Mexico Oil Opening May Be Foreigners’ Gusher as Pemex Struggles

May 13, 2014 4:23 am ET

May 13 (Bloomberg) -- When Mexican President Enrique Pena Nieto arrived at the March 18 rally, he was greeted like a rock star. Hundreds of local residents and employees of Petroleos Mexicanos had gathered in the eastern state of Veracruz for the annual celebration of the 1938 expropriation of foreign oil wells and the founding of Pemex. The workers, all dressed in white shirts and guayaberas bearing the Pemex logo, leaned over waist-high barriers to try to touch the photogenic president. They cheered and sang, breaking frequently into a chant normally reserved for the national soccer team, Bloomberg Markets will report in its June issue.

An outsider would never have guessed that, just three months earlier, Pena Nieto, 47, had signed into law a constitutional amendment that Pemex, its powerful union and its political backers had fought against for decades. The amendment opens up Mexican oil and gas fields to foreign and private investment for the first time in 76 years.

After signing the constitutional change into law on Dec. 20, Pena Nieto told his countrymen that it would be a boon. “We’ve decided to overcome the myths and taboos to take a great leap into the future,” he said. “A new history begins for our country.”

Yet at the March rally, he amplified the cheers by assuring the Pemex workers that none of their 153,000 colleagues would lose their jobs.

Petrostate

Pemex has always functioned as an arm of the state. It’s the biggest Mexican company and the country’s biggest taxpayer. In the final quarter of 2013, Pemex paid 50 percent of its revenue -- $16 billion -- in taxes to the federal government, which uses the state-owned company to fund a third of its budget.

Pemex posted a loss of $5.8 billion for the quarter, bringing its total loss for 2013 to $13 billion. The loss for the first quarter of 2014 was $2.74 billion.

Congress approved a broad tax overhaul last year designed to increase collection of personal income and consumption taxes to begin to wean the government off Pemex revenues. Yet Pemex Chief Financial Officer Mario Beauregard says company taxes will not be cut this year. And it will likely be years before enough new tax revenue from foreign oil drilling comes in to replace the lost tax levies from Pemex.

Edgar Rangel, commissioner of Mexico’s National Hydrocarbons Commission, which oversees and regulates oil exploration, predicts that the opening of the country’s energy industry will bring in up to $30 billion of foreign investment annually and create as many as 2 million jobs.

Moody’s Upgrade

The law’s approval prompted Moody’s Investors Service in February to raise Mexico’s credit rating one level to A3 from Baa1, saying it will help add about 1 percentage point to the country’s annual gross domestic product growth by 2018.

For Pemex, the constitutional change will mean it gets much-needed help in increasing its oil production, which has declined for nine consecutive years and, as of the end of March, reached its lowest monthly level since 1995.

For foreign oil giants such as Chevron Corp., Exxon Mobil Corp. and Royal Dutch Shell Plc, it means they’ll get access to untapped oil reserves that Pemex says could total 113 billion barrels, including 26.6 billion in the deep waters of the Gulf of Mexico. At current prices, the reserves are worth $11 trillion. The government says foreign investment together with the revamping of Pemex’s aging infrastructure will drive up production to 4 million barrels a day by 2025 from 2.47 million at the end of March.

‘Shale Frenzy’

Pemex Chief Executive Officer Emilio Lozoya says Mexico also boasts 13 trillion cubic meters (460 trillion cubic feet) of unexploited shale gas in the rock formations beneath its soil, worth an estimated $2.2 trillion. Kent Moors, executive chair of research firm Global Energy Symposium, says five major fields identified so far could produce a “shale frenzy” among private companies.

The foreign incursion into the oil and gas fields will begin later this year, after the Mexican Congress passes secondary legislation, introduced in early May. The measure calls for foreign drillers to use Mexican suppliers for 25 percent of equipment and services by 2025. It proposes that the tax Pemex pays to the government be reduced over 10 years. The bill also relieves the Finance Ministry of its duty to approve the company’s budget. The sale of gasoline, now a Pemex monopoly, would gradually open to competition.

‘All the Cake’

Lourdes Melgar, Mexico’s deputy energy minister, says Pemex likely lacks the financial and technical resources to operate all of its existing fields efficiently, much less expand into new ones. Nevertheless, the company has told the government it wants to maintain control of most of its current operations, with any private companies joining it as junior partners.

“Pemex wants to eat all the cake, but it can’t,” Melgar said at a press conference in March. “I think there will be gray areas where we will have to ask Pemex for more information and, at some point, tell them, ‘This one won’t work or you can’t have these two things.’”

Mexico’s near-term goal is to raise production 20 percent, to more than 3 million barrels a day, by 2018. Delays in passage of the implementing legislation and the awarding of contracts makes that unlikely, says Maria Jose Hernandez, a Washington- based associate at global risk consulting firm Eurasia Group.

“Initial increases in oil production volumes could be seen in 2016, but at very small levels,” Hernandez says.

Government Decouple

Pena Nieto’s plan is for Pemex to cease to be, in effect, a government department and function like a for-profit company. To further that goal, the government plans to allocate $28 billion to Pemex for oil exploration and production in 2014.

As part of the overhaul, the National Union of Mexican Oil Workers will relinquish its five seats on the Pemex board. The board will be trimmed to 10 members from 15 and will include five government officials selected by the president and five independent members, according to Pemex board member Fluvio Ruiz.

The models for a new Pemex, CEO Lozoya says, are Petroleo Brasileiro SA, the Brazilian oil major that opened to foreign competition in 1997; Norway’s Statoil ASA; and Colombia’s Ecopetrol SA, which has seen production almost double since state control was limited in 2003.

“When you are the last one to the party, you can learn from other people’s mistakes,” says Juan Carlos Gay, a partner at Bain & Co. in London who has studied Mexico’s oil industry. “One thing that Pemex and the Mexican government should leverage is the way to use joint ventures in a smart way, which includes bringing in and developing the expertise and capabilities of other companies.”

1938 Seizure

Pemex was born in a surge of nationalist sentiment during the presidency of Lazaro Cardenas (1934 to 1940). On March 18, 1938, Cardenas nationalized the country’s oil fields and seized the assets of Royal Dutch Shell and Standard Oil Co., at the time major suppliers of oil to the U.S. The government monopoly on petroleum production was later enshrined in the constitution.

The Pena Nieto government’s proposal to repeal that provision sent thousands of protesters into the streets of Mexico City last year. The legislation passed only after promises by the government and company executives that Pemex workers wouldn’t lose their jobs and that the move would boost Mexico’s slowing economy, which expanded 1.1 percent in 2013, far below forecasts.

The rapid fall in Pemex oil production helped drive the decision. Mexico became a major oil exporter after the 1971 discovery of one of the world’s biggest oil fields in the shallow waters of the Bay of Campeche. The field was named Cantarell after fisherman Rudesindo Cantarell, who alerted Pemex when he saw oil in the water.

Falling Production

Cantarell’s output has fallen almost 90 percent since it began production in 1979. That would have been a catastrophe for the government had the price of oil not increased to more than $100 a barrel during the past decade.

The failure of Pemex and its government overseers to invest in the latest drilling and exploration technology is partly to blame for the decline. Pemex could have earned an average of 48 percent in additional revenue each year from 2001 to 2009 if it operated more efficiently, according to a 2011 study of Mexico’s oil industry by the University of Oxford and the James A. Baker III Institute for Public Policy at Rice University in Houston.

A critical issue for the future of Pemex is manpower. The company is overstaffed with unskilled workers whose jobs are guaranteed for life and understaffed with engineers and other skilled laborers, says Marcelo Mereles, a former Pemex director who’s now a partner at EnergeA, an energy consulting firm in Mexico City.

‘Cultural Handicap’

“Pemex continues to have a very big cultural handicap,” Mereles says. “The government has converted Pemex into a very bureaucratic company that operates like a government office and not like an international oil company.”

Pemex’s ability to compete with foreign companies will also be hampered by deficiencies in Mexico’s educational system.

“We’ve all heard the excellent news about Mexico’s great potential in the energy sector, but the question is, who’s going to do it?” Rangel of the hydrocarbons commission said in a March 12 speech. “We have very few universities committed to oil production, petrochemicals, chemical engineering or physics. And we produce very few engineers. Many of the engineers we produce in those fields work anywhere else but Mexico.”

Raising Pay

That’s because until now a petroleum engineer’s main potential employer in Mexico was Pemex, and he could earn more money abroad. The legislation implementing the constitutional change will give Pemex “the capacity to compensate our workers with industry salaries,” Lozoya says.

Whoever does the drilling, one area of greatest potential for Mexico is its shale deposits. Victor Herrera, managing director for Latin America at Standard & Poor’s, says that the petroleum embedded in shale is the “low-hanging fruit” of Mexico’s energy overhaul, and new exploration could come as soon as the second half of this year.

“We could see a lot of investment coming very quickly from Texas,” Herrera says.

That’s because one so-far underexplored shale formation lies in northern Mexico across the border from Texas’s prolific Eagle Ford field. Oil output at Eagle Ford rose to 1.2 million barrels a day last year from about 50,000 in 2007, according to data compiled by Bloomberg New Energy Finance.

Fracturing Shale

The Mexican portion of the underground formation holds an estimated 3 billion barrels of oil and 4.2 trillion cubic meters of natural gas, according to Pemex. Company officials say it will need outside help to exploit any gas finds.

Another area where Mexico needs outside expertise is deep- water drilling. Pemex has only four deepwater platforms in the gulf, compared with 53 on the U.S. side, according to Houston- based oil services company Baker Hughes Inc. Foreign companies will partner with Pemex and will likely be permitted to drill independently in Mexico’s deep waters, Lozoya says.

“The energy reform is the most important economic change in Mexico in the last 50 years,” President Pena Nieto told the Pemex employees on March 18.

The question is how quickly Pemex itself can benefit from it.

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--With assistance from Carlos Manuel Rodriguez in Mexico City.