In late November Dubai reintroduced world markets to sovereign credit risk when it announced the restructuring of some $26 billion in debt relating to the Dubai World conglomerate. The city-state’s credit default swap spreads (CDS)–a form of insurance against debt default–spiked from less than 300 basis points (3 percent) to over 650 virtually overnight. The search was on for other countries that might have vulnerable fiscal positions.

Not long thereafter, the market’s attention shifted to Greece; the nation’s debt relative to its gross domestic product (GDP) is projected to top 130 percent by the end of next year. Greece’s own CDS spreads have nearly tripled since late summer to 280 basis points.

But neither Greece nor Dubai is an oil producer. For energy-focused investors Mexico’s deteriorating fiscal position and the actions of the country’s national oil company (NOC), Petroleos Mexicanos (PEMEX), are cause for concern. Pemex is the third-largest supplier of crude to the US, behind only Canada and Saudi Arabia. To put the company’s operations in perspective, Pemex produced more crude oil than US energy giant Exxon Mobil (NYSE: XOM) in 2008.

Of course, other energy producing nations such as Venezuela face more dire fiscal challenges. But the Chavez government’s chronic mismanagement of the national oil company, Petróleos de Venezuela (PDVSA), and the economy in general are well known and largely priced into the market. After all, CDS spreads on Venezuela are trading at 1,130 basis points, second only to the Ukraine; traders are already pricing in a healthy dose of credit risk.  

Mexico’s troubles are less severe but also less well-recognized and understood. Standard & Poor’s lowered the country’s long-term sovereign debt rating from BBB+ to BBB on December 14. The graph below provides insight into why S&P downgraded Mexico’s credit rating.

Source: Bloomberg

This graph tracks Mexico’s national deficit in billions of Mexican pesos. The figures are released monthly; the above graph shows the cumulative trailing 12-month total deficit.

It’s not hard to see that since early 2008 Mexico’s deficit has grown to unsustainable levels. There are two major reasons for this escalation: a severe contraction in the Mexican economy and plummeting oil revenues.

As to the first point, Mexico’s economy declined at an annualized rate of more than 10 percent in the second quarter and at a rate of more than 6 percent in the quarter ended September 30. Analysts estimate that Mexico’s economy shrank 7 percent in 2009.

And the nation’s recovery doesn’t look robust: Analysts expect the Mexican economy to grow 2.95 percent in 2010 and just 3.25 percent in 2011. The health of Mexico’s economy depends heavily on what transpires in the US; unlike Brazil, China and India, there is little chance of the Mexican economy decoupling from the fortunes of its northern neighbor.

The second problem is just as insidious and has been building for some time. Mexico’s crude production topped out at 3.4 million barrels per day in 2004, declined to 3 million barrels per day in 2007 and 2.8 million barrels per day in 2008.

According to PEMEX’s estimates, production will total just 2.5 million barrels per day in 2010, and exports will be in the neighborhood of 1.1 million barrels per day–down over 40 percent from 2004.

This forecast has major implications for Mexico’s fiscal health. State-owned PEMEX is the sole producer of crude oil and natural gas in Mexico; the company’s oil-related export revenues account for roughly 40 percent of Mexico’s budget.

Source: Bloomberg

This graph depicts the revenues Mexico generates from petroleum exports. Clearly, the massive drop-off that occurred in 2008 is due primarily to the fall in crude oil prices.

But even though oil prices have more than doubled since late 2008, Mexico’s monthly oil revenues are running at levels last seen in 2005. Even worse, oil prices averaged around USD50 per barrel in 2005, a far cry from current prices. It adds insult to injury that Mexican oil production is falling when prices are again favorable for exports.

Mexico’s two largest oilfields are Cantarell and Ku Maloob Zaap (KMZ), both offshore fields located in the Gulf of Campeche. Taken together, these two fields produced around 1.7 million barrels of oil per day in 2008, roughly 60 percent of the country’s total production.

Cantarell was discovered in 1976 by fisherman Rudesindo Cantarell and is one of the largest fields ever discovered in the world. In fact, from 2000 to 2005, the Mexican giant ranked among the world’s three top-producing fields alongside Saudi Arabia’s Ghawar and Kuwait’s Burgan fields. Here’s a look at the Cantarell oilfield’s production history.

Source: Pemex

Production from Cantarell began in 1979 and ramped up quickly through the early 1980s to around 1 million barrels per day. Production then hovered around 1 million barrels per day into the mid-1990s.

In the mid- to late 1990s production began to show signs of tailing off. Like most maturing fields underground pressures that helped drive production of oil at Cantarell dissipated. To combat this process, Pemex drilled more aggressively and began injecting nitrogen gas into the field in 2000. As you can see in the above graph, this USD6-billion project worked; the field’s oil production nearly doubled between 1996 and 2004.

But ultimately nitrogen injection can’t counteract the natural decline of a field. In the case of Cantarell, the project appears to have accelerated the subsequent rate of decline. As of May 2009, production from Cantarell had dropped to less than 700,000 barrels per day, its lowest level since the early 1980s. Pemex has plans to stabilize that decline, but these efforts will be expensive and can’t reverse Cantarell’s maturation and terminal production decline.

Ku Maloob Zaap (KMZ) is a smaller field in terms of total reserves but in 2009 overtook Cantarell to become Mexico’s largest producing field. KMZ’s history resembles that of Cantarell. Production held steady at roughly 300,000 barrels per day from 1998 to 2005, when Pemex initiated a nitrogen injection program that pushed production to over 800,000 barrels per day in 2009.

Just as Cantarell’s production peaked in 2003-04, it appears KMZ’s output will likely top out this year or next and begin its terminal decline. If its neighbor’s history serves as a model, that decline should be steep. Some analysts have reported that internal Pemex documents indicate that KMZ is producing increasingly large quantities of water along with oil–a sign that the aging field may have already peaked.

Geology is at the heart of the decline in Mexican oil production and revenues, but political factors further complicate these challenges. Mexico has a constitutional ban on foreigners owning its oil and natural gas resources, and the nation is unlikely to change that law in the near term.

Historically, national oil companies like Pemex partner with foreign oil companies to produce fields in exchange for granting the foreign partner a stake in their fields. Foreign partners supply the crucial capital and technical know-how needed to produce oilfields. Under Mexico’s current constitution, such deals are impossible; Pemex and other Mexican oilfields are effectively closed to foreign investment. Without such a prohibition foreign operators would be queuing up for a piece of the action in Cantarell, KMZ and deepwater acreage in the Gulf of Mexico.

In addition to constitutional impediments, the Mexican government all too often uses Pemex as a sort of glorified piggy bank, taxing the company heavily and leaving the NOC with insufficient capital to reinvest in development. A series of reforms have given Pemex a freer hand in recent years and allowed the firm to offer certain performance-based incentives to service companies that work on its key fields. In addition, the company’s capital investment budget has quadrupled since 1999 to around $18 billion, nearly $16 billion of which flows into Pemex’s exploration and production projects.

But even these moves appear insufficient to stem production decline, and the company still isn’t free of political influence. The onshore Chicontepec oilfield contains more than half of Mexico’s reserves outside Cantarell; Pemex had drilled aggressively in the field in conjunction with foreign services firms to offset production declines elsewhere. But the field produces only 30,000 barrels of oil per day, well under Pemex’s targets; in October the company announced that it will cut its Chicontepec investment by 22 percent in 2010 and reassess the field.

Although Pemex’s management has stated that the Chicontepec investment is necessary, the NOC came under heavy fire from government officials for disappointing production figures. Politics were undoubtedly behind Pemex’s recent decision to cut spending on Chicontepec.

Further complicating matters is the fact that Partido Accion National (PAN), the party of Mexico’s center-right President Felipe Calderon, lost control of Mexico’s lower house in July to the opposition Partido Revolucionario Institucional (PRI). Although Calderon’s term doesn’t end until 2012, the result of recent elections is likely to slow economic reforms and produce a business-as-usual approach to Pemex.

There are a few major implications for investors. First, if Mexican oil production continues to decline, the country could lose its status as a net exporter within five years–a change that would have devastate Mexico’s fiscal health. The Mexican CDS market was relatively quiet in the wake of the Dubai World debacle and downgrade to Greece’s credit rating, but this is definitely a market to watch in coming years.

Second, Pemex’s decision to cut back on its Chicontepec investment catalyzed a selloff in several services firms and contract drillers with exposure to contracts in the field. I see that as a major overreaction and opportunity for investors; Pemex has been known to change plans quickly and after their reassessment, I expect the NOC to decide it has no choice but to push development at Chicontepec.

Finally, while Mexico is an extreme case, the fate of Chicontepec illustrates a trend underway globally, especially in countries outside OPEC. As massive super-giant fields such as Cantarell decline, it’s becoming expensive and technically complex to offset those declines with production from other fields. The demise of easy and cheap-to-produce fields is a major support for oil prices over the long term.