STRATFOR 700 Lavaca Street, Suite 900 Austin, TX Tel: BUSINESS-RISK ASSESSMENT: Mexico, Iraq and Algeria

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1 STRATFOR 700 Lavaca Street, Suite 900 Austin, TX Tel: BUSINESS-RISK ASSESSMENT: Mexico, Iraq and Algeria Oct. 20,

2 BUSINESS-RISK ASSESSMENT: Mexico, Iraq and Algeria Editor s Note: The following is an assessment of the political, economic and security risks associated with investing in business operations in Mexico, Iraq and Algeria and how those risks may change over the next six months. The specific focus is on the energy sector in each country, including its current state and pace of development and the regulatory environment. Our conclusions overall are that Algeria currently offers the most promising investment climate, while Mexico offers the possibility of an improved climate over the next two or three years and Iraq will remain the least promising until a durable and sustainable government can be formed. Mexico Political Environment Mexico s political environment can be summed up in one word: stagnation. Ironically, the political paralysis Mexico has experienced over the past decade is the result of a radical political transformation. The center-left Partido Revolucionario Institucional (PRI) lost its 71-year monopoly on power in the 2000 presidential election when it was defeated by the center-right Partido Accion Nacional (PAN). Since the 2006 presidential election, the PAN has retained executive authority through Mexican President Felipe Calderon, while the legislature has been divided among the PRI, PAN and the far-left Partido de la Revolucion Democratico (PRD), which split from the PRI in the late 1980s. The PRI and PRD are strongest in Mexico s central and southern states while support for the PAN is concentrated in the northern and central states. Traditionally, power in Mexico had been concentrated in the executive branch. Political reforms in the late 1990s and the turnover to the PAN in 2000 created a situation in which the Congress was strengthened at the expense of the executive, but this also opened the way to more competition in a body that lacked experience in consensus-building. The result, unsurprisingly, has been severe political gridlock on nearly all fronts. Also, a major issue complicating Mexico s political system is the existence of single-term limits for politicians, a relic of the Mexican Revolution, when revolutionaries sought to prevent despots from holding power indefinitely. As a result, Mexican politicians enter office already searching for their next job, there is little accountability for their policy decisions and they have little incentive to move ahead with political or economic reform. There has been discussion of removing the single-term limit, but no such reform can be expected in the near future, particularly with elections approaching. Electoral Landscape Ahead There are two elections on the horizon: the 2011 gubernatorial elections and the 2012 presidential election. The PRI is eager for a comeback now that Mexico has undergone two terms of stagnant PAN rule and has seen the level of violent crime in the country skyrocket since December 2006, when Calderon declared war on the drug cartels. However, the PRI now faces a more strategically, though not ideologically, unified opposition. After a contentious showdown in the 2006 presidential election, alliances formed between the conservative PAN and the left-wing PRD during 2010 municipal elections, though the results from these alliances have been mixed. The PRI held constant, winning a total of three seats from the PAN and PRD while losing three seats to the alliance. The PRI s losses, however, were more significant than its wins; it yielded the strongholds of Sinaloa, Puebla and Oaxaca, which the party had held for eight decades. More recently, the PAN and PRD began formally discussing allying with each other in 2011 gubernatorial elections, raising suspicions that the unlikely partners would maintain their alliance for the 2012 presidential race. The gubernatorial races in Guerrero, Nayarit, Michoacán, Baja California Sur and Estado de Mexico (aka Edomex, short for State of Mexico ) may prove a good test for the 2

3 viability of the alliance in the race for the top office. A key race to watch in determining the trajectory of the 2012 election is the upcoming gubernatorial race in Edomex, where the current governor is PRI member Enrique Peña Nieto. The charismatic Peña Nieto is widely believed to be a front-runner for the presidency and enjoys a wide base of popularity. A PAN-PRD alliance would aim to unseat the PRI in one of its key strongholds and undermine Nieto s popularity ahead of national elections. Anticipating such an alliance for the national elections, Nieto is finding new, more creative tactics to break up this rival pact. The state legislature on Sept. 15 voted in favor of abolishing a law that allowed multiple parties to put forward a common candidate. This move will help Nieto undermine a PAN-PRD agenda to unseat him in upcoming gubernatorial elections. The political scene remains in flux as PAN and PRI heavyweights compete for PRD votes. Meanwhile, the PRD itself is experiencing internal tension, with firebrand politician Andres Manuel Lopez Obrador, who barely lost the presidential election in 2006, condemning his PRD colleagues for aligning with the PAN. Also, PRD founder Cuauhtémoc Cárdenas also has spoken against PAN-PRD alliances, saying the parties have contradictory goals. Ultimately, the PRD and PAN do share one political goal -- preventing the PRI from dominating the political scene as it did until Regardless of who emerges as president in 2012, the next Mexican government is unlikely to break free from its current paralysis. Neither the PRI nor PAN is expected to win a large majority in the Senate, the Chamber of Deputies or more than half of Mexico s state legislatures, where critical reforms could be pushed forward. Hence, the potential for political instability lingers. Obrador, in particular, is prone to resort to widespread blockades and protests to contest election results as he did during his 2006 presidential run in his home state of Tabasco, a stronghold for the PRI and PRD. Obrador has a history of organizing civil resistance movements when he loses in elections and has led groups of supporters to block the entry to several oilrigs and other Pemex facilities in Tabasco for several months. He also has staged demonstrations and protest caravans to Mexico City. Though Obrador gained a lot of visibility through these actions, his support base has weakened since the 2006 election fallout. Challenges to the Country s Leadership Currently, the political agenda in Mexico is dominated by violent crimes associated with the government s war with the drug cartels, declining oil production and a narrowing tax base (discussed further in the Economic Environment section below). With the possible exception of the cartel war, there is little reason to expect much movement on these issues at least for the next two years. While pitching policy proposals of its own to appear constructive, the PRD will use its current majority position in Congress to block legislation on key issues and try to portray the PAN-led government as ineffectual in the lead-up to national elections. In looking at the path to the 2012 presidential race, it is important to note that Calderon must bring down the level of cartel violence well before voters go to the polls if he wants the PAN to have another chance at the presidency. Mexicans are, by and large, worn down by the war and do not see the struggle as having been worth it. Much of this has to do with a general abhorrence of the war s violence, but there is also a critical economic factor to consider. An estimated $25 billion to $40 billion flows into Mexico annually from the sale of narcotics, most of which are sold in the United States. This estimate is likely quite low, but it is still a staggering amount when considering the enormous profit margins made on each sale. This money makes its way into the Mexican financial system, providing valuable liquidity. Indeed, Mexico was one of the few countries during the global financial crisis in 2008 that was able to continue making loans for commercial real estate. It follows, then, that the Mexican leadership has little appetite for sustaining high levels of violence or stemming the flow of drug money into the economy. This is the time for Calderon to shape a political exit strategy from the cartel war (to be discussed in the Security Environment section below). 3

4 Economic Environment With a large and growing population and a massive market across the border in the United States, Mexico boasts the world s 13th largest economy in nominal gross domestic product (GDP). Mexico s ongoing recovery from the 2008 global recession is tightly linked to that of the United States. Mexico s current GDP growth has been averaging 4.6 percent but month-to-month growth remains weak, with the biggest declines in construction and mining. Foreign direct investment (FDI) fell to $12.52 billion at the end of 2009, down from $23.68 billion in Throughout the crisis, Mexico acquired ample foreign exchange reserves ($103 billion through July 2010) to help cushion itself against further volatility in the markets and, as a precaution, obtained a $47 billion credit line from the International Monetary Fund that has been renewed until April Mexico s export economy relies heavily on manufacturing (80.9 percent of 2009 export earnings), followed by oil (14.8 percent) and agricultural products (3.6 percent). Since the signing of the North American Free Trade Agreement (NAFTA) in 1994, the Mexican economy has become tightly linked to that of the United States, with most U.S. FDI flowing into the manufacturing sector. Challenges and Constraints Mexico faces a persistent problem with capital shortages. This is not due to lack of foreign investment but is more of a reflection of constraints in the political system, entrenched corruption, structural limitations in public finances, declining oil revenues and a narrow tax base. Slow internal development has fueled migration from Mexico to the United States, making remittances a critical part of the Mexican economy. Remittances average around $20 billion annually, but there is a serious question as to whether that money is being reinvested in a productive manner in Mexico. Mexico s tax base, which stands at 10 percent of GDP, remains critically low because long overdue tax reforms have stalled in Congress. The country s highly distorted tax system also allows ample room for evasion, undermining the country s fiscal stability. Some reforms have been passed under Calderon to widen the tax base, including a move to give states more power to raise local revenue and increasing transparency and accounting in the tax system. A value-added tax (VAT) of 16 percent applies to the sale of goods and services, while a reduced 11 percent VAT applies to the sale of goods and services within 20 kilometers of Mexico s borders with the United States and Guatemala. Exports are exempt from the VAT. The Impuesto Empresarial a Tasa Unica (IETU) law created a business flat tax (now at 17.5 percent) to try and simplify the tax system and remove special tax regimes, but taxpaying in Mexico is still very cumbersome. Since the IETU runs parallel to an existing 28 percent corporate income tax, businesses have to pay the higher of the two taxes. The government has introduced an electronic payment system for payroll, property and social security taxes as well as for company registrations. Mexico s energy and power sectors also impact its economic health. The world s sixth-largest oil producer, Mexico depended on oil income for roughly 31 percent of total public revenue and for 14.8 percent of export revenues as of 2009, making the country extremely vulnerable to global price shocks in the oil market. Oil production peaked in 2005 and is now steadily declining, which means Mexico s biggest challenge is creating new sources of revenue. National oil company Pemex is not financially capable of offsetting this decline, and delayed energy reforms have hampered private and foreign investment in the energy sector to increase the exploration and development of deepwater offshore oil reserves in the Gulf of Mexico. Energy reforms passed in 2008 created a new tax regime that sets different tax rates for oil fields depending on risk, exploration and production costs. The reforms also legalized incentive-based service contracts and allowed Mexican citizens to buy Pemex bonds to help finance the company s operations. After considerable delay, Pemex has recently submitted three models of incentive contracts to the Chamber of Deputies for approval, although movement on these reforms could face further delays as the PRI continues to object to the legislation (it has even taken the case to the Supreme Court). Mexico has been slow to encourage investment in the offshore fields. Pemex has drilled only 10 4

5 offshore wells at depths exceeding 500 meters. Catamat-1, at 1,230 meters, has been the deepest well drilled to date by the company, while drilling evaluations continue for tapping reserves at Catamat-1, Leek-1 and Tamil-1. Instead, Pemex is focused on mature and (severely) underperforming onshore fields, particularly the Chicontepec project in the states of Puebla, Hidalgo and Veracruz. Pemex announced Sept. 29 that it would reduce drilling operations at Chicontepec by 60 percent from 1,250 to 499 oil wells. The move will squeeze out smaller, local contractors and make room for companies like Halliburton and Schlumberger, who have the technological skill to improve production in these fields, which have consistently missed their production output targets. To help move along Pemex s stated plans to issue up to 14 incentive-based contracts by the end of 2010 and increase production efficiency, U.S. Export-Import Bank has granted Pemex a $1 billion loan to finance the purchase of U.S. goods and services for oil and natural gas production and exploration. The government is trying to improve Pemex s financial position and thus the financial position of the government by giving more tax breaks to compensate for peso appreciation, lower output and higher input costs, but these half-measures will do little to reverse the energy sector s decline or provide greater funding to the state. The power sector is also in poor shape, as years of low private investment have hampered development even along the U.S.-Mexico border, while electricity demand continues to outpace supply. Private companies must still sell their electricity output to the highly inefficient state-owned Federal Electricity Commission. Struggling to attract the investment needed to install 16.3 gigawatts of capacity by 2016 under current regulations, the government has relied more heavily on natural gas for power consumption (further depressing energy revenues) and has considered importing lighter crude and blending it with Mexico s heavier crude to aid in the refining process and reduce fuel imports. Investment and Regulation The 1993 Foreign Investment Law guarantees equal legal treatment to foreign and local investors. Foreign investors are not allowed to own property within 100 kilometers of Mexico s borders or within 50 kilometers of its coastlines, but they can use bank-administered trusts to obtain property in the restricted zones. The Secretariat of Environment and Natural Resources, which steadily increased its rate of inspections from 2,597 in 2008 to 3,468 in 2009, has shut down 247 business operations that it deemed in violation of environmental regulations. Companies are advised to accept voluntary audits to avoid inspections; self-audits are typically granted to larger multinational corporations (MNCs) with approved audit certification. Mexico also has become more safety-conscious regarding its deepwater drilling operations since the BP spill and has postponed drilling at the deepwater Maximino well (expected to commence in the fourth quarter of 2010). The National Hydrocarbons Commission, born out of the 2008 energy reforms, is limited to making recommendations to the Energy Ministry, but it is calling for regulations on par with those of the United States. One such proposed regulation is the double key standard, in which more than one Pemex worker would make final decisions on drilling procedures. Other regulatory factors to consider include the government s introduction in June of new regulations to make it more difficult to exchange U.S. dollars for pesos at local banks due to the high rate of money laundering by Mexican drug cartels, a move that has greatly irritated the business community. Upper limits of $7,000 in cash per month for businesses and $4,000 per month on accounts for Mexican nationals have been imposed, while foreigners are allowed a maximum exchange of only $1,500 per month. Labor Force Mexico s average per-capita GDP in purchasing power parity was $15,570 in 2009, above the $11,000 average in Latin America. The country of million people hosts a large and active labor force of roughly 46.2 million, with an unemployment rate averaging around 5.7 percent, with the most job losses from the global recession occurring in manufacturing and construction. Most laborers are unskilled due to the country s poor education system and work in the informal sector, which employs some 12.5 million workers and is largely a result of strict labor laws that make hiring and firing 5

6 workers costly. Under NAFTA regulations, at least 90 percent of a company s total workers must be Mexican citizens. The Mexican Congress has been debating labor law reforms that would allow more flexibility in hiring and firing and allow for seasonal employment as well as internships. The labor reforms also call for reducing the work week from 48 hours to 40 hours in all industries, prohibiting the employment of minors under age 16 who have not completed basic education and increasing overtime pay for work on Sunday (political stagnation in the lead-up to elections will likely delay a decision on this). Most companies provide their own training due to lack of skilled workers in the labor force. Labor unions are powerful and have strong political ties, although they have been divided in recent years, a situation that is not expected to change within the next three years. The Confederation of Mexican Workers (CTM) is the largest union, with 5 million claimed members, followed by the Revolutionary Worker and Peasant Confederation with 4.5 million members and the National Workers Union with 1.2 million workers. The PRI has the most influence with the unions, particularly the CTM, with which the party has had a longstanding relationship. The PRI could use its links to labor to apply pressure on the PAN government, as the PRI has done before through labor strikes in the power sector. Mexican workers hold the constitutional right to strike. If they are granted permission by the government, management is restricted from entering company premises and from hiring replacement workers and must cease operations until the strike is resolved. If they are refused permission, the employees are required to return to work within 24 hours or face termination. However, unionization in the manufacturing sector is low, as are average wages, and there is little job stability or access to social security benefits. The frequency of strikes depends on location. They are more frequent in Oaxaca and most of the southern states but are extremely rare in Querétaro, Guanajuato and Nuevo León. Strikes have decreased overall (likely out of job insecurity) during the recent recession. Security Environment The escalating cartel war in Mexico, which has created the most severe security crisis that the country has seen in nearly a century, consists of three fronts: the government s battle against the drug cartels, the battles among the various cartels themselves and the violence being inflicted by the cartels and other criminal groups against the civilian population. The campaign President Calderon launched against the cartels in December 2006 has steadily escalated over the last four years, and while there is no denying that the government is making progress in fracturing the largest and most powerful cartels, one result has been a steadily deteriorating security situation nationwide. Ongoing turf battles among rival criminal groups have only intensified and increased over the past several years, particularly along the U.S.-Mexico border, where many multinational corporations operate. Territorial disputes among drug cartels have long been the norm in Mexico, but Calderon s offensive against the country s most powerful cartels has severely disrupted the criminal balance of power, leaving power vacuums other criminal groups seek to fill. This conflict is especially visible in border cities such as Ciudad Juárez, Monterrey, Reynosa and Nuevo Laredo, which the cartels use as drug-smuggling corridors into the United States. But the conflict also affects other parts of Mexico that fall along the drug supply chain, such as ports in southwestern Mexico and areas along the Guatemalan border. This cartel power struggle is far from over, and until a lasting balance of power has been solidified, the bloody warfare will continue and perhaps even worsen. Foreign businesses must thus conduct daily operations in an increasingly volatile environment, threatening their employees safety and the profitability of their business operations. The threat of violence has forced some companies to close their doors and others to develop exit strategies should the violence become too intense. The Sinaloa Federation is the largest and most powerful cartel at present, with operations primarily along Mexico s west coast, but their influence reaches from Chihuahua to Chiapas. The main opposition to the Sinaloa Federation is the Los Zetas organization, which operates largely along the eastern half of the country from Tamaulipas to Chiapas along the Gulf coast, although their influence reaches all 6

7 the way to the western Pacific states. Los Zetas and the Gulf Cartel maintain the largest presence and have the most influence in Nuevo León and Tabasco states. However, since the rupture in relations between the two in January 2010, Los Zetas dominance has waned in places like Tamaulipas and Nuevo León as the Gulf Cartel has aligned itself with the Sinaloa Federation and La Familia Michoacana against Los Zetas. The conflict between these two regional powers has yet to spread to Tabasco state, but anywhere the two organizations operations overlap the potential for violent conflict between the two exists. Criminal Threat in Nuevo León and Tabasco The general crime threat in Mexico is at a critical level and has been for more than a decade. Changes in the security landscape over the past year, however, have led to an expansion of criminal threats in the country. Three factors in particular are contributing to this growing problem: Mexico s rampant corruption, pressure on the cartels to seek other forms of revenue, and a general breakdown in law and order that has created an environment in which criminal organizations unrelated to the drug trade can operate with impunity. The corruption problem is not one that can be resolved easily. The billions of dollars Mexican drug cartels make each year mean they have plenty of cash to bribe government officials. The most noteworthy official so far has been the country s drug czar, Noe Ramirez Mandujano, who allegedly disclosed classified information to the Beltran Leyva Organization (BLO) for monthly payments of $450,000. Moreover, the low education requirements and poor salaries of police officers have traditionally made law enforcement a career of last resort. Given this reality, few police officers would refuse a bribe, especially when the alternative is death. Moreover, there is also a historical culture of 7

8 graft in Mexican police departments whereby street cops are expected to pay bribes to their superior officers. Being poorly paid, the street cops must get the money to pay their superiors from somewhere, hence their corruptibility. Los Zetas and the Gulf Cartel have heavily penetrated local and state authorities in Nuevo León and Tabasco. Several state and local officials have been arrested for working for, or having links to, these organizations. The Public Security Director for Paraíso, Tabasco, was arrested Oct. 14 on allegations of working for Los Zetas. In Monterrey, Nuevo León s largest city, elements of the Gulf cartel assassinated several members of the Monterrey Municipal Police in March and April for their collaboration with Los Zetas in the Gulf campaign against the Zetas support structure in the area. All of these issues mean foreign businesses in Mexico are forced to deal with security on their own, since the local authorities have proven unreliable (and at times malicious) partners. In addition, the tendency to employ retired Mexican law enforcement or military personnel in corporate security positions elevates the risk to businesses. In these cases, it is important to pay close attention to vetting procedures, which requires additional time and resources from both security and human resource departments. The second factor contributing to the increase in criminal threats is that many drug-trafficking organizations (DTOs) have begun to turn to other criminal activities to supplement their incomes. Previously, drug traffickers generally focused their attention solely on the lucrative drug trade. This meant drug traffickers rarely crossed paths with civilians not associated with the drug trade. Due to the government offensive against the cartels and U.S. efforts to interdict drug shipments from South America over the past two years, however, cartel turf battles have intensified, as have feuds within the organizations. As a result, many drug traffickers are becoming increasingly involved in crimes such as extortion and kidnapping for ransom. It is important to note that accurate statistics regarding the kidnapping and extortion threats in Mexico do not exist, since the vast majority of kidnappings are not reported to authorities. One inquiry by a Mexican legislative committee estimated there are some 4,500 kidnappings per year in Mexico, only one-third of which are reported to police because families fear reprisals from the kidnappers and because the police often are involved in such crimes. Nevertheless, statistics available from the Mexican Public Security Secretariat show reported cases of kidnappings in Mexico rose by 40 percent from 2008 to 2009, increasing from 838 to 1,181 incidents. While these reports should not be considered comprehensive, they do provide a useful baseline for gauging the threat level. The kidnapping and extortion threat has increased exponentially over the course of the past four months in Nuevo León due to the conflict between Los Zetas and the Gulf cartel. Los Zetas have experienced several organizational and operational setbacks during this time period, particularly in Nuevo León. The organization has lost five of its Monterrey regional leaders in the past four months to Mexican security operations, which also have resulted in the detention of numerous operational assets and the seizure of large arms-caches. There also has been a corresponding increase in kidnapping and extortion reports from the Monterrey metropolitan area, including attempts on high net worth individuals and members of their families. This has prompted the U.S. State Department to ban diplomatic personnel from bringing children into the city. Los Zetas have not experienced the same losses in Tabasco state and thus have not resorted to kidnapping or extortion in this region. Tabasco does, however, lie on the primary transit route for Central American immigrants headed north towards the United States. Los Zetas often kidnap these Central American immigrants, transport them to the border and hold them for ransom before taking them across. The hiring of security personnel with Central American backgrounds could draw unwanted attention from Los Zetas given the lucrative nature of human smuggling in the region. 8

9 Los Zetas have also been known to be involved in fuel theft from Pemex facilities. The fuel is often sold on the black market to stations in Mexico or just across the border in the United States, and according to a Pemex report released at the end of 2009, Los Zetas were responsible for up to $1 billion in losses from siphoning operations. Due to their involvement in this type of criminal activity, there are portions of Pemex property in Tamaulipas state Los Zetas have taken over altogether, prompting Pemex employees to refuse to work in these areas. To maintain their grip on this market, Los Zetas have been known to kidnap Pemex executives to ensure their complicity in Los Zetas operations. In the first six months of 2010, Los Zetas members kidnapped six Pemex executives throughout Mexico, including an executive from Pemex s Exploration and Production unit in Tabasco. The threat of further action from Los Zetas has prompted Pemex officials to ask the Mexican military to provide additional security for their executives and operations. This threat will likely continue for at least the next two to three years, although it could remain focused on refined products, not drilling or extraction operations, since criminal groups can sell the finished products more easily than crude. The third factor contributing to the crime increase is the distracted security apparatus. With Mexican military forces and police agencies tied down in the cartel battle, common criminals not involved in the drug trade have flourished. Car theft, robbery, mugging and pick-pocketing have long been staples in the Mexican crime scene, and such crimes have increased throughout the country in recent years. Indeed, these more common crimes are much more likely to affect multinational corporate operations and personnel in Mexico than the cartel-related violence dominating the headlines. The obvious risk associated with these developments is that, while the government continues to make it difficult to traffic drugs, very capable DTOs and other criminal groups will continue to target businesses and citizens throughout Mexico for kidnapping and extortion. These trends can be expected to persist at least for the next two to three years until the country s security situation stabilizes. 9

10 Impact on Business Operations The deteriorating security situation in Mexico presents a range of security implications for multinational corporations operating in Mexico. As organized-crime groups expand their targeting, it seems all but inevitable that multinational corporations personnel and facilities will become part of that growing target set. Executives and employees who have not received protective services may begin to demand them for themselves and their families. Expenses related to these services, which may include armored vehicles and armed security personnel, can quickly add up. And while executives are perhaps most at risk during their workday routine, the deteriorating security situation in many parts of the country could make it necessary for some companies to provide personal protection during business travel, also at a considerable expense. The host of threats facing multinational corporations in Mexico will require many corporate security teams to reassess their security programs. Increasing protective services for employees, for example, not only would require hiring executive protection teams but also could require employing additional corporate security managers to oversee enhanced programs. These security managers would also find themselves busy addressing and updating related programs, such as reliable communications systems, business-travel protocols and contingency plans. Many of these security measures certainly pose difficult financial decisions for many companies already operating or looking to expand operations in Mexico. At the same time that companies search for ways to reduce costs, they must now address whether to increase spending on security measures (assuming they have or can obtain the funds to do so). But while these costs may be uncomfortable, many companies will find them necessary to maintain business operations and ensure employee safety. Security Forecast As we look ahead two to three years, which is the time it will take for the Mexican government even to begin to stabilize the security situation, Mexico will continue to face some extraordinary challenges. The current cartel conflict has led to unprecedented levels of violence that the Mexican government has been unable to control. The government has exhausted vast amounts of national resources to try to reduce the violence to politically acceptable levels, but violence has continued to increase steadily throughout the country. While it is difficult to forecast the security environment for a particular city or region, indicators of broader trends in violence in Mexico lead STRATFOR to believe there is hope. The fact is that violence in Mexico is reaching a saturation point politically and socially. As politicians try to save face and citizens fed up with the violence become more vocal, Mexico is reaching a point where something must change. And something certainly will; it is just the form of that change that remains uncertain. As we see it, there are two possible scenarios. One is the eventual involvement of the United States in the conflict. There is mounting pressure for Mexico s northern neighbor to take a more active role in counternarcotics efforts, but political and social sensitivities in Mexico have prevented a significant U.S. presence on the ground in Mexico. Indications are emerging, however, that this sentiment is beginning to change. The president of the Mexican War College recently said Mexico cannot handle the cartel problem on its own. Even more indicative of this changing sentiment was the recent decision to embed U.S. intelligence analysts and operatives in the Juárez Intelligence and Operations Fusion Center to better facilitate information-sharing. However, STRATFOR believes the trigger for a dramatic increase in U.S. involvement will be the targeting of a U.S. elected official or high net worth individual on U.S. territory by Mexican drug cartels. With an increase in U.S. involvement, the situation in Mexico could become similar to the situation in Colombia, where U.S. advisers trained and sometimes led Colombian troops and law enforcement personnel in countercartel operations as part of Plan Colombia. It would also mean an increase in aid to Mexico in addition to the $1.4 billion Merida Initiative already in place, in which U.S. federal drugenforcement agents provide equipment and limited training to their Mexican counterparts. A significant increase in U.S. assistance, including more hands-on involvement by U.S. advisers in conjunction with the ongoing Merida Initiative, would give Mexican security forces a distinct advantage in combating 10

11 cartel power throughout Mexico. Once Mexican security forces are able to reduce drug-related violence to politically acceptable levels with more direct U.S. assistance, Mexican security forces could then divert excess resources to focus crimes such as kidnapping, extortion, cargo theft and other more common crimes that permeate the security landscape throughout Mexico, affecting both Mexican nationals and foreign business operations. The second scenario would be to restore the balance of power among the cartels and the Mexican government, an equilibrium that could be achieved over the next two or three years. In order for this to happen, an agreement must be reached between the cartels and the Mexican government that does not necessarily involve President Calderon shaking hands with Sinaloa cartel leader Joaquin El Chapo Guzman. A unified DTO able to consolidate and prevent itself from fracturing would be the most likely candidate to enter into such an agreement. It is not unreasonable to assume that sometime between now and the end of 2012, one cartel will have co-opted and/or destroyed most of its competitors and emerged as the dominant DTO in all of Mexico s embattled regions. Currently, the Sinaloa cartel appears to be the most likely choice, given the geography it controls and the upper hand the organization seems to have in various conflicts throughout Mexico. The Sinaloa cartel is engaged in just about every region of Mexico, giving it a geographical advantage compared to more isolated organizations like La Familia Michoacana, which controls only the state of Michoacán. While many of the regions the Sinaloa cartel is engaged in are considered disputed territory, the cartel is often on the winning side. The New Federation, an alliance between the Sinaloa, Gulf and La Familia Michoacana cartels, is a testament to how the Sinaloa cartel might coopt willing organizations while destroying rivals like Los Zetas. Going forward, if the Sinaloa cartel were able to consolidate its power and gain hegemony in the world of Mexican drug trafficking, the cartel would be able to divert some of it enforcement resources to quell the activities of other criminal organizations that have risen up in the chaos. This is not to say that crime in Mexico would disappear, only that the crime that did occur would run the risk of Sinaloa blowback or be heavily regulated by the cartel. However, this kind of transition would take time, and the security situation in many parts of the country would remain chaotic. Should the Sinaloa scenario play out, businesses operating in Mexico would likely have to deal with the cartel in some form or fashion, and whether this would involve extortion payments is not entirely certain, although it is likely. In both scenarios, the level of violence would get much worse over the next two or three years before it improved. Both situations represent a single entity essentially taking over control of geography presently controlled by multiple actors. STRATFOR has always maintained that the cartels will defend their turf ferociously. The eventual domination of the geography by a single entity, however, will force the weaker groups to move away from traditional methods of generating income, primarily drug trafficking, to other criminal activities. We already have begun to see indications of this in the current conflict. Overall, if multinational corporation can persevere through the next two to three years of continuing turmoil in Mexico, it could be rewarded with a more secure and predictable operating environment. 11

12 Iraq Political Environment Despite the challenges in the years since the dismantling of the Baathist state structure, Iraq has developed a rudimentary democratic political system. This post-baathist order, with all its weaknesses and flaws, serves as a framework within which the country s various political stakeholders and their respective international backers continue to compete for power. At least this has been the case thus far. Given that this framework has been held together by a large U.S. military force that is now withdrawing, its structural integrity is uncertain. The U.S. military presence in-country is now down to a little less than 50,000 troops, all of which have to be withdrawn by the end of next year (unless the current agreement can be renegotiated). Complicating the situation is the complex and fragmented political landscape, where all three principal ethno-sectarian groups (Shia, Sunni and Kurds) have been significantly divided at the intra-communal level. This situation has made it difficult for the external players with interests in Iraq (the United States, Iran, Saudi Arabia, Turkey and Syria) to achieve their preferred balance of power. The most glaring example of the fragmentation is the fact that the four major blocs that won the most seats in parliament in the March 7 election have been unable to form a coalition government, which, given the election results, means that we are not just looking at a new government but an entirely new power-sharing agreement. The old one, which gave birth to the first constitutional post-baathist government led by Prime Minister Nouri al-maliki, held office for four years and is now merely a caretaker administration because of significant shifts in the Iraqi political landscape. Unlike the previous two votes (in January and December of 2005), the Sunnis participated en masse this time around, and the Shia participated in the form of two rival blocs. This realignment of political forces manifested in the March 7 election has created a situation where the country s majority Shiite community (backed by its Iranian patrons) is facing a challenge to its domination of the country, which it has enjoyed since the foundations of the post-baathist republic were laid in mid The Sunnis overwhelmingly put their weight behind the centrist, non-sectarian al-iraqiya bloc led by former interim Iraqi Premier Iyad Allawi, which also picked up a considerable amount of votes in Shiite and ethnically mixed provinces and secured the largest number of seats (91). The Shiite vote was divided between al-maliki s State of Law (SoL) bloc with 89 seats and the Shiite Islamist Iraqi National Alliance (INA) with 70 seats (this bloc is led by Tehran s main Iraqi proxies, the movement of radical Iraqi Shiite leader Muqtada al-sadr and the Islamic Supreme Council of Iraq led by Ammar al-hakim). The Kurdish vote was also much more fragmented than in the past, but the two main Kurdish groups were able to form a post-electoral alliance with the smaller groups to create the unified Kurdistan Blocs Coalition (KBC) in order to sustain the strength of the 53 seats they held in the previous Parliament. In order to prevent the Sunni-backed al-iraqiya from leading the next government, the two rival Shiite groups also engaged in a post-vote merger to form a unified Shiite bloc called the National Alliance. This super-shiite bloc, with a combined strength of 159 seats, was formed in late May or early June but has not been able to agree on a prime ministerial candidate, with the INA opposing al-maliki s bid for a second term. While the Shia continue to sort out their internal differences, they have also been engaged in talks with the Sunnis on how to share power. Iran is trying to iron out the differences among its Shiite proxies so that they can agree on al-maliki remaining as prime minister. The United States has also put its support behind an al-maliki premiership -- the result of a back-channel understanding of sorts with Iran. While the lingering intra- Shia disputes over al-maliki continue to bog down the formation of a new government, the key issue is 12

13 the sectarian balance of power between the Shia and the Sunnis, which is at the heart of the U.S.- Iranian struggle. The Iranians want to limit the Sunni share of power while the United States and its regional allies (largely Arab) want to ensure a sufficient Sunni presence in Baghdad. Tehran wants to ensure that Iraq will not pose a future threat and will instead serve as a launch pad for wider Iranian regional ambitions. The United States and its regional allies would like to see a significant Sunni stake in the Iraqi government that, together with Shiite disunity, could form a bulwark against Iranian efforts to project power in the Persian Gulf region. Any negotiated settlement that translates into a government will have to be seen by both sides as an acceptable outcome, and there are signs that such a government (in a preliminary form) will likely emerge before the year is out. A new power-sharing formula would be only a beginning, since any such government would be very fragile, especially since it would have to shoulder increasing responsibility for internal security as the Americans withdraw and its various factions try to work together. The Shia will try to hold onto their dominant position in the government while the Sunnis work to increase their share of power. The Kurds will be using the sectarian tensions to enhance the autonomy they currently enjoy in their northern region. A new government also would not settle all the issues that stand between the United States and Iran, chief among them the nuclear issue. The Americans and Iranians would both like to see the remaining 50,000 U.S. troops leave the country, which would require an agreement between the two. Tehran will want security guarantees, the end of sanctions and recognition of its sphere of influence in the region while Washington will demand that Iran not exploit the vacuum created by the departure of U.S. forces. In other words, there is a lot that can go wrong and a lot that can have significant security implications for Iraq and the region. Economic Environment Political uncertainty and the security risks stemming from it are the main hurdles in the path toward Iraq s overall economic improvement. Investors are daunted, above all, by the lingering militant threat against Iraq s oil facilities. Nevertheless, many investors are willing to take some risks to make substantial profits once the country gains a certain level of lasting stability. Although the overall business climate in Iraq is murky for the moment, some investors are interested in getting a foothold in the country now to consolidate their future presence. Headway has been made in infrastructure and oilfield development, and incremental steps are likely to continue. A continually improving political and security environment would have a positive effect on other sectors, such as retail, but again this depends on the strength of the future Iraqi government. The oil-rich southern port city Basra seems to be the current target of investors, who are pumping in money for robust development projects despite militant threats (more on the region s union issues below). The fact that more and more foreign consulates are being opened there shows an increasing interest by other countries in the city and province. But, again, the Shiite south as a whole is vulnerable to Iranian interference. The Iraqi economy already is -- and will become even more -- dependent on the oil and gas sector, as indicated by the difference between GDP numbers for 2009 (when oil prices declined sharply) and forecasts for The International Monetary Fund estimates that Iraqi GDP will grow by 2.5 percent in 2010 and 11.5 percent in 2011, since OPEC recently decided to maintain output to keep the price of oil between $70 and $80 a barrel. Given that 95 percent of the Iraqi government s budget relies on oil revenue, Iraq s preliminary budget proposal for 2011 is 102 trillion dinars ($86.4 billion), based on a world oil price of $70 a barrel, according to a statement by the country s deputy finance 13

14 minister in September. Vigorous economic growth is also likely to continue in the Kurdish region to the north, but its relationship with the central government in Baghdad -- the Kurdistan Regional Government is involved in Iraqi government talks and will be a part of any coalition deal -- will affect the speed of this economic growth. While there are many investors willing to take the risks, political instability and the security situation are still preventing many MNCs from investing in Iraq despite lucrative deals offered by the Iraqi government. Those that have invested work away from the cities in isolated desert areas. Few if any major housing, agricultural or food companies have invested in the country, since it would involve a presence near urban areas, where the potential for militant activity remains significant. Ultimately, the uncertainty surrounding the political and security situation in Iraq as well as regional geopolitics will prevent the new political system from maturing. Iraqi factions have yet to evolve from a basic state of political survival to a level from which they can engage in meaningful governance and produce important legislation. What this means is that the central government, while it has established its writ in raw form, has yet to develop the institutional mechanisms and procedures necessary to provide real business opportunities in the country. Energy Potential As far as Iraq s energy potential is concerned, the country is in a position to rival Saudi Arabia and Russia in terms of oil production and export. According to estimates, production can increase from the current 2.4 million barrels per day (bpd) to 10 million to 12 million bpd over the next decade and a half. But as is evident from the political stalemate and precarious security situation, the country remains far from achieving the conditions necessary for maximizing crude production and emerging as one of the world s top three oil producers. In addition to the struggle over political power and control of security forces, influence over energy resources is a key point of contention among Iraqi factions. There are three core reasons for this: 1) Most oil and gas reserves are located in either the Shiite south or the Kurdish north, putting the Sunnis at a serious disadvantage. 2) Kurdish autonomy in a federal Iraq further complicates this picture, since the Kurds believe they deserve authority over energy-related policies in their region. 3) The status of the oil-rich region of Kirkuk remains disputed between Kurds and Arabs (the Shia and Sunnis). For these reasons, Iraq has not been able to make any headway toward enacting a national hydrocarbons law, which, in addition to the uncertainties over the political and security situation, remains an obstacle to substantial outside investment in the country s energy sector. There has been some interest on the part of international energy firms seeking development contracts. Initially, this interest was limited to the northern Kurdish enclave, where security has been better than it has been in the rest of the country. Recently, however, as many as 10 different multinational consortiums have won contracts to increase production at fields in the Shiite south and central Sunni parts of the country. Iraq held an auction for three major natural gas fields Oct. 20. Because the next government will have more than a token Sunni presence and the Kurds will drive a hard bargain with the Shia for their share of the political pie, disagreements over energy issues will be the subject of bargaining long after a new government is in place. But implementation of these sought-after contracts will likely be stymied, as they have in the past, by the political stalemate and questions about the future of country -- and region -- in light of U.S.-Iranian tensions and the American withdrawal from Iraq. Another key issue is the link between development of Iraq s energy sector and the status of Iran s energy sector, given the influence Iran has over its western neighbor and the sanctions imposed on Iran. The Islamic Republic is not interested in Iraq emerging as a major oil producer at a time when its own oil and natural gas production is suffering from sanctions, especially with the decades-long sanctions regime being tightened. Even in a scenario where Iran -- as part of a settlement with the 14