Itaú BBA - Risks for the energy reform

Scenario Review - Mexico

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Risks for the energy reform

August 7, 2015

The recent further decline in oil prices increases the risks for the coming oil field auctions.

 The results of the first oil tender missed expectations. In addition to the uncertain outlook for oil prices, contractual terms could also be behind the disappointment. In response, the government is already improving the terms for the following tenders to attract more interest from private firms, but the recent further decline in oil prices increases the risks for the coming auctions.

• Mexico’s economy remains weak. Besides the falling oil output, manufacturing exports, which contracted for the second consecutive quarter in 2Q15, were a drag on the economy. On the positive side, indicators linked to internal demand are improving. We continue to expect growth at 2.4% this year, as we believe that the recovery of the U.S. economy will lead to higher growth in Mexico during the second half of this year. In 2016, the U.S. economy will likely continue to help, but we reduced our growth estimate to 3.0% (from 3.3%) because the investments associated with the energy reform will probably come more slowly than we previously thought.    

• Headline inflation stood at 2.74% in July – the lowest result on record – as core inflation remained well below the center of the target. We expect annual inflation to end this year and the next at 3.0%.

• The Mexican peso depreciated further in July, but continues to outperform the region’s commodity-related floating currencies. Despite the outperformance, the Foreign Exchange Commission (made up of members of the central bank and of the ministry of finance) announced stronger intervention on July 30, together with the policy rate decision. We now see the currency ending this year and the next at 16.0 pesos to the dollar (from 15.5 in our previous scenario). Lower oil prices and lower-than-expected FDI inflows related to the energy reform are behind our revision.  

• As was widely expected, the policy rate was left unchanged in July. However, a day after the decision, Central Bank Governor Agustín Carstens stated that the central bank has full flexibility to modify its monetary policy if volatility increases due to “actions by the Fed or for any other reason.” We continue to expect rate hikes only in 1Q16 (after the Fed’s liftoff, expected by us in December), due to the weak economy, low inflation, and stable inflation expectations.

• The escape of Joaquin “El Chapo” Guzman Loera (head of the Sinaloa drug cartel), from a maximum security prison in the State of Mexico led to a further decline in President Peña Nieto’s popularity.


 

Disappointing First Oil Field Auctions

The results of the first oil tender missed expectations. Only two of the fourteen blocks offered were awarded (around 14% of the fields put up for auction). Expectations were set at around 30 to 50%, based on international experience and recent government statements. From the list of 25 potential bidders, nine were present at the auction and only seven made actual bids. Of the 14 auctioned blocks only six received bids, two were awarded and four received bids below the minimum threshold (government take). Given that the government take was announced only after the bids were placed, the fact that most fields did not receive a bid suggests that the offered contractual terms are partly to blame for the disappointing auctions. In fact, the government recently announced adjustments in the contracts to be awarded in September 30´s phase two auctions. Among the changes, the economic incentives were improved, the high burdens (mostly guarantees) of the previous contracts were relaxed, stronger contract rights were provided and there is more flexibility for consortium participation and bids. 

The migration of Pemex’s 22 service contracts with private firms to profit-sharing contracts is also behind schedule. Half of the total contracts were originally expected to migrate by the end of 2014, and the rest by June of this year. Pemex is only expected to announce the first contract migrations in August.

Given that the government is being pressured to deliver economic growth and, more specifically, reverse the declining trend in oil output, we expect it to continue to adjust the contractual terms, as needed, to attract private oil companies. On the other hand, the worsening outlook for oil prices implies greater risks for the implementation of the energy reform.   

Weak Economy and Record-Low Inflation

Mining output and weak manufacturing exports weighed on growth in 2Q15. The IGAE (monthly GDP proxy) increased by a modest 0.1% between April and May (from 0.6% previously), bringing the quarter-over-quarter annualized rate to 1.1% (down from 1.3% in April). Although mining output (which includes oil production) expanded 0.7% from April, it deteriorated to 11.6% qoq/saar. Manufacturing exports fell by 1.3% (annualized) from 1Q15 to 2Q15, after an 11.8% decline. While the performance of the Manufacturing sector seems at odds with the evolution of the U.S. economy, we note that industrial production growth in the U.S. (which is the portion of the U.S. economy most closely correlated with Mexico’s exports) underperformed GDP growth in both 1Q15 and 2Q15.

On the positive side, many indicators linked to internal demand performed well. Retail sales slowed but continued to grow at a robust pace (4.5% in May vs. 9.6% qoq/saar in 1Q15), boosted by the solid growth in formal employment (4.4% YoY in June) and historically low inflation. The Services sector posted a solid 3.1% qoq/saar expansion in May, while consumer goods imports ex-fuel registered a strong 27.1% qoq/saar increase in 2Q15. Capital goods imports (which closely track investment in machinery and equipment) expanded 11.4% qoq/saar in 2Q15 (after a 19% increase in 1Q15).   

We maintain our GDP growth forecast of 2.4% for 2015, but lowered our estimate for 2016 to 3.0% (from 3.3% in our previous scenario). While the recovery of the U.S. economy will likely lead to higher growth in Mexico, we are less optimistic about the volume of investments related to the energy reform in 2016, given the considerable uncertainty surrounding oil prices. Moreover, lower oil prices could force the government to cut expenditures further to meet its fiscal deficit targets next year. 

The negative output gap is keeping inflation very low. Headline inflation stood at 2.74% in July – the lowest reading on record (from 2.87% in June). Core inflation came in at 2.31% (from 2.33%), close to the lower bound of the target. Prices for core goods increased by 2.47% (compared with an increase of 2.48% June), showing negligible pass-through effects from the weaker currency, and inflation for core services stood at 2.18% (down from 2.20%). Non-core prices also contributed to the low inflation figure (4.12% versus an increase of 4.63% in June). We expect annual inflation to end this year and the next at 3%.

Exchange Rate Commission Announces Stronger Intervention

The exchange rate commission (made up of members of the central bank and the ministry of finance) announced stronger intervention in the currency market on July 30, together with the policy rate decision. The commission significantly raised the daily sale of dollars with no minimum price, from USD 52 million to USD 200 million (from July 31 to September 30). Authorities also lowered the required daily depreciation to trigger the USD 200 million daily auctions with a minimum price, to a 1% depreciation from the previous trading day (from 1.5%). So dollar sales can reach USD 400 million per day, but no less than USD 200 million. The announcement is a response to the continued weakening of the Mexican peso in July, although the Mexican peso continues to outperform the region’s commodity-related floating currencies. We now expect the currency to end this year and the next at 16.0 pesos to the dollar (from 15.5 in our previous scenario). Lower oil prices and lower (than we were previously expecting) FDI inflows related to the energy reform are behind our revision.

As was widely expected, Mexico’s central bank left the policy rate unchanged at 3.0%. In the statement announcing the decision, the board noted that the balance of risks for activity has deteriorated since the previous meeting, while the short-term balance of risks for inflation improved (though the board also noted that they remain high). Even so, a day later, Central Bank Governor Agustín Carstens stated that the central bank has full flexibility to modify its monetary policy due to “actions by the Fed or for any other reason.” While the comment sounds like a departure from the message set forth in the minutes of past decisions – because it opens the door for rate hikes before the Fed moves – we continue to expect rate hikes only in 1Q16 (after the Fed’s liftoff, expected by us in December), due to the weak economy, low inflation and stable inflation expectations. We note that according to the minutes of the past decisions, most board members opposed raising rates before the Fed. Finally, the more successful the intervention is in limiting the depreciation, the higher the likelihood of our base case for the timing of the Mexican Central Bank’s first hike.

Drug Lord’s Escape from Maximum Security Prison Hurts Peña Nieto’s Popularity

Joaquin “El Chapo” Guzman Loera (head of the Sinaloa drug cartel) escaped a maximum security prison in the State of Mexico using a mile-long tunnel that connected his cell to a construction site near the prison. This is the second time that “El Chapo” escapes from prison; the first time was during President Fox’s term in 2001. Guzman’s escape is another blow to the President Nieto’s popularity. In the 2Q15 poll by the Reforma newspaper, the president’s approval rating was at a historical low 34%. A total of 87% of the survey participants mentioned that government officials were behind the escape of “El Chapo”, while 40% believe that the government will not punish the federal officials involved in the escape.


 

João Pedro Bumachar

Jesus Gustavo Garza-Garcia


 



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