PEMEX, Risks Ahead – bridport and co

PEMEX, Risks Ahead – bridport and co

Background

 

PEMEX is a fully integrated Mexican oil and gas company. It is involved in every aspect of the oil and gas value chain, from exploration, production, refining, distribution and marketing. It is owned 100% by the Mexican Government. PEMEX is Latin America’s largest corporate bond issuer and with nearly USD 100bln in debt, it is the most indebted oil major.

PEMEX is the largest tax contributor to the Mexican Government. It generates approximately 2.5 million barrels of oil daily and more than 6 million of cubic feet of natural gas. It also has 6 refineries and petrochemical complexes, 9 gas processing complexes, operates 83 land and maritime terminals, as well as oil and gas pipelines, maritime vessels, and varying fleets of ground transportation in order to supply over 10’000 service stations throughout Mexico. In 2017, PEMEX exported 60% of its crude oil production.

 

Regulatory framework

Until 2013, the ownership of Mexico’s subsoil, and its content, was awarded to the Mexican State and PEMEX had the exclusive right to manage all petroleum activities. PEMEX was viewed as a revenue maximiser by the government, focusing on volumes rather than profitability, and the lack of capex and investment in exploration led to the deterioration of infrastructure and the depletion of resources. This underinvestment forced Mexico to import about half the gasoline it consumed.

However 5 year ago, the current Government, led by President Enrique Pena Nieto, managed to implement a series of institutional reforms to improve competitiveness and the growth potential of the Mexican economy. The constitution was amended to allow foreign and private investment in the petroleum sector, as well as in deep water oil which had long been underdeveloped.

The aim of the reform was to attract foreign investment and transform the sector into an open market, in an effort to gradually reduce PEMEX’s debt and tax burden, and reverse a trend of 13 years of production decline. For many years PEMEX had borrow to pay taxes and the Mexican government borrowed to fund PEMEX deficits. The situation got better after the energy reforms but PEMEX remains highly indebted, its liquidity ratios and free cash flow are weak, and there is still a lot of room for operational performance to be improved.

Risks lying ahead

Despite the recent move by Moody’s to revise its rating outlook to stable from negative, we believe much of the upward price movement has been achieved and that the price downside risks outweigh the upside potential.



First of all, Mexico will elect a new president in July this year. The poll leader is Former Mexico City Mayor Andres Manuel Lopez Obrado, a left wing-wing populist politician who strongly advocates against the energy reforms and foreign investments in the oil sector. He has pledged to review, or even revoke, the energy reforms if elected. While this might prove difficult, it is likely more red tape will lead to a deterioration of the climate for foreign investment, which in finality will reduce PEMEX cash flow prospects and therefore debt servicing ability.




Another consequence could be that PEMEX would see its cash siphoned by the new government, as it was the case for many years prior to the reforms.



Secondly, the climate on the international scene is not favourable to Mexico and political risk is high. The North American Free Trade Agreement, NAFTA, is currently being renegotiated, but its fate remains uncertain. President Donald Trump has threatened to quit the agreement if he cannot get a better deal. The US bought nearly three quarter of Mexico’s USD 435bln of exports in 2017 and inversely Mexico is the United States second largest export partner behind Canada. Even though the energy sector is out of the scope of the agreement, any change to the agreement that would weaken Mexico finances is likely to negatively impact PEMEX given how one depends on the other.



Finally, with years of depressed government rates and compressed credit spreads, PEMEX bonds in every currency have been prime choice for “yield hunting” investors, who favoured credit risk over duration risk – PEMEX was amongst the most traded credits by bridport & cie in 2017. Along with traditional risks associated with emerging markets credits, if a credit spread widening event were to unfold, it is very likely that PEMEX bonds would be subject to a lack of liquidity, magnifying and accelerating price falls, as our client flows tend to show that yield hunters are the same investors that do not hold to their positions on the occurrence of negative credit events.
Given the strategic importance of PEMEX for the State of Mexico, and the oil company’s rating being implicitly tied to the government rating, any material change in one entity would affect the other. Below are ratios of other integrated oil and gas companies of lesser quality, but which show better credit metrics. Highlighted in blue are where the metrics are better for PEMEX.

Conclusion

Investors holding PEMEX positions should be wary over the coming months as we believe most of the positives are priced in, there is limited potential for a near-term upgrade or further spread compression – risks are skewed to the downside.

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