John Dizard: Pipeline to a good buy lies south of the border

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There are all sorts of trends or slowly developing risks out there for the investing class – and, if you care, the rest of the world – but there is one mega-event risk: a US air strike on Iran’s nuclear facilities, possibly some time in the latter part of next year.

One hears details of preparations for this from just too many well-informed, well-corroborated sources to reject the prospect as too insane even for the cast of the dinner theatre revival of Dr Strangelove that is playing in Washington.

True, the recent Israeli experience in Lebanon discredited the idea of “precision strikes” delivering a strategic victory.

But then the concept of air power as the decisive arm in modern war has been discredited every few years for the past three generations, only to be revived by ever-hopeful politicians, air force commanders and contractors.

So an attack on Iran has better than even odds for being the climactic surprise party of the current administration.

It will not happen immediately because every service branch other than the US Air Force, the intelligence community, the Americans in Iraq and almost every US ally are opposed to this.

That gives you more time to position yourself. There will be plenty of securities you will want to consider selling as the time approaches. But what to buy? Which issuers would look better?

US domestic energy producers would look pretty good. Which oil majors could count on an enhanced position in the capital markets?

One of my nominees would be Pemex, the Mexican oil monopoly. Pemex sells about 2m barrels of oil a day to the US, an amount about equal, coincidentally, to Iran’s exports. Its status as the exclusive property of the Mexican state is engraved in the Mexican constitution and, for the moment, on the heart of the Mexican polity.

Pemex does, however, issue bonds. There are the equivalent of about $35.6bn outstanding, of which $21.6bn are in dollars. They are in my view – and in the opinion of those on Wall Street who follow them – undervalued pieces of paper.

Even after the post-election rally in Mexican securities, they yield from 105 basis points over the US Treasury curve at the three-year point to 119bp for a 2022 issue. They yield between 40bp and 50bp more than the equivalent issues of the United Mexican States.

As a relative value proposition, this doesn’t make a lot of sense to me. If the Mexican state oil company is unable to pay its debts, the US is going to have a lot of problems of its own.

Before the Mexican elections, I wrote a column that was bullish on the prospects for Mexican bonds, including peso bonds, even if Andrés Manuel López Obrador, the leftist candidate, won the presidential election.

Most American analysts on Wall Street who commented on the article agreed with me, while the informed Mexicans were scathing about my ignorance of the risks.

In the event, the idea worked pretty well, in part because the Mexican government has continued to buy back its dollar debt.

By now, the foreign currency debt burden of the Mexican state is about 5 per cent of gross domestic product.

The government has been buying back its foreign bonds with the proceeds of peso bond issues to the rapidly growing domestic capital market.

That means that Pemex will soon be the only way to get paid in dollars for taking Mexican government risk, which in a post-Iranian strike scenario would look pretty good.

There is, of course, a bear story to be told. In one word, it is “Cantarell”. That is the biggest oil field in Mexico, which produced more than 2m barrels a day last year, or 60 per cent of Pemex’s total output. That output is now rapidly declining – more rapidly than originally projected by the engineers.

Cantarell’s production is expected to decline about 8 per cent this year, 10 per cent next year and 15 per cent in 2008.

As Ted Izatt, a fixed-income analyst with Bear Stearns, says: “They can probably maintain their total production over the next three years from new production and by developing existing fields. It’s after 2010 that they begin to have a problem. For that they will need a lot of money, and, more to the point, expertise in deep offshore production from inside and outside the company”.

Pemex’s executives know that. One Mexican who knows the thinking of the upper management says: “There is a consciousness among the political class that wasn’t there before that Pemex has to be made strong. So the fiscal regime [taxes that Pemex pays the government] will give the company $2bn to $2.5bn more per year for capital expenditure. That compares with the couple of hundred million a year the company was spending in the 1980s and 1990s.”

In order to ramp up capital expenditure from 2003 to 2005, Pemex went to the capital markets to borrow $7bn to $8bn a year. Now, says our Mexican source: “The capital markets will be tapped for $4bn to $5bn a year, rather than the higher levels”.

The problem isn’t available exploration prospects, which include huge tracts of promising offshore territories as well as the entire rest of the country. It is not even cash. It is technological capacity. Pemex is willing to offer cash incentive payments to engineering contractors but the best companies want the upside optionality of production-sharing agreements.

Those probably are not constitutional – at least not yet. Any change to the oil regime will have to be public, intensely debated, and open. And it will take a while.

However ham-fisted the US administration has been in the Middle East, it has been careful not to be seen to interfere in Mexican politics. Not a peep was heard out of Washington regarding Mr López Obrador, for example. That was smart.

Should there be an Iran “event” you can expect Pemex to receive lots of carrots and no sticks from the US to increase its production. That will go to cover your interest income as surely as the 16-fold larger Pemex cash flow does now.

johndizard@hotmail.com

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