Defiant Energy Policy of Mexico’s President-Elect Rattles Moody’s and Fitch

But it’s going to be tough; he’ll need more than luck to pull it off.

By Don Quijones, Spain, UK, & Mexico, editor at WOLF STREET.

Moody’s rated the $2 billion of senior unsecured notes due 2029 that Mexico’s state-owned oil company Pemex is in the process of issuing one notch above junk. Pemex is offering to pay a coupon interest rate of 6.5%. In its report on Friday, Moody’s blamed the company’s “weak liquidity, a heavy tax burden and the resulting weak free cash flow, high financial leverage and low interest coverage; and challenges related to crude production and reserve replacement.” Moody’s is also worrying about the large amounts of debt coming due in 2020 and beyond. And Pemex will continue to be “dependent on debt capital markets to fund negative free cash flow,” it said.

Fitch Ratings downgraded the outlook for Pemex’s debt from stable to negative amid concerns about the incoming government’s proposed energy policies. It rates Pemex three notches above “junk” (BBB+), but only because the company is state-owned. Its standalone credit profile — if Pemex were not backstopped by the Mexican state — is junk, seven notches into junk (CCC).

Fitch has also warned earlier that if Pemex’s credit rating drops, so, too, will Mexico’s sovereign debt rating. Even a small deterioration in credit risk could exact a heavy toll on both the company and the country.

The outlook revision to negative from stable “reflects the increased uncertainty about Pemex’s future business strategy coupled with the company’s deteriorating standalone credit profile,” Fitch said in its report.

Fitch’s downward revision was cited by analysts as one possible factor in the fall of the peso last week to its lowest level in over a month. CI Banco analyst James Salazar said that Fitch’s Pemex assessment is a reminder that the company’s “finances should continue to be handled with great caution so as not to cause additional imbalances that will increase its debt.”

In other words, Mexico’s president-elect, Andres Manuel Lopez Obrador (AMLO), should think long and hard before proceeding with his ambitious energy plans. A key part of that plan is the proposed construction of a new $8 billion oil refinery in Tabasco as well as the rehabilitation of the six refineries already in operation.

In 2017, Mexico’s refineries registered their lowest production in 27 years. In fact, Pemex’s refining business is in such dire straits that it loses money if it raises output. This problem has created “a reverse incentive to refine less and import more,” Bloomberg reports. Last year over 70% of the gasoline used by Mexicans was imported, 60% more than in 2013. Much of it came from the US.

Now, AMLO wants to reverse that trend, by expanding Mexico’s refining capacity and upgrading existing refineries. There’s an obvious need for investment. But finding the money to fund that investment is not going to be easy, especially given the parlous state of Pemex’s finances.

Over the past decade, the shrinking oil giant has failed to stem long-term production declines, though there are hopes that up to 180 million barrels of newly discovered reserves may help change that dynamic. Pemex has also failed to reverse refinery losses and has continually piled on fresh debt.

In the last six years, Pemex’s total debt has increased from €64 billion in December 2012 to $106 billion in March 2018. That’s the equivalent of over 10% of Mexico’s GDP. Of that debt, 87% is denominated in dollars or other foreign currencies. That isn’t a problem as long as most of the oil Pemex sells goes onto the international market and bring in dollar-revenues. But that could be set to change.

AMLO has pledged to sharply reduce Pemex’s exports in order to boost oil supply to domestic refineries. During a speech last week, he said Mexico would stop exporting oil while importing refined products, in favor of building refineries and supplying them with oil. “We’re not going to sell crude oil abroad in the medium term, we want to process all our raw material,” he said. “We’re going to extract only what is needed for our internal consumption.”

But under AMLO’s plan, Pemex would have to pay off its dollar-denominated debt with revenues largely denominated in Mexican pesos. Like most emerging market currencies, the peso has a long tradition of losing its value against the dollar. If Pemex were to begin earning most of its revenues in pesos, it would become much more vulnerable to the vagaries of the currency market and would be even more likely to go into default.

Moody’s warned last week that AMLO’s plan to stop exporting oil could pose a threat not only to Pemex’s finances but also to Mexico’s credit rating. “The oil company’s operating cash flow would decline and become more volatile under AMLO’s refining-focused business model,” it said. Pemex’s cash flow situation could also suffer as a result of the incoming government’s stated intention to not increase domestic fuel prices even if the upward momentum on crude prices continues.

The federal government’s fiscal performance would also take a hit. Pemex’s contributions to the government may have fallen as low as 11.3% of total government revenues by 2016-17, from a long-term average of 25-30%. But the loss of oil revenue from Pemex “could still substantially widen Mexico’s fiscal deficit,” Moody’s warns. The agency calculates that AMLO’s plans to halt oil exports would deprive the government of nearly 2% of GDP in revenue, forcing it to “either raise taxes or abandon its pledge of fiscal discipline.”

So far, AMLO and his team have downplayed the ratings agencies’ warnings. Rocío Nahle, Mexico’s next energy minister, called Fitch’s decision to downgrade Pemex’s outlook “absurd”. “I respect them [Fitch] but I don’t agree with them, we’re going to get to work,” she said. “We have to start producing and building”.

AMLO’s team will need more than luck to pull this off. It’s going to be tough. After decades of corruption at every level, while bleeding Pemex of its financial resources, the Mexican state is now trying to rebuild Mexico’s oil industry, revitalize the embattled company, and develop a more nationalistic approach to energy policy, even as it risks Pemex’s investment grade status and Mexico’s own credit rating that may raise the cost of borrowing for both of them. By Don Quijones.

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