For 36 years, Raúl Muñoz worked in relative obscurity at the Mexican division of a major U.S. chemical company, rising through the ranks to become president of the subsidiary. Then last January, Mexican President Vicente Fox plucked Muñoz out of Dupont Mexico, assigning him one of the toughest jobs in the country: to lead Pemex, the national oil company.

Pemex is, of course, no ordinary company. It is one of the largest and most powerful organizations in Mexico, operated for decades as an arm of the ruling political party rather than as the oil giant that it is. Profits from Pemex provide the government with a third of its revenues. Yet the world’s fifth-largest oil company, which generated $40 billion last year, is struggling to maintain production for lack of investment. Muñoz must fix that and more.

His spacious office on the 44th floor of Pemex’s headquarters has the polish of a U.S. executive suite and the 61-year-old Muñoz is focused and intense. “There is a general feeling throughout Mexican society that now is the time to create a more meaningful Pemex,” says Muñoz, a chemical engineer by training. He speaks of giving Pemex an “entrepreneurial focus” but knows that shaking the company out of its statist torpor is a monumental task.

“Even though the job is complex, I find that there is significant support,” he says in accentless English. “That does not liquidate the bureaucracy because there are rules to be changed and regulations to be looked at. How do you tell a significant portion of your staff that they don’t have a job anymore? That takes some doing.”

Indeed, on the floors beneath him, thousands of workers dawdle at jobs with little real purpose in offices with stained carpets, chipped furniture and grubby walls. Industry analysts say that Pemex’s 130,000 employees are more than twice what it needs.

For decades, bosses of the Institutional Revolutionary Party and the Petroleum Workers Union shared out power and used Pemex’s wealth as a prodigious source of patronage. The company’s political importance and potent symbolism of national sovereignty allowed it to avoid reform despite corruption and abuse of power.

But the heavy weight of history is not Muñoz’s most immediate problem. Pemex is practically starved of cash. The company – indeed, Mexico’s entire energy sector – needs to raise billions of dollars a year to meet rising demand for power. Raising that kind of money for an energy system still firmly under government control is one of the country’s principal challenges. Mexico needs to find close to $90 billion over the next 10 years to invest in its oil, gas and electricity industries. The Fox administration knows it will be hard to push fundamental changes and constitutional amendments through a fractious Congress. Instead, it must find ways around the existing rules without violating the letter, if not the spirit, of the law.

The Mexican constitution requires Pemex to transfer its profits to the government. Last year Pemex handed over $29.1 billion in earnings to the Finance Ministry – 33% of the federal budget – leaving the company with a $195 million loss. Due to these vast transfers and its own inefficiency, there are hardly enough resources to cover investments in exploration, improvements in production or new refineries. Pemex has scarcely benefited from the sharp rise in oil prices in the last two years because the government appropriates its windfall profits. If the average price of oil is higher than that established in the federal budget, the difference in revenue is passed on to the government.

Crude Pumping
For the last two decades, Pemex has been able to do little more than pump crude oil out of its existing wells. Pemex’s oil output of three million barrels per day is much less than the company could produce, given Mexico’s enormous reserves. “Pemex has been flat for about 18 years in crude production,” says Muñoz. “It is now important to change that trend.”

Raúl Muñoz, CEO and director general of Pemex, says
he wants to turn the state monopoly into the best oil
company in the world.

He must also spend more on exploration to reverse the decline in Pemex’s oil and gas reserves. At 56 billion barrels of oil equivalent, Pemex’s proven reserves are at their lowest levels since 1980. The government estimates that its oil and gas business requires at least $36 billion in capital over the next decade. The government can provide only a small portion of that and Pemex’s ability to issue bonds in the international markets is limited because its debt is included in the consolidated public sector balance sheet. Mexico is an investment-grade country, but Finance Minister Francisco Gil Díaz is a fiscal hawk who warns that the official figures the previous government provided on the budget deficit underestimate the gap by about 3% of GDP. And since the constitution bans private sector investment in oil, Pemex cannot share development costs with international oil companies.

The same goes for the gas industry. Mexico has significant proven reserves of natural gas, but it became a net importer of gas in 1999 when it shifted to gas-fired power plants. Strong economic growth of over 5% a year increased demand for gas still further. Consumption now is expanding at double the country’s economic growth rate. Mexico’s demand for natural gas should grow by about 10% a year according to Roger Diwan, managing director of markets and countries at the Petroleum Finance Company, an energy advisory firm “They are in a race against the clock,” Diwan says. “If [Pemex] cannot produce the gas themselves and cannot fuel the economy, there will be a revolt by the industrialists.”

Says Sondra Scott, director of Latin American energy for Cambridge Energy Resource Associates, “Mexico is reaching a short-term near crisis situation. It would be one thing if the country wasn’t rich in resources. The problem is not one of prospectivity, it is one of investment.”

Mexico’s electricity industry also requires massive investment, another $50 billion over the next 10 years, according to the Ministry of Energy. Demand for electricity in Mexico, Latin America’s strongest economy, is booming. The government estimates the country must install capacity to generate an additional 26,000 megawatts of electricity over the next eight years. Private companies can generate and sell electricity in Mexico only under certain circumstances and Fox plans to submit a proposal to Congress that would accelerate the role of outside capital, “In the investment plans that have been made for the next 10 years, over 50% is expected to be funded by private investors,” says José Luis Aburto, advisor to Energy Secretary Ernesto Martens. “The numbers are close to $5 billion per year, and half of that might, and we hope will, be undertaken by private investors. Aburto says that if Congress approves the reforms, perhaps this fall, that 50% share could increase rapidly throughout the next decade.

National Jewel
Opening Pemex to private interests will likely prove a far greater challenge for Fox and Muñoz. Since 1938, when Mexicans donated their jewelry and savings to help President Lázaro Cárdenas nationalize the country’s oil assets after U.S. and British oil companies refused to raise wages and meet union demands, Pemex has become synonymous with national sovereignty. Over the years, the company grew into a federal jobs program and provides employee benefits that few modern companies would consider, such as providing free hospitals and schools throughout Mexico for workers and their families.

Though Fox suggested privatizing Pemex last year when he was a presidential candidate, he quickly dropped the idea after taking office in December. But Fox is determined to open Pemex to market discipline. However, his first step in that direction went down badly. In February, he appointed some of Mexico’s wealthiest and most powerful business leaders to Pemex’s board of directors, previously packed with government and union officials. Lorenzo Zambrano, head of the Mexican cement company Cemex, and Carlos Slim, the main shareholder in Telmex, the phone company, were two of Fox’s appointees.

The move stunned the country. Particularly for members of Pemex’s powerful labor union, Fox’s decision was heresy, a threat to the regime that has controlled Pemex for 63 years. Members of Congress asked Fox to rescind the appointments, which he has refused to do. Meanwhile, union board members have boycotted meetings, preventing any decisions.

Congressional Challenge
Fox faces even greater challenges with Congress over Pemex’s future. He wants Congress to amend the constitution to reduce the percentage of profits Pemex must give to the government. However, Fox must first push a package of fiscal reforms through Congress that would among other things, raise the country’s tax burden of only 11% of GDP to replace revenues from Pemex. The tax reform package may not pass until this fall, when Congress reconvenes.

Juan Antonio Bargés, Mexico’s undersecretary for energy policy and development, says it is critical that Mexicans understand the importance of fundamental reforms. “One of the things that we are going to demonstrate to the Congress is that if we are unable to obtain financing under the existing rules, we are not going to be able to obtain the energy that we are going to require,” he says. This could be tremendously harmful for the Mexican economy, he says. “We have to convince Congress that tradition is important – that we are going to maintain our sovereignty – but also that we want to promote the development of our oil fields.”

Muñoz cannot afford to wait for Congress. He must immediately find ways for the company to access long-term capital, slash costs and raise the value of its products. Muñoz says his goal is to transform Pemex into the world’s best oil company. Although there is little chance that Pemex can be privatized soon, he still wants to throw off Pemex’s public sector culture and make it behave more like a profit-oriented private company capable of meeting international standards of efficiency.

The contrast between Mexico and Brazil 10 years ago are striking. Petrobras, Brazil’s state oil company, has worked to transforming itself from a plodding state entity into a lean, transparent and profit-oriented business. Brazil scrapped Petrobras’s monopoly, allowed foreigners to buy voting shares and threw the entire oil industry open to foreign capital, both local and international. The transition at Petrobras, led by Philippe Reichstul, has not been easy. But today, Petrobras is listed on the New York Stock Exchange and raises long-term capital on the global capital markets.

Last year, it executed a ground-breaking deal that helped it overcome the same public borrowing limits that Pemex faces. Through an off-balance sheet transaction arranged by Deutsche Bank and Merrill Lynch, Petrobras raised $1.5 billion of eight year debt for its Marlim offshore oil field. A special purpose company owned by ABN AMRO and Brazil’s national development bank issued the debt.

Petrobras provided $200 million in equity to secure the debt and agreed to cover any shortfall in debt service and operating expenses that Marlim couldn’t meet from its oil output. This was the first time that Petrobras was able to secure substantial amounts of medium-term, off-balance sheet financing, which it is using to increase production at Marlim. Petrobras also closed a $3.2 billion financing for its Barracuda and Caratinga fields, which used a different structure to achieve its first-ever maturity of 10 years.

“Petrobras was forced to accelerate development of its offshore fields or they risked losing them to privatization,” says Greg Moroney managing director for project finance at Deutsche Bank Securities. The three projects enabled Petrobras to develop the fields, increase production, and help move Brazil towards self-sufficiency in oil. “Brazil went from [output of]1.1 million barrels a day, to 1.5 million, and it is on its way to 1.9 million,” says Moroney.

However the recent explosion and sinking of what was the world’s biggest offshore oil rig, owned by Petrobras, has raised questions about the management skills of Reichstul and his team.

At Pemex, Muñoz says his central concerns are to raise hydrocarbon reserves and improve the efficiency of the company’s operations. Like Reichstul, he believes those changes must start with a new management structure capable of breaking the corporatist stranglehold over Pemex. He says that one of the main components of his strategy is to hire a new cadre of highly qualified, driven managers. “We will be making personnel changes as required, starting with the strengthening our corporate staff so that we can provide stronger leadership and exercise more discipline and control in operations and projects,” he says. “There will be coordination of plans and considerable effort in organizational development toward this culture change.”

But critics say Muñoz lacks the decisiveness and industry experience to make far-reaching changes at Pemex. “I don’t think he can change the culture,” says Diwan of the Petroleum Finance Company. “You need someone very strong at the helm. He wants to change the culture of Pemex over 10 years. Unless he wants to come and cut the heads off of a lot of people, I say to him ‘good luck.’”

Bending the Rules
Muñoz still needs to raise fabulous quantities of capital. But the government has to move ahead cautiously in negotiating its tax reform with Congress and in reforming Pemex’s finances. Muñoz says, “We are looking at the possible effects of the fiscal reform, exploring additional financial opportunities with the Treasury and looking at creating some investment opportunities through alliances with the private sector.”

Investors, both local and foreign, are keen to put money into Mexico. But Mexico’s oil monopoly laws prohibit private sector investments in the oil and gas industry. Pemex can sign contracts with private companies for services such as drilling oil wells. Private companies can transport and distribute natural gas that they buy from Pemex. But these relationships do not give contractors any ownership rights over these resources.

Muñoz says he wants to expand existing service contracts for exploration of non-associated natural gas – so-called dry gas deposits that are not found with oil. “We need to try to minimize our investment, which has not been done in the past,” he says. “We obviously have to operate within the legal framework but we are looking at ways that we can expand the limits of what is allowed in service contracts, access to technology and alliances with world leaders,” says Muñoz. “We want to be very aggressive in finding ways that we can work on a case-by-case basis or a project-by project-basis. For example in the exploration of non-associated gas, we do not have the best technology, equipment and people around.”

That problem exists in associated gas production as well. Pemex lacks the technology to capture significant amounts of gas found with oil deposits, so a lot of the gas literally goes up in smoke. At Pemex’s huge offshore Cantarell oil field in Campeche Bay, thick plumes of black smoke rise up from rigs flaring gas. Pemex has taken a small step toward addressing this problem. Pemex has a contract with Westcoast Energy, a Canadian firm, to capture some of the hundreds of millions of cubic feet of Cantarell’s wasted gas and compress it for distribution.

Westcoast also is a partner in the $1.6 billion Cantarell nitrogen injection plant that produces nitrogen for injection into the nearby reservoir to maintain pressure, which declines over time as oil is pumped out. “These are very, very successful projects,” says Deutsche’s Moroney. “They improve oil production by using a cost-effective method of increasing reservoir pressure and increase gas available for consumption at the same time.”

One way the government has benefited from outside capital is through a special instrument called Pidiregas, the Spanish acronym for Deferred Impact Projects for Government Spending, which it created four years ago to finance development and drilling contracts, increased production projects and downstream activities. “Pidiregas is a device to bring private capital for specific projects that generate their own cash flow to repay the financial requirements for investment,” says José Luis Aburto, of the energy ministry. “In exploration, it is very difficult to support this type of result because there is no short-term cash flow.”

But the government and Pemex are working to raise private capital for exploration as well, which may pose the greatest financial challenge. “It costs anywhere from $5 million to $25 million to do one perforation,” says John Donnelly, of J.P. Morgan in Mexico City, who has worked closely with Pemex over the last decade. “The government doesn’t have the money to keep on drilling.”

Energy ministry officials say a financing plan in the works would allow Pemex to hire service companies to develop its wells. “You have a field in operation and a drilling company comes and funds the services that they are going to provide, and the repayment is directly tied to income derived from increased production,” says José Luis Aburto, Martens’ advisor. “But it is a service contract, and not a sharing agreement of any sort, which is not allowed.”

Pemex’s refineries are also desperate for investment. Government officials say they have found a way to work within existing laws that allow the private sector to shoulder some of the investments needed to modernize the company’s petrochemical business. “We are not going to change any kind of regulation,” says Juan Antonio Bargés, the energy undersecretary. “What we are now developing is how we are going to connect the private and public [sectors]. I am speaking about strategies and management, not regulation.”

More Short Cuts
The government is also searching for short cuts to find capital for Mexico’s electric industry. The federal government permits private companies to build and operate electric power plants. But there is little chance Congress will permit the government to privatize Comisión Federal de Electricidad (CFE), the state power company. Like amending the laws governing Pemex, changes at CFE would require a constitutional amendment and no single party has a large enough majority in Congress to quickly execute broad-based changes.

Currently, private companies can invest in Mexico through independent power projects, in which a developer agrees with CFE to supply it with power for a fixed return. Mexican companies that use a lot of electricity can also build their own power plants under self-supply arrangements. These may be useful for industrial power users but they don’t increase supply for consumers very much. “There is a limit to how many deals can like that can be done,” says Thomas Plagemann, director of energy project finance at Deutsche Bank. “Industrial users make up 30% to 50% of demand. You need capacity installed to deliver to the general consumer market.”

Meanwhile, independent projects are becoming less attractive for private power developers. The competitive bidding proces drives down returns to contractors and the fixed rate of return is a problem too. Power developers want some upside, not just a fixed rate, says Plagemann. “It’s not interesting enough to them.” He says Mexico needs to raise substantial volumes of debt and even equity financing to meet its power needs.

An important first step to attracting equity investments would be to make the electricity system more transparent. CFE subsidizes its rates, so few private operators really know what it costs the government to generate power. Without adequate price signals, private producers are naturally wary of investing in Mexico. Moreover, since CFE is a monopoly, it is still motivated by political factors rather than market forces, making it all the harder to predict prices.

Brazil has shown that state-owned companies can become more efficient and self-financing if they become subject to the discipline of the marketplace. Petrobras remains majority-owned by the federal government, but is subject to the same tax, legal and regulatory framework as any private sector company.

There is broad agreement in the Fox administration that a system in which Pemex could invest its profits as it sees fit would certainly help the company manage itself more efficiently. Munoz says, “A lot will depend on the [federal] fiscal reform. Change has to be gradual and fair, and ensure the possibility of growing so that we can ideally provide significant portions of income to the government but also access that money for our growth plans.”