Jorge Silva / Courtesy Reuters Oil workers at a petroleum well in Venezuela, May 2006.

Crude Calculus

Latin America's Risky Bet on Pricey Oil

Falling global oil prices are wreaking havoc on Latin America far beyond the economic mess in Venezuela. True, the near-60-percent drop in the price of a barrel of oil since June 2014 has compounded Venezuela’s problems—hyperinflation and deteriorating finances—that resulted from decades of mismanagement. But other countries with more prudent economic policies, including Brazil and Mexico, are also feeling the pinch. 

For different reasons and in different ways, all three Latin American countries have bet big on high oil prices. Now they must deal with the consequences—and at a time when elected leaders across the region are already facing a series of popular political challenges. Whether it’s addressing a scandal within the state oil company (Brazil), delivering the benefits of painful economic and political reforms (Mexico), or grappling with the economic chaos created by profligacy and corruption (Venezuela), the year of low oil prices will be a tough one for some of the largest economies in the region.

BRAZIL: RUNNING ON EMPTY 

For a while, the 2007 discovery of Brazil’s offshore pré-sal oil deposits—so named because they lie under a hard salt cone off the coast of Rio de Janeiro—was a symbol of the success of Brazil’s national energy company, Petrobras, and the country’s bright future. The fields were estimated to hold at least 50 million barrels of oil. So exciting and promising was the discovery that then President Ignácio Lula da Silva traveled to the rigs to welcome the first spurt of crude oil that came from the reserves, calling the find a “winning lottery ticket.”

Privatized under the administration of former President Fernando Henrique Cardoso, Petrobras retains a monopoly on Brazil’s energy sector. The energy behemoth accounts for 90 percent of the oil produced in the country, controls most of the retail gas distribution, and dominates everything in between. Although Petrobras is listed on the Brazilian stock market, the government retains a majority stake in the company, and the president appoints its CEO. 

This close relationship deepened with the government’s plans to exploit the pré-sal fields. Brasilia granted Petrobras sole ownership of 30 percent of the oil under the salt cone. It also established high local content rules, requiring that 85 percent of the technology and equipment used to develop the fields had to be produced by Brazilian firms (among which Petrobras and its subsidiaries were the strongest contenders). At the time, some observers worried about the restrictive nature of the regulations and the potential for corruption in the absence of open bidding. These concerns were largely justified: An ongoing federal investigation has revealed that some of Brazil’s largest construction companies might have paid bribes to Petrobras to receive $23 billion in contracts—with some of the kickbacks going to the governing Workers’ Party. 

Moreover, with oil prices falling, many of the contracts have now been placed on hold, leaving major Brazilian companies (such as the construction firm OAS and the drilling company Sete Brasil) struggling to pay their debts. Petrobras recently admitted that it had overvalued its assets by more than $30 billion, and the credit ratings agencies Moody’s, Standard & Poor’s, and Fitch have downgraded the company’s bonds to their lowest investment-grade status. As a result, Petrobras’ stock price has fallen by 55 percent since September, reducing the company’s value by almost $50 billion.

The prognosis would have been less grim if Petrobras and its contractors could tap the pré-sal reserves to pump their way out of their debts and fines. But to make pré-sal exploration profitable, they need oil to be close to $100 per barrel. It is nowhere near that, and an unholy knot of corruption kickbacks deters any would-be investor. Brazil’s economy is expected to contract by 0.1 percent this year, and broiling political turmoil has tainted the governing party, plunging President Dilma Rousseff’s popularity to less than 20 percent. The once-promising oil industry increasingly appears to be a symbol of Brazil’s endemic corruption and a reminder of things that could have been.

MEXICO: OIL TURMOIL

For Mexico, the drop in oil revenue comes on the heels of politically wrenching regulatory and constitutional reform to open up the long-closed national energy industry to foreign investment and production. Since the discovery of large oil reserves in the 1970s, Mexico has become the region’s third largest oil producer, but the government has sought to avoid becoming a petro state, in part by diversifying exports. (Today, oil represents less than 15 percent of the country’s exports even though it accounts for 30 percent of public revenue.) As a result, Mexico was in a better position than Brazil to withstand the economic hit of declining prices. Still, the crisis could hardly have come at a worse time.

Oil has been protected in Mexico’s constitution since early in the twentieth century, and, in 1938, then President Lázaro Cárdenas nationalized the oil industry. The state-owned oil company Pemex has a monopoly over all aspects of the country’s hydrocarbon industry, from exploration to production and retail sales. Shortly after his election in 2012, President Enrique Peña Nieto, a leader from the same party Cárdenas belonged to, set out to open the oil sector to foreign investment. The reform had been long anticipated; Mexico’s large Cantarell field was approaching depletion, and Pemex needed both technical expertise and new funds to explore the challenging deepwater wells in the Gulf of Mexico as well as the possibility of producing shale gas. The final package of reforms, put in place in December 2013, granted foreign investors greater scope in exploration, drilling, and production. The post-reform elation led some economists to predict that the changes would boost Mexican GDP by more than one percentage point.

However, those predictions didn’t take price fluctuations into account. The recent cratering of oil prices will lower Mexico’s public revenue and place Pemex under growing financial strain—not to mention fail to deliver the anticipated GDP boost. A recent study by the Council on Foreign Relations predicted that the Mexican government would come under severe stress if oil falls to less than $70 per barrel and stays there for a year or more. And last month, Mexico’s Central Bank lowered its growth outlook for 2015 from the earlier prediction of 3.0 to 4.0 percent to a rate of 2.5 to 3.5 percent. These blows came just as the Mexican economy appeared to gather steam after being dragged down by the 2008 recession in its biggest market, the United States. Fortunately, years of solid fiscal and macroeconomic management has put the government in a comfortable place to borrow. 

The oil price drop has also slowed the opening of countries oil fields for exploration. Mexico recently invited foreign companies to submit two separate rounds of bids for exploring the shallow-water oil fields in the Gulf of Mexico’s Sureste Basin. Response to that particular invitation has been strong—but that was mainly because the oil in the fields was already guaranteed and will be easy to reach. Lower prices have now forced the government to shelve plans for exploring deepwater reserves and will likely delay any efforts to explore shale gas. 

But the greatest toll may be political. In addition to launching the oil sector reforms, Peña Nieto overhauled Mexico’s tax and education systems shortly after assuming office. Each of these steps had key detractors: His energy reforms angered the powerful petroleum workers’ union and his tax reforms angered the business community. The measures also hit at sacred cows—Mexican sovereignty over its oil has been a nationalist touchstone since the revolution—and generated loud political protests. The implicit bet was that the reforms would unleash enough economic growth to drown out the criticism. 

Not only has the global oil market failed to follow that plan, but the Peña Nieto administration has been battered by a series of political crises, including several corruption allegations and protests over the government’s slow response to the disappearance and murder of 43 teaching students in September. As a result, the president’s approval ratings have fallen to the lowest point for a Mexican head of state in over two decades.

VENEZUELA: AN OILY MESS

And then there’s the political and economic basket case that is Venezuela. Since 1999, when former President Hugo Chávez came to power, the share of oil in Venezuela’s exports has risen to 95 percent. Over the same time period, lack of investment in new exploration and technology has cut down the country’s production rate from 3 million barrels a day in 2000 to just 2.4 million barrels at present.

Now, with a sharply overvalued exchange rate and falling oil prices, Chávez’s successor, President Nicolás Maduro, is teetering on the brink of default. His government has attempted to maintain a complicated three-tiered exchange rate, under which the national currency trades at 6.3 bolivares to the dollar at the top end and at 170 to the dollar at the low end. But even the low-end rate doesn’t reflect the prevailing black-market price of some 190 bolivares to the dollar. 

And if exchange rate inflation were not enough for a central bank struggling with reduced export income, the government has long been dipping into the central bank reserves for its generous public programs. As a result, federal gold and foreign currency reserves stood at a paltry $21 billion in November, according to some estimates, with close to $11 billion in debt payments due in 2015 alone.

Venezuela’s economic woes have sent the political fortunes of charisma-challenged Maduro plummeting; his public approval rating now stands at 22 percent. His response has followed his preferred strategy: to crack down on the opposition and to blame the United States. As just the latest example, Maduro has arrested Caracas Mayor Antonio Ledezma, whom he accused of participating in a coup plot hatched by Washington. Many have speculated that such far-fetched claims betray desperation and indicate that Maduro’s days at the helm are numbered. 

Whatever the outcome of Venezuela’s bleak economic and political situation, a collapse of its economy would send ripples throughout the region. For more than a decade, Venezuela has provided cheap oil—shipments subsidized through low-interest-rate loans—to 16 countries in the Caribbean Basin. Cuba is the most obvious beneficiary, receiving close to 100,000 barrels of oil a day, as part of Venezuela’s total economic aid that could account for around 10 percent of Cuban GDP. But other countries, from the Dominican Republic to Haiti, have also come to depend on Venezuela’s generosity. True, many of these countries would benefit from lower oil prices for their energy imports if Venezuela’s economy collapses altogether, taking with it the patronage support. Yet the loss of easy oil will present a challenge for many leaders in the region, elected and nonelected alike.

CHEAP BETS

The three countries—Brazil, Mexico, and Venezuela—illustrate the danger of betting political and economic stability on high oil prices. Their recent troubles show just how risky that strategy was. If the downturn continues, these and other regional governments will have to face severe economic constraints while grappling with diverse political challenges, including demands for accountability, more equal economic benefits, and human rights. The results could be at best disappointing and at worst destabilizing. 

Only a few years ago, many observers, caught up in the celebration of the region’s robust economic growth, were declaring a new era for Latin America. What they were forgetting is that high commodity prices of the early 2000s had much to do with this progress. The costs of earlier hubris will now be felt by all, and for some governments and their citizens, those resource-based lotteries could seem, in retrospect, just a fickle scam. 

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