Simmering social strife, endemic corruption, an eroding trade balance, and a burgeoning current account deficit are just some of the challenges facing Mexico ’s incoming president, Felipe Calderon. The quietly determined politician who narrowly seized power amid drawn-out post-electoral wrangling, now faces a critical challenge: how to create growth and strengthen democracy, or risk losing a grip on both.
But matters – especially on the economic front – have become more urgent given an impending US slowdown, which threatens to drag Mexico ’s fortunes with it. The problem is compounded by another murky substance: oil. Mexican oil production is falling by 14% per year, and, at the current rate, output will drop 80% by 2015. The oil export price has dipped below its targeted level, raising the risk that the government might have to consider adjustments to its 2007 budget, which is based on an average price of $42.80/barrel for the country’s mix of oil exports.
Newly appointed finance minister Agustin Carstens, until recently a top IMF official, says a budget revision is not yet necessary, but the below-budget price drop could give greater momentum to the administration’s planned fiscal reforms, designed largely to cut the federal treasury’s dependence on volatile oil income.
While the current oil price drop has triggered warning bells about the course of Mexico ’s future fiscal revenue and spending, it has also brought into sharp relief the question of how to reform Petroleos Mexicanos (Pemex), Mexico ’s state-owned oil monopoly.
Production slump
The ageing firm is facing a slump in production, a rapid decline in its biggest field, a 25% decline in reserves-replacement-to-exploration – it is the world’s most indebted oil company. Pemex owes about $100 billion, including pension liabilities and corporate debt.
After peaking in 2004, Pemex’s oil production began to decline due to a lack of investment: the company needs an injection of $34 billion to turn the tide. The problem, analysts say, is largely a legacy of the previous administration led by Vicente Fox, which diverted many of Pemex’s investment funds to government coffers to compensate for a lack of fruitful economic reform. In the process, they left the oil company loaded with debt and dwindling reserves.
The company is in dire need of more investment but also needs to step up its exploration activities in uncharted areas such as deep waters, moves that require expensive technology. The problem is Pemex can only access a small amount of funds for capital expenditures – $14 billion this year, at least.
“More resources are needed for investment, debt financing is not the way; the issue is, basically, that the fiscal contribution of Petroleos Mexicanos is diminishing,” says Pemex director-general Jesus Reyes Heroles.
Pemex earned $100 billion last year, but the company passes most of its revenues – $79 billion in 2006 – to the government to fund federal spending, and in recent years took on more debt to finance its investment programme. The Mexican constitution prohibits private investment in oil, so the possibilities of raising money through joint ventures or risk contracts, where partners have an equity stake in prospecting, are off limits.
“We are not working under the supposition that, in the short term, there are going to be constitutional reforms that would substantially change the activities of Pemex,” says Reyes Heroles.
Congress changed Pemex’s fiscal regime in 2005, allowing the oil monopoly to hang on to more resources for investment. The firm should be able to self-finance $2-3 billion in annual upstream expenditures over the next three to four years.
But Pemex needs to invest about $14 billion annually in exploration and production just to maintain its current output level, and prospects for a significant improvement in current Pemex finances are dim. This year, it will fall $1 billion short of the $15 billion Pemex needs to invest in upstream development.
Production at the huge Cantarell offshore field, the source of half of Mexico’s crude, is now falling at a rate of 13% per year. As a result, the production platform has dropped from 3.3 million barrels per day (bpd) to 3.0-3.1 million this year, with exports fluctuating around 1.6 million bpd, though some analysts predict they could go as low as 1.3 million bpd.
“This is a challenge that implies more financial resources, access to technology and being able to find the modalities that allow us to join forces with companies that provide services for exploring and exploiting those fields,” says Reyes Heroles.
The oil company is believed to have far more reserves than its current proven levels, but new discoveries are scarce because reserves are hard to reach. It also lacks the technology for deep-water drilling in the Gulf of Mexico. While Pemex can contract out services such as distribution and storage, maintenance and platform construction, in the exploration and production segments it is expressly prohibited by the Constitution from offering concessions and so-called risk contracts that would pay a private firm a percentage of the value of any finds. Potential contractors are only interested in exploration if they get a percentage of new finds.
Fiscal reform
Reyes Heroles is well aware that Pemex’s dismal condition is having an impact on government priorities. “During this administration, the moment of inflection is occurring,” he says.
A comprehensive fiscal reform plan should be on the congressional agenda before September, though hope for boosting tax collection remains modest: after Guatemala, Mexico has the second-lowest rate of tax collection in Latin America, the result of widespread informality, a high rate of evasion and the complexity of the tax system.
“I suspect fiscal reform will be approved at year-end, but it will probably not be easy to free up much more money for Pemex under any scenario,” says David Shields, an energy analyst and Reforma newspaper columnist in Mexico City.
A similar package of reforms was opposed and then faded away in Congress during the Fox administration. Analysts can be forgiven for remaining circumspect: “I don’t know whether there will be a fiscal reform,” says Santiago Carniado, director of corporate ratings with Standard & Poor’s credit rating agency in Mexico City.
But a big drop of fiscal revenues from oil would put greater pressure on lawmakers to agree to the proposed changes. “Some believe the Cantarell decline will put a whole new burst of reality into Mexico,” says George Baker, director of Energia.com, an oil consultancy based in Houston. In this perspective, the drop in net production, which could reach 400,000 bpd this year, would not be offset by development of the Ku-Maloob-Zaap fields with their heavier oil.
Calderon, a former energy secretary, has placed fiscal reform at the top of his structural reform agenda but has so far been silent about energy reform. It’s a thorny issue: Pemex remains a symbol of Mexican nationalism, and opposition leader Andres Manuel Lopez Obrador, who came within a hair’s breadth of winning the presidency last July, has already announced he will campaign against energy reform.
A tentative proposal for reform – though still unclear and focused heavily on the electricity sector – is being floated by Mexican senator Francisco Labastida, the 2000 presidential candidate of the then-ruling Institutional Revolutionary Party (PRI) and another former energy secretary. It would be supported by Calderon’s National Action Party (PAN). The two houses of Congress are divided, with PAN the largest minority party in both, Lopez Obrador’s Democratic Revolution Party (PRD) the number two party in the lower house and the PRI bloc only slightly larger than PRD in the Senate.
In this context, a glimmer of hope remains. “If you let little groups in Congress run with it [reform proposal], it could happen,” says Federico Estevez, a political scientist at the Instituto Tecnologico Autonomo de Mexico (ITAM) in Mexico City.
Even so, a constitutional reform opening Pemex to private investment is still a remote possibility as it would require a two-thirds majority in Congress as well as passage by 17 of the 32 state legislatures.
Change at the margins
Changes could occur at the margins, however, which could benefit both Pemex’s finances and operations. For instance, setting up “a better fiscal framework that allows Pemex to retain more resources for reinvestment, eliminating certain labour rigidities and creating more flexible rules for contracted operations,” would go some way towards strengthening the company, according to Sergio Rosado, an oil sector analyst with Cambridge Energy Research Associates in Mexico City.
Against the backdrop of a Congress that’s expected to push legislative rather than constitutional reform, “[lawmakers] could open up refining, pipeline ownership, fuel distribution and storage to the private sector, but not exploration and production,” says Shields. Those downstream segments are bound only by legal restrictions, not by the Constitution, which specifically prohibits risk contracts and concessions in the upstream operations. However, he cautions that private-sector interest is probably greater in the upstream-exploration and production – and that Pemex’s upstream problems are more urgent due to depleted oil reserves.
There are many scenarios for fixing Pemex’s financing and exploration problems. George Baker of Energia.com argues that cross-border field development in the Gulf of Mexico – where international oil companies are already extracting oil from fields less than 10 kilometers from Mexican territory – is an obvious move. By doing nothing, “you run the risk of having oil drained out (on the Mexican side) by natural gravity,” he warns.
Cross-border field development, known as “unitization”, is common in the North Sea, where the United Kingdom and Norway have developed protocols and treaties to share production. In these schemes, one company is the operator and another is the partner. The concept of unitization was presented to a congressional commission last November by departing Pemex CEO Luis Ramirez Corso.
Some specialists are less enthusiastic about cross-border oil production. “It’s not the same thing as having a lot of rigs,” says an analyst who spoke on condition of anonymity.
This year, Pemex is expected to make smaller debt issues than in the recent past. The company will seek between $1 and $2.5 billion in international capital markets, analysts say [compared to what?]. It will also pay down $5.5 billion in debt this year.
For the foreseeable future, Pemex will be trapped between its debt burden, high operating costs and narrow manoeuvring room for exploration. In the next three years, production at the Ku-Maloob-Zaap fields will increase to a peak of about 800,000 bpd, but from 2010 overall production could drop below 3 million bpd, analysts say.