High Oil Prices Present Tough Choices to Mexico

MEXICO CITY —  With the price of oil surging to unheard-of levels in this petroleum-rich nation, the president was bursting with confidence: “We must prepare ourselves,” he declared, for “the historic opportunity to administer abundance.”

The date was Jan. 7, 1978, crude oil was racing toward an astronomical price of $38.50 a barrel, and Mexico was in a frenzy spending the billions of oil dollars pouring into government coffers.

Yet within just three years, President Jose Lopez Portillo could only watch as world oil prices crumbled and with them his dream of perpetual prosperity. Mexico plunged into a decade of crisis.

Today, as crude oil prices are again surging toward $30 a barrel, Mexican government officials and opposition party politicians have memorized that bitter lesson, and they are treating their oil windfall far more gingerly this time around. They are even creating a first-ever oil-windfall investment fund.

Even so, one downside of high oil prices for an oil-producing country remains evident: Mexico is finding it easier to put off the kind of tax reforms that would reduce its dependence on a volatile commodity, one that for the last several years has provided more than 30% of government revenue.

“Our heavy dependence on petroleum delays the economic development of Mexico,” said professor Miguel Garcia Reyes, an economist and oil industry analyst at the Colegio de Mexico in Mexico City. “Both the government and the opposition play with the oil price for their own interests, [and] when the oil price is high, there is even less incentive for the politicians to enter discussions on fiscal reform.”

OPEC Cuts Production

For every dollar that oil rises or falls, the Mexican government gains--or loses--about $800 million a year, according to the Finance Ministry.

After oil prices plunged to about $7 a barrel in 1998, on the heels of a deep Mexican recession, the government was forced to slash the budget three times, with painful cuts in social programs and investment projects.

But the recent success of the Organization of Petroleum Exporting Countries, backed by Mexico, in engineering global cutbacks in oil production has changed everything. Those production cutbacks are expected to continue, and with inventories shrinking, high prices are likely to persist.

To be sure, high crude prices are better for Mexico than low prices, if the revenues are used carefully. Even in 1998, when oil prices were much lower, the industry generated more than $18 billion for the government, helping to support education, health care and other critical needs. And, of course, oil production also directly supports a huge industry and thousands of jobs, and higher prices permit more capital investment by Petroleos Mexicanos, or Pemex, the state-owned oil company.

But high prices also tend to push back debate on big strategic questions: whether to privatize the vast Pemex chain of petroleum and natural-gas production, refining and distribution; or whether to tax Pemex like any other business and not treat it as a government-owned cash cow.

Nonetheless, chastened by memories of Lopez Portillo’s costly excesses, the government and opposition parties have begun working together to address the windfall conundrum. And, it’s important to note, all sides agree that any windfall should be spent only for long-term investments, not to finance ordinary spending programs.

“A country with one-third of its government income based on a raw material that is exported at volatile prices is subject to great vulnerability to events abroad,” said Sergio Benito Osorio, chairman of Mexico’s House Energy Committee. “Mexico has known both sides--high prices and low prices--and both extremes have caused us problems.”

Most analysts agree that the government remains dangerously dependent on oil.

That dependence flows partly from Mexico’s inefficient and porous tax system, which collects just 15% of gross domestic product in taxes and fees, one of the lowest rates in the Americas.

“We would like to break the tradition that only in moments of crisis does society recognize the need to reform the tax system,” said Deputy Finance Minister Carlos Noriega. He hopes that once the July 2 presidential election is over with, politicians will come to grips later this year with fiscal reforms.

To be sure, the temptation to use the oil money for popular good works remains strong. Said Noriega: “There is always a propensity to spend ‘easy income’ from petroleum.”

Heading Off Inflation

But Congress and the government have agreed that most of the revenue above $16 a barrel produced by oil will be earmarked for paying down Mexico’s foreign debt and for establishing the windfall fund. If oil stays around its current $27-a-barrel level, the contingency fund could easily reach $2.5 billion to $3.5 billion in the next two years, says Osorio, Congress’ energy chief.

He adds that keeping much of the money in an insurance fund would avoid another danger that often besets oil-producing countries when prices rise: inflation.

“If these excess amounts were fed fully and immediately into the economy, that could lead to overheating of the economy,” Osorio said. By keeping the dollar-based earnings in a stabilization fund, Mexico also would be building up reserves that would help sustain the value of the peso, he added.

“Almost all countries that export primary materials have some stabilization mechanism, including Norway with oil and Chile with copper,” Osorio said. “Mexico has never had this before, [and] it will be a tool for us to ride out the rises and falls in petroleum prices.”

Garcia, the Colegio de Mexico professor, said that thanks to Mexico’s boom in exports of industrial products from its assembly plants, oil today brings in less than 10% of the nation’s export earnings, whereas it brought in more than 70% two decades ago.

But oil’s share of Mexico’s tax revenue is actually higher today than at the start of the ‘90s, making the government even more vulnerable to swings in world oil prices.

One reason is that the revenue-starved government takes an ever-rising share of the royalties from Pemex’s oil production. That, in turn, has bled Pemex of funds for capital projects, even as the company has worked to modernize and make itself more efficient.

Although opinion surveys show the public continues to favor the state’s owning Pemex, the government has sought, albeit halfheartedly, in recent years to open oil and certain other energy sectors up to foreign investment. But little has come of it.

George Baker, an energy industry consultant in Houston who publishes the Mexico Energy Intelligence newsletter, said Mexico’s state ownership of the oil business exposes it to a direct risk from price fluctuations, in much the way holding a single stock, rather than a diversified portfolio of mutual funds, would.

“Increasingly around the world, countries including Venezuela, Argentina, Brazil and Norway are coming to the conclusion that they can have tax revenues from oil without the state’s being the principal wildcat risk-taker,” Baker said.

“If there were private money at risk, the government would be protected, there would be a buffer between changes in the oil market and changes in tax revenues,” he said. “Now there’s a 1-to-1 relationship: The price falls a dollar, and social programs get cut. That’s a terrible way to run a navy.”

Avoiding Mistakes

That such issues are debated at all these days is a major departure from Lopez Portillo’s time. George W. Grayson, a U.S. expert on the Mexican oil industry, wrote in the 1988 book “Oil and Mexican Foreign Policy” that Lopez Portillo had given his Cabinet members a book that contended that oil prices “can only continue to rise” and that they would again double in the ‘80s.

Grayson wrote of those times: “Like a heroin addict who sells his blood in the morning to get a fix from an eager, well-heeled supplier at night, Mexico coped with the pressures of petrolization by exchanging oil for loans.”

Noriega, one of the young technocrats seeking to modernize Mexico’s fiscal system, sounds a very different note.

“What we must never have under any circumstances is current spending programs financed by nonpermanent petroleum revenues,” he said. “One of the gravest problems we had in 1980 was to suppose that the high oil prices would be permanent and to push current spending ever higher. We built up $20 billion in foreign debt. Even now it would be a barbarity. Then it was a super-barbarity.”

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The Lure of Oil

Mexico, the world’s eighth-largest oil producer, remains at the mercy of oil markets, with much of its fortune tied to the volatile price of crude. As prices now soar again, leaders are trying to resist spending the windfall.

U.S. crude oil

prices since 1983:

Share of Mexico’s tax revenue from oil:

Friday: $27.22

per barrel

1999: 31.3% of tax revenue

from oil (estimated)Sources: Bloomberg News, Mexico Finance Ministry, Statistical Abstracts of the United States