Marco Oviedo
Director of Research
Barclays
/
View from the Top

State of the Post-Reform Mexican Economy

Mon, 09/01/2014 - 12:32

Q: What do you believe will be the short to medium-term economic impact of the Energy Reform approval?

A: In the short run, it reduces pressure on Mexico in a very complicated macroeconomic context. The US Federal Reserve is in the process of reducing monetary stimulus and that has put some pressure on the economies of emerging markets, including Mexico. However, investors are differentiating between emerging markets with solid fundamentals and those that have imbalances. The Energy Reform provided a better outlook for growth, which, in the short-term, implies that investors are comfortable with their position in Mexico. This has been reflected in the exchange rate. Since 2013, most of the emerging market currencies have depreciated in an important manner but the Mexican peso has remained relatively strong. That provides certainty to the private sector and will eventually have an impact on future investment. In the medium-term, we need to see the secondary laws to accurately estimate the impact of the Energy Reform. Barclays estimates that the Energy Reform could add as much as 1.5 percentage points to Mexico’s GDP growth on average between 2016 until 2030. The economy is expected to grow at around 3% but this could increase to 4.5-5% in the coming years. That is a positive framework for a bank like Barclays, since its business in Mexico would take on a very good outlook.

Q: Within this new framework, what are the main legal and economic factors that will determine the reliability necessary to attract foreign investment?

A: In the definition of the secondary laws, the government needs to clearly establish which government office or agent will be responsible of managing new licenses and contracts to be awarded following the Energy Reform. If we begin this new era by having several government offices like SHCP and SENER, as well as the regulatory agencies such as CNH and CRE, involved in the same processes, it will not be clear who is in charge and who can decide how to proceed in certain special cases. The government also needs to clearly define the fiscal treatment for these concessions and licenses, while assuring companies that the established fiscal framework will not change in the short-term. Foreign companies need to be given the certainty of a medium-term outlook, as well as a clear definition of the domestic content requirements for investments. There have to be good incentives in terms of domestic requirements for these foreign companies to come to Mexico to operate. Congress should be debating about how much domestic content these investments should have. If that amount is too high, it could reduce the incentives for firms to come to Mexico. Getting this balance between domestic content and foreign investment right would also help to have a higher impact on the country’s growth.

Q: What will be the respective roles of foreign and national investment in the development of the Mexican oil and gas industry?

A: Both foreign and national investment have a very important role to play. The best thing about the Energy Reform is that everybody wins, since there are elements up for grabs for each player. There is already noise in the media that mining companies are interested in shale gas projects, important operators such as Shell and ExxonMobil will start working on deepwater projects, and other companies are interested in the distribution of energy products. There is room for everybody, which means that both domestic and foreign investment will be very important for the growth of the industry. The foreigners may have better know-how in some of the more challenging areas, but we will see how the post-Energy Reform industry unfolds.

According to PEMEX, the potential for investment in the sector is triple what it has been investing. But setting the objective of doubling that amount seems reasonable. Even a 50% increase would mark an important development. The probability of seeing an acceleration of investment in the sector is very high, while the probability of the secondary laws messing up the general spirit of the Constitutional changes included in the Energy Reform is very low. It is reasonable to think that, with investment currently hovering around US$25 billion per year, it could pick up to US$35 billion or US$40 billion within seven years.

Q: How will the country’s fiscal burden be redistributed among the different operators that will now be active in Mexico?

A: This Energy Reform is the best type of fiscal reform. In the end, the government is going to increase its revenue from all operators while reducing the burden on PEMEX. The government is probably going to see a small decrease in revenue in the short run, but when production from new operators starts materializing, federal revenue will accelerate. It is also a good sign that the government is thinking of collecting all the excess revenues into a fund, which could have important resources amounting to 5% or 6% of GDP within a decade. I think that the fiscal position of the country is going to improve, even if the dependence on oil revenues grows.

Q: What will be the most important fiscal mechanisms needed to achieve this diversification process?

A: International practices should be applied here as well. The government should not try to reinvent the wheel, so I think there will be a royalty base and then profit-sharing or production-sharing, whatever the contract mandates, for the government to extract the full rent. This will be added to the income taxes collected by the government. The Mexican government could have a similar taxing system as that seen in the US. Mexico does not want to give a bad signal by either lowering taxes or by charging more, it wants to be at the same level as other players.

Q: How can the participation of Mexican SMEs be optimized and promoted in an open oil and gas market, where international firms come and compete?

A: Firstly, SMEs are going to benefit from lower energy costs. Secondly, they will benefit from larger firms providing inputs to the smaller companies so they can improve. Having said that, I do not see SMEs being involved on the operation side, this will be reserved for larger than average companies that can find enough investment to build pipelines and operate fields. I do not see smaller companies providing shale oil and gas services, unless they are specialized in fracking and drilling.

Q: What are the most pressing questions that need to be answered in the secondary laws?

A: The first is defining the concept of licences. The government has made an effort to establish that licences are neither concessions nor contracts. They have to define exactly what the licence concept is, how it will operate, and what it implies. This becomes particularly relevant as Congress is also considering an initiative to reform and open up the railway system in Mexico. This would likely imply the removal of certain concessions granted in the 1990s. Doing this might send the wrong signal to private companies, showing that the government can take those kinds of contracts away when it so desires. It might show that the concept of licences is weaker than concessions. The government needs to be very careful in answering the following question. What is the medium and long- term legal certainty that investors are going to have in these new contracting models, particularly in an already risky sector? The other pressing matter is to analyze the timeframe for the first licensing round. This will allow companies to assess when the first foreign investment will enter the country, and the potential participation of domestic firms.

Q: What is the economic potential of this Energy Reform for Mexico?

A: My estimation is that investment will grow around 50%, with most of this coming from the private side. That is a huge increase as it involves around 1 percentage point of GDP in new investment that will probably need funding, technical advice, and support. If Mexico starts growing above 5% between 2018 and 2030, it will definitely become one of the major economies in the world. This is good timing, as by then, it will benefit from the younger population that will be peaking in 2020. People will be more productive during the climactic moments of the country, increasing the potential output at faster rates. This is why I think this Energy Reform could not be delayed any further, and why we will see strong rates of growth if its implementation is successful. But implementation remains a major challenge. Congress is dealing with too many laws to be reformed so something is bound to go wrong. One optimistic aspect is that the government has removed constraints within the Constitution, which allows it to make additional modifications down the road without needing a majority.

Q: What sort of knock-on effect do you expect the energy industry to have on other industries or sectors of the economy?

A: That is already happening. We have seen many companies that have announced an interest in investing more money in Mexico, in food and beverage or automotive among others. The foreign direct investment results for 2013 are already encouraging: it amounted for US$35 billion, from which US$13 billion was related to Grupo Modelo. Even taking the Grupo Modelo operation away, US$22 billion is a figure that we have not seen since 2005 or 2006. We will probably see levels of US$25-27 billion in the coming years because of the spillover in the economy, and not only because of the energy sector. If that happens, we will probably soon see levels of FDI to match Brazil, around US$40 billion.