Elisabeth Dellinger
Into Perspective

What to Do About Mexico’s Energy Reforms

By, 08/15/2013

Pop quiz: Should equity investors with zero Mexican exposure care about the country’s plans to allow private and foreign firms to drill for oil?

If you answered “No,” you’re probably not alone—it’s easy to assume localized policy developments in one Emerging Market economy can’t impact stocks globally. But in reality, they can have big downstream effects on companies around the world. And should they take effect, Mexico’s planned reforms could provide new sources of revenue and profits for Energy firms globally in the very long term. However, investors in the here and now likely shouldn’t get too jazzed—markets typically price in events about 12 to 18 months in advance, and the potential impact on Energy stocks within this window appears minimal.

In a vacuum, the proposed changes are a big deal. For decades, Mexican oil production has been a constitutionally enshrined, state-run monopoly. Foreign and private firms used to have oilfields aplenty in Mexico, but President Lázaro Cárdenas gave them the boot on March 18, 1938, nationalizing all resources and production. To this day, the anniversary is a national holiday, and state-run Energy firm Pemex is a source of national pride. That makes potential reform a very sensitive, politically difficult endeavor—but it would be hugely beneficial. Mexican oil production has fallen for a decade, and Pemex lacks the financial and technical wherewithal to develop new resources. Breaking the constitutional monopoly on production could drive increased production through private investment—all very long-term positives for stocks, but not actionable in the short term.

In short, there are simply too many unknowns, and the timeframe for change is too long. Together, the ruling Institutional Revolutionary Party (PRI) and the National Action Party (PAN) have enough seats to pass the required constitutional amendments, but at the moment, they have competing measures. Two weeks ago, PAN proposed ending the constitutional restriction on oil and gas concessions and, potentially, tendering shares of Pemex to the public—sweeping change. PRI’s proposal, announced by President Enrique Peña Nieto on August 12, doesn’t go quite as far. It would allow private firms to partner with Pemex on oil and gas projects and share in the profits, but it wouldn’t allow concessions—resources would remain the property of the state. It would also keep Pemex fully state-owned.

Despite the parties’ differences, PRI’s measures do appear likely to pass. PAN might prefer more extensive reform, but they likely understand the PRI’s more incremental changes will still benefit Mexico over time. Plus, given the popular stance against energy monopoly reform, PRI’s measure likely stands a better chance of being ratified by the states—it represents a workable middle ground. In fact, Peña Nieto was careful to couch his plans as adhering to the original intent of the 1938 expropriation, which should help shore up popular support. We may see some politicking and protesting as the amendment circulates the national and state legislatures, but it should ultimately find sufficient support.

However, amending the constitution is only the first step. Once the constitutional restriction on private investment is lifted, Congress will need to pass secondary legislation to cement the reform specifics, including guidelines and requirements for structuring joint ventures and the taxes and royalties on new production. This process could trail well into 2014, so a year could pass before we know how much firms could potentially profit. Right now, investors’ expectations seem high. If the incentives are misaligned and firms’ profit potential is smaller than folks anticipate, there will likely be limited upside potential for stocks.

Even if the opportunity is huge, firms won’t be able to capitalize for some time. The lengthy legislative process makes it unlikely new investment inflows begin before late 2014, which means production likely wouldn’t increase significantly until 2015 or 2016—potential profit gains are very far downstream. Granted, markets likely move in advance, but this is still far outside of markets’ normal visual field. If investors don’t expect Energy firms to start reaping higher profits for three-plus years, they likely won’t see much point in owning these firms during the less profitable interim—especially with Energy firms facing so many other headwinds right now.

So investors should keep an eye on Mexico’s progress and be mindful of potential opportunities in the future—always think globally! But rushing headlong into Energy stocks today in an effort to capitalize on something that might happen years from now likely isn’t the best portfolio move.

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*The content contained in this article represents only the opinions and viewpoints of the Fisher Investments editorial staff.


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