NGI Mexico GPI
Editor’s Note: NGI’s Mexico Gas Price Index, a leader tracking Mexico natural gas market reform, is offering the following question-and-answer (Q&A) column as part of a regular interview series with experts in the Mexican natural gas market.
This 28th Q&A in the series is with John D. Padilla, Managing Director and partner at IPD Latin America, and one of the premier experts on the politics and policy of Mexico’s energy industry. Padilla joined IPD in 2001 and led the consultancy’s expansion into Mexico, where among other things he has played a vital role in the development of lobbying efforts to encourage a healthy, more vigorous Mexican energy sector.
Padilla co-heads IPD’s business throughout Latin America, contributing a strong pragmatism and tactical expertise to support project risk and opportunity assessment. He has devised comprehensive government relations, key stakeholder management, and legislative and regulatory analysis services to enhance clients’ ability to navigate Latin America’s complex business environments.
Prior to joining IPD, John was Vice President and a Global Relationship Manager with Dresdner Kleinwort Benson in its N.Y. based Energy, Utility and Infrastructure Group from 1994-2000, focusing on large domestic and international projects in Latin America, the U.S. and Asia.
Padilla holds a B.S. in Finance from Boston College.
NGI: Could you explain the Mexico oil hedge as it relates to the OPEC plus supply cut?
Padilla: Mexico has two hedges related to oil. One is a hedge that Pemex puts in place, which was 234,000 barrels per day for 2020. The other is the hedge the Finance Ministry puts in place, which we don’t know the volumes, but historically it’s been in the range of 500,000 to 900,000 barrels per day.
There’s been a lot said this week about how the hedge relates to OPEC and that Mexico is more protected. Yes, there’s a certain level of protection that Mexico has by having the hedge, but it’s not this magic silver bullet that a lot of government officials, as well as bankers, have suggested. The Finance Ministry hedge is partially protected by the stabilization fund, which was depleted about 46% last year, and it will absolutely be fully depleted this year one way or another, without question. Further depletion this year may occur from cash injections to Pemex that will be required. Government funds are fungible but to say that the stabilization fund will fully cover the rest of its hedge is debatable and unknown.
As it relates to OPEC, to say “Mexico couldn’t cut production because they have this hedge” is pure nonsense. If Pemex is producing just under 1.7 million b/d, it has far in excess of the 400,000 b/d that are not covered based on the numbers noted above, and represents the amount that it was originally supposed to cut at the April 9 OPEC+ virtual meeting. The two hedges Mexico has certainly give it a level of protection, though not as much protection as Mexico would like people to believe. A good portion of that hedge this year was actually tied to Brent crude and not the Mexican oil basket price, which was done in part because the hedge has gotten more and more expensive every year. The rising cost of the hedge relative to how much production is covered is why Mexico has become more secretive about it.
The fact that a good portion of the hedge this year is tied to Brent is problematic because as you have an increasing price differential between Brent and the Mexican oil basket price, Mexico loses that differential. As a result, Mexico’s hedge has value, but it won’t be at the $49 per barrel that has been widely touted, and it certainly doesn’t cover its entire production.
NGI: With coronavirus and the oil prices falling so much, what would you say is the worst possible scenario for the Mexican energy industry, Pemex and the national economy?
Padilla: I think you have to look at this in two parts: external and internal market factors. Much of the current situation is being dictated by the external, specifically the supply and demand shocks that are plaguing the global marketplace.
I think the worst possible outcome on the external side is that we rapidly run out of storage capacity. As we run out of storage capacity, prices will collapse further. There is just too much oil supply available today. We’ve already seen evidence of negative prices, at least in one market, which is Wyoming. There are now rumors that certain big global traders are paying indemnities to some of their customers as they have no place to put crude. If you run out of storage capacity, there’s no place to put production, period. That’s really the worst-case scenario.
Internally, I think the worst outcome is that there’s no real meaningful strategy put in place for Pemex. We’ve already seen meaningful cuts in capital expenditures from NOC peers such as Ecopetrol and Petrobras, and private sector companies across the board, along with buyback programs halted and other cost cutting strategies implemented. Pemex has basically only called for more austerity at this point, but that’s not much of a solution. Announced lower taxes (DUC being further reduced from 58% to 54%) will marginally help reduce the massive losses Pemex will incur in 2020 but is not game changing.
The big overhang that you have with Pemex is its incredibly high fixed costs, which remain irrespective of what you produce and whether its lifting costs are below current prices or not. People always try to use the same industry metrics when discussing Pemex and, quite frankly, they don’t apply. When you have such a high royalty burden (it’s really not a tax burden), and interest expenses on $105 billion in debt, as well as major pension liabilities that keep growing, you have to continue to feed the machine, regardless if your production is 3.5 million or 1 million barrels per day.
I think those are the worst outcomes, which is really Pemex proceeding without a strategic game plan and continuing to move forward on economically nonviable projects such as the Dos Bocas refinery.
NGI: What would be the best possible outcome for the Mexican energy industry as a result of the current chaos we’re seeing in national and international markets?
Padilla: In Mexico, a lot of people continue talking about moving back to bid rounds, and farm downs. The sector is in the middle of a firestorm and bleeding badly. Executive management and boards are not really thinking about new bid rounds and farm downs right now. The focus needs to be on taking care of what you already have in place.
So, from an internal perspective, the best outcome would be that you have a government that starts to meaningfully embrace existing private sector activities that are already being undertaken. Mexico has a lot of contracts that are contractually locked in with required investment that must be fulfilled. The best thing that you could do would be to try to meaningfully incentivize that activity to the extent possible.
If Mexico does not do so, you will have companies looking to further minimize their investments in the country over the next couple of years to the greatest extent possible, which is already happening. Deep-water project investments are particularly vulnerable at current price levels.
Mexico has a captive audience it is neglecting. In an environment where you have an even more devastating economic recession in sight, logic would dictate that Mexico look to incentivize all the economic activity it can. Ideology has to take a back seat. This would be an opportunity lost by not pursuing such a strategy.
The other component of a best-case scenario, with regards to exploration and production, would be that the government assumes a big chunk of Pemex’s debt and/or pension liabilities. The market has already priced that reality in, and Pemex is no longer in a position to issue debt without government support. With spreads over US Treasuries on their 10-year notes over 1,000 bps, this becomes a non-starter. There is certainly the question of whether a government should pay down debt or stimulate economic activity, but Mexico won’t have enough money to do both in 2020 unless it changes its position on taking on more debt and incentivizing economic activity. The failure to do both will have enormous consequences.
On the natural gas front, the government should be doing everything in its power to ensure pipelines still under construction are brought online. With natural gas prices so low right now, your cheapest alternative that lessens the economic burden on all end users, as well as potentially helps stimulate some level of economic activity, is to allow as much U.S. gas as you can into the system.
In the external market, the best outcome is some type of agreement to address both the colossal crude oil oversupply and storage issues being witnessed, whether this comes from an OPEC-led, G20 supported agreement, or some other mechanism. Although suppliers are desperate for a deal, the bigger problem will be adherence to quotas over time. OPEC members have a long history of breaking quota compliance. And with plans to extend reductions through April 2022, many oil revenue dependent countries will find it impossible to not cheat and increase production over time. But some type of agreement or change in model that the market finds credible represents the best external outcome.
NGI: A lot of people expect a ratings downgrade for Mexico, Pemex and CFE. Do you think Mexico will soon be downgraded, and if so, when?
Padilla: We have already played witness to S&P’s recent downgrade of the sovereign, Pemex and CFE on March 26 from BBB+ to BBB with negative outlooks on these ratings. Importantly, they also reduced the stand-alone credit rating on Pemex to CCC+, a clear reflection of the company’s questionable ongoing viability without major government support. Pemex’s only real way of shoring up its cash flow and balance sheet on its own would be to sell off assets, which is a non-starter with the current administration. Pemex can slash all the costs it wants at this point, and it’s still not in a position to make money.
Eight days following the S&P downgrades, Fitch further downgraded Pemex on April 3, taking its already junk rating of BB+ down to BB, maintaining its negative outlook on the credit. And then on April 15, it lowered its rating on the Mexican sovereign rating from BBB to BBB-, with a stable outlook. The impact on the cost of capital will be felt by both the government and the private sector, alike.
Now all eyes are really on Moody’s. As it currently rates Pemex at Baa3, a downgrade of Pemex would result in the second junk rating of the company, which would limit the universe of investors that could hold and buy Pemex debt. A downgrade of the sovereign, based on the methodology Moody’s employs, will have the same result. To answer the question about how soon or how fast those downgrades might come, I would just say it is imminent.
Moody’s has said publicly that it would wait a full year before it reviewed its rating again, which based on its last rating action would place a rating announcement at the end of June. But when you see the kind of spreads on Pemex and sovereign bonds that you’re seeing right now, for their own credibility, Moody’s has to make a move and soon. The A3 rating Moody’s has on the sovereign is impossible to support based on comps. The Fitch downgrading to BBB- will only place more pressure on the situation.
The market knows the Moody’s downgrade is coming and anticipates it. You can see this in bond prices and to some extent, the value of the Mexican peso.
NGI: In the last couple of weeks, we’ve seen so many oil and natural gas producers cutting Capital expenditures (capex), how do you think that will impact exploration and production activity in Mexico?
Padilla: If Mexico continues to prioritize Pemex, the negative impact will be greater all around. If you’re giving operators no reason to do more than they have to right now, why would they?
As I previously said, in the current environment, we can expect companies to reduce as much capex spend as they can. The companies that are producing will have to decide if it still makes sense to continue at current prices, taking into consideration what technical risks they run by potentially shutting in production. This is always an issue for conventional production. It is not as simple as turning on and turning off a valve.
Private sector investment is largely governed by contractual obligations. But investment decisions could be heavily influenced based on what the message is from the government.
NGI: If you’re in Mexico’s shoes right now, would you import as much natural gas as possible from the U.S. right now while the prices are so low?
Padilla: A priority should be to build a lot of natural gas storage. That would be the thing to do. It would be wiser and economically sound than building a refinery. Mexico should do everything that it can to get as much cheap U.S. natural gas as it can possibly get its hands on right now.
NGI: What is the most urgent need for both the Mexican energy industry, as well as natural gas industry?
Padilla: For the natural gas industry, I think there are several. For starters, as I mentioned, it is vital to add storage and improve infrastructure in general. Transparency and an even playing field are two other vital items.
Now that Mexico has private sector operators and has a more robust and dynamic market (despite current efforts to roll that back), more infrastructure is needed, period. Mexico lacks significant infrastructure across the energy market. In the natural gas sector, we still have several natural gas pipelines not online or without the logical connections in place to serve all available markets, and a complete lack of dedicated storage facilities.
Infrastructure could create jobs, provide access to cheap sources of supply sitting at its doorstep, and help stimulate economic activity. What’s not to like?
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