Latin America: Oil drop prompts Mexico review

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Growth rates revised downwards; investors still ‘cautiously’ optimistic.


by Rob Dwyer

Investors and economists have been downgrading their previously optimistic view of Mexico’s potential long-term economic growth. In late 2013, when the country’s energy reforms were being unveiled, investment banks such as Barclays projected 1.5 percentage points of added long-term growth from the energy reforms alone, and after also factoring in the expected impact of other structural reforms and an anticipated boost to domestic consumption, the bank projected GDP growth at between 5% and 6% by 2018.

However, falls in oil prices, growing political and security concerns and frustration at the low economic expansion since these forecasts has led to more sober projections – of both GDP growth and expected financial markets activity.

"The average growth of the Mexican economy in the past 20 years has been 2.6%, and this year we will grow very close to that," says Gabriel Lozano, chief Mexico economist at JPMorgan, who recently downgraded the bank’s GDP growth forecast for 2015 from 2.8% to 2.7%. 

"We are finding fresh evidence that maybe the long-term growth trend isn’t 3% or 3.5% but is actually closer to 2.5%. Maybe we have been mistaken in thinking that potential growth is higher than it actually is – potential growth is most probably lower than most people are expecting, and expectations need to be revised down given oil prices, oil production and the tricky external macroeconomic environment.​"

Oil knock

The Mexican government reported that the fall in oil prices knocked 0.4 percentage points off growth in 2014 and there will be a negative impact in 2015. It is also complicating the liberalization of the country’s oil reserves, as much of these reserves are pre-salt, deep fields, which are uneconomic to produce at today’s lower oil prices. 

The government is likely to defer the auction of shale and non-conventional projects until 2016 and will prioritize the auctions of shallow water reserves that should still hold plenty of interest for the private sector.

On February 27 the government invited bids for nine shallow water areas in the Gulf of Mexico, part of the so-called Round 1 of energy reforms. This is the first time since 1938 that private companies will be allowed to exploit hydrocarbon reserves in Mexico.

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Bank of America Merrill Lynch predicts strong bidding. "Companies remain interested in all areas [despite the 50% drop in oil prices since 2014] given the cheap oil that can be found in Mexico. Years of underinvestment and under-exploitation by Pemex left many opportunities that are now available for the private sector," it says in a research report.

Carlos Capistrán, Bank of America Merrill Lynch´s chief economist for Mexico, says the bank has recently downgraded its growth forecast. "We expect GDP growth to be 2.8% in 2015 and 3.2% in 2016. We downgraded our expectations a few weeks back to reflect lower oil prices, lower oil production and the resulting tightening of fiscal policy. However, both forecasts are above Mexico’s average GDP growth rate [2.7% in the last 20 years], as non-oil exports, investment and consumption continue recovering."

Capistrán says the oil price is weakening but not eliminating the country’s positive growth momentum. "Despite lower oil prices taking some of the shine off the energy reform, we remain constructive because investments in deep waters consider long investment horizons; and there are plenty of fields in Mexico with breakeven prices below current oil prices."

He adds that firms may move away from production in high-cost areas in other countries and into low-cost production areas in Mexico. "We expect $10 billion dollars per year in extra FDI from the energy reform, with resources flowing from the end of 2015 onwards. The transformational energy reform will increase Mexico’s potential growth, but this process will take years."

Production fall

Greater investment is badly needed as production from existing fields stalls: in 2015 oil production was 5% below its target of 2.5mbpd, compounding the negative impact of lower oil prices. However, the oil prices were the not the only cause of disappointing growth.

"We are still not seeing traction in terms of the sources of growth, and this is the key issue for this year. This has a lot to do with the confidence with all the economic actors, in terms of low consumption and investment – not only from the government side but also from the private sector," says JPMorgan’s Lozano.

"The economy is still seeing a negative impact from last year’s fiscal reform, which is very frustrating and something we haven’t seen in the past. The new transparency regulations for the public sector is good in one sense, but it has slowed down expenditures and it is a causing the economy to be more sluggish than it otherwise might have been."

Bankers continue to report that investors are optimistic about the future of Mexico’s economy but frequently temper that assertion with the use of "cautiously". 

Appetite for Mexican equities and fixed income remains high – not least because of lack of other supply from the region. The four-times oversubscribed $6 billion bond for Pemex earlier this year and the appetite for the sovereign’s $1.5 billion and €2.5 billion deals are testament to the continued demand for Mexican debt from international investors.