Itaú BBA - A Far-Reaching Energy Reform

Scenario Review - Mexico

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A Far-Reaching Energy Reform

January 14, 2014

We do not expect policy rate moves this year, but we see rate hikes in 2015.

•   Mexico’s government approved a far-reaching energy reform in December. With the reform, foreign capital flows and growth will likely increase, but not in the short term.

•   Mexico’s recovery continues to be fragile. External demand is slowing, while internal demand fails to pick-up. Still, our growth forecast for this year is unchanged, at 3.6%, due to the improved outlook for the U.S. economy. In 2015, the first effects of the structural reforms will add to above-trend U.S. growth. We expect a strong 3.8% expansion next year.

•   Inflation ended 2013 close to the upper-bound of the target, because of higher non-core prices. Tax hikes will likely sustain headline inflation around the upper bound of the target for most of this year. We see inflation at 3.7% in December 2014. In 2015, we expect inflation at 3.2%, close to the target center.

•    In spite of the positive news on the energy reform, the Mexican peso did not appreciate against the U.S. dollar. The U.S. monetary policy is the dominant driver. We now see the peso at 12.8 both by the end of this year and by the end of the next.

•   We do not expect policy rate moves this year, but we see rate hikes in 2015. As the FED raises rates, we expect Mexico’s central bank to increase the policy rate by 100 bps starting in 2Q15. A more rapid normalization of the monetary policy in the U.S. than markets currently expect could lead to higher interest rates in Mexico sooner than in our baseline scenario.

A More Aggressive Than Expected Energy Reform

In December, Mexico’s government approved the energy reform. The bill passed in both chambers of congress and in the majority of state legislatures (which is required for constitutional reforms). President Peña Nieto signed it into law in December.

The energy overhaul is far-reaching. The reform is similar to the proposal submitted by the PAN (Mexico’s largest opposition party), so it is much bolder than the reform presented by the PRI (the ruling party) a few months before. With the approved reform, most activities of the Energy sector lose their strategic status, so private companies will be able to freely invest in them. For oil and gas production and exploration, private companies will have to partner with the Mexican state. However, the bill allows for a wide range of contracts between the state and the private sector. Specifically, production-sharing agreements, licenses, profit-sharing agreements and service contracts are all allowed. Thus oil companies could be paid in cash (profit-sharing agreements and service contracts) or in oil (licenses and production-sharing agreements). A constitutional ban on concessions remains, but according to a number of oil-and-gas analysts, license contracts don’t differ meaningfully from concessions. 

The reform also addresses other politically sensitive constraints on private sector involvement in Mexico’s Energy sector. The PEMEX workers union will be removed from the board of the company (currently one-third of the seats on the PEMEX board is reserved for the union). This will help turn PEMEX into a much more efficient company, laying the groundwork for better working conditions with the private sector. In addition, the bill allows private companies to book the reserves that they will explore.

With the reform, a new sovereign fund to manage the oil income of the government will be created. The fund will work like a stabilization fund, as it aims to keep the oil revenues of the federal government constant (as a proportion of GDP). So, excess revenues would be saved. While during bad times (when oil prices or production disappoints), the fund would transfer resources to the federal government.

The next step is the approval of the secondary legislation. This will likely be done before the end of the second quarter of this year. The legislation will make clear what type of contracts (profit-sharing, licenses, etc.) will be assigned for each type of oil-and-gas activity (shale gas extraction, deepwater drilling, etc). Furthermore, the secondary bill will shed more light on how the new sovereign fund will work. This legislation only requires a simple majority in congress for its approval, so we expect it to pass through both houses smoothly.

The energy reform will likely have a meaningful impact on both cyclical and potential growth. The oil and oil-related investment should boost demand significantly. If there is spare capacity in the economy when investment comes, growth will be higher without adding inflationary pressures. If there is no spare capacity left, the central bank will have to tighten monetary policy to curb growth and prevent the economy from overheating. But the most important impact of the reform is on potential growth. While there is a lot of uncertainty on how much the reform can lift potential output, some calculations are available. According to Itaú’s Oil and Gas analysts, the reform can increase oil investment by 2%-2.5% of GDP over one decade, which means that potential growth could increase by around 40 bps. It is important to highlight that this estimate does not include the extra investment in energy-related infrastructure and in downstream activities, so the impact of the energy reform on long-term output will probably be higher than 40 bps.

Foreign capital flows will likely increase with the energy reform. Much of the investment in energy will come through FDI. So foreign capital flows to Mexico are expected to remain robust, even with a tighter monetary policy in the U.S. However, just as with growth, it is very uncertain at this point how large FDI flows are going to be.  

Although the reform is significant, it is very unlikely to have a meaningful impact on growth and FDI in the short term. Because the secondary legislation is yet to be approved and contracts and auctions will take time to be designed, nothing significant is expected before 2015, and the bulk of the impact will likely come later.

Finally, we note that there are some important open questions on the impact that the reform will have on the exchange rate. Although foreign capital flows will likely be strong, it is unclear how large net foreign-exchange flows are going to be. First, oil investment could demand a lot of imports, considering that Mexico may not have the technology available to supply domestically much of the necessary capital goods. Also, if the new sovereign fund invests its resources abroad (like most sovereign funds do), the higher foreign capital inflows will also be partially offset by higher resident capital outflows.

A Fragile Recovery

After the economic rebound recorded in 3Q13, many activity indicators hint at a slowdown during 4Q13. The IGAE (monthly proxy for GDP) increased by 0.3% month over month in October, not enough to offset the 0.34% contraction the previous month. On a quarter-over-quarter basis, the index weakened to 1.5% (annualized) from 3.0% in September. The deceleration would have been much sharper if it weren’t for the very volatile Primary sector. In November, industrial production increased by a very modest 0.1% month over month, which brought the quarter-over-quarter growth rate back into negative territory (-0.6% annualized).


External demand is losing momentum in spite of the solid activity data in the U.S., while internal demand is yet to show signs of recovery. Manufacturing production, which is the component of industrial production closely linked to external demand, fell by 1.0% between October and November, reducing its quarterly growth rate sharply, to -0.75% (annualized) from 3.4%. Consistent with slower manufacturing production, manufacturing exports are also decelerating. The very weak auto production data coupled with low IMEF-PMI readings suggest that manufacturing activity in Mexico is unlikely to improve significantly in December. Meanwhile, indicators related to internal demand continue to be weak. Although retail sales increased by 0.8% month over month in October, they contracted by 4.8% qoq/saar. Also, imports of non-fuel consumer goods fell from October to November, and consumer confidence deteriorated further in December. On the investment side, data are even poorer: in October, gross fixed investment contracted for the sixth consecutive month and fell by 9.4% qoq/saar.

The weak activity readings during 4Q13 worsen the carry-over for 2014. Still, considering the improved outlook for the U.S. economy, we left our GDP forecast unchanged for this year. In our view, the decoupling between Mexico’s exports and the U.S. economy will not last much longer. In addition, internal demand is unlikely to repeat the same weakness of 2013. In the end, Mexico’s trade openness means that stronger exports easily spill over to consumption and investment. The reversal (or at least partial reversal) of the negative shocks that impacted internal demand in 2013 (the Housing sector problems and sluggish fiscal spending) are also going to help growth this year. We expect the economy to grow by 3.6%, after a modest 1.2% estimated growth during 2013 (in our previous scenario we were expecting a 1.3% expansion for 2013). For 2015, we see growth at 3.8%, as the U.S. economy continues to expand above trend and the first meaningful impacts of the structural reforms are felt.   

Headline Inflation to Remain High This Year, but Closer to the Center of the Target in 2015

Headline inflation ended 2013 close to the upper bound of the target. On a year-over-year basis, inflation reached 3.97%, up from 3.62% in November. The increase was mostly due to higher non-core inflation (7.84% from 7.02% previously), which was led by a 113-bp gain in inflation for non-processed food items (to 6.67%). Regulated prices were up by 8.65% year over year (from 8.01%). Meanwhile, core inflation increased from 2.56% to 2.78%. Although the exchange rate weakened over the past few months, inflation for core goods continued to fall, to 1.89% (core goods ex-food inflation is now at 1.26%). Core services inflation went up to 3.54% (3.06% in November). Unfavorable base effects (namely the discount in prices for telecom services that took place in November 2012 and that was reversed in the second half of January 2013) are lifting inflation for core services, so we do not see demand-side inflationary pressures in Mexico at this point.    

We expect inflation to remain near the upper bound of the target in 2014, as a result of the tax hikes that will be introduced this year. Still, we expect inflation to end this year below its current level (our current forecast for year-end is 3.7%), because non-core prices are unlikely to increase as much as they did in 2013. Having said that, it is likely that inflation will stay above 4% during some of this year. In 2015, we see inflation approaching the center of the target (at 3.2%), as the impact of the tax hikes fades.

Despite Positive Surprises in the Energy Debate, the Peso Didn’t Appreciate

Although the energy reform was significantly more aggressive than market participants were expecting, the Mexican peso did not appreciate against the dollar. In addition, the peso did not outperform other LatAm currencies in December. The U.S. monetary policy is clearly the dominant driver of the peso at this point.

We now expect the peso to end this year at 12.8 to the dollar. Thus, we do not expect the peso to deviate much from the range that it has been trading over the past few months. In our previous scenario, we were expecting an appreciation to 12.5. In 2015, we also see the currency at 12.8 (a small real exchange-rate appreciation). We note that these forecasts imply an appreciation of the peso against the currencies of the commodity-exporter LatAm countries.  

Interest Rates on Hold This Year. Rate Hikes Will Likely Come in 2015

As widely expected, Mexico’s central bank left the reference rate unchanged, at 3.5%, in its last monetary policy meeting of the year. The statement did not reveal any surprises, as the guidance for future policy moves continues to have a neutral bias. The board continued to pledge, in its concluding remarks, that it will monitor the progress of the domestic economy, the potential second-round effects from the tax hikes that will be introduced in 2014 and the relative monetary policy stance of Mexico vis-à-vis the U.S.

We don’t expect rate moves this year. As the Fed raises rates in 2015, a tightening cycle in Mexico is also likely. We see Mexico’s central bank raising rates by 100 bps in 2015, with the first hike in 2Q15. In our view, the risk is that the central bank starts to raise rates in anticipation of the Fed’s policy rate moves.   

João Pedro Bumachar


Forecasts: Mexico


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