Of the many initiatives Enrique Peña Nieto's administration is attempting to enact, energy reform is among the highest profile and potentially the most impactful.
For approximately a decade, oil production in Mexico has been on the decline due to under-investment and inefficiency. Despite that, revenues from the state-owned Petróleos Mexicanos (Pemex) constitute approximately 34% of the federal budget. If the country can successfully attract outside investment to help reverse this decline in oil production, in addition to exploiting its substantial shale resources and generally improving the efficiency of the industry, the implications are broadly positive.
Most directly, businesses and individuals will benefit from lower oil and gas prices, and the government will benefit from increased royalties. Less directly obvious, but also important, in our view, is the positive signal that the successful privatization of the energy sector will send within Mexico and to the international community.
Success in this effort should do much to bolster confidence in the competence and fairness of the administration, as well as diminish the shroud of corruption and inefficiency that has hung over the energy sector and the government for some time. In our view, this could be a meaningful turning point for Mexico.
Of course, there is much to be done before reaching this point. Most immediately, we are awaiting legislation by the end of June that would actually implement the reform and lay out the details for investment by the private sector. Negotiations between Pemex and the government will then take place to determine which assets Pemex will keep and which assets will be made available for bid by the private sector. The key here will be carving out ample high-quality assets to attract the large multi-national energy players.
Our expectation is that while all of this may not go perfectly, it will be generally successful. In our discussions with Pemex management, Mexican companies, consultants and analysts, it seems clear that the government understands the implementation challenges and the importance of this reform to the country. This understanding, along with the high level of scrutiny and the political importance of success to the Peña Nieto administration, gives us confidence that the roll out of the energy reform program will be largely successful.
With investment grade Mexican corporate bonds having returned 7.95% this year1 versus the JP Morgan Corporate Emerging Markets Bond Index (CEMBI) index return of 5.75%, a high level of optimism regarding energy reform and the Mexican economy appears to be priced in. However, we do not think it is fully priced in, and when we compare spread differentials between Mexican corporate credit and developed market corporate credit, we see room for further spread compression as the country makes progress in the roll out of its energy reform program.
With the turmoil that we have seen in recent times in emerging market countries, such as Ukraine, Russia, Turkey, Venezuela and Argentina, we think Mexico - with its positive fundamental trajectory, close ties with the U.S. and low geopolitical risk - continues to offer compelling opportunities in corporate bonds.
1 Source: JP Morgan
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