For my Energy and Capital article this week, I draw connections between Mexico’s violent drug cartels, the declining state of the Mexican economy and the outlook for Mexican oil and gas imports to the U.S.

Mexico’s Troubles Are Our Troubles

Falling Imports to U.S. Spell Domestic Profits

By Chris Nelder
Wednesday, March 11th, 2009

A new contender now tops my long list of worries: Mexico.

I have been keenly aware of Mexico’s troubles for most of my life. I lived in Mexico City for a short while as a kid, and saw its crushing poverty firsthand. I vividly remember certain formative experiences, like seeing kids my age dressed in rags and panhandling for centavos, or eight full-grown men riding a single motorcycle, or a rural cave dwelling with a TV antenna sticking out of the top, powered by an illegal tap on a nearby power line. I also grew up in Tucson, where shopping excursions to the border town of Nogales 60 miles away was standard fare when we had visitors.

But I have written about Mexico’s oil production repeatedly in this column primarily because it is so essential to US supply. Mexico is our #3 source of imports, providing 1.3 million barrels per day (mbpd), or about 6% of our total petroleum supply (EIA, Dec 2008 data).

Yet Mexico’s days as a top oil producer, and possibly its days as a democratic nation, are numbered.

Mexico’s largest oil field, Cantarell, is one of the four largest “supergiant” oil fields in the world, and was once the world’s second-largest producer (after Saudi Arabia’s Ghawar field). It peaked in 2003 at 2.1 mbpd, but thanks to a program of nitrogen injection that was pursued to maximize the rate of production (probably at the expense of long-term production), its production is crashing at an accelerating rate, currently about 38% per year. It is now producing about 0.77 mbpd, and will probably fall to 0.5 mbpd before tailing off at a gentler rate (or so Pemex hopes).

Mexico’s largest producing region is now the Ku-Maloob-Zaap (KMZ) complex, adjacent to the Cantarell complex. It’s a much smaller complex than Cantarell, and at 0.78 mbpd it is near its planned maximum production rate. Nitrogen injection was initiated from the beginning, which we could take as an indication that Mexico would rather maximize its revenue now than worry about tomorrow.

One doesn’t have to look too far to see why that might be.

Oil is Mexico’s number-one export. With its oil revenues in decline, the state is finding it increasingly difficult to fund operations-including operations against one of its other top exports: illegal drugs. 

“A State of Undeclared War”

Drug cartels have grown in power and wealth in Mexico, and have now taken to open war with the authorities, who are finding themselves increasingly outgunned against better funded and supplied adversaries sporting military-grade weaponry.

An estimated 10,000 people have died in the violence since Mexico’s president Felipe Calderón took office in 2006 and began a campaign against organized crime. Over 6,000 died last year alone, of which about four-fifths were criminals killing criminals, plus about 800 police, soldiers, prosecutors and other officials who dared to fight organized crime. Another 1000 have already died in 2009.

The atrocities committed are brazen and horrific, including torture, beheadings, and public displays of mutilated corpses. Gangs hang banners in the streets announcing their views, make public threats against officials, and make YouTube videos of their executions. Extortion and protection rackets are proliferating as the federal crackdown has splintered the cartels into warring factions. The nation’s framework of 32 independent states, a decrepit judicial process, and an ineffective and disorganized federal police force have left the nation with a corrupt law enforcement system that is ill-equipped to control the cartels.

The violence is primarily concentrated in the Sinaloa region, and along the border with the US, as gangs fight with one another for market share and try to smuggle their goods north, and guns and cash south. Consequently, the border cities of the US are fighting an escalating battle of their own.

Phoenix is now the kidnapping capitol of the US, with 366 abductions last year, mostly conducted by and against cartel members for financial gain and displays of power, but increasingly also against innocent civilians and even against anti-kidnapping authorities. Phoenix is now also the top gateway city where illegal drugs enter the US. Other US cities along Mexican borders of California, Arizona and Texas are contending with increased violence and trade in weapons.

The reach of the cartels now extends to every corner of the US, from distribution of marijuana and cocaine in major cities, to guerilla pot farms in national parks and the mountains of Northern California. Mexican drug cartels are now the major criminal force in America, surpassing the Mafia.

In a congressional hearing with the Department of Homeland Security yesterday, Rep. John Culberson of Texas called the conflict “a state of undeclared war on the southern border.”

Strangely, Mexico’s troubles have remained mostly off the radar in the US, until the State Department issued a warning on February 20 urging American travelers—particularly students on spring break—to avoid going there for their own safety.

So what does the estimated $20 billion trade in illegal drugs from Mexico have to do with energy, you ask?

Oil Exports Are Crucial

Mexico’s exports of oil and gas to the US account for over one-third of the government’s revenues, and their decline is expected to widen the country’s current-account deficit to an average 3.6% of GDP in 2009-13. Its economy is projected to contract by 2% this year as its exports to the US fall due to the recession, which has weakened the peso badly; around a third of its value relative to the dollar has eroded since last August.

The declining production of Cantarell alone will deprive Mexico’s economy of roughly $5 billion, or half a percent of its approximately $1 trillion GDP.

At the same time, a large number of migrant workers in the US are going back home as their work here dries up. (On a trip to Oregon a few weeks ago, I visited a commercial farmer who put a sign up at the end of his driveway saying “No Trabajo” after being hounded by up to five worker gangs per day looking for field work.) The loss of that income to the workers’ families back home will be keenly felt.

Add to that declining tourism revenues—my family doesn’t take shopping trips to Mexico anymore, due to poor security and other problems—and a loss of income due to the falling price of oil, and you have an economy that is truly on the ropes.

It will be very difficult for the Mexican government to maintain order, keep its people fed and sheltered, and fight the drug cartels under such severe pressures. Some experienced analysts of Mexico have even speculated that the country will not survive as a nation-state for more than another few years.

It will also make it very difficult for Pemex, under whose sole domain the Mexican petroleum industry operates, to raise the necessary capital to expand its oil and gas production. Mexican law prohibits foreign companies from owning its petroleum resources, so it relies heavily on debt backed by foreign issuers to fund its operations.

Given the increasing uncertainty of Mexico’s future, the inability of its law enforcement to maintain security, the crippling of its currency, declining tourism, and a possible downgrading of its investment grade on the horizon, I find it hard to imagine how Pemex will continue to invest at the necessary levels—$20 billion in capital expenditures are planned for this year—to keep its oil and gas flowing to US markets.

On current trends, Mexico’s oil and gas exports to the US will cease entirely within seven years.

How will the US adjust to a 6% loss in its oil supply from Mexico alone, when all of its other major suppliers are also in decline, and foreign competitors are able and willing to pay hefty sums for the last, marginal barrel of exported oil?

It won’t be easy, but our remaining reserves right here at home will become an increasingly important answer to that challenge, and those barrels will sell for much higher prices than they do today. Not only is Mexico my number-one worry, it’s also my number-one reason to invest in domestic oil and gas producers with significant reserves.

Much of our unconventional oil reserves are too expensive to produce at a profit while oil is still in the $40s. But that might turn out to be a good thing. If we were to leave them in the ground for another three years, they could be worth three times as much when we do produce them, and make a crucial contribution to our national security.

Until next time,

Chris