Mexican officials could be left looking pretty smart if the price of oil keeps falling. Earlier this year, Mexico locked in contracts to sell its oil for $70 per barrel. Since the market price for a barrel recently fell to $35.35 per barrel, America’s largest trade partner south of the border is raking it in. Unfortunately, the fun is about to end for the U.S.’s Mexican neighbors—and that has big implications for America.

Oil is the single most important revenue stream for Mexico. A whopping 40 percent of its budget is derived from oil sales. And as the third-largest supplier of oil to America, most of it heads north to gas stations across the U.S.

However, Mexico could be facing a serious problem.

The Mexican government needs $70-per-barrel oil prices to balance its budget. For now, government spending is covered. But by the end of 2009, its fixed-rate contracts to sell oil at $70 will have expired.

If oil prices are still low by the end of next year, the government could be in real trouble. If oil had to be sold at today’s prices, almost 20 percent of the government’s budget would disappear.

Falling oil prices have already taken their toll on Ecuador, which announced that it would default on its national debt. According to the analysts at Stratfor, Venezuela needs oil at $120 to pay for all its social programs. And since Venezuela recently announced it would be “nationalizing” the nation’s gold mines, it seems like it too could be on the verge of failure.

But in Mexico’s case, falling oil prices are only one problem.

The bigger problem is that its oil production is also plummeting.

Cantarell is Mexico’s super-giant oil field. Located in shallow waters off the coast of the Gulf of Mexico, this field alone supplied about 60 percent of Mexico’s output until recently. Output peaked in 2004, after which pumping volumes drastically declined. Production cascaded 13.5 percent in 2006 and 15 percent in 2007, and 2008 looks like it may be an even bigger disaster.

Total oil exports to the United States will be down approximately 17 percent this year.

Making matters worse is that for every 10 barrels of oil pumped out of the ground last year, only four new barrels were discovered. If trends continue, Mexico will stop exporting oil and begin importing it in just four to six years.

If not for record-high oil prices earlier this year, Mexico would have already faced a severe budget crisis. With 40 percent of government revenues at risk, the whole country is in danger of social upheaval.

If Mexico loses its oil revenue, the government will probably collapse.

Mexico is locked in a life or death struggle with various drug cartels. And it is oil revenue that is bankrolling the war. As it stands, it is still not clear whether the army is winning or losing.

Mexico was forced to employ its army to battle the drug lords since its domestic police forces were deemed too corrupt. However, as Stratfor has noted, the longer the war drags on, the more infiltrated and corrupt the army will become. It is not just a battle against drugs, guns and crime, but also against time.

At a press conference early this week, Mexican Attorney General Eduardo Medina Mora summed up the progress in the fight against the drug cartels by noting that the country’s drug violence has not yet peaked and that the trend of escalating violence in 2008 is expected to continue into the first months of 2009.

Highlighting the violence in the state of Guerrero was the recent gruesome discovery of nine severed heads—eight soldiers and one former state police director. Next to the bodies was a note that read: “For each one of mine that you kill, I will kill ten soldiers” (Stratfor, December 22).

Stratfor says that it is possible that incidents like the above in a prolonged war with the cartels could lower morale to the breaking point. The army could experience the mass walkouts and resignations that crippled local police forces. Desertion is already a chronic problem for the military.

On top of that, falling oil revenues could break the budget and therefore the army.

And if the army breaks, the viability of the Mexican government will be in question.

The possible implications for America are many and include: less oil from Mexico, empowered crime cartels infiltrating the U.S., chaos and social disorder across the border, increased illegal immigration, and diminished trade.

At a time when America’s economy is also facing collapse, an unstable neighbor is the last thing America needs.

For additional information on the economic prospects for Mexico, and how they will affect the U.S., read “Disorder South of the Border.”