Latin America's commodities downturn problem

The Oilholic finds himself roughly 5,300 miles west of London in Bogota, Colombia wandering around the city’s rustic and charming La Candelaria area. 

It’s the beginning of a journey through South America to find out how the recent commodities downturn is affecting the market mood and investment outlook in what (still) remains a very commodity-exports driven continent. 

One gets a sense of opportunities missed and dismay from those who saw the downturn coming – not just here in Colombia, but looking outside in at Chile, Argentina, Peru and of course that colossal corruption scandal at Petrobas in Brazil. While the sun was shining, and China’s double digit economic growth was fuelling the commodities boom, attempts should have been made at macroeconomic diversification instead of relying on a party that was bound to end sooner or later.

We’re not just talking oil and gas here; take in everything from minerals to soya beans, or copper specifically in the case of Chile. Most Latin American currencies got marginal power boosters during the commodities boom, if not a case of full blown Dutch disease, which resulted in lacklustre performance from non-commodities sectors that became increasingly uncompetitive and to an extent unproductive over the last 10 years.

The International Monetary Fund reckons come the end of 2015, if headline regional growth touches 1% we’d be lucky. In fact, in its latest update the IMF confirmed that Latin America would see its fifth successive year of economic output deceleration. While past commodity busts have triggered regional financial crises, thankfully not many locally as well as internationally, including the IMF, expect a repeat this time around. That’s largely down to the fact LatAm economies, with notable exception of Venezuela, have not indulged in fiscal populism and daft economic policies.

In sync, ratings agencies, while negative on the economic outlook of many countries in the region, but only fear a sovereign default in Venezuela. However, another negative aspect of dependency on the commodities market is that investment – especially on terms prior to the market correction – would be hard to come by.

Just ask Mexico! As the Oilholic noted in a recent column for Forbes, phase I of round one of Mexico’s oil and gas licensing was a damp squib. Hence, with the September 2015 (phase II) bidding round, the Mexicans had to adjust their thinking to attract (and eventually) secure a decent take-up of available blocks.

Peru’s nascent oil and gas market, Colombia’s emerging and hitherto impressive one face similar challenges as will the copper market in Chile. Argentina faces a general election on October 25th while Brazil is in a technical recession with the IMF seeing few improvement prospects for 2016.

Productivity, in all five countries is down with workers spending hours in a day commuting, and traffic jams (the first of which the Oilholic has already experienced) are legendary enough to give Bangkok and Delhi a run for their money. 

Over the coming weeks yours truly will make sense of it all talking to experts, policymakers, fellow analysts and local folks one is likely to meet and greet while having the odd touristy mumble about. That’s all for the moment folks! Keep reading, keep it ‘crude’!

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© Gaurav Sharma 2015. La Candelaria, Bogota, Colombia © Gaurav Sharma, October, 2015

Oil prices, OPEC shenanigans & the North Sea

It has been a crude fortnight of ups and downs for oil futures benchmarks. Essentially, supply-side fundamentals have not materially altered. There’s still around 1.3 million barrels per day (bpd) of crude oil hitting the markets in excess of what’s required.

Barrels put in storage are at an all time high, thanks either to those forced to store or those playing contango. US inventories also remain at a record high levels. 

However, the biggest story in the oil market, as well as the wider commodities market, is the strength of the US dollar. All things being equal, the dollar’s strength is currently keeping both Brent and WTI front month futures contracts at cyclical lows. The past five trading days saw quite a few spikes and dives but Friday’s close came in broadly near to the previous week’s close (see graph on the left, click to enlarge).

In the Oilholic’s opinion, a sustained period of oil prices below $60 is not ideal for unconventional exploration. Nonetheless, not all, but a sufficiently large plethora of producers just continue to grin and bear it. While that keeps happening, and the dollar remains strong, oil prices will not find support. We could very well be in the $40-60 range until June at the very least. Unless excess supply falls from 1.3 million bpd to around 750,000 bpd, it is hard to see how the oil price will receive support from supply constriction. 

Additionally, Fitch Ratings reckons should Brent continue to lurk around $55, credit ratings of European, Middle Eastern and African oil companies would take a hit. European companies that went into the slump with stretched credit profiles remain particularly vulnerable.

In a note to clients, Fitch said its downgrade of Total to 'AA-' in February was in part due to weaker current prices, and the weaker environment played a major part in the downgrade and subsequent default of Afren.

"Our investigation into the effect on Western European oil companies' credit profiles with Brent at $55 in 2015 shows that ENI (A+/Negative) and BG Group (A-/Negative) were among those most affected. Both outlooks reflect operational concerns, ENI because of weakness in its downstream and gas and power businesses, BG Group due to historical production delays. Weaker oil prices exacerbate these problems," the agency added.

Of course, Fitch recognises the cyclical nature of oil prices, so the readers need not expect wholesale downgrades in response to a price drop. Additionally, Afren remains an exception rather than the norm, as discussed several times over on this blog.

Moving on, the Oilholic has encountered empirical and anecdotal evidence of private equity money at the ready to take advantage of the oil price slump for scooping up US shale prospects eyeing better times in the future. For one’s Forbes report on the subject click here. The Oilholic has also examined the state of affairs in Mexico in another detailed Forbes report published here.

Elsewhere, a statement earlier this week by a Kuwaiti official claiming that there is no appetite for an OPEC meeting before the scheduled date of June 5, pretty much ends all hopes of the likes of Nigeria and Venezuela in calling an emergency meeting. The official also said OPEC had “no choice” but to continue producing at its current levels or risk losing market share.

In any case, the Oilholic believes chatter put out by Nigeria and Venezuela calling for an OPEC meeting in the interest of self-preservation was a non-starter. Given that we’re little over two months away from the next meeting and the fact that it takes 4-6 weeks to get everyone to agree to a meeting date, current soundbites from the ‘cut production’ brigade don’t make sense.

Meanwhile, the UK Treasury finally acknowledged that taxation of North Sea oil and gas exploration needed a radical overhaul. In his final budget, before the Brits see a General Election on May 7, Chancellor George Osborne cut the country’s Petroleum Revenue Tax from its current level of 50% to 35% largely aimed at supporting investment in maturing offshore prospects.

Furthermore, the country’s supplementary rate of taxation, lowered from 32% to 30% in December, was cut further down to 20% and its collection at a lower rate backdated to January. Altogether, the UK’s total tax levy would fall from 60% to 50%.

Osborne’s move was widely welcomed by the industry. Some are fretting that he’s left it too late. Yet others reckon a case of better late than never could go a long way with the North Sea’s glory days well behind it. That’s all for the moment folks! Keep reading, keep it ‘crude’!

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© Gaurav Sharma 2015. Graph: Tracking Friday oil prices close, year to date 2015 © Gaurav Sharma, March 20, 2015.

A seminal moment has arrived for Pemex

For 76 years, Mexico’s state-owned oil and gas company Petroleos Mexicanos (or Pemex) has had a near monopoly over the country’s oil production. However, 2015 would be its 77th and final monopolistic one as Mexico prepares to open up oil exploration and production to foreign and domestic private sector participants.

Declining production levels for the last 10 years seem to have forced the government’s hand to invigorate the sector and shake-up Pemex. Mexico currently produces around 2.5 million barrels per day (bpd), nearly a million less than it did in 2004 when production peaked.

Unlike his predecessors who promised much but delivered little, President Enrique Peña Nieto changed Mexico’s constitution to facilitate private investment in a bid to revive Pemex’s fortune, given that it provides nearly a third of Mexico’s tax revenues. However, desperate to keep the public opinion onside, Peña Nieto vowed that “Pemex itself would never be privatised.”

Some still say the reforms did not go far enough. Yet by Mexican standards, it’ll be one heck of shake-up for a state-owned oil and gas company which has never competed itself to bid for overseas exploration rights (unlike many other state-owned behemoths especially from China and India).  

Pemex will have a new board of directors, procedural overhauls, process streamlining (at least on paper) and for the first time in its history face competition from private sector participants. If all that wasn’t enough, Pemex will allow its petrol stations and forecourts to compete with each other on price at the pump for the first time ever.

However, nothing is ever plain sailing in Mexico. The general public has largely embraced the change so far but some union leaders who carry considerable clout haven’t and are peddling alarmist ideas about an American takeover of Mexico’s precious resource. A negative vote in a referendum on further changes could bring things to a grinding halt. 

While the oil price decline is worrying, commentators say market volatility is not enough to derail things as one noted earlier. As for Pemex, Moody’s seems to suggest it is on the right track. On Friday, it affirmed the ratings of the state-firm and its subsidiaries, including Pemex's A3 and (P)A3 global long-term ratings with a “stable” outlook.

Moody’s notes that despite significant changes arising from the new energy law, Pemex will remain closely linked to the government of Mexico, which will continue to provide strong support, given the company's importance to the government's budget, to the oil sector and to the country's exports.

In the short to medium term, Moody's does not expect any material reduction in Pemex's tax burden and its debt amount is likely to rise to fund higher capital expenditures. “However, its managerial and budgetary autonomy will increase, improving its efficiency,” says Moody’s analyst Nymia Thamara Cortes de Almeida.

While Moody’s reckons Pemex will be able to maintain its production level around 2.5 million bpd level for three years at the very least, the government thinks it’ll be able to do so for the next 15 years! Suitably modest as usual! 

In the so-called “Round Zero” allocation last year, Pemex was still given rights to 83% of all proven and probable reserves in Mexico. But in “Round One”, scheduled to end by September 2015, Peña Nieto administration will put tender 169 blocks covering 28,500 square kilometres open to private participation in (or without) cooperation with Pemex.

A major test will come if an oil major gets drilling without Pemex and it’s not inconceivable given the pace with which things are moving here. The government is seeking oil and gas foreign direct investment in the range of US$50 to 60 billion by 2018.

Over the course of three days, the Oilholic has spoken on and off record to several market participants. Mood here is upbeat to begin with and several commentators also said Pemex had given them direct feedback about wanting to put its house in order. It's early days so lets see how this plays out.

The biggest question in a bearish market, is whether investors, especially foreign investors and IOCs would buy the idea of entering the Mexican oil and gas sector.

The Oilholic intends to explore this in greater detail from Houston and London over the coming weeks and months. However, one thinks it won’t be easy convincing the private sector especially when it comes to bidding for subsequent exploration rights offers. The initial and most lucrative exploration rights were given to Pemex. The next round puts forward exploration rights to areas where there is only a 50% chance of finding and tapping out the crude stuff in an economically viable fashion. In the following round, the probability percentage falls to 10%, and the ultimate round would see potential suitors vie for untested prospects.

If the Oilholic were a bidder, this doesn’t really fill one with confidence from the outset. It’ll all depend on the terms on offer and the jury is still out on that one. One thing is for sure, with Mexico’s proven oil reserves standing falling from 5th to 18th in the global league table, no one is opening that premium tequila bottle just yet. Much will depend on Pemex's capacity to finally embrace change. That’s all from Mexico City folks as an amazing but short trip comes to an end! Next stop, Houston Texas! Keep reading, keep it ‘crude’!

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© Gaurav Sharma 2015. Photo 1: Pemex Petrol Station in Mexico City, Mexico, May 2015. Photo 2: Pemex Signage © Gaurav Sharma.

Oil price vs. investment: A view from Mexico City

The Oilholic has temporarily swapped London for the quaint charms of Mexico City in order to get a perspective on the current oil market melee and its impact on sector investment here.

On the face of it, there’s no panic in policymakers’ ranks and commentators of all description agree that as a major oil producer Mexico could well do without an oil price decline. President Enrique Peña Nieto’s bid to boost economic activity via oil and gas sector reform legislation announced last year remains on track. It has taken 76-years for Mexico to get where it did last year and people are in a buoyant mood.

In fact, Peña Nieto surprised global markets and Mexicans in equal measure by biffing through his pre-election promise of sector reform in a short space of 18 months. In précis, via the said reform package, Sener (Ministry of Energy) gave state-owned Petroleos Mexicanos (or Pemex) 83% of Mexico’s proven and probable hydrocarbon reserves and 21% of the prospective resources. However, new private sector participants, while expected to explore the remaining 17%, would have access to 79% of prospective reserves in the next round. Many prospects are promising according to seismic data and market evidence. 

The move carries massive changes for Pemex, something which the Oilholic will discuss in greater detail shortly. On paper, we’re still in nascent stages of what the government says it is trying to achieve. So does the current volatility constitute a proverbial spanner in the work? No, say most commentators yours truly has spoken to since arrival.

Benjamín Torres-Barrón, Baker & McKenzie's Energy, Mining & Infrastructure Practice Group leader in Mexico, whom the Oilholic first met at the 20th World Petroleum Congress in Doha back in 2011, says the oil and gas sector is better placed than it has ever been in recent years. 

“Timing of the oil price decline could be described as unfortunate. You could say that we’ve waited 76-years for change and when that change arrives, this happens. However, my argument is that there is never a good or bad time for legislative reform; it’s about seizing opportunities. Imagine if we were stuck in the same place as we were in 2011 [with the Felipe Calderón administration promising much with little to show for it] and the oil price nosedived as it has; you would have found the domestic market in a terrible state. Declining production and archaic legislation would have been a double blow.

"Right now Mexico is sending a positive message albeit in a tough climate. A drive has been set in motion and the dampening effect of oil market volatility on the capacity for reform would be negligible," he adds.

Most of Baker & McKenzie's corporate clients are not necessarily put off by the oil price dip. “Current investment is not about the here and now, but rather about the future. Those waiting for market access could [and should] have a broad range of potential concerns from security to politics, corruption to red tape, but not a single client has told us we’re no longer interested in participation singularly on the basis of oil price fluctuations.”

Torres-Barrón’s colleague Carlos Linares-Garcia, the international law firm’s Principal Economist attached to its Latin America Transfer Pricing practice, underscores why Mexico must carry on regardless.

“Royalties and tax takings from private investors might well be lower in the current climate. Stated production level of 2.5 million barrels per day (bpd) still makes Mexico the world’s sixth-largest oil producer. Yet, people long for the days in the not so distant past when production stood at 3.4 million bpd [3.6 mbpd in boepd] in 2004.” 

The subsequent decline made Pemex a familiar figure of farce as far as bloated state entities go and criticism followed in editorials ranging from local media to The Economist. “There is a determination to shake off that image. In my direct interactions with Pemex since August, I’ve noticed a clear recognition of the challenges and a desire for change. Pemex wants things to change, as much as people in legislative circles and the wider public,” Linares Garcia adds.

In fact, most energy sector reforms in any jurisdiction (e.g. shale exploration framework amendments in various EU markets), is accompanied by protests and rabble-rousing. Just ask the Brits. Yet, in Mexico, bar the odd noise made by labour unions, the Oilholic feels the general public has largely embraced sector reforms potentially moving Pemex away from state protectionism that has plagued it for years.

Right now Mexicans have a lot of things to protest about including socio-political mishaps, but oil and gas sector reform isn't one of them. Furthermore, the reform agenda extends beyond Pemex, something which external commentators often forget to take into account, says Ingrid Castillo, Head of Research at Grupo Bursátil Mexicano (GBM).

“Beyond Pemex, Comisión Federal de Electricidad (or CFE - the state-owned electricity firm) and government agencies are likely to feel the effects. For CFE, improved and viable access to natural gas is crucial, and market reform puts it on the agenda. Mexico has its own ambitions for shale exploration and there is clear recognition of the role played by the private sector in bringing shale gas to market across the border in US.”

Castillo also says industry stakeholders are more pragmatic than many of their European partners about a future windfall from shale and the time it takes to materialise. “We have noted the pitfalls, false starts, challenges, time scale and the ultimate success when it comes to US shale exploration. People are under no illusion about the effort required and the private sector’s role in bringing it about in Mexico.”

An unbundled, improved pipeline infrastructure seen in the US also remains a pipedream according to GBM, Baker & McKenzie and commentators from the big four global advisory firms. “The good thing is we’re finally talking about it more seriously than we used to. The chatter has not cooled off despite turmoil in the oil markets,” says a senior financial adviser.

Castillo’s GBM colleague Olaf Sandoval, a Senior Regional Economist, says the Mexican government has handled the oil price decline well so far. “The government recently introduced austerity measures to the tune of MXN124 billion (US$8.26 billion) with implications for Pemex and CFE. However, what's key here is that most cuts will primarily take place in the shape of ordinary expenses rather than capital expenditure on infrastructure with a 65:35 split in favour of the former.”

While the price decline is not an immediate concern this year, subsequent years could prove challenging if bearish sentiments get entrenched. For the current fiscal year, the Peña Nieto administration has already hedged via seven global financial institutions. The price of oil negotiated was $76.4 barrel, which implied a cost of $773 million in line with previous years. So 2015 would see the government largely protected for the spread between its budgeted price of $79 per barrel and currently chaotic spot markets. 

“Yet, in 2016 and 2017, it could be a very different story. Concerns over volatility could be more pronounced then, which could have implications for capital expenditure on infrastructure much more than it is currently having,” Sandoval adds.

But Mexico is undoubtedly in a much better shape than before. “We’re in the middle of intense economic pressure in Greece and talks of a Venezuelan default. Not that long ago, Mexico would be in that club. That the country is not, suggests things while not perfect, are certainly on the right track,” says Linares-Garcia.

As for the viability of oil and gas projects, Torres-Barrón says some would even be profitable at an oil price as low as $30 per barrel. “Additionally, selected shallow water prospects could cope with even $20. The first contracts are expected to be awarded this year and there is no anecdotal indication of delays or lack of investor appetite. Several IOCs will turn-up, and there’s the inevitable interest from Asian, especially Chinese, state-owned firms.”

The sector remains on the cusp of something important. Market reforms could add as much as 1%-1.5% to headline economic growth by 2018. An increase in gas production could boost the nation’s industrial production and grandiose forecasts of Mexico achieving 6% growth are around should you want to believe them.

“But you shouldn’t; for in Mexico we have had many false dawns. If we exceed 3% in 2015, that would be something to cheer about. Energy sector reform is likely to play a part, but there is no point getting ahead of ourselves,” says Castillo.

Linares-Garcia adds that diversification to other oil and gas export markets would be crucial for future prospects. “If China’s economy is not growing as fast and the US is importing less, we should be [and are] looking other markets. Even so, reliance on the US market persists. The next five years would be critical but Mexico is on the right track towards market diversification.”

A return to 2004 oil production levels by 2018 would be more than welcome. For that, welcoming new participants to town seems to be the mantra as oil price fluctuation dominates headlines.

That’s all for the moment folks, as one leaves you with a view of the Monumento a la Independencia (see above right) built in 1910 to commemorate Mexico's war of Independence. It's now a focal point for everything from celebrating a win of the national football team to political protests! The Oilholic spotted a few protests himself but none were of the 'crude' variety. More from Mexico City soon. Keep reading, keep it ‘crude’!

To follow The Oilholic on Twitter click here.
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To email: gaurav.sharma@oilholicssynonymous.com

© Gaurav Sharma 2015. Photo 1: Mexican Flag at Palacio Nacional, Mexico City. Photo 2: Monumento a la Independencia, Mexico City, Mexico © Gaurav Sharma, February, 2015