Mexican Economy: Does What Happens in Mexico, Stay in Mexico?

What is that giant sucking sound I hear? It is a nice little news tidbit on Mexico and its potential threat to the United States. Huh? Isn’t Mexico our friendly neighbor to the south that provides the U.S. with goods and services both legal and illicit?

In November, the Joint Force Command (JFC) released the Joint Operating Environment (JOE) report, (pdf file) which details the threats that the U.S. faces from various nations. By its own admission, this report is highly speculative and meant to be a discussion starter rather than a forecast. In the report, the JFC identified potential weak and failing states. Number one on the list is Pakistan (no surprise). Any guesses as to number two - that’s right, Mexico! Mexico is in the middle of a war with drug cartels and all branches of the government are under attack. The JOE suggests that an escalation in violence could lead to the sudden and rapid collapse of Mexico. I must emphasize that the report is highly speculative and admits the likelihood of a Mexican collapse to be remote.

One precursor to political collapse is financial collapse. Let’s examine what could lead to economic distress in Mexico. Clearly, the weakness in the U.S. economy is the number one suspect, and more specifically, the falling demand for Mexican oil in the U.S. In a piece titled, I Can Tango, Can You?, I discussed how the contango in the oil market was causing a huge build in inventories in Cushing, OK. The impact of this build is fewer oil imports, - this, is the Mexican connection.

The Mexican economy is highly dependent on crude oil exports; according to the EIA, Saudi Arabia, Canada and Mexico are the top three importers of oil to the U.S. In July and August, Mexico made one of the greatest trades of all time and bought put options on their own oil production locking in prices of $70. So how can the country be unstable?

Glad you asked.

Approximately 40% of the Mexican government budget is financed by oil exports and 32% of those exports come from the Cantrell field. In December, Pemex, the state owned oil company announced that production from the Cantarell field fell 33%, twice the official estimate. As a result, the government is devoting more money to fighting drug cartels and the main source of financing is disappearing more rapidly than expected.

Furthermore, the contango in the oil market has resulted in a huge build in inventories of West Texas Intermediate (WTI) crude in Cushing, OK. WTI is a light, sweet crude, meaning it has low sulfur and is easier and cheaper to refine. In contrast, Mexican crude is sour, oil-speak for more sulphur and more costly to refine. The inventory build means there is more, desirable oil for the refiners to buy before they think of purchasing Mexican crude. Luckily, for Mexico, and the U.S., the put options on Mexican production have bought some time.

So there you have it - a country fighting a war with criminals, running out of money and losing its main source of income. While I believe that any financial instability in Mexico is likely, a story for the second half of 2009, without either a significant decrease in violence or a dramatic rise in oil prices, Mexico is a candidate for rapid collapse.

Disclosure: I am short FXM.

Comments

[Roberm73:]

I agree, with the annoucment that pemex profits fell at double the rate expected, Mexico is qucikly running itself out money. A collapse of Mexico would be sesmic event for the US.

Jan 28 11:16 AM

[Advill:]

Mexico is one of the less explore lands in Earth, because of the historic problems of mexicans (they relate oil production with liberty and sovereing) the country has only PEMEX as oil explorer, production, transportation refining etc.... they are 40 years behind in the oil business .
Mexico has about 200 new wells per year (compare with 10 000 in US ) normally is 1:1000 .

Mexico has a lot of oil but the moment is already behind mexicans who are unable to solve their internal contradictions, if they now decide to explore and produce it ...will be to late anyway.

Mexico can survive and prosper without oil income but important changes must be meet for this and is seems highly improbable, 2009 and 2010 is not a problem 2012 will be.

Jan 28 01:36 PM

[FGH:]

Unless I'm mistaken, the second biggest source of national income for Mexico is dollar remitances from Mexicans in the United States...any guesses on which direction that is going? This adds up to a looming "triple whammy" for the Mexican economy: drug cartels threatening government and social stability; rapidly declining oil production and plunging dollar remitances. Yikes!

Jan 28 05:49 PM

[Duude:]

I fully support what the Mexican President has been doing. The only reason that it is so violent now is due to the ineffective government leadership over the last....well forever. They have only made a token effort in combatting this cancer that has taken a hold of the country. Drug smuggling and all that goes with it has become institutionalized in Mexico. It takes an incredibly courageous leader to take on these murderous thugs head on. He has the support of the people for now, but they too will grow weary. If this fight fails, everyone opposing the building of a border fence will become pariahs in the U.S.

Jan 28 10:05 PM

[Stockmaven:]

Mexico is a wreck. Watch the border states, They are going to get hit hard.

Jan 29 02:35 PM

[kotika98:]

Mexico is a whole different country now compared to 1994. A rapid collapse? Are you joking?

But about the war-on-drugs thing, i am not sure. For one, drugs are an export commodity for mexico, so it is a net contributor to GDP. As an economist you have to worry not if the drug cartels win the war, but if they lose. All those unemployed drug runners will have alot less dough to spend! Also, one could say that all wars are good for the economy, with increased government spending on the police and the army being a stimulus for the economy.

On the budget side, Mexico does indeed derive high percentage of its revenue from oil, but otherwise their public finances are solid. If the revenue from oil shrinks they might have to rely on deficit spending - just like their mighty northern neighboor.

Feb 02 12:38 PM

[GaryCamaril...:]

Ultimately, our worst problem[danger] from Mexico is the US allowing the Mexican criminal underclass to emigrate [legally or not] into the USA.Those folks are some of the most terrifyingly evil humans on earth and have a devastating impact on ANY comunity in which they reside.The multifaceted financial costs impacting comunities from insurance losses and law enforcement [apprehension , prosecution ,incarceration] alone are devastating,not even considering the obvious social trama surrounding they cause.

Mar 21 01:55 PM