Publish in Analysis - Thursday, July 26, 2018
Mexico's president-elect Andres Manuel Lopez Obrador wants to stop the $13 billion Mexico City airport and control fuel prices, direct investments to build or upgrade refineries, and potentially delay oil and gas auctions. (Photo: @Lopezobrador on Twitter)
Mexico's President-Elect Andres Manuel Lopez Obrador (center) with his chief-of-staff Alfonso Romo (right) in a photo posted on his Twitter account July 24, 2018.
Investors ask whether Mexico’s next president will be a new Hugo Chavez or Lula.
BY JOACHIM BAMRUD
Will Mexico’s Andres Manuel Lopez Obrador, who in December assumes the presidency of Latin America’s second-largest economy, become a new Hugo Chavez (the man who ruined Venezuela’s once-prosperous economy) or a new Luiz Inacio Lula da Silva (the leftist firebrand who in the end implemented relatively pragmatic economic policies and presided over Brazil’s best economic performance in 25 years)?
What is certain so far is that Mexico is in for more uncertainty than it has seen in a while. Although Lopez Obrador (popularly known as AMLO) was seen as a pragmatic mayor of capital Mexico City in 2000 to 2005, he has scared investors with his threats against Mexico’s historic energy liberalization and construction of the new, $13 billion Mexico City international airport.
While his anti-corruption pledge wins widespread praise – and was likely a key factor behind his resounding election victory -- his other policies less so.
Some observers are taking comfort in that AMLO’s ambitious plans to boost social spending will depend on making the economy grow, forcing him to follow traditional pro-growth economic policies.
“In order for many of AMLO promises, he needs money -- for example subsidies for younger people, to overcome extreme poverty,” says Juan Francisco Torres Landa, office managing partner for Mexico City at Hogan Lovells. “That’s all good, but you need the economy to grow, you need activities to be fluid.”
However, investors are deeply concerned that AMLO will roll back Mexico’s recent energy liberalization.
Outgoing president Enrique Peña Nieto opened up the energy sector by ending the monopoly state oil giant Pemex had held since the oil sector was nationalized in 1938 by then-president Lazaro Cardenas from the same Institutional Revolutionary Party (PRI). He also allowed competition in the distribution of gasoline, leading to a rush in foreign oil companies operating in upstream and downstream business.
But some observers like Torres Landa believe AMLO will leave the core of the reform in place.
“Everything indicates that substance of the reform will not be modified,” he says. “At its core, the substance, the architecture, the design is embedded in the constitution. Amending that is not impossible, but difficult without a big political cost. They will not mess up the reform as such. The commitment is to wait a couple of years.”
The AMLO team’s concern is that some of the oil awards were tainted by corruption.
“Our own independent research [shows that] it’s not fairly easy to contemplate that actually any of the bidding procedures were tainted with corruption,” Torres Landa says.
Any suggestion that contracts are being unfairly revoked will be met with deep concern by investors, and not only those in the energy sector, points out Duncan Wood, Director of the Mexico Institute at the Wilson Center. “As AMLO is determined to avoid financial volatility, he must step carefully on this front,” he says (See AMLO & Mexico’s New Energy Model).
AMLO has said he wants to control fuel prices, direct investments to build or upgrade refineries, and potentially delay oil and gas auctions.
“The concept he has in mind, he wants the country not to be so dependent on foreign imports of gasoline [seeking] energy independence or self sufficient supply,” Torres Landa says. But “in order to do that, building those refineries will be very costly. He needs to strike a balance [and not] waste resources for years.”
AMLO’s designated energy minister Rocío Nahle announced July 25 that the new government would spend 38 billion pesos (US$2 billion) to upgrade and modernize Mexico’s six existing refineries .
Both AMLO and Nahle favor a stronger state role in Mexico’s energy sector, led by state oil producer Pemex. The problem? Pemex has a dismal track record in terms of both production and financial results. Two of Pemex’ refineries are operating at near-zero levels, according to El Universal. Others have been plagued by continued underperformance as well.
Meanwhile, Pemex is the worst company in Latin America in terms of financial performance. Pemex saw its losses jump from $9.3 billion in 2016 to $16.8 billion last year, thus keeping its position as the worst performer on the Latinvex 500 ranking of Latin America’s largest companies. (In contrast, Brazilian state oil producer Petrobras went from 2016 losses of $4.5 billion to a loss of $134.8 million last year.)
Moody’s warns that AMLO’s plans could hurt the credit ratings of Pemex. "If the refinery plans take effect, which is not at all confirmed, it would weaken Pemex's credit metrics to finance such an investment with debt, while also diverting funding the company badly needs to spend to help increase oil and gas production," Nymia Almeida, a Moody's senior vice president, said in a statement.
Another risk to Pemex's finances stem from whether the new administration will control fuel prices, Moody’s warns.
Crude prices have increased and the weaker peso has made fuel production more expensive. Pemex purchases crude in US dollars, regardless of whether produced or imported. Currently, taxes represent roughly 30 percent of fuel prices at the pump. The new administration could adjust taxes to maintain price stability, but changes in fuel prices in line with inflation pose cash flow uncertainty for Pemex, the ratings agency says.
A third risk involves foreign partnerships and whether Pemex will have the ability to continue doing so, Moody’s says.
Fitch Ratings also wars against risks to Mexico’s energy sector. “There are risks that the pace of opening the sector to foreign companies could be slowed. Protracted uncertainty over energy policy could affect FDI, economic growth, and oil production over time,” it said after AMLO won the election.
The 2018-24 governing plan of AMLO’s party, Morena, favors postponing the involvement of Pemex in future farm-out agreements.
As a result, IHS Markit energy expects a slowdown in the pace of investment in new reform-related projects, especially in high-impact deep water fields, could lead to Mexican oil production continuing to decline for longer than previously expected.
Although Morena is unlikely to secure the two-thirds needed in Congress to reverse the current administration's energy reform, AMLO has previously suggested the possibility of holding a referendum against it and Morena's governing plan proposes the modification of secondary oil-related legislation (where only 51 percent of the congressional vote is needed), IHS says.
Then there’s the new, $13 billion international airport being built for Mexico City. AMLO has said he opposed the new airport and instead wants to build two runways at a military base elsewhere.
After his election victory he announced plans to hold a referendum on the project, with three alternatives for voters: cancelling it and instead building the runways as he wants; continuing to build the proposed airport but concession it out to a private company or keep the current structure, whereby the government owns the airport (the latter is favored by most experts).
As a result of the uncertainty, Grupo Aeroportuario de la Ciudad de Mexico (GACM -- the state group overseeing the construction) said that it has suspended four contract tenders, Reuters reports.
In potentially good news, polls show that most Mexicans oppose canceling the airport project, El Financiero reports. AMLO may in the end decide to keep the new airport, but it will by then have been delayed unnecessarily.
AMLO wants all government procurement to go through the Finance Ministry in an effort to reduce corruption.
Torres Landa says the idea may have some merit in light of a recent study showing that as much as 70 percent of the spending in the Peña Nieto administration went through direct awards, not public bidding – a process he calls outright “offensive.”
“They didn’t even respect basic process, not seek bids,” Torres Landa says.
The new system would provide better prospects for more transparency, he believes.
However, it may not be that easy. There are 1,537 government procurement entities and many of them require specialized knowledge and staff, experts tell El Financiero.
Meanwhile, AMLO has repeatedly said he wants to get rid of Mexico’s new presidential airplane, which the government acquired from Boeing in 2012 for $218 million.
The problem is that the plane has depreciated in value (as is normal) and its customized refurbishment for the president is useless for other buyers, making it likely that it is now worth $142 million for a private suitor and only $82 million for a commercial airline, according to El Universal.
In other words, Mexico stands to lose between $76 million and $137 million over the sale – a controversial move as AMLO says he wants to cut government waste.
AMLO also wants to decentralize the headquarters of key government companies and entities, including Pemex, electricity company CFE and the transport and tourism ministries, Expansion reports.
“They’ll need to analyze how many [entities] it makes sense to move,” Torres Landa says.
But challenges include the fact that many people are not willing to move, while face to face meetings will be complicated if everybody is all over the country, he says.
The process itself is not simple and may require a staggered approach, Torres Landa warns.
AMLO also proposes salary cuts for public servants. While that in theory sounds like a good goal, it could easily lead to a brain drain, experts tell El Universal.
Torres Landa says he hopes AMLO reverses his pledge to not give the attorney general’s office full independence. The Fiscalía General de la República (FGR) will replace the Procuraduría General de la República (PGR).
“The only way to increase transparency is to ensure that the Fiscalia is independent,” Torres Landa argues. “Right now, in reality there is no real independence.”
AMLO argues that he is a good person and that he can only do good things.
“No one is infallible [and] humans are fallible by nature,” Torres Landa says.
Many investors were relieved that AMLO has named a well-respected economist as his finance minister. Carlos Urzúa holds a PhD in economics from the University of Wisconsin-Madison and served as AMLO’s Secretary of Finance in Mexico City for three years. AMLO’s chief of staff is Alfonso Romo, a leading Mexican businessman who should also have a calming effect on investors.
However, a good finance minister is not always enough if the president ignores his advice or undermines him. That was the case in Brazil, when then-president Dilma Rousseff in 2014 named Joaquim Levy, who in the end resigned after only one year. (See Will “CIA Levy” Be Able to Reform “Rousseff’s KGB”?).
Local and foreign investors in Mexico are facing a high degree of uncertainty just as they have to deal with the consequences of Hurricane Trump on everything from the North American Free Trade Agreement (NAFTA) to world trade and economy.
“The uncertainty about policy continuity will hurt business sentiment and investment,” warn Rafael Amiel, director for Latin America for IHS Economics and Carlos Cardenas, Head of Latin America Country Risk Analysis and Forecasting at IHS, in an analysis. “Andrés Manuel López Obrador (AMLO)'s relationship with the private sector will not be completely amicable as he is likely to seek to appease his support base by targeting specific businesspersons or sectors, either through the cancellation of contracts awarded by the current administration or through a targeted tax collection strategy focused on large Mexican firms and businesspersons perceived to belong to what AMLO describes as representing the "Power Mafia.””
However, Wood, from the Mexico Institute at the Wilson Center, agrees with Torres Landa that economic reality in the end will trump many campaign promises. “Economic, fiscal, and energy necessities may bring the new government to opt for a less radical departure from the status quo than many fear,” he says.
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