7/10/2008: Commentary: America Has Its Problems, But Mexico Is Worse:

The world’s second-richest man is Mexican. His estimated net worth is
$60 billion. Yet, more than 50 million people living south of the
border live on just dollars per day, and the standard of living for
many millions is about to get worse.

Over the past few years, Mexico has made big strides in reducing
poverty and increasing the standard of living for many. However, it is
becoming increasingly evident that the Mexican miracle was built on a
sand foundation. The economic tide is now turning, and the current
pillars of its economy, oil production, foreign remittances and low
inflation, are being undermined.

Mexico is primed to boil, and the spillover could scathe the United
States. Mexico supplies massive amounts of oil to the United States,
behind only Canada and Saudi Arabia in volume. So any interruption in
the flow of oil will have huge implications for America as well as
Mexico. In dollar terms, oil is the single most important revenue
stream for the Mexican government, providing for a whopping 40 percent
of all federal spending.

However, Mexican oil production is plummeting. Much of the problem
stems from Mexico’s super giant oil field Cantarell. Located in
shallow waters off the coast of the Gulf of Mexico, this one field
alone supplied about 60 percent of Mexico’s output until recently.
Output peaked in 2004, after which pumping volumes drastically
declined. Production cascaded 13.5 percent in 2006 and 15 percent in
2007, and 2008 looks like it may be an even bigger disaster.

Making matters worse is that for every 10 barrels of oil pumped out of
the ground last year, only four new barrels were discovered. If trends
continue, Mexico will stop exporting oil and begin importing it in
just four to six years. A turnaround is not likely, due to a number of
factors.

According to Mexican law, Petróleos Mexicanos (pemex), the state owned
oil company responsible for all the nation’s oil production, is not
allowed to partner with any foreign oil corporations to look for oil
on Mexican territory. This is a huge handicap for pemex because it
does not have the technology it needs to efficiently explore the
Gulf’s deep water. So potential resources are left undiscovered and
untapped.

Additionally, since pemex is government-owned, its annual profits are
used to cover government spending as opposed to exploration and
development. Instead of creating future revenues, current revenues
subsidize the living standards of the Mexican populace. The state
requires pemex to sell fuel at prices sometimes less than half the
market value. This kind of management has virtually bankrupted the
company, despite the fact that oil is trading at over $140 per barrel.
In 2006, pemex was the most indebted oil company on the planet.

If not for record-high oil prices, both pemex and Mexico would have
already faced a severe budget crisis. With 40 percent of government
revenues at risk, the whole country could have easily descended into
chaos, with resultant devalued currency, rising interest rates and
much higher taxes. Record oil prices have temporarily plugged the gap
left by plunging production levels. But if high oil prices eventually
retreat, Mexico is going to face a huge cash crunch.

For now, there are other serious ramifications. Declining Mexican oil
production means that either Mexicans or Americans will have to do
without. With global oil supplies as tight as they are, either
decision will have far-reaching effects.

Mexico is left with ugly choices. If it chooses to reduce exports to
America, it will lose its largest source of foreign capital.
Consequently, the Mexican trade gap will soar, government spending
will plummet, and the peso will come under intense pressure, leading
to price inflation even more severe than current levels. Yet if Mexico
decides to restrict local supply in order to maintain its foreign
income streams, it risks choking off local commerce by inducing local
price spikes and shortages not only of fuel, but also of essential
petrochemical products like lubricants, synthetic fabrics, plastics
and fertilizer. A cauldron of social and political upheaval is
bubbling.

Mexico’s easy oil days are over. Currently, it looks like Mexico has
decided to limit exports to America, recently announcing a sizeable
reduction of 150,000 barrels per day. So America’s easy oil days are
ending too.

But faltering oil prices are not the only problem facing Mexico.
Mexico’s host country of its second-largest source of foreign income,
remittances from the U.S., is also wavering. The phenomenon of
Mexicans working in the United States and sending money home to Mexico
is well documented. In fact, foreign money sent home from Mexicans
working abroad totaled nearly $24 billion in 2006, which was over 3
percent of the nation’s gross domestic product. But these remittances
are going off a cliff too.

Mexican workers’ remittances decreased 2.4 percent in the first four
months of this year. This was the first decline for a January to April
period since the central bank began tracking the data in 1995, and
could mark an important turning point in the structure of the Mexican
economy. Add on the fact that a weak U.S. dollar means that the
dollars that are sent back are worth less, and Mexicans are really
feeling the pinch.

There are several theories explaining the dropoff, but it is most
likely a combination of a slowing U.S. economy, a drastically reduced
home construction sector, and reduced immigration due to increased
border security. Regardless of cause, the effect is that Mexican
Americans have less money to send home, and Mexicans have less to
spend.
And falling oil revenues and foreign remittances probably couldn’t
have come at a worse time, because inflation is also tugging at
Mexico’s economic and social fabric.

Although the government has sought to shelter Mexicans from rising
fuel prices, it has not been able to protect them from soaring food
and import prices. Since 2000, the price of corn, wheat and rice have
each risen over 200 percent, even spiking into the 300 percent range
at times. And much of the price increases have come during the past
two years. For example, cooking oil has risen 50 percent this year.

In 2007, thousands of protesters in multiple cities took to the
streets to protest the rising price of tortillas. The food situation
is especially dangerous for Mexico since it relies on imports for the
majority of its grain consumption, 30 percent of its corn consumption
and over 80 percent of rice consumption.

The government’s solution will only make matters worse in the long
run. On June 18, President Felipe Calderón announced a price freeze on
150 food items including beans, tinned tomatoes, fruit juices, ketchup
and cooking oil. But artificially lowering prices has a nasty side
effect. It reduces the incentive for producers to increase production.
If producers cannot make a profit because the government mandates that
you must sell at a loss, it makes more sense to close up shop. This is
why price freezes don’t work and can actually lead to higher prices,
because artificial price freezes create further shortages. If
conditions deteriorate enough, and price freezes become more
widespread, Mexicans won’t be complaining about the high cost of food,
they will be complaining about the widespread shortage of food.

Pressure is building in America’s southern neighbor. Jim Willie,
editor of the Hat Trick Letter, described how conditions in Mexico are
commonly coming to include extortion motivated kidnappings,
revolutionary insurgency, murders of police officers, execution-style
killings, gangster warfare and bomb attacks against oil pipelines.
Willie thinks the future could be even more drastically unstable:

A failed nation state is the likely outcome south of the U.S. border.
Energy network attacks, growing poverty and inequality, inadequate
government services, growing power of organized crime, corruption and
desertion of police forces, assassination of judges and officials
without consequences, and growing farmer bankruptcy are contributing
to a failed system in Mexico.

And this is coming off relatively good times, economically. Things are
going to get much worse. America’s increasingly unstable southern
neighbor is facing many stresses and declining revenue, and the
situation could melt down quickly. The amassing of tens of millions of
hungry and unhappy people across the Rio Grande is sure to also affect
America far beyond simply reducing oil deliveries.