News Quickie: July 30, 2007

Contagions: Sub-Prime is Hard to Figure…

    But Mexico Is a Clear and Present Danger

Nobody can know the impact that sub-prime mortgage defaults will have on the broader stock market and the economy. It’s clearly a negative vector for U.S. economic growth, but the question is whether it is a strong enough vector to outweigh such positive vectors such as excellent foreign growth, especially for Chindia. I doubt that and I also think any U.S. recessionary evidence (of which we have seen none thus far) would likely be rapidly met by the Fed lowering interest rates since we are headed into a Presidential election cycle.

The most likely future, therefore, continues to be mild economic growth, benign interest rates and an upwardly biased stock market. Thus, my investment strategy has not changed; I am staying long. I could be long and wrong, but I think the major impacts of the sub-prime fallout will be better lending discipline and less LBO activity, both of which could help to keep interest rates low and therefore be a good thing for both stocks and for the economy longer term. While the current correction in stocks could certainly last longer I am very confident that in three years few people will remember this event.

Nonetheless, we should keep in mind that a U.S. recession would likely cause the price of oil to fall, thus potentially causing a “double-whammy” for the now popular energy stock sector. So with oil prices approaching historical highs, this is a time of heightened risk to the energy investor. On the other hand, the global supply/demand relationship for oil, which seems fairly tight now, looks to tighten further based on rapid decline levels that are occurring in places like…

Mexico, a Potential Crisis Spot

Mexico is a highly predictable vector for higher oil prices, particularly because of its critical role in supplying the U.S. market. The short story is this: The U.S. currently imports about 1.5 million barrels of oil from Mexico every single day, our third largest source of oil after Canada and Saudi Arabia and fully 7% of all the oil used in the U.S. Within a period of five years, Mexico may not be able to export a single barrel of oil to anyone.

The full story is that Mexico faces increasingly higher probabilities of rapidly declining oil production, financial collapse, and political upheaval. The undisputable facts are stark and nearly self explanatory:

 • Mexico’s primary oil field, Cantarell, which produces 60% of all Mexican oil, has entered into a very rapid state of decline, a prime example of the rapid decline of oil fields that have been subjected to many years of Enhanced Oil Recovery. Production from Cantarell is declining at about 15% per year. At the same time domestic Mexican oil consumption is increasing at about 2% per year.

 • The decline of Cantarell is behind a recent news release that starts as follows:

Mexico, Jul 27 (Prensa Latina) Petroleos Mexicanos (PEMEX) announced that oil reserves may run out in seven years.

“Supplies of this economically exploitable resource are running out,” informed a report sent by the state owned company to the United States stock market.

A link to the full story can be found here.

 • The Mexican Constitution gives PEMEX, the national oil company, the monopoly on Mexican oil production and prohibits it from sharing ownership of its oil reserves with either private Mexican companies or foreign entities. This severely limits the incentives Mexico can offer to attract outside capital and skills to the very difficult and time consuming project of exploring for and developing new oil fields in the Gulf of Mexico.

 • Tax revenue from oil exports provide 40% of the funds spent by the Mexican government. Clearly, to the extent that oil exports decline (at a rate greater than the increase in the price of oil), the Mexican budget will have less funds to spend. This is likely to reduce Mexico’s ability to provide both police security and social services, thus increasing social unrest.

 • The Mexican government is currently fighting a two-front war for social calm. One front is the drug dealers’ corruption of the regional police. Since taking office and through June of 2007, President Calderon has replaced 284 officers of high rank in the regionally-based federal police forces. The other front is against the socialist and largely Indian (Mexicans of native and mestizo descent) political forces led by the former Mayor of Mexico City who was very narrowly defeated in the 2006 Presidential election, which was disputed in much the way Bush-Gore was in the U.S. Recently, Mexican terrorists blew up oil and gas pipelines in three explosions, so it seems that the government is already being challenged militarily. Any significant diminution of the federal government’s financial capabilities from reduced oil income will hurt their ability to pursue this war on both fronts and thereby increase the likelihood of social unrest throughout the country.

 • If Mexico enters a period of increased social unrest and civil strife, the job of developing additional Mexican oil reserves will be made that much more difficult.

One cannot review these facts, it seems to me, without concluding two things:

1. Mexico faces an extremely difficult near term economic and political future, and

2. U.S. oil supplies will be made increasingly tight over the next five years by reduced Mexican imports which will require the U.S to import more from other countries. Such substitution can only occur by means of the U.S. bidding more aggressively in the global oil auction process. That will substantially increase the pressure for higher oil prices.