The liberalization of the Mexican energy sector is a once-in-a-generation event. The world’s sixth-largest user of hydrocarbons is moving to free-market pricing, and domestic and foreign investors alike have already made significant capital commitments to the sector in anticipation of this change.
However, along with the opportunities comes risk. Most domestic companies in Mexico’s energy sector have had little need to worry about managing price risk for the past several decades, as margins were almost entirely predictable thanks to the government’s pricing schedule. Going forward, importers, distributors and retailers can reasonably expect to bear considerable risk of price fluctuations on their own books.
Oil is one of the most liquid markets in the world, but it has had significant volatility at times. Consider that the price of oil can fluctuate daily by about 13 peso cents per liter. For many companies in the sector, that fluctuation could easily represent half their margins. That is a considerable risk.
It’s crucial for companies to plan for how they will operate in this new environment.
Mexico’s near-term energy future: Three scenarios
Since free pricing began almost a year ago, there has been a great deal of uncertainty in the market. Trade disputes and tariffs with Mexico’s neighbor to the north, a renegotiation of NAFTA, and domestic elections have largely been responsible for this. Yet behind the headlines, a hybrid pricing system has evolved, and it is equally important.
Despite the nominal move to free pricing, Pemex’s dominance in the market has caused many companies to continue to buy at the discounted Pemex price in order to mitigate the risk of being priced out of the market. This status quo had been reinforced by the rise in global oil prices earlier this year, which widened the gap between what an actual free-market price would be and what Pemex was offering. The recent decline in global oil prices may put stronger pressure on Pemex’s pricing and profitability.
As the new presidential administration takes office this month, its campaign promises of drastic changes in the cost of fuels stand to be tested. The new administration could do any of these things: reverse the reforms (which could unleash significant confusion given the contracts and investments that have already been inked); continue in the current limbo; or push forward to a truly free market.
Only the first scenario reduces the potential of price risk (after the dust settles). The second scenario may not have much price risk in the short-term, but it could be difficult for companies to know how stable that equilibrium will be. And the third scenario could result in price risk falling on those operating in the supply chain.
Now is the time to plan for the future
Given that there is still a strong chance that the market will emerge into a free-pricing environment in 2019, companies in Mexico’s energy sector should be planning now for how they will manage price risk in the future.
As a starting point in this planning, they should ask questions such as:
- What are the sources of risk in our business, and how substantially could those risks impact our operations and profitability?
- How will we mitigate these risks (this could include using any number of risk management tools like physical hedges, futures contracts, swaps, derivatives or structured solutions)?
- Who in our organization will be accountable for enacting this plan and monitoring its effectiveness? And how will we put this governance structure in place?
These questions are not quickly or easily addressed. Defining and implementing a risk management program on par with those used by other companies in the global energy supply chain is worth exploring now, even if the future of liberalized pricing has not yet arrived.