America’s oil business is booming, thanks to breakthrough techniques and heightened E&P. To the south, Mexico is struggling, and its shortage of fuel is becoming a concern. The head of Mexico’s oil production is state-owned Petróleos Mexicanos, or Pemex.  Mexico has become a major non-OPEC oil producer, exporting $40 billion in crude oil per year to the United States. Pemex dominates the country’s energy sector due to strict government policies and tight limitations on foreign ownership. The grasp on the energy sector is a major asset for the government, who receives one-third of its total revenues from the company.

However, the restrictions don’t allow Pemex to partner with any private companies, preventing the producer from receiving additional expertise or resources. Additionally, Pemex is not treated as a profit-making company. The government compensates for its lack of tax revenues at Pemex’s expense. Last year 55% of the company’s revenues went in royalties and taxes. This perpetual drain on its cash flow means its debt has soared to $60 billion. The hole in its pension reserve is a whopping $100 billion for its 150,000 employees.

IV-AA463_MEXICO_G_20130919144204Pemex’s most reliable source, the Cantarell Field, is steadily declining. The site lost a total of 2,784 BOEPM from 2008 to 2011, and Pemex’s fiscal year-end 2012 release did not list results but noted that production from the Cantarell Field is still trending downward.

The situation is “unfixable,” according to an article by The Economist, and cites several organization flaws that led to Pemex’s current situation. In order to offset the Cantarell, Pemex has poured income into exploration projects. However, the company was ill-equipped to perform in such areas, and its $70 billion in exploration costs has yielded low results. The deficiencies are reflective on Mexico’s entire industry.

According to statistics from the Energy Information Association, Mexico’s total oil production fell by more than 900,000 million barrels per day from 2004 through 2012. During the same period, the country’s refining capacity declined by nearly 9% from just under 1.7 million barrels per day to approximately 1.54 million barrels per day. The persistent underachievement has prompted the government for reform.

President Enrique Peña Nieto released a plan on August 12, 2013, to lift the ban on private contracts. Eventually, he hopes to end Pemex’s dominant role in oil utilities, including shipping and refining.  The statement created a political firestorm, and approximately 61% of Mexicans polled by The Dallas Morning News disapprove of privatizing the industry and opening the doors to foreign influence. However, 53% agree reform is necessary, and 62% believe the country is headed in the wrong direction.

chart-1Mexico’s unwillingness to broaden its oil sector is a staple of its national pride. In 1938, then-president Lazaro Cardenas nationalized foreign oil producers and established Pemex. The deal was praised at the time, and was so celebrated it was instilled in Mexico’s constitution.  However, Pemex’s public image in Mexico has fallen during the past few decades. Locals routinely describe the company as corrupt and fraudulent. A change in Mexico’s oil policy will surely be a difficult procedure. Since Pena’s amendment warrants a change in the constitution, the proposals must receive a two-thirds approval by both chambers of the Mexican Congress and ratification by 17 of Mexico’s 32 states’ legislatures.

Carlos Solé, a Houston-based attorney with the firm Baker Botts who specializes in energy industry cross-border investment and corporate transactions in Latin America, expanded on the situation in an interview with Rigzone. He said: “Mexico is unique as a result of its constitution, its expropriation history and the evolution of its energy industry over the last 75 years. Thus, other countries in Latin America do not offer easy “templates” that Mexican policy-makers can copy. Nonetheless, in proposing the reforms, the Institutional Revolutionary Party (Pena’s affiliation) has mentioned the experiences of Brazil, Colombia and even Norway as countries that offer “lessons learned” both for Mexico and Pemex. Of course, the details of what those “lessons learned” are will depend on the implementing legislation that will be presented if the constitutional amendments are enacted.”

According to Sole, the process will likely take months. He said: “In September, the Mexican Congress reconvenes and the Senate is expected to take up the constitutional amendments first. At the same time, the left-of-center political parties have already planned opposition rallies and so there may be another flurry of media attention, but this time it may center on the opposition to the reforms.  However, the key consideration for readers will be to follow the timing of when the Mexican Congress will vote on the constitutional amendments.  Most political commentators expect those votes to occur in the October to November timeframe; if passage of the constitutional amendments has not occurred by year-end, then it could signal a derailment of any meaningful reforms … Assuming the constitutional amendments are enacted, then the next key consideration will be to assess the initial details that emerge with respect to the necessary implementing legislation.”

Sole also says the differences in views between dominant political parties can further strain progress. The Institutional Revolutionary Party will pioneer the bill. The right-centered National Action Party (PAN) has proposed its own aggressive energy reform measures. The left-wing Party of the Democratic Revolution (PRD) prefers a different route, and seeks to grant Pemex greater funding and prevent private investment per its August 16, 2013, proposal.

John Padilla, managing director at energy-consulting firm IPD Latin America, calls Pemex’s business model broken and outdated. In an interview with The Wall Street Journal, he said: “Pemex, or any other oil company, simply can’t do everything alone, especially when Mexico has one of the largest shale-gas and shale-oil deposits in the world. It doesn’t have the experience. It’s doing what it can do, but it’s a far cry from the dynamic and robust industry in the U.S. The same is true for deep waters.”

Padilla says the revised oil structure in Mexico could have similar affects to the North American Free Trade Agreement (NAFTA) of 1994. Mexico’s sales to the United States increased six-fold as a result of NAFTA.

Carlos Sole says NAFTA’s presence can make Mexico’s transitioning oil market attractive to foreign investors.  “The U.S. and Canada will enjoy certain investment protections and tax advantages that are provided under NAFTA. Yet Mexico also has trade agreements with 42 other countries and the energy industry is a capital-intensive one with a global demand and so competition with investors from non-NAFTA countries will remain significant.”

John Padilla agreed. “From a financing perspective, the sky’s the limit,” he said. “You have a very robust local financial market, which includes the Mexican stock exchange, and you have a healthy banking market. So, is there long-term peso financing? Absolutely. Is there long-term U.S. dollar financing? Absolutely. Do we expect to see more listings on the Mexican stock market? There are people right now spending tremendous amounts of time and effort looking to list. We will see companies looking for financing at every level.”

Padilla added: “This is going to be a work in progress. This isn’t something that’s going to happen very fast… [Mr. Peña] made it clear that they would be fully implementing the long-overdue 1995 gas regulations, which basically means that Pemex would no longer have monopoly control over the natural-gas pipeline system. That in and of itself will open up all kinds of activity.”

The only contract Pemex has signed was a tentative agreement with Brazil’s state-owned Petrobras (ticker: PBR) on January 26, 2013. Petrobras, however, posted $6.2 billion in net income in its Q2’13 results after taking a more entrepreneurial approach. Padilla says Mexico should let Pemex run its course.

“The trouble that happens in Latin American governments is they are too tempted, too frequently, to meddle with things in the wrong way … Good decisions are decisions to let the market function.”

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