July 12th, 2020

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Mexico: the State, Oil and Silver

by Roland Watson
The New Era Investor Newsletter
June 30th, 2005

The giant Cantarell oil field lies deep under the water of the Gulf of Mexico. But in financial terms it stands astride the entire nation of Mexico. Since its discovery in 1979, it has been the mainstay of Mexican production accounting for nearly 60% of the country’s total production of over 3.3 million barrels of oil per day.

That number of 60% is also appropriate as it is the cut that the Mexican government takes from the revenues of the state oil company, Pemex in taxes every year. With those revenues totalling $69 billion last year, the Mexican state is whistling all the way to the bank. And the good times just seem to keep on rolling as crude oil has stubbornly stayed in the $50 region most of this year.

At the political level, these revenues add up to about one third of government spending on welfare subsidies and so on. A small calculation shows that the output of Cantarell provides about 20% of government spending funds.

Now for the bad news, this is set to decline at an alarming rate with the recent announcement from Pemex that 2005 is the year that Cantarell will begin an irreversible decline in production. This is set to drop from 2.11 million barrel per day to 2.02 million for this year. At $50 a barrel, that is a loss to the State coffers of nearly a billion dollars over the year. And what is more, we can expect the rate of decline to accelerate into double digits. Why is that? A look at the chart below will explain it.

Since the field came online in 1979, reservoir pressure has continually dropped as production extracted more and more oil. The crunch came in 1999 when production began to decline and massive injections of nitrogen gas were employed to stabilise reservoir pressure. At 1.2 billion cubic feet of compressed nitrogen per day, nearly half of global nitrogen production was used on the Cantarell field.

The result was dramatic with production nearly doubling to its recent maximum of 2,155,680 barrels of oil per day. But the end is now nigh and decline rates of 15% per annum can be expected as the pressure begins to drop markedly. Indeed, decline rates would have been a lot less (perhaps 5%) if the forced nitrogen pressures had not been used. It seems the Mexican government was in a hurry to cash in on rising oil prices that have more than quadrupled since the late 1990s.

For the time being, the Mexican government is urgently seeking to shore up production from smaller fields. But with production outside of Cantarell falling 18% between 1996 and 2002, this can only slow down the total decline. Beyond these, the great hope was in the 3000m depths of the underwater Abyssal Plain. But initial suggestions of a 54 billion barrel bonanza before even a test drill was attempted were shattered recently when a survey showed the terrain unsuitable for exploration. This led to a downgrading to 25 billion barrels and the possibility that such an amount would make serious drilling uneconomical. Well, maybe they’ll reconsider that when oil exceeds $100 a barrel?

So with liabilities of $88 billion dollars (four times that of Exxon) and an annual investment requirement of $10 billion just to maintain current production levels, Pemex is on the verge of bankruptcy. The Mexican government has reacted by trying to push a bill through their two houses to reduce the tax burden on Pemex over a period of several years. It should pass, subject to the two houses agreeing on the level of tax reductions.

But Mexico stands again at one of those inflection points where calm suddenly turns to turbulence and no more so for its currency, the Peso. The Mexican Peso is fiat money, but it is backed by oil. When oil revenues go up, so does the peso. When they go down, so does the peso. Consider the peso crisis of 1982. Overproduction of world oil had led to an oil glut in 1980 and subsequently prices crashed from a peak of $40 to $12 by 1986. In that downturn, the government borrowed heavily to offset lost oil revenues. Overall, they had to deal with the interest on $40 billion in loans they had taken out between 1977 and 1982 – a lot of it using the high oil prices as collateral.

The outcome was inflation rates averaging 30%, the peso being devalued by 30% and then 75% in 1982, investors pulling money out of Mexico and the government desperately nationalising the banks to impose currency and credit controls. This process was completed in 1986 with the final oil price collapse from $30 to $12 and a further devaluation and recession.

Again, another crisis hit in 1994 when a run on the peso caused it to half in value against the US dollar. Although irresponsible government borrowing and spending mainly exacerbated this crisis, the drop in oil prices from the Gulf War spike of $36 down to $15 by 1994 was obviously a factor.

But now we enter a new paradigm for the Mexican Peso. You see, the problem in 1982, 1986 and 1994 was not dropping oil prices but dropping oil revenues and hence tax revenues. Now as Mexico joins the growing list of countries in oil production decline, revenues will drop not because of a low oil price, but because of lower and lower production figures.

Back in the 1980s, pumping more oil may have eased the revenue problem, but now the Mexican government hopes that sustained oil prices will ameliorate the tax revenue situation. It will not, firstly because more tax will have to be given back to Pemex to finance more expensive exploration and extraction. Secondly, the increased debt burden will outweigh any gains. Finally, the only situation in which oil prices will rise at the same rate to offset Pemex’s production declines will be an overall peak in global world production. When that happens, we will all be too preoccupied with our own economies to think much about the Mexican Peso.

Which brings us finally to silver. Mexico is the largest producer of silver in the world at nearly 100 million ounces per year. It has produced nearly 10 billion ounces of the metal historically and probably has about 1.5 billion ounces left underground. It seems Mexico experienced “Peak Silver” a long time ago with over 80% of reserves gone.

But, unlike oil, the silver reserves will not drop as fast as 15% per annum and they are not combusted on consumption. The Mexican government faces a choice in its oil-backed peso currency. This time there is no recovery, the oil reserves will be in permanent decline and there can be no return to the glory days. Will they realise this and move from an oil-backed currency to a silver-backed currency?

Back in 1984, just after the first oil-induced peso crisis had unfolded, the Mexican government introduced the 1 ounce silver Libertad. Perhaps to bring back some dignity against the depreciation of the paper peso, but certainly a mintage that fostered a whole host of silver bullion coin programs worldwide.

However, the Libertad has limited legal tender value, what would it take to push a silver coin towards true legal tender? The 1982 oil crisis may have influenced the first issue of the Libertad; will a more permanent downturn in Mexico’s oil future convince the Mexican State to put some of their circulating currency under a more sure footing?

Many readers will be aware of Hugo Salinas Price’s campaign to convince the Mexican government to introduce a circulating silver Libertad. The mechanics of introducing it are discussed here. The question in this article is not the mechanics but the catalyst for introduction. New Era Investor thinks the downturn in Mexico’s oil revenues will precipitate another peso crisis. Allied with a future peak in global oil production and the resulting economic contractions, Mexico’s hand should be forced towards stabilising the currency.

From silver’s point of view, it may have been better if the full force of that peak in Mexican oil production had been now. It would have swayed some of the doubters in the Mexican legislature and softened the opposition of the Mexican Central Bank.

But then again, with the bill to reduce Pemex’s tax obligations very much in the forefront of the Mexican Senate; they know why that bill is before them. Will they do what politicians are elected to do? That is, to look ahead into the future and to lead their nation forward; and not only their nation, but also a host of other nations seeking certainty in uncertain times. Only time will tell, but that time is shortening rapidly.

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July 12th, 2020

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