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Mexico plays hardball

Regional outlier initially baulked at Opec’s demand to scale back barrels, before bleeding oil revenues forced a rethink

Mexico proved an unusually stubborn negotiator during last week’s Opec+ alliance crisis talks in Vienna. President Andres Lopez Obrador refused to revise down production targets, despite the oil price crash’s heavy financial toll on state oil firm Pemex. Indeed, confidence that Mexico would consent to the cuts was at one point so low that US president Donald Trump weighed in with an offer of support to help it achieve the 10pc supply drop.

Mexico eventually accepted a 100,000bl/d reduction, a cut significantly short of the 400,000bl/d that Opec and its allies originally demanded. The decrease represented half the volume pledged by Latin American rival Petrobras, despite the Brazilian company’s lifting costs being considerably lower.

“Pemex is [cutting output] for political reasons,” says Ruaraidh Montgomery, director at Latin American research consultancy Welligence Analytics. “Lopez Obrador’s main promise has been to avoid production declines to try to differentiate himself from his predecessors. But such posturing comes at a price. [By undermining an Opec+ deal] Pemex would have traded ‘maintaining production flat’ [for] losing billions of dollars of cash flow in the process.”

Flight of fancy

Lopez Obrador’s initial refusal to accept cuts, beyond the political implications, was in part because of the country’s hedging strategy. Mexico has run a sovereign oil hedge for the past two decades,

protecting its fiscal budget from a low-price environment, while Pemex has hedged c.20pc of its portfolio this year.

But with the price of Mexican crude plummeting and the spread to the WTI and Brent benchmarks widening, the logic ultimately failed to stand up. “Without the restricting Opec+ agreement, our own estimation of profits shows that they would be in the order of $2.1bn versus $2.6bn for the restricted case,” says Arnulfo Rodriguez, principal economist at Spanish bank BBVA.

“Markets and finances will place a further damper on Pemex’s plans to sustain production even at lower Opec-agreed levels” Padilla, IPD

And, even if Mexico had refused any cuts, it would still have struggled to meet its upstream targets. At the start of the year, the government announced plans to increase production by around 250,000bl/d in 2020, to 1.85mn bl/d. This was despite already being behind schedule on the startup of its 22 new oil fields.

“Production increases seen in November, December and January did not come from new fields and are not sustainable,” says John Padilla, managing director at Latin American consultancy IPD. “Markets and finances will place a further damper on Pemex’s plans to sustain production even at lower Opec-agreed levels.”

The scale of Pemex’s unrealistic ambitions was perhaps best highlighted by the company’s plan to drill 25 new wells at the onshore Ixachi field this year. “These onshore wells are not easy, taking six months to drill at a cost of $35mn each due to the high pressure/high temperature nature and depth of the reservoir,” says Montgomery.

Heavy load

The financial burden on Pemex was onerous even before Mexico came to the Opec+ table. The government pledged not to add to the company’s $105bn debt but failed to scale back capex or production targets, even as an imminent economic recession loomed and regional peers slashed unnecessary costs.

Industry experts questioned the logic of the government’s strategy. “Our spending recommendation for Pemex is to cut capex across the board, as big liquidity needs could arise this year and the prospect of either issuing more financial debt or tapping lines of banking credit would not be seen positively by financial markets and rating agencies,” says Rodriquez.

$1.85mn bl/d – Mexican production target in 2020

Pemex is tasked by the Lopez Obrador administration in achieving its output targets largely without assistance from international operators—hence going it alone on the 22 new fields. But the company’s credit rating was recently downgraded amid the economic turmoil and could be in danger of dropping further notches later in the year. Pension liabilities have also soared into the billions and, despite some government tax relief, the royalty burden remains high.

Another key factor limiting Pemex’s ability to fund its upstream commitments is the Dos Bocas refinery project in Tabasco, home state of Lopez Obrador. Construction costs are projected at around $8bn, yet domestic fuel demand was lacking even pre-coronavirus. Utilisation at the country’s six refineries averages below 60pc, raising questions about the sense of allocating crucial funds to the project.

“It was not clear that the investment was ever an optimal use of capital even before the Covid-19 crisis,” says Jim Heidell, energy and utilities expert at management consultancy PA Consulting.

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