Perception is Reality… by Brian Kelly

What is that giant sucking sound I hear? It is a nice little news tidbit on Mexico and its potential threat to the United States. Huh? Isn’t Mexico our friendly neighbor to the south that provides the US with goods and services both legal and illicit?

In November, the Joint Force Command (JFC) released the Joint Operating Environment (JOE) report which details the threats that the US faces from various nations. By its own admission this report is highly speculative and meant to be a discussion starter rather than a forecast. In the report, the JFC identified potential weak and failing states. Number one on the list? Pakistan – no surprise. Number two, any guesses? That’s right, Mexico! Mexico is in the middle of a war with drug cartels and all branches of the government are under attack. The JOE suggests that an escalation in violence could lead to the sudden and rapid collapse of Mexico. I must emphasize that the report is highly speculative and admits the likelihood of a Mexican collapse to be remote.

One precursor to political collapse is financial collapse. Let’s examine what could lead to economic distress in Mexico. Clearly the weakness in the US economy is suspect numero uno, but more specifically the falling demand for Mexican oil in the US. In a piece titled, I Can Tango, Can You?, I discussed how the contango in the oil market was causing a huge build in inventories in Cushing, OK. The impact of this build is fewer oil imports, this is the Mexican connection.

The Mexican economy is highly dependent on crude oil exports; according to the EIA, Saudi Arabia, Canada and Mexico are the top three importers of oil to the US. In July and August, Mexico made one of the greatest trades of all time and bought put options on their own oil production locking in prices of $70. So how are they unstable?

Glad you asked.

Approximately 40% of the Mexican government budget is financed by oil exports and 32% of those exports come from the Cantarell field. In December, Pemex the state owned oil company, announced that production from the Cantarell field fell 33%, twice the official estimate. So the government is devoting more money to fighting drug cartels and the main source of financing is disappearing more rapidly than expected.

Furthermore, the contango in the oil market has resulted in a huge build in inventories of West Texas Intermediate (WTI) crude in Cushing, OK. WTI is a light sweet crude, meaning it has low sulfur and is easier and cheaper to refine. In contrast, Mexican crude is sour, oil-speak for more sulphur and more costly to refine. The inventory build means there is more desirable oil for the refiners to buy before Mexican crude. Luckily for Mexico, and the US, the put options on Mexican production have bought some time.

So there you have it. A country fighting a war with criminals, running out of money and losing its main source of income. While I believe that any financial instability in Mexico is likely a story for the second half of 2009, without either a significant decrease in violence or a dramatic rise in oil prices, Mexico is a candidate for rapid collapse.

Disclosure: I am short FXM.