Fitch: Reform to Support Long-Term Mexican Growth, Energy Sector

NEW YORK--()--Landmark energy reforms should be positive for Mexico's energy sector by boosting investment and potentially spurring Petroleos Mexicanos (Pemex) and Comision Federal de Electricidad (CFE) towards greater efficiencies. But they also create challenges for Pemex and in particular for CFE. The degree to which the reforms increase foreign direct investment and growth will depend on implementation and how market participants respond to liberalisation.

Energy reform follows several other structural reforms passed since President Pena Nieto took office in late 2012. This highlights the ability of the administration to negotiate with other political parties to pass long-pending reforms.

Of the various structural reforms passed, energy has the most potential to boost growth, but it will take several years to materially increase oil production. Falling electricity costs as a result of competition could improve industrial competitiveness. Mexico's economic growth was sluggish in 2013 and is likely to remain below 3.0% in 2014. Ten-year average growth of approximately 2.5% is also low by emerging markets standards. Growth will need to pick up meaningfully for per capita income to converge with higher rated sovereigns.

Mexico's fiscal flexibility has been constrained by the narrow government revenue base, high reliance on oil receipts and lack of substantial fiscal buffers. Establishing the Mexican Petroleum Fund for the Stability and Development (to be administered by the central bank) should promote the accumulation of long-term fiscal savings.

The legislation contains provisions that could result in the federal government absorbing a part of the pension liabilities of Pemex and CFE under certain conditions. However, there is uncertainty related to the magnitude of the possible increase and the time horizon over which this could occur. Currently, Mexico's general government debt burden (excluding debt of these entities) is broadly in line with the 'BBB' median. Fitch will monitor the likelihood of these liabilities being transferred and the possible impact on the sovereign credit profile.

Pemex will lose its legal monopoly while CFE, Mexico's electric utility, will see increased competition in generation while retaining the electricity distribution and transmission monopoly. Business risk for Pemex could be potentially lowered and return on invested capital increased by diversifying its asset base as the company is now allowed to partner with international oil and gas companies to share exploratory risk and technologies and expertise. However, Pemex's ability to improve efficiency remains unclear, given its strong union.

Private sector participation will ease both companies' capital investment requirements. But CFE faces greater challenges as the legislation will allow high margin industrial customers to buy directly from new independent power producers. Without significant savings, CFE's cash flow generation will probably deteriorate.

While the overall impact for Pemex will be positive, it will be gradual, and the company still faces a heavy tax and royalties burden in the medium term. Reform gives Pemex more financial flexibility through greater budgetary independence (until now, Pemex has had to obtain budgetary approval from congress annually).

However, both company's ratings will remain closely linked to those of the Mexican sovereign (both currently rated 'BBB+' with a Stable Rating Outlook by Fitch, in line with the sovereign). Both have strong strategic and operational links with the sovereign. We think Pemex will continue to face heavy cash transfers to central government in the short to medium term, as the government wants to maintain the federal government revenues from oil and gas at current levels of around 4.7% of GDP.

CFE could need support from central government without tariff changes to offset the potential loss of industry load. Tariff increases for residential and agricultural users are unlikely given the political and social costs. It is not certain that the government would provide cash injections or explicit guarantees.

Low investment, due to high cash transfers from Pemex to central government and the lack of private investment, has seen oil and gas production fall in the past decade. As a result, Mexico's estimated resources of approximately 159 billion barrels of oil equivalent have been underexplored.

Additional information is available on www.fitchratings.com.

The above article originally appeared as a post on the Fitch Wire credit market commentary page. The original article, which may include hyperlinks to companies and current ratings, can be accessed at www.fitchratings.com. All opinions expressed are those of Fitch Ratings.

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Contacts

Fitch Ratings
Lucas Aristizabal
Senior Director
Corporates
Fitch Ratings
Floor 13, Space 11126
70 West Madison Street
Chicago, Illinois
or
Shelly Shetty
Managing Director
Sovereigns
+1 212-908-0324
or
Mark Brown
Senior Director
Fitch Wire
+44 20 3530 1391
or
Kellie Geressy Nilsen
Senior Director
Fitch Wire
+1 212 908 9123
or
Media Relations:
Elizabeth Fogerty, +1-212-908-0526 (New York)
elizabeth.fogerty@fitchratings.com