Report in the Wall Street Journal, January 17, 1984, p. 1.
Petróleos Mexicanos
Petróleos Mexicanos, or Pemex, is the Mexican national oil company. It is the largest company in Mexico and ranks as one of the biggest non-U.S. industrial companies. Most of its sales are overseas. Suppose Pemex borrows U.S. dollars. If the peso devalues, is Pemex a better or worse credit risk?
The instinctive response of most people is that devaluation of the peso makes Pemex a poorer credit risk. This response is wrong. Consider Pemex’s revenues. Assume that it exports all its oil. Because oil is priced in dollars, Pemex’s dollar revenues will remain the same following peso devaluation. Its dollar costs, however, will change. Most of its operating costs are denominated in pesos. These costs include labor, local supplies, services, and materials. Although the peso amount of these costs may go up somewhat, they will not rise to the extent of the devaluation of the peso. Hence, the dollar amount of peso costs will decline. Pemex also uses a variety of sophisticated equipment and services to aid in oil exploration, drilling, and production. Because these inputs are generally from foreign sources, their dollar costs are likely to be unaffected by peso devaluation. Inasmuch as some costs will fall in dollar terms and other costs will stay the same, the overall effect of peso devaluation is a decline in Pemex’s dollar costs.
Since its dollar revenue will stay the same while the dollar amount of its costs will fall, the net effect on Pemex of a peso devaluation is to increase its dollar cash flow. Hence, it becomes a better credit risk in terms of its ability to service dollar debt.
Might this conclusion be reversed if it turns out that Pemex sells much of its oil domestically? Surprisingly, the answer is no if we add the further condition that the Mexican government does not impose oil price controls. Suppose the price of oil is $20 a barrel. If the initial peso exchange rate is U.S.$0.16/Mex$, the price of oil in Mexico must be Mex$125 (20/0.16) a barrel. Otherwise, there would be an arbitrage opportunity because oil transportation costs are a small fraction of the price of oil. If the peso now devalues to $0.08, the price of oil must rise to Mex$250. Consider what would happen if the price stayed at Mex$125. The dollar equivalent price would now be $10. But why would Pemex sell oil in Mexico for $10 a barrel when it could sell the same oil outside Mexico for $20 a barrel? It would not do so unless there were price controls in Mexico and the government prohibited foreign sales. Hence, in the absence of government intervention, the peso price of oil must rise to Mex$250 and Pemex’s dollar profits will rise whether it exports all or part of its oil.
This situation points out the important distinction between the currency of denomination and the currency of determination. The currency of denomination is the currency in which prices are stated. For example, oil prices in Mexico are stated in pesos. However, although the currency of denomination for oil sales in Mexico is the peso, the peso price itself is determined by the dollar price of oil. That is, as the peso:dollar exchange rate changes, the peso price of oil changes to equate the dollar equivalent price of oil in Mexico with the dollar price of oil in the world market. Thus, the currency of determination for Pemex’s domestic oil sales is the U.S. dollar.