Mexico's relationship with state-owned oil giant Pemex will remain a fiscal challenge for the country's next presidential administration. The national elections in June encompass the presidency and both chambers of Congress, and the new government's fiscal policy path will be key to sovereign creditworthiness.

Leading presidential contenders are the Morena party's Claudia Sheinbaum, who is President Andres Manuel Lopez Obrador's preferred successor, and opposition coalition Strength and Heart's Xochitl Galvez. Both candidates aim to bolster standards of living, albeit with different policy approaches. The composition of Congress will determine the latitude with which either candidate as president can advance policy initiatives.

What's key to S&P Global Ratings' sovereign credit ratings on Mexico (foreign currency: BBB/Stable/A-2; local currency: BBB+/Stable/A-2) is continued cautious macroeconomic management, and we assume it will prevail in the run-up to the elections, during the presidential transition period, and under the next administration. Such caution has been a hallmark of Mexico's macroeconomic policy execution for several decades.

Pemex Presents A Fiscal Challenge

We assume a return to a path of lower fiscal deficits that limit the rise in net general government debt to GDP, following a rise in this year's general government deficit and debt, mostly associated with pre-election spending. The government's preliminary 2025 budget guidelines signal an assumed adjustment next year. However, it's not binding. The actual 2025 budget proposal will depend on the policy preferences of the next president's administration, which will assume office in October.

Incoming policymakers will have to consider how to manage various budgetary tradeoffs. These include higher and less discretionary social spending, a heavier interest burden, limited fiscal buffers, a comparatively low non-oil tax base, and the challenges associated with Pemex's finances. Since 2019, we have signaled that our sovereign credit ratings on Mexico could face pressure from Pemex as a contingent liability to the sovereign.

Given the weak state of Pemex's finances and our expectation that any government will continue to back its debt repayment, the potential for pressure on the sovereign rating remains. And our rating on Pemex remains reliant on the sovereign credit rating. How the next administration tackles Mexico's overall fiscal trajectory, chooses to support Pemex, addresses policy in the energy sector, and organizes Pemex's management will likely affect our ratings on both Mexico and Pemex.

Pemex And Mexico Ratings Are Aligned

The almost certain likelihood of sovereign support dominates S&P Global Ratings' analysis of Pemex's creditworthiness. Under our rating methodology for government-related entities, this likely support aligns the issuer credit rating with the sovereign credit rating, irrespective of Pemex's stand-alone credit profile (SACP).

The almost certain likelihood of support reflects our view of Pemex's critical role to and integral link with the sovereign, which have not changed, in our view, since we began rating Pemex in 1995. Since then, the rating has been aligned with that on the sovereign despite changes in administrations, parties, and energy policy preferences, namely the role of private participation and how to organize and run Pemex. The Zedillo, Fox, Calderon, Pena Nieto, and Lopez Obrador administrations have all recognized the importance of Pemex.

While the contour of energy policy would likely differ under a Sheinbaum or Galvez administration, we don't expect the backing for Pemex--namely, the critical role and integral link--to change, and we assume the ratings will remain aligned with the sovereign credit rating. Should our view of extraordinary support weaken--for example, if Mexico's political class came to broadly view Pemex as of lesser national economic importance--the role and/or link could change, as would the rating.

Persistent Weakening In Pemex Liquidity

Over the past decade, Pemex's SACP has weakened considerably. Since 2020, it has been 'ccc+', reflecting the company's dependence on favorable business, financial, and economic conditions to meet its financial commitments.

Pemex has stabilized its production at 1,875 barrels per day of crude oil, up by 5% in 2023 compared with 2022. This owes in part to increased crude output through the incorporation of new fields in the portfolio (although with high decline rates). However, the portfolio mainly consists of mature fields, which require higher investments to maintain production levels.

Additionally, continued losses in operating efficiencies have the national refining system running at less than 50% of installed capacity. Refinery activities are costly and posted a negative variable margin of US$3.53 per barrel in the fourth quarter of 2023.

As a result, despite slightly higher upstream volumes, the reference price fell, dragging the company's top-line growth and EBITDA generation. Therefore, cash flows remained under pressure and leverage remained high at about 5.8x in 2023.

Moreover, Pemex faces significant debt maturities in the next couple of years. The sovereign, which tapped global markets early in 2024, for the first time included a budget item to cover almost all of the 2024 amortization payments (about US$11 billion). However, debt repayment for Pemex will remain a source of strain in 2025 and 2026 with around $6.8 billion and $10.5 billion due in these years, respectively. These challenges to debt and liquidity underpin our SACP.

Capital investments to maintain the crude oil platform are high, and with lower cash flow generation prospects and no availability on the company's credit facilities, already weak liquidity will continue tightening.

Government Support Has Been Solid Under Current Administration

Since 2019, the Lopez Obrador administration has provided about Mexican peso (MXN) 869 billion (or US$51 billion) to Pemex through different mechanisms. These include equity injections specifically targeting debt repayment and liability management, as well as investment in the fertilizers chain, the national refinery system, and the Olmeca refinery.

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Moreover, this administration reduced Pemex's heavy tax burden by slashing the profit-sharing duty (Derecho por la Utilidad Compartida, or DUC) to 30% from 65% during 2019-2024. Although the company still has other taxes and duties to cover, the DUC reduction allows Pemex to release some resources to invest in the hydrocarbon value chain. In 2023, taxes and duties represented only 9.3% of the company's total revenue (incorporating a 100% tax credit for the DUC from October 2023 to January 2024), compared with 54% in 2013.

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Weak Finances At Pemex Could Weigh On Sovereign Rating

Given the significant likelihood of support, weak finances at Pemex could negatively affect Mexico's fiscal profile. Our starting point in assessing a sovereign's fiscal stance is the general government--which excludes Pemex. However, we also consider various off-balance-sheet risks that present contingent liabilities. For a nonfinancial public-sector entity, we consider the likely need for government support for debt repayment and the materiality or magnitude of that support. Pemex's 'ccc+' SACP indicates the need for support for debt repayment. And the almost certain likelihood of extraordinary support means that under our sovereign methodology, any needed support would be forthcoming.

However, we don't expect the combination of net general government debt and Pemex's debt will be large enough to produce a materially weaker debt burden over the next several years. This reflects our key assumptions that the incoming administration will extend Mexico's track record of cautious fiscal management and limit the rise in net government debt, while Pemex won't increase its debt either. As a result, we assess a limited contingent liability from Pemex.

Conversely, assuming no improvement in Pemex's financial standing and continued almost certain likelihood of support, we would likely consider Pemex to pose a moderate contingent liability should the government's and Pemex's debt rise more pronouncedly. This would weaken our view of Mexico's fiscal profile and could pressure the sovereign rating.

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Since March 2019, the downside scenario for our sovereign ratings on Mexico has included a Pemex contingent liability risk. This possibility gained relevance because of 1) the deterioration in Pemex's finances (SACP), 2) the size of Pemex's debt, and 3) the shift in government policy to rely solely on Pemex to develop Mexico's energy sector--which we viewed as asking Pemex to do more when it had limited capability to do so.

However, the generally contained increase in net general government debt under the Lopez Obrador administration, as well as limits on Pemex's taking on new debt, have contained this risk. In July 2022, we revised our sovereign rating outlook to stable from negative in part because of our expectation that over the remainder of President Lopez Obrador's term in office, debt management would remain cautious, implying Pemex would not pressure the rating.

Ahead of the elections, the rating outlook now assumes that the next government will continue to cautiously manage the combined debt burden. Given Pemex's still-weak SACP and our expectation of sovereign support under any new government, our downside scenario for the sovereign rating still considers a weaker fiscal commitment and deterioration of Mexico's debt trajectory.

Local Governments Have Already Had To Adapt To A Weaker Pemex

Mexican subnational governments' exposure to Pemex, as measured by the share of oil revenue in federal transfers, has declined over the past decade. We expect it to remain relatively low. Over the past 15 years, various reforms to Mexico's federal fiscal framework affected the revenue constituting the distributable federal income (Recaudacion Federal Participable, or RFP), alongside a decline in Pemex's oil production. The reforms in effect supported higher non-oil federal revenue collection that more than compensated for the decline in oil revenue.

That said, volatility in oil revenue vis-a-vis budgeted transfers, even at this lower level, can affect local finances, whether from swings in market prices or from federal policies to support Pemex, such as with a lower DUC or postponed payments. In recent years, this volatility and economic shocks led to leveraging local governments' stabilization funds to offset some loss in expected budgetary transfers.

In general, we expect local governments with greater own-source revenue to be more resilient. On average, 90% of states' and 75% of municipalities' operating revenue relies on federal transfers. This underscores the opportunity for local policies to enhance own-source revenue collection and strengthen the resilience of local budgetary performance to external shocks.

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