Impact of Lower Oil Prices on Latin America

By: Roberto Erana

The decline in the price of oil, over 55% during the last six months to below US $50 per barrel, brings important economic and political implications to Latin America. Most negatively affected are oil producers such as Venezuela, Colombia and Ecuador, which rely on oil for exports and tax revenues, and to a lesser extent Brazil and Mexico, which have more diversified economies. Conversely, the price decline benefits oil importers such as Chile, Peru, Central America and the Caribbean. As for the world economy, the IMF recently released a study stating that lower oil prices will add between 0.3% and 0.7% to global GDP in 2015.

Increased Production, Weaker Demand

Strong oil demand, particularly in China, and geopolitical conflicts in Libya and Iraq contributed to steady price increases throughout the last decade. While prices experienced a steep decline due to the 2008 financial crisis, it was short-lived, and by early 2011, prices once again rose above US $100 per barrel.

This prolonged period of high oil prices spurred exploration across the globe, particularly in the United States and Canada via their shale oil and tar sand projects, which have added 4.0 million Barrels Per Day (bpd) to the global market since 2009. Increased global supply from Saudi Arabia and Russia over the last four years, combined with weaker than expected demand from China and Europe, contributed to the current decline in prices. The slide further escalated in late 2014 when OPEC, whose member nations produce roughly 40% of the world’s oil, left production unchanged. Saudi Arabia took a public stand that even if oil reaches US $20 it would not reduce production.

Venezuela

A prolonged decrease in oil prices will affect Venezuela more than any other Latin American nation given that oil revenues account for an estimated 95% of exports, 40% of fiscal receipts and 50% of GDP. Venezuela, which produced 2.8 million bpd in 2014 and is the world’s fifth largest oil exporter at approximately 1.7 million bpd, is estimated to possess the world’s largest oil reserves (300 billion barrels). While resource rich, sliding prices, declining production due to underinvestment, and a consistently mismanaged economy are catching up with the country. Locals are experiencing shortages on basic food and staple items, while international investors are raising concerns about the possibility of a sovereign default on their bonds. Venezuela and state-run oil company Petróleos de Venezuela SA (PDVSA) have US $66 billion in outstanding debt, which was recently downgraded to “CCC” from “B” by Fitch Ratings agency, and to Caa3 by Moody’s (one step above default).

As compounding economic issues intensify, the country will face increasing political destabilization. President Nicolás Maduro’s approval rating dropped below 30% this year, down from about 50% last year. While former President Hugo Chavez used high oil prices to promote his social agenda internally and Venezuela’s influence on the region, Maduro may have no option but to reverse course on both. Cuba, one of Venezuela’s closest allies, recently thawed its cold relationship with the U.S. after nearly five decades of diplomatic isolation. The decision was likely influenced by the near-term reality that Venezuela will reduce the sale of discounted oil to them and others in the region. Instead of being a beacon to states in the region, Venezuela is turning to others for help.

Since 2007 China has lent US $47 billion to Venezuela, making it the country’s largest creditor. Venezuela traditionally repays the loans in oil, but given recent developments, was forced to limit promised shipments. Fortunately for Venezuela, after Maduro’s visit to Asia during the first week of January, China announced a new US $20 billion investment program in Venezuela. The trip came on the heels of similar visits to Russia and Saudi Arabia. Qatar also pledged “several billion dollars” in financing to Venezuela in the second week of January. Long term, Venezuela’s crumbling economy and the dire situation of the domestic population needs to be addressed with something other than foreign credit lines.

Mexico

While Mexico ranks as the world’s tenth largest and Latin America’s second largest oil producer (2.4 million bpd), a widely diversified economy and a strong hedging program implemented by Petróleos Mexicanos (Pemex) will limit the impact of low oil prices over the next year. Mexico hedged all of its 2015 oil exports at US $76.40 in one of the largest sovereign programs of its kind in the oil market.

The biggest challenge for Mexico in the short term is how international investors react to the first set of Pemex auctions. Originally expected by mid-2015, Finance Minister Luis Videgaray announced that the auctions would likely be delayed to later in the year. Pemex is counting on the reforms to reverse the declining output. Mexican oil production in 2014 fell for the 10th consecutive year to 2.4 million bpd from 3.4 million bpd in 2004. It is expected to rebound to 3.0 million bpd by 2018 as a result of the new investment programs.

To entice investors and offset current prices, Pemex CEO Emilio Lozoya indicated that Pemex is willing to offer international companies a greater share of projects than initially envisioned. Some projects, whereby Pemex was planned as the majority owner, might now have the state oil firm as a minority partner. In addition to new wells and exploration, Pemex is looking for partners to develop pipelines, build storage terminals and industrial facilities.

Still, some of the projects, such as the shale oil and gas fields in north-central Mexico, may already be at risk due to low prices. These fields have break-even points in the US $40’s, versus overall production costs in the low US $20’s for most of Mexico (and low US $10’s for easily accessible oil in the Gulf of Mexico).

Long-term consequences of low oil prices could pose a challenge to Mexico’s economy. The impact would be felt in both fiscal revenue and in Pemex’s long-term investment program. Fortunately, Mexico has access to tools to combat such a scenario: a US $72 billion IMF credit line and the flexibility to raise taxes or reduce new government programs. While such options would not be popular or politically favorable, they could be effective in countering prolonged low prices.

Brazil

The drop in oil prices is forecasted to have a mixed effect on Brazil, Latin America’s third largest oil producer (2.0 million bpd). Much of the oil Brazil produces is used for internal consumption, with only 20% exported (8.5% of total exports). Given energy is already subsidized by state-run oil company Petróleo Brasileiro S.A. (Petrobras), domestic relief for consumers is unlikely. However, as prices decline, the size of the subsidy should decrease, easing spending pressure on the government.

Short term, lower oil prices in Brazil could strain plans for increased investment in new development and production capacity. Petrobras plans to invest some US $221 billion from 2014-2018 to exploit its “Pre-Salt” oil fields off the coast of Rio de Janeiro. Brazil’s energy minister, Eduardo Braga, stated: “Even with the current low price of oil, Petrobras needs to continue its heavy investment in the country’s offshore oil fields.” The “Pre-Salt” fields are essential to Brazil’s goal of becoming a Top-5 global oil producer by the end of the decade. However, Petrobras’ mounting debt of US $170 billion, the drop in crude prices, and a heated corruption scandal are putting those exploration projects in jeopardy and could lead to cutbacks in investment.

The state-run company is caught in the middle of a US $3.9 billion bribery scheme. The scandal involves multiple executives at the firm allegedly conspiring with construction companies to inflate the cost of contracts, skimming money to enrich themselves and funneling kickbacks to political parties. President Dilma Rousseff has come under pressure to replace Petrobras’ CEO, Maria das Graças Foster, but so far has stood by the chief executive, claiming no evidence has implicated senior management.

Navigating declining oil prices is a difficult hurdle for Brazil to contend with. Though spending has soared, production has lagged and current oil prices are adding additional tension to the world’s most indebted major oil company. Together, these factors may prevent Brazil from reaching its 2020 target goal of boosting output to 4.0 million bpd.

Colombia

Colombia is Latin America’s fourth largest oil producer (988,000 bpd), third largest exporter (650,000 bpd), and depends on oil for 55% of the nation’s total exports and 22% of government revenue. The majority of the country’s oil comes from onshore conventional basins and has some of the cheapest production costs in the region. However, low prices will cut the incentive for oil exploration, an activity vital to the industry’s future growth. Production in 2014 dropped for the first time since 2005.

The fall in prices will widen the Andean nation’s fiscal and current account deficits. Lower oil revenues, are slated to expand the fiscal deficit to 3.0% of GDP, while driving the current account deficit to 5.1% of GDP. The government implemented tax increases (passed by Congress in 2014) to close the budget gap, but further fiscal adjustments may be necessary throughout the course of the year. Still, President Juan Manuel Santos asserts that Colombia is equipped to handle the estimated US $3.8 billion budget shortfall in 2015 and aims to reduce the country’s structural deficit to 1.9% of GDP by 2018.

Proposals to help producers cope with the decline in global prices are also underway. Such measures include easing investment costs and reducing the percentage of oil that goes to the government. A meeting scheduled for January 27th with government ministers will weigh in on the aforementioned topics to prevent further drops in oil production amid spending cuts. Other options could involve lowering a fee tied to the price of oil and decreasing per-hectare charges to oil companies. If approved, the proposals would benefit companies such as Ecopetrol, the country’s largest and primary petroleum company, Canadian oil and natural gas producer Pacific Rubiales Energy Corp., and Canacol Energy Ltd., a leading production and exploration company focused in Colombia.

Ecuador

Much like Colombia, the decrease in oil prices is expected to drag on Ecuador’s economy. However, thus far, the government has been proactive in bracing for the impact. OPEC’s smallest member produces 550,000 bpd and exports 250,000 bpd. Ecuador relies on oil for nearly half of its total exports and about a third of its budget.

To mitigate the decrease in oil prices, Ecuador lowered its 2015 budget in January by US $1.4 billion (3.9%), cutting US $840 million of investments and US $580 million of expenses. The government cut expenses by reducing costs and delaying bonuses payments and salary increases, rather than directly cutting services and employment. Finance minister Fausto Herrera mentioned that the majority of the investment projects reduced and expense cuts would not have a significant impact on economic growth due to the nature and timing of the expenses.

Ecuador is also preparing its finances to combat lower fiscal revenues. On the tax side, the country implemented new taxes on telecom companies and is shoring up loopholes and exemptions aimed at reducing fraud. More importantly, the nation added significantly to its liquidity position. Ecuador obtained a US $300 million line of credit from the Inter-American Development Bank in December 2014 and a US $296 million credit line from the Development Bank of Latin America in July 2014. Additionally, the nation received a massive US $7.5 billion financing package from China, including a 30-year, 2.0% US $5.3 billion line of credit from the Export-Import Bank of China. The downside to such a facility is that it likely has strings attached and puts Chinese firms at the head of the table for future trade with Ecuador, when they may not necessarily have the best price or quality product.

Given its dollar-based economy, Ecuador faces challenges most countries in the region do not have to contend with. It cannot utilize monetary policy as a tool to offset oil price declines to spur economic activity. Further, even though Ecuador in recent years has diversified its economy by expanding its fishing and agriculture sectors, a strong dollar has made imports from Peru and Colombia cheaper than national products. Ecuador responded by implementing import restrictions and trade tariffs up to 21% on some Peruvian and Colombian items.

Argentina

Argentina, a net importer of oil, will generally benefit in the short term from the price decreases. However, the nation is in a situation similar to that of Brazil and Mexico; the low price of oil puts into question aggressive new investment programs to increase exploration and production. A prolonged decrease in prices affects the country’s directive to become more energy efficient, specifically by exploiting the Vaca Muerta fields. The U.S. Energy Information Administration (EIA) estimates that the Vaca Muerta region, located southwest of Buenos Aires and roughly the size of Belgium, may hold 16.2 billion barrels of shale oil and 308 trillion cubic feet of shale gas.

Potential Winners

Net oil importers, specifically Chile and Peru, will profit from the price slide. Both economies are dependent on sectors that use oil as a major cost component, such as mining and construction. In Chile, the global oil price slump has begun to curb the country’s high inflation. Inflation in the world’s number one copper producer dropped 0.4% in December 2014. A near 10% decline in the cost of transport fuel contributed heavily to the fall. Naturally, Chile has a deficit of hydrocarbon supplies and imports most of its energy. Currently, the country imports over 90% of its oil requirements.

In Peru, the decrease in oil prices will provide a favorable setting for its industrial, mining and construction sectors, which combined make up 36% of the Andean nation’s GDP. Overall, the country imports around US $6.0 billion of oil, lubricants and refined fuels. Cheaper oil will help cut costs for Peru’s mining and construction firms, including transport costs and the final price of end products. Lower energy costs will also benefit new copper projects, such as Chinalco’s US $3.5 billion Toromocho mine and Hudbay Minerals’ US $1.7 billion Constancia mine. Both are expected to step-up operations this year. Further, the drop could drive up consumers’ disposable income and help reduce the nation’s trade deficit, which is projected to reach US $1.6 billion in 2015. As in Chile, lower prices for the commodity will help trim inflation in Peru.

Sources: Bloomberg, Business Insider, Latin Post, MarketWatch, Miami Herald, MoneyWeek, Oilprice, OPEC, Reuters, San Antonio Business Journal, The Economist, The Wall Street Journal, Vox