Oil Rich, Cash Poor

The Mexican government has cut its debt, reformed its financial system and opened the country to foreign trade and investment. But it has virtually ignored its decaying energy industry. The constitution bans private-sector investment in the oil and gas industry, but the government has prevented Pemex, the oil monopoly, from investing enough in finding new oilfields or upgrading its refineries. On the contrary, the government is bleeding Pemex white. Mexico may be fabulously rich in energy resources, but it is experiencing a steep decline in proven reserves and in production because of years of under-investment.

Mexicans often talk about the energy “crisis,” although they are referring to a shortage of capital, not an oil shortage. Pemex executives are warning that oil output could drop unless the company is restructured and allowed to increase investment. Since the government relies on Pemex to provide a big chunk of its budget revenues and all of the country’s oil needs, a plunge in production would be disastrous.

President Vicente Fox has said that he intends to end a system in which the government “takes all [operating profits] and leaves no resources for investment, maintenance or technology.” Last year, Pemex transferred $29.1 billion to the government, equivalent to 33% of the federal budget. Although it posted nearly $50 billion in revenues, Pemex actually lost $195 million last year.

Pemex has proven reserves of 55 billion barrels of oil equivalent, enough for about 22 years of production at current rates. But it failed to keep up with the global oil industry’s rise in productivity during the 1990s. Proven reserves are at their lowest level in 20 years and company officials say that unless it begins investing $33 billion in exploration, Mexico’s oil output of 3.1 million barrels per day could drop by a third within five years.

Revenues could plummet by two-thirds during the same period because of the company’s crumbling infrastructure. In August, Raúl Muñoz, Pemex’s director general said, “We are doing nothing intelligent to avoid this. The situation is that we have made the same mistakes repeatedly and we have not managed to make any decisive moves in the right direction.”

Mexico is a major exporter of crude oil, which is relatively cheap to produce, but it must import growing volumes of expensive refined oil products because it lacks sufficient refinery capacity. “Their oil production is declining, they are a net importer of gas, they have not upgraded their refineries and they are importing refined products,” says Greg Moroney, managing director, Latin American project finance at Deutsche Bank. “They need close to $30 bilion for the upstream sector, $20 billion for the downstream sector and another $1 billion for the petrochemical sector.”

Mexico’s electricity and gas industries are also suffering from years of neglect. Although Mexico owns some of the world’s largest natural gas reserves, it cannot develop them properly. Instead, Mexico must import more and more gas to meet the growing demand from new gas-fired electricity generators. In July, natural gas imports doubled to 375.9 million cubic feet per day from a month earlier. Consumption is forecast to expand twice as fast as the economy over the next decade.

Meanwhile, the country needs to invest around $50 billion over the next 10 years to upgrade and expand the strained power grid. The government estimates that the country must install capacity to generate at least an additional 26,000 megawatts of electricity.

One of Fox’s principal objectives when he took office last December was to allow private investment to boost the oil, gas and power industries, without violating constitutional restrictions on private sector involvement in these sectors. Mexico’s national identity and sense of sovereignty is bound up with state control of the oil industry, ever since the government expropriated foreign oil wells in 1939.

Fox has suggested a number of ways private companies would be able to invest in the industry without violating the constitution, saying he intends to open oil refineries and part of the natural gas sector to private-sector investment.

“Fox needs to create a politically acceptable structure to allow foreign companies to come in and increase production and reduce the country’s need for gas imports,” says Moroney. “But these are very sensitive political issues.”

The depth of the public opposition to allowing the private sector into the industry became clear shortly after Fox’s inauguration when he proposed putting some of Mexico’s corporate bosses on Pemex’s board of directors. But his choice of two of the country’s richest men was politically maladroit. Fox wanted Lorenzo Zambrano, head of the Mexican cement company Cemex, and Carlos Slim, the main shareholder in Telmex, the phone company, to serve on a board packed with government and union officials. Furious union board members boycotted meetings and congressional pressure forced Fox to withdraw his proposal.

However, Fox is expected to submit an energy reform plan to Congress soon that will include a formula for allowing private investment in developing oil and gas reserves, and boosting electricity generating capacity. Juan Antonio Barges, Mexico’s undersecretary for energy policy and development, says, “We have to convince Congress that tradition is important – we are going to maintain our sovereignty – but also that we want to promote the development of our oil fields.”

Pemex is permitted to sign contracts with private companies for services such as drilling oil wells, but contractors do not earn a percentage of production revenues, called risk payments, as is common elsewhere in the world. Private companies can also transport and distribute natural gas that they buy from Pemex, but only Pemex has the right to explore for and produce hydrocarbons.

Muñoz, a chemical engineer whom Fox hired from Dupont Mexico to run Pemex late last year, wants to expand existing service contracts for exploration of so-called non-associated natural gas, or dry gas deposits that are not found with oil. This would allow Pemex to reduce its investments in gas and redirect these resources to expanding oil output.

“We need to try to minimize our investment, which has not been done in the past,” says Muñoz. “We obviously have to look at ways that are within the legal framework but we are looking at ways that we can expand the limits of what is allowed in service contracts. One possibility is to add risk payments to the flat fees paid to private producers of non-associated gas.”

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.” The government could also try to reinterpret the constitution and open the door to private investment in the country’s aging petrochemical plants. Muñoz says Pemex’s main challenges are to expand Pemex’s reserves, particularly those of light crude oil and non-associated gas, to improve the efficiency of its operations and to gain more freedom for Pemex to operate independently from the Ministry of Finance.

Fox wants to give greater operating autonomy to Pemex and to the Federal Electric Commission, the state electricity generation and distribution company. He also wants Congress to reduce the amount of money that Pemex must give to the government, allowing it to invest more in exploration and development of the country’s energy reserves. However, before that happens, Fox needs to push tax reform legislation through Congress that would increase value added tax revenues to replace lost revenues from Pemex.

In spite of its monumental financing challenges, Pemex is a remarkably solid credit in the international markets. In September, Moody’s upgraded the company’s foreign currency bond rating to Baa2 from Baa3, one notch above Mexico’s Baa3 long-term foreign currency ceiling. Moody’s said the upgrade reflects Pemex’s “sizeable hydrocarbon reserve base, its monopoly powers within the Mexican petroleum industry, its importance to the Mexican economy, the fully integrated nature of its operations and its position as a leading exporter of crude oil to the United States.”

In August, Pemex raised $600 million in a three-and-a-half year bond issue with a yield of 6.6% and at a narrow spread of 203 basis points over comparable US Treasurys.

Deutsche’s Moroney says Pemex has solid market access to meet its immediate financing needs. “The wind is at their back right now and they are sailing free and clear for the time being.” But he warns, “Demand for capital in Mexico’s energy industry exceeds amounts available to Pemex directly, due to its own capital and buget consrtaints, by tens of billions of dollars.”