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    MARKET EDGES

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In a November 11th 2008 note entitled, “Mexican Short Thesis: Oil Production”, we laid out the core tenet of our short thesis, which was based on declining national oil production in Mexico. We stated that:

“To this day, PEMEX owns and operates all of Mexican oil production and is a 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.”

Since then, the iShares Mexico etf, EWW, is down ~14.7% and Mexican Peso Currency Shares etf, FXM, is down 10.8%.

While the oil issue outlined above continues to be a core component of our thesis, a lunch we had yesterday with a Yale professor who in a former life was a Chief of Staff at the State Department and is a close confidante with the likes of Henry Kissinger, highlighted another key risk. We asked him what was the singles largest sleeper in terms of potential geo-political risk and his unequivocal answer was Mexico, due to the burgeoning power of the regional drug lords.

With a domestic economy that is under serious duress and a governmental income statement that is declining dramatically y-o-y, as outlined in the chart below, due to downward trending oil prices and domestic production, the drug lords have only been empowered.

In aggregate since December 2006, it is estimated that over 40,000 troops have been deployed against Mexican drug cartels. Over that time period, it is also estimated that there have been more than 8,000 fatalities associated with the drug war. News reports from south of the border over the last week suggest that the battle between Mexican drug lords and the government is turning into a veritable civil war.

In the past week, there has been a wave of street demonstrations and border crossing obstructions to protest the involvement of the military. These protests have shut down border crossings in Reynosa, Nuevo Laredo, Maramoros and Ciudad Juarez. They have also shut down part of the industrial hub Monterey.

According to the New York Times:

“Without providing evidence, the Mexican authorities say they see the hidden hand of traffickers in the splashy events, which have included men, women and children, some of whom cover their faces as they wave placards and denounce President Felipe Calderón’s decision to deploy more than 40,000 soldiers to combat a booming drug trade.”

These protests along with more brazen attacks on police and army officials highlight the growing power of these drug lords, which coincides with the declining economic power of the Mexican government due to its dependence on oil.

The emergence of a full blown civil war in Mexico is a risk that is moving from the tail into the normal distribution with every passing day.


Daryl G. Jones
Managing Director