Mexican Short Thesis: Oil Production

We re-shorted the Mexican etf (EWW) yesterday in the Hedgeye portfolio. While Keith has been trading around the EWW versus some of our long positions, there are a number of key long term trends that make us negative on Mexico. A primary trend is that of Mexican oil production.

Mexico is the sixth largest producer of oil in the world and the tenth largest in terms of net export as of 2007. On March 18, 1938, citing article 27 of the 1917 constitution, President Cardenas embarked on state-expropriation of all oil resources and facilities, nationalizing the U.S. and Anglo-Dutch operating companies, creating Petróleos Mexicanos, or PEMEX.

To this day, PEMEX owns and operates all of Mexican oil production and is meaningful contributor to the Mexican economy. In 2007, Mexican oil exports contributed 10% of Mexican export revenue. PEMEX pays out over 60% of its revenue to the Mexican state in the way of royalties and taxes. In aggregate, PEMEX contributes almost 40% of the federal government’s budget. Despite record oil prices over the last few years, the Company has a substantial debt balance estimated at over $42.5BN as the vast majority of profits have gone to the government rather than to pay down debt, let alone investing in the business.

The Mexican government’s dependence on revenue from Pemex is a major issue for two reasons. First, oil is a commodity and as we have seen over the last five months the price of any commodity can change quickly. While the inherent long term value of Pemex’s reserve base does not change, the royalties and taxies paid to the government can be very volatile. Second, and more importantly, is that Pemex crude oil production has been in decline since 2004 and is down 10% ytd.

The issue of Pemex’s production issues first gained international notice in 2005 when an unknown PEMEX employee suggested on an oil news website that both the country and company were at Hubbert’s peak (a term named after M. King Hubbert and used to signal a peak in a region’s oil production). According to Hubbert, the oil under the ground in any region is finite and the rate of discovery which initially increases will eventually reach a maximum and decline. While we don’t have concrete evidence that Mexico has reached a peak, the chart of Mexican production outlined below points to a trend that is worrisome as production has decreased consistently for the last 5 years.

On October 22nd 2008, the Mexican Senate approved legislation that would free Pemex from many government controls and allow the company more flexibility in the way it signs contracts. The idea is that this legislation will make Pemex more agile in its pursuit of new reserves. Many experts suggest that Pemex’s best opportunities are in the deep water Gulf of Mexico. To date, Pemex has not had the technology to adequately explore these opportunities. The new bill would allow Pemex to pay cash incentives to contractors for finding oil or using a new technology. Critics of the bill suggest that cash incentives are not enough and that future partners need to be offered a percentage of reserves.

If this new legislation does not stimulate investment and if this investment does not stimulate increased production, the Mexican state budget is likely facing a major shortfall in the coming years particularly if oil stays at relatively depressed prices.

Daryl G. Jones
Managing Director

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