They sang the national anthem and raised their fists in victory. Senator Carlos Navarrete, leftist leader of the Mexican senate, was especially joyful. “We triumphed! We triumphed!”he said.

What the victors did not realize — or refused to recognize — is that their “triumph”merely took Mexico one step closer to the brink, to a deep, dark chasm into which the entire economy could fall…

Monday was Cinco de Mayo, the “Fifth of May,” so it’s fitting to touch on Mexico this week. Many believe Cinco de Mayo is to Mexico as July 4th is to the United States, but that isn’t quite true. It’s actually a regional holiday for the state of Puebla. (Mexican independence day falls in September.)

In other news, crude oil hit new record highs above $120 a barrel this week. Arjun Murti, the Goldman Sachs analyst who first called for a $105 oil “super-spike” three years ago, now sees the possibility of $200 crude in the next 12-24 months.

You might not see the connection between Mexico and the price of crude at first glance. But believe me, the connection is there — and it’s frightening.

Let me explain…

Bigger Than Exxon

Though not a member of OPEC, Mexico is the seventh-largest oil producer in the world. Petroleos Mexicanos, or “Pemex,” is the country’s state-owned oil company. Pemex pumps out more oil each year than Exxon.

Needless to say, oil is a key driver for the Mexican economy. The cash flow from Pemex alone pays for 40% of Mexico’s federal spending.

Imagine if the U.S. government drew nearly half its funding from the revenues of just one company. That would be one heck of an important company. You would think the powers that be would do everything in their power to keep the cash flowing in.

You would think… and yet, Mexico’s oil giant is headed for collapse.

According to Bloomberg, Pemex is plagued by “too little investment, high taxes, laws that forbid competition, corruption, and corroding and exploding pipelines.” That’s just for starters.

A Budding Crisis

It’s not as if the Pemex crisis is new. Observers have been sounding the alarm with ever-heightening concern for at least the past decade. In the past few years, though, things have taken a serious turn for the worse. The company’s 110,000 union workers are poorly trained and hard to control. Fatal accidents are increasing.

Worse still, Mexico’s oil fields are running dry.

Take the Cantarell field, for example. Cantarell is Mexico’s biggest field. In fact, it’s the second-largest oil field on the planet, behind only Ghawar in Saudi Arabia. In 2005, it came to light that Cantarell production had declined rapidly. “Fallen off a cliff” is how some might put it, in terms of the speed and suddenness of the drop.

If Cantarell production spirals downward into collapse, then Pemex — and, by extension, the entire Mexican economy — will be in deep, deep trouble. Mexico’s finances have been boosted in recent years by the sky-high price of crude, and those extra dollars have hidden Pemex’s behind-the-scenes problems. But fewer barrels from the ground means fewer dollars in the bank. Eventually the dropoff becomes too big — and too painful — to ignore.

Mexico’s Energy Minister predicts that, without new production, the country could be forced to import light crude for gasoline by 2011. (Most of Mexico’s oil is of the heavy, sour variety.) By the year 2016, Mexican oil exports could plummet from 1.67 million barrels per day, last year’s levels, to a shockingly low 289,000 barrels per day. That’s quite a dropoff.

Think how much the world’s oil thirst has grown these past eight years. Now think how much it will grow in the next eight years. Now consider how tight the supply-demand situation has already become — and imagine pulling another 1.4 million barrels or so off the market.

Too Deep to Contemplate

The funny thing is, Mexico has more oil that hasn’t been tapped yet — maybe a lot more.

Bloomberg again has the details: “The Mexican Energy Ministry estimates 30 billion barrels of oil and gas are sitting below deep water on the Mexican side of the Gulf of Mexico. Yet it’s unclear whether Pemex, which hasn’t been permitted to form partnerships with foreign oil companies, has the technology, money or competence to drill successfully.”

The problem comes down to technology and experience. To conquer the deep water and drill for oil 10,000 feet down, you need a heaping helping of both. Pemex has neither. The company’s engineers are not savvy enough, its technology not nearly cutting-edge enough, to handle the challenge of deep-water drilling in the Gulf.

This is where politics comes in.

Almost all Pemex profit — and as much as 60% of sales revenues — goes straight to the government. At the end of the day, the company is little more than a cash cow for the state. And because the Mexican presidency can only be held for a single six-year term, the holder of that office typically cares little about long-term planning. The focus is on spending for the here and now instead.

The nature of the beast explains why Pemex is poorly outfitted and poorly run. Political promises are expensive and Pemex cash is there for the spending; only scraps are left over for upgrades and maintenance. Can you imagine running a company whose masters have no regard for the future? I can’t. Perhaps that’s why Pemex has had four different CEOs and five chairmen in the past eight years. Most of them threw up their hands and quit in disgust.

[Perhaps President Chavez could be tempted out of his chaos-causing rule in Caracas with the offer of a rich and perk-filled oil-analyst’s job at Goldman Sachs Group Inc. (GS)].

My colleague – Money Morning Investment Director Keith Fitzgerald – agrees with Chavez that oil prices are headed much higher: In fact, since back in December, when crude oil was trading at $90, Fitz-Gerald has been predicting that petroleum prices would reach $187 a barrel. And there’s growing support for his view: In mid-March, Goldman Sachs forecast oil prices of $175 within two years while just yesterday (Tuesday), noted MSNMoneycentral columnist James Jubak predicted that oil would reach $180 a barrel in the next few years.

What’s “Fueling” the Oil Price Rocket?

Crude oil rose to a record $119.90 a barrel on the New York Mercantile Exchange yesterday, as the greenback dropped to an all-time low against the European euro. Crude oil is up 24% so far this year, and 88% from this time last year, Bloomberg News reported.
With this unrelenting march, it’s no wonder that industry observers continue to roll out ever-higher target prices for the “black gold.”
If we’re only considering economic factors, the steep crude prices now being predicted would be unlikely to stick for any protracted period; there are huge new oil sources of oil that become economically profitable once oil rises above $100 per barrel. The Orinoco tar sands in Venezuela and the Athabasca tar sands in Canada – each of which contains larger oil reserves than the entire Middle East are viable even at $50 per barrel (Orinoco holds an estimated 1.8 trillion barrels and Athabasca 1.7 trillion barrels, versus a current Middle East estimate of 1.6 trillion barrels).

Then there’s Colorado oil shale – also containing at least 1.5 trillion barrels of reserves – that becomes economically viable at about $100.

The bottom line: If oil prices stayed at $180 to $200 per barrel for more than a year or two, huge new oil supplies would come on line, causing crude prices to plummet and tipping the market decisively back towards consumers. The environmental cost of getting really large quantities of oil out of Athabasca and Colorado would be immense, particularly if we attempted to supply the needs of the entire U.S. market from these sources, but at $180 per barrel, I’m confident that the economic necessity would probably trump the environmental problems.

As we said, however, these scenarios consider only economic factors. And as we’ll see, there are two additional factors that make this a much-less-straightforward analysis, meaning oil prices could linger at significantly higher prices for a much-longer period than economics alone would justify.

I’ve labeled these two “wild card” factors as “politics and a paradigm shift.” Let’s look at each one.

First, political factors are increasingly restricting the areas that can be explored for oil. In fact, there are a number of places on earth where large reserves are known to exist, but political obstacles make it impossible to drill for—and remove—the crude.

So there it stays, heavily dampening an increase in production that would otherwise be taking place.

Second, world economic growth has been exceptionally rapid, and two huge population centers, India and China, have simultaneously been introduced to the joys of the automobile culture. And that’s created a major global paradigm shift that promises to shift the auto center of the world from Detroit to Shanghai, while simultaneously causing worldwide oil consumption to soar.

Now that we understand the demand side of the equation, let’s consider the outlook for supply.

Foreign Intervention

Countries that allow foreign oil-sector participation and avoid punitive taxation can reap two distinct benefits. First, production from existing fields is increased by greater efficiency. Second, modern exploration techniques are brought to bear, often resulting in new reserve finds in areas that have been closed to international exploration for decades.

For instance, it is especially noteworthy that Saudi production peaked in 2004, and that Saudi oil reserve figures are in doubt; indeed, most Saudi oil reserves derive from fields that were discovered in the 1970s, if not before.

To see how production may stagnate without the benefit of such outside participation, just take a look at Russia.

After 2000, Russia was the principal source of new oil outside the Middle East. Since 2003, however, the most efficient Russian oil company – Yukos NK OAO – has been dismembered, contracts with foreign oil companies such as Royal Dutch Shell PLC (RDS.A and RDS.B) and BP PLC (BP) have been forcibly renegotiated, and Russia has imposed an 80% tax on oil revenue above $27 per barrel.

The result of these heavy-handed machinations has been pretty much what you’d expect: We recently learned that Russian oil production declined by 1% in the first quarter of 2008, following several years of rapid growth. An oil industry with capitalism, foreign partners and modern technology has given way to autarky and state control.

When it comes to foreign oil companies, other companies are adopting a game plan that’s very similar to that of Russia. Mexico bars foreign participation in oil exploration, and expropriates almost all the net revenue of its oil monopoly Petroleos Mexicanos, more commonly referred to as Pemex. Consequently, Mexican oil production is undergoing a steep decline: It is currently about 12% below its 2006 average, according to the International Energy Agency.

Mexican President Felipe Calderon is attempting to change that, by allowing Mexico to sign joint-venture agreements with foreign energy companies (the first such agreement under discussion is not with a hated “Yanqui,” but is instead with Brazil’s Petroleo Brasilero SA (PBR), usually referred to as Petrobras – itself a state-controlled enterprise, albeit one that’s much-more open to modern exploration techniques). However, even without proposing the politically impossible privatization of Pemex, Calderon’s attempted legislation is running into huge political opposition. 

Other examples abound. Venezuela recently seized majority control of foreign owned oil concessions, so even with the world’s largest oil reserves in the Orinoco tar sands its production has declined by about 6% since 2006. Nigeria taxes foreign oil companies at 98%, so its production has declined 10% since 2006.

There are a few counterexamples. Where the oil industry is open, new reserves are found and production increases. Brazil’s Petrobras participates freely with foreign companies, and has discovered several large offshore fields recently. Iraq’s oilfields were opened to foreign participation after 2003, and Iraq’s estimated oil reserves have since doubled to 200 billion barrels, ranking it second behind only Saudi Arabia as having the largest crude-oil reserves in the entire Middle East.

Globally, oil production from existing fields has declined 7.7% annually since 2000, with British and Norwegian offshore fields showing a particularly sharp decline. That means that large new oil discoveries are required simply to keep pace with demand and to halt oil prices from spiraling up toward infinity. Allowing international participation in oil exploration and production is essential to this process, but the list of countries in which such participation is allowed has declined and appears to be diminishing further.

And while some of the more-timid investors are already retreating from the region, the actual panic some are experiencing is premature, as Latin American economies are demonstrating a much stronger ter resilience than they’ve been given credit for.

A report from the International Monetary Fund, released Friday, noted that “the region’s banking systems have so far remained largely immune to the financial stresses in the United States,” but financial conditions are “beginning to show some signs of tightening.” Ultimately, the IMF expects the turmoil in the United States to start catching up with Latin America.

U.S. economic growth is expected to fall to 0.5% this year and be just 0.6% in 2009. The IMF sees growth in Latin America slowing as a result. After regional growth hit 5.6% last year (2007), the IMF thinks growth will fall to 4.4% this year and 3.6% in 2009.

History supports the IMF’s position. An economic slowdown – or worse, a recession in the United States – was once the death knell for Latin American economies, which rely heavily on America as a market for their exports. When the United States, the leading importer of Latin American goods, struggled through a recession in 2002, six of Latin America’s most prominent currencies dropped by 20% or more.

But the story for 2008 has been very different.

Brazil’s currency, the real, hit a nine-year high Friday, climbing 0.3% to 1.6577 per dollar, Bloomberg News reported. Earlier, the currency touched 1.6530, its strongest showing since May 1999. The real has gained about 23% over the past 12 months, the best performance among the 16 most-frequently traded currencies tracked by Bloomberg.

The Colombian peso has jumped more than 17% over the last 12 months, reaching 1,792 versus the dollar. It’s now trading at its highest level since July 1999, as foreign investment has rushed into the Andean country. Colombia’s economy expanded 7.5% in 2007, the fastest pace since 1978. Foreign direct investment (FDI) rose 40% last year, reaching $9.03 billion. In the year through March 19, it had increased 25% to $2.16 billion, according to the central bank.

“I would be very critical of the IMF,” said Money Morning Contributing Editor Horacio R. Marquez, an emerging-markets specialist and Argentine native. “The IMF said growth in China was going to slow down in response to the U.S. and you saw its first quarter.”
China’s economy expanded by 10.6% in the first quarter of 2008, despite complications stemming from the U.S. credit crunch, the Chinese New Year, and the worst ice storm the country had seen in decades.

Marquez also pointed out that Latin American economies have been bolstered by huge trade surpluses – a lingering result of the commodities boom. Countries like Chile, Brazil, and even Mexico are sitting on huge caches of foreign reserves that will offer substantial support should conditions in the U.S. continue to deteriorate.

Emerging markets have an estimated total of $4.1 trillion in central bank reserves, The Wall Street Journal reported. That includes a cushion of $185 billion in Brazil, $49 billion in Argentina and $80 billion in Mexico.

“This time, we have something of a vaccine when the U.S. sneezes,” said Claudio X. Gonzalez, chairman of Kimberly-Clark de Mexico SA.
Mexico’s economy expanded by an unexpected 3.8% in the fourth quarter, as U.S. growth slowed to a paltry 0.6%.

“This is going to be the first time in many years in which Mexico is going to move in the opposite direction as the U.S. business cycle,” Alfredo Coutino, senior economist for Latin America at Moody’s Economy.com (MCO), told Bloomberg in an interview.

Latin America’s New Best Friend

Even as Latin America’s trade with the United States slows down, China has been quick to grab the baton and pick up the import-export slack with the Latin American region.

Trade between China and Latin America surpassed $100 billion last year, a milestone the Chinese government didn’t expect to reach until 2010. Commerce between the two regions totaled $102.6 billion in 2007, a 46% increase from 2006, according to Chinese government data.

Brazil sent 6.7% of its goods to China last year, double the level of 2001. Chile, Peru and Argentina exported to China twice what they imported from their Asian trade partner. Mexico exported $3.2 billion worth of goods to China last year.

Speaking to bankers in Acapulco last month, Mexican President Felipe Calderon touted last year’s increase in his country’s exports to non-U.S. markets: Goods sent to the Middle East increased 48%, while goods shipped to Europe jumped 30% and those to Asia rose 25%.

The United States now absorbs less than 20% of the exports coming out of Brazil, Argentina, Chile and Peru.

Brazil President Luiz Inacio Lula da Silva predicted that his country’s economy would grow at least 5% annually through 2010.

“People are buying more and exports are growing because we don’t depend on the United States, and Europe alone,” he said. “Now we’re exporting to many more countries around the world, and this leaves us calm in the face of an American crisis.”

The government of Brazil recently made plans to establish a permanent commercial center in the United Arab Emirates to promote investment between the regions. The U.A.E. is home to the Abu Dhabi Investment Authority, or ADIA, a sovereign wealth fund with an estimated $875 billion in assets. Brazil is the world’s sixth-largest economy and home to an internal market of approximately 190 million consumers.

The new center will serve as a permanent exhibition of products from Brazil and Latin America, and tap developing investment and marketing opportunities between the regions.

It will also enhance Arab-Brazilian relations through the presence of future Gulf investments in Brazil, Ahmed Yassine, president of the Trade Exterior Chamber of Brazilian-Arabian Gulf and North Africa, told the Emirates News Agency. Yassine led a delegation of Brazilian businessmen on a tour of the region.

“An estimated 20 million people of Arab origin live in Latin America and 7 million of them are in Brazil,” Yassine said.
In 2007, Gulf countries imported $4.6 billion in goods from Brazil, an increase of 4.8% from 2006.

The amount of the region’s debt denominated in foreign currencies fell to 24.7% of gross domestic product in 2007, down from 44.1% in 2002, according to the International Monetary Fund.

What’s he talking about? Mexico has just over 12 billion barrels of oil reserves, or ten percent of the world’s total. It exports 1.5 million barrels per day to the U.S., putting it third behind Canada and Saudi Arabia, and just ahead of Nigeria and Venezuela.

Source: U.S. Energy Information Administration

The trouble is that Mexico’s government has been using the state oil company, Pemex, like a cash machine that never runs out. Pemex contributes 40% of the total tax revenues of Mexico’s Federal Government. It’s a resource of the people, for the people, and by geology. But you cannot print oil on a printing press. There is no such thing as “just in time” energy resources.

Mexico’s government has not been investing enough in exploration or new production to top off Pemex’s reserves. Those reserves are being depleted. What’s more, its largest oil field Cantarell, is in an alarming state of decline. Cantarell was discovered in the Gulf of Mexico in 1976 by a fisherman. Estimates are that it was a 20 billion barrel discovery.

Mexico has been producing from it ever since in huge numbers. But those production numbers appear to have peaked in 2004 at around 2 million barrels per day. Today, Cantarell produces just 1.4 billion barrels per day-a loss of 600,000 barrels a day in four years. Overall Mexican production peaked at 3.4mbpd 2004 but is now under 3mpbd. In the first two months of this year alone, Mexican oil production fell 6.4% compared to the same time last year.

Enjoy the oil while it lasts folks. Of course, it’s going to last for a very long time. Peak oil doesn’t mean that all the world’s oil will be gone. It means that all the world’s cheap oil will be gone.

That loss will have a radical effect on economic and social arrangements that were built on cheap energy. And for nation states like Mexico (and Venezuela, and Saudi Arabia) that finance welfare states with oil revenues, it will be a disaster unless oil profits are turned into income producing capital assets-instead of merely redistributed as transfer payments…or tuned into new Towers of Babel.

“We should leave oil before it leaves us,” said International Energy Agency chief economist Faith Birol in an interview with German monthly journal International Politics. There’s an idea.

Birol says the world has time to make other energy plans, but not much. The rise in the oil price will be gradual he says, as a function of declining production and growing demand. “But looking at this long-term, it becomes clear that nothing changes whether oil runs out in 2030 or 2040 or 2050.”

We are assuming he’s referring to cheap oil and not the world’s total supply of oil. Either way, the warning is unambiguous. “One day it will definitely be finished. And I think we should leave oil before it leaves us. That should be our motto. We should prepare for that day with research and development, how we can replace oil, what kinds of living standards we will be able to maintain, what alternatives we can develop.”

Here here. Finding the commercial alternatives to oil is mainly what we’re up to in the Australian Small Cap Investigator.

Dan Denning
The Daily Reckoning Australia

P.S. to get The Daily Reckoning direct to your inbox sign up to our free e-mail newsletter or if you prefer to use RSS, subscribe to the Daily Reckoning RSS feed.

On the one hand, you have authoritarian rule and government-controlled natural resources. On the other, you have a liberalization of state control and a booming economy. Hmm. That’s a tough decision.

Right now, the president of Mexico is fighting to bring more autonomous control to the country’s nationalized oil company Petroleos Mexicanos (Pemex). But he may have trouble convincing his congress to make the changes.

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Pemex is the single largest revenue source for the Mexican government. It produces 40% of the country ’s national budget each year. The country has used it as a one-way ATM, taking money out but rarely putting much back in.

And now Pemex is in trouble. Its major oil field is running low. It has hundreds of workers on staff who literally do nothing all day because they’re unionized and Pemex can’t fire them. And its only chance of expanding oil production is with deep sea drilling in the Gulf of Mexico.

Mexican President Felipe Calderon and the managers who actually run Pemex are telling the public that the company has to tap the oil field sitting under their country’s portion of the Gulf of Mexico or stand by and watch its production dwindle each year.

Last year saw an 18% drop in production from Cantarell, Pemex’s major oil field. Total production at the company has been falling for three years. And record oil prices were all that kept revenue from sliding in 2007.

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Loss of revenue would be bad enough for the Mexican government, but the country’s energy minister predicted Mexico will have to begin importing light crude oil in less than five years and oil exports will fall from 1.67 million barrels in 2007 to as little as 289,000 in 2016.

According to Calderon, Pemex needs more autonomy to make deals with other oil companies since it doesn’t have the expertise or the technology to drill offshore, where the oil is. Calderon wants to follow the lead of Brazil’s Petrobras, a government-controlled public oil company that saw its production more than double since the country took measures to privatize the industry and make Petrobras competitive.

But Calderon’s opposition is decrying him for trying to take the Pemex cash cow away from “the people of Mexico.” And that opposition is getting fairly loud.

Calderon’s former opponent for office Andres Manuel Lopez Obrador and his cronies are screaming to the rafters of public halls (and now even your living room since his group is selling a DVD denouncing Calderon’s plan) that Calderon wants to take Pemex private.

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Assumably, Obrador is counting on the fact that no one in Mexico has heard of Petrobras or the economic boon it’s provided to the Brazilian people since it was reformed.

Removing government controls on Pemex may mean the company doesn’t have to employ as many Mexicans as it currently does, but it could also mean the government and “the people of Mexico” Obrador is so concerned about could see much higher returns from the company in coming years.

Let’s hope the people and Mexico’s congress look at Petrobras and don’t listen to Obrador.

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