Mexico is Burning

Dateline:Outta Gas and Outta Patience

Mexico suddenly finds itself in dire straits. A number of things which were neither foreseen nor planned-for have suddenly occurred. Three years ago, sub-$100 oil seemed like an impossible fantasy, at least for consumers. A slowdown or reversal of globalization was seen by no one until quite recently, when Brexit shook the establishment. Trump was considered a long-shot candidate right up to the eve of the election. Worse, the peso has lost nearly 50% of its value over the last two years, recently exacerbated by the Trump victory. And the final blow, gasoline, which remains in plentiful supply on global markets, is now having trouble finding its way to Pemex stations across the country, even at newly elevated prices, which should theoretically stimulate supply.

Of course, the most pressing of these issues is gasoline. Even back in 2014 when I did my road trip, gasoline was a contentious topic in Mexico, having seen a steady upward climb in prices. Now it’s everything.  Given the recent, hefty, and indeed record-setting price hike in Mexico, combined with shortage, I decided to do some research to better understand the facts. I looked at DOE data on global production and pricing of crude, and domestic pricing of gasoline. I looked at historical Mexican gasoline prices, and I looked at the exchange rate. I even read through bits of Pemex’s 2015 annual report. I’ve also read many articles in the Mexican press about the situation.

I learned some interesting things. First, since 2010, the price of Magna (regular unleaded) has had one very minor dip (Jan 2016) in an otherwise uninterrupted rise. Mostly those rises have been around 1% per month. Sure, they add up over time, but any given monthly hike is not too big, so people grumble, but then move on.

Relentless Price Increases in Pesos

However, the most recent hike was the biggest ever, 14% in a month for Magna, more for premium. That, along with shortage, has unleashed the simmering fury.

Poor Policy Making in Action

But the real culprit is not gasoline; it’s the USD/MXN (peso) exchange rate. Over a very long time frame, the peso has mostly only moved in one direction versus the US dollar: down. Sure, it’s not a perfectly smooth downward path, but the longer term trend is about as inexorable as any seen in finance. Historically it’s been a mostly gentle depreciation, with a few twists and lurches along the way. More importantly, it’s been manageable both for the economy and for Pemex.

One Direction: It’s Not Just a Boy Band. Pesos per USD Over Time

But things changed in the fall of 2014, when crude oil started to tumble in earnest and OPEC gave up trying to stop it. Suddenly the peso’s gentle, long-term swoon turned into a dive, creating a host of problems, particularly for energy and imported goods.

Gentle Peso Decline Turns into a Swan Dive. Source: Federal Reserve

Not only do currency traders view Mexico’s economy as dependent on oil, and thus vulnerable, but the picture for Mexican oil continues to worsen, well beyond the price of crude. In 2014, along with the global crude price, Mexico’s crude production began to decline at an accelerating rate. Add to this the fact that as the most liquid emerging market currency the Peso gets used as a proxy to short oil, and you have a pile-on to the poor Mexican peso.

Production Continues to Decline, Now at a Faster Pace. Source:DOE

So the gasoline problem is really an exchange rate problem, exacerbated by political bungling, and crippled, inefficient Pemex. In USD terms, the price of gasoline in Mexico has fallen since 2014, which reflects the global reality of excess supply against relatively fixed demand. And prior to late 2013, gasoline was actually cheaper in Mexico than in the USA. Even now, the Mexican price premium is nothing compared to places like Europe or Japan.

US vs Mexican Gas Prices. Converted to USD/Gal at Avg Monthly Foreign Exchange Rate

As for political bungling, Peña Nieto hasn’t helped his own cause. During his 2012 campaign, he promised that the energy reform would spur foreign investment and lower the price of gasoline to consumers. Had he been able to wave a magic wand and immediately turn the creaky Pemex-controlled monopoly into a thriving, competitive marketplace, this might have come true. But given the reality of a very long lead time to that promise, it was nearly impossible that it would work out as expected. In order for him to have been correct, he would need to accurately forecast both the peso exchange rate and the price of crude more than three years out, an impossible task for anyone. Sure, he was correct in essentially saying that Pemex was wildly inefficient. But he erred in thinking he could foresee future prices.

So instead of what he might have expected — a soft decline in the peso, and crude oil trading around $100/BBL — he got a collapse in both, exacerbated by steep production declines at Pemex. Worse, Pemex’s finances collapsed along with the crude price, thus cutting off a source of financing for the Mexican government. So by the time the Energy Reform was passed, and Mexico held its first auctions for oil drilling rights, the big, global energy producers responded with a collective yawn. Most of the drilling rights went unsold, leaving yet another hole in government finances. The majority of Mexico’s crude lies offshore, and it’s expensive to find and expensive to extract. Below $50/BBL it probably isn’t worth the hassle, especially when fracking costs onshore in Texas continue to plummet. Add to that the political risk of operating in Mexico, where the rule of law can be a variable thing, and a weak and bureaucratic justice system operates at glacial speed, and foreign oil producers stayed away.

As for Pemex, it is rapidly on its way to becoming a national liability instead of a national asset. It’s suffering perhaps the worst possible business nightmare of rapidly falling production, and a steep fall in the prices it can charge. Add to that enormous liabilities in the form of pensions and union contracts, and it’s in a tough spot. Oh, and the drug cartels have expanded into pipeline theft, stealing millions of liters of gasoline and disabling pipelines in the process. Add all that together and suddenly you have a state-owned albatross which can only be bailed out by radically higher oil prices, something not on the immediate horizon.

As for the immediate shortage, the above longer-term issues collided shorter-term with the law of supply and demand. While I have zero evidence to support the following thesis, it makes economic sense. Knowing that gasoline prices would be 14% or more higher in January than in December, Pemex and the gas station operators had every incentive in the world to “run out of gas” as December rolled to a close. Right? Hold your gasoline for an extra week or two and suddenly it’s worth 14% more. What sensible capitalist wouldn’t do that? Now, I don’t know if that’s what actually happened, but it seems to be the simplest explanation for sudden shortages around the country. And if that’s correct (and I have to believe it is at least partially correct), then policymakers erred big league in not foreseeing and addressing this problem, possibly via weekly price increases or some other measure.

But whatever caused the shortage, Mexican consumers are now mad as hell, and they feel betrayed once again by a government which is widely seen as rapacious and unresponsive to the needs of the ordinary people. Sadly and ironically, their protests are making things worse. Yesterday I read about a typical Mexican form of protest, shutting down federal highways. While such protests are, in my view, almost always misdirected, in this case they are almost comically misdirected. Not only are hapless drivers now wasting more gasoline idling on stopped freeways, but stalled gasoline trucks can’t make deliveries. Add to that the fact that people are trashing, burning, and sacking those gas stations, and any reasonable observer would conclude that this will only exacerbate the problem.

No Gas? Let’s Steal Toys!

Alas, Mexico is now in a tough spot. There’s zero confidence in the government. People are just angry, and acting out. There are reports now of looting all around the country. Toy stores, electronics stores, and other businesses completely unrelated to gasoline are being looted with abandon. Civic order seems to be breaking down in an unprecedented manner. Given the above, it’s hard to see a rapid resolution to the problem, even at higher prices. Gas stations will take time to rebuild, and as long as the highways remain blocked, gasoline won’t flow. Add to this misery the fact that the peso takes a dive every other time that Donald Trump issues a tweet, and you have a formula for more social unrest. As for the longer-term fallout, no one comes out looking good in this. The government manages to look incompetent, and possibly heavy-handed. The looters look just as bad as looters everywhere, and with handful of deaths to boot, Mexico just got another black eye.

At the root of the problem is the exchange rate as I’ve demonstrated, yet there’s little the government can do, though it is trying. Banxico, Mexico’s central bank, has raised overnight rates five times in 2016, for a total increase of 250 basis points. Each hike put a temporary floor on the peso, but ultimately did nothing to halt its slide. Mexico now has one of the higher overnight rates in the world, which should theoretically attract peso purchases.

But it’s not working. Thursday Banxico intervened directly in the market, purchasing one billion dollars worth of pesos, but the effect lasted all of six hours or so. Friday, Banxico intervened again with another billion.

Market Not Impressed With Banxico Intervention

This time it seems to have halted the slide, at least for now. But such intervention is not sustainable as it will chew up foreign exchange reserves in a hurry. And Mexico’s foreign reserves took a hit in 2015 and haven’t recovered. Moreover, central bank interventions in currency markets have a long and storied history of failure. If the market wants to take the peso lower, it will.

Foreign Exchange Reserves Off Their Highs

So Mexico finds itself in a tough spot. Though the peso could bounce a bit from here in the short term given the recent bolus of bad news, I suspect that it will find lower levels before stabilizing. Trump indeed will build the wall. Though that shouldn’t affect Mexico’s economy directly, it will be a psychological blow for the country and its investors. Worse, Trump has already persuaded several high profile companies not to invest in Mexico. And whether he can actually carry through with his threats or not, we can be certain that any company which had been considering inbound investment in Mexico has to at the very least be delaying such plans to see what comes after the inauguration.

As for this gringo, I’m fairly convinced that now is not the time to be buying property in Mexico. The peso is likely to get cheaper in my view. Between higher interest rates, higher gasoline prices, likely increases in inflation, and a “Trump-nado” about to be released, Mexico is probably looking at a recession in the next year. Given the social fragility that this episode has revealed, one can only wonder what might occur during a full-fledged recession. Buckle up. It’s going to be a bumpy ride.

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P.S. This post has been a couple days in the making. This morning’s news suggests that the worst of the rioting and shortages may be over or on the mend. Nonetheless, I believe my conclusion still stands.

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P.P.S. For an earlier analysis of the Mexican Peso I wrote in January 2016, click here.