been passed, including education bills, telecom reform, increasing efficiency of tax collection and transparency in spending.

Energy reform is the government's largest reform to date. Here is the problem. Since 1938 the Mexican government has had a monopoly on the energy sector. Despite a dramatic increase in spending by PEMEX, the nation's oil company (to $20 bln a year from $4 bln a decade ago), there has been on persistent decline in output from 3.4 mln barrels a day to about 2.5 mln BPD.   The US Department of Energy projects Mexico could become a net importer by 2020. 

The key element of Pena's plan is that it treads a middle path.  It does move to break the PEMEX monopoly, against what the populist left advocates, but it does not grant concessions, like the global oil companies would like.  Instead, Pena's plan calls for profit and risk sharing contracts.  Oil companies would be paid in cash for their services, not given oil or ownership of some fields, as is the case in other countries.  

Pena's plan does require changing a couple of articles of the Constitution and this is also controversial.  A recent poll found nearly 2/3 of Mexicans are opposed to altering the constitution.  The opposition to the Pena's reforms are likely to come from a seemingly unlikely alliance between the populist left and nationalists.  

At the same time, reform of PEMEX may have serious knock-on effects on fiscal policy.  Currently, taxes on PEMEX fund about a third of the government's budget.    The breaking up of PEMEX into two entities and profit-sharing agreements will likely require Mexico to explore other revenue streams.  Diversifying its tax base is also part of the structural reforms that often been advocated. 

Although the full details of Pena's plan is being scrutinized, the initial response by the IMF and a number of oil companies seems supportive.   The rating agencies are likely to be a bit cautious, perhaps even waiting for more indications that the bill will pass the divided congress and that the secondary laws (regarding implementation) are also moving forward.  S&P is the most likely to upgrade Mexico's credit rating.   Its current rating of BBB is one notch below Moody and Fitch, and it adopted a positive outlook in March. 

The market has been anticipating the energy reforms in recent weeks.  The Commitment of Traders from the CFTC showed a doubled of gross long peso futures position in recent weeks (from 31k contracts at the end of June to 62k contracts on Aug 6).  The dollar's downtrend drawn off the early July highs comes in near MXN12.77 today and a convincing break of it may signal a move back toward MXN12.90. 

Over the longer-term, we continue to like Mexico's macro story and recognize the peso remains among the most under-valued OECD currencies.  It unit labor costs are lower than China.   If the energy reforms are implemented, it will boost Mexico's growth (1-2% a year) and is part of  the North American energy and manufacturing story.