Mexico: An oil nation in crisis

Oct 20, 2009 02:00 AM

Mexico is currently facing one of the biggest economic recessions in the country's two hundred-year history of independence. Some Mexican policy makers blame the economic crisis on this year's decrease in tourism, while others attribute it to the continued dependence of the Mexican economy on the United States, pointing to its neighbour's recession as a principal cause for the country's woes.
Nonetheless, Mexico's plummet in oil production and the decline in the price of oil are two main contributors to its present economic downfall. While other countries have begun to pull out of the recession, it appears that the fall in oil production and prices have further led to an ongoing decline in Mexico's economy, which the country's planners are finding difficult to reverse.

Current oil situation
Oil is at the heart of the Mexican economy. Profits on its extraction are the country's number one revenue, accounting for approximately 40 % of Mexico's total revenues. Due to the decline in the price of oil that began last year with the escalation of the global recession, Mexico's oil-dependent economy has suffered grievously.
Prior to the sag in oil prices, when other oil producing countries were taking advantage of the tremendous peak in prices, Mexico was hit particularly hard; government officials reported that last year's drop in oil production cost the Mexican government an estimated $ 20 bn in lost revenues. This year's plunge in oil prices has resulted in oil export revenues being recorded at only $ 1.25 bn per month for the first seven months of 2009, a fall from an average of $ 1.44 bn per month in 2008.

The falling prices and production rate continue to damage the economy, and many blame the Mexican government for its failure to channel new investments in to various oil-producing fields, along with its mismanagement of revenues. Mexico feels the pressure to convert its oil profits into public spending in order to generate immediate results and to keep a lid on the country's mounting social tensions; instead it sometimes foolishly refuses to put aside some of the profits to ensure financial stability.
Petroleos Mexicanos (Pemex), Mexico's state owned petroleum company, and one of the ten largest oil companies in the world, is an indispensable contributor to the country's public sector earnings. Despite being one of the world's largest crude oil producers and exporters, Mexico still must import 40 % of its refined petroleum products. In fact, the International Energy Outlook predicts that by 2020 Mexico is going to be a net importer of petroleum products, reaching 300,000 bpd by 2030.

Mexico is forced to import such a large percentage of refined petroleum products because it currently lacks the technologies to refine them itself, creating another issue for Mexico's already crushing economic tribulations. Even though state-owned Pemex is the country's main source of revenue, contributing $ 98 bn to Mexico's economy in 2008, the company still reported a loss of $ 8.7 bn last year after it paid the national treasury $ 57 bn in taxes and royalties.
The government is so dependent on Pemex that it forces the company to pay exorbitant taxes, pushing it further into debt so that the government can barely discharge its economic obligations.

Internal chaos
In addition to lost revenue as a result of declining prices and production, Pemex has also suffered losses due to the megalithic levels of corruption on the part of Pemex executives which is also related to the operation of the pipelines.
Corruption is not a new occurrence at Pemex, and has in fact been occurring for decades. In 2007, Raul Munoz, a former Pemex executive, was fined $ 80 mm and banned from holding a public office for ten years for the misappropriation of $ 170 mm in company funds, some of which was used to pay for not one, but two liposuction operations for his wife. It is not just the top executives at Pemex who are involved in corruption scandals within the company: in 2000, Pemex dollars were inappropriately used by the petroleum workers union, Sindicato de Trabajadores Petroleros de la Republica Mexicana (STPRM), to help fund the campaign of presidential hopeful Francisco Labastida of the Partido Revolucionario Institucional (PRI).

Pipeline corruption is rampant in Mexico and costs Pemex an estimated $ 2 bn in lost revenue each year. Tapping pipelines to steal gasoline, diesel, and jet fuel occurs in most, if not all, of Mexico's 31 states. Pemex found nearly 400 illegal connections to pipelines last year, estimated to have cost the company roughly $ 720 mm.
According to the Mexican government, gangs use siphoned fuel to power their aircrafts involved in drug smuggling. In fact, in 2004, former Mexican president Vicente Fox launched an investigation to curtail widespread oil theft. However the investigation was unsuccessful because the practice continues to be a growing issue for Mexico's oil industry. Thieves are now stealing crude oil, which they must smuggle out of the country and have refined elsewhere in order for it to have value. In May, US oil trader and former president of Trammo Corporation Donald Schroeder pleaded guilty to purchasing stolen Mexican condensate, a raw hydrocarbonate similar to crude oil used to make plastic, as well as coordinating its shipment to Texas via barge.

Additionally, in August another company was discovered purchasing oil which had been illegally taken from Pemex: a Texas chemical plant owned by German based BASF Corporation. The chemical plant was found to be purchasing $ 2 mm worth of petroleum products smuggled into the US; the company denies having any knowledge of the illegitimacy of the oil, and court documents yielded no evidence of their awareness.
Georgina Kessel Martinez, Mexican Secretary of Energy, believes it will take some time before oil theft is no longer practiced in the country, stating, "This is a process that is going to take some time because Pemex not only needs to install new technology but also needs to conduct an extensive analysis of its system of ducts and create better tools to combat fuel theft." She acknowledges that fuel thieves have far more advanced technology and techniques than Pemex, and stated that Pemex plans to spend $ 76 bn between now and 2012 to create a system in order to better monitor the oil ducts.

Although Pemex claims to be making progress in putting an end to the practice, oil theft is ongoing, due in large part to the participation of numerous as well as strategically situated Pemex employees in theft rings.
In July, federal officials from the Procuraduria General de la Republica (PGR) and other government agencies seized documents from the security department at Pemex headquarters that implicated various Pemex employees in a scandal involving millions of dollars in oil siphoned from various pipelines. Authorities have yet to arrest anyone in the case.

The PGR is investigating nine customs inspectors, 20 Pemex employees, and 100 business owners believed to be involved in an elaborate conspiracy. The STPRM workers' union is believed to be linked to the scheme as well.
"The problem... of corruption in Pemex... is so huge that this case requires a thorough investigation by the Senate," said Sen. Ricardo Monreal, a member of the centre-left Partido del Trabajo (PT). Pemex needs to resolve its internal inconsistencies if it ever wants to make headway in restoring lost revenues.

Where does the oil come from?
The largest source of oil and most crucial source of income for Pemex is the offshore oilfield, Cantarell. The problem now facing Pemex and the Mexican economy is that oil production at Cantarell has fallen at a rate averaging about 25 % since its peak in 2004.
This year alone, production at Cantarell has declined by nearly 35 % to just 737,400 bpd, 11 % below the minimum figure anticipated in the company's budget. Even President Felipe Calderon has acknowledged that Pemex's oil production has fallen between 2008 and 2009 by about 215,000 bpd.

With production decreasing significantly, the only way that Mexico can sustain revenue levels is by having the price of oil remain above $ 70 a barrel. At one point in the year however, the price for crude oil fell to nearly $ 30 a barrel, far from the figure that Mexico needs for obtaining the required profit increase.
Even if oil prices were to spike today, Mexico would still not benefit for quite some time, as oil production is not expected to pick up for the remainder of the year. Some, such as Pemex Director General of Exploration and Production Carlos Morales, claim that Cantarell's production will stabilize when it reaches 400,000 bpd; others predict that this vital oilfield will only be productive for another nine years.

Yet despite the plunge in oil production, Mexico continues to depend on Cantarell to supply the country with the majority of its oil. Engineers at Pemex have long known that production at the reserve would begin to dwindle; however, government officials did not take these warnings to heart until the predicted problem became a national crisis.
The Mexican government has relied too heavily on an oilfield that is expected to run out shortly and failed to invest in oilfields outside of Cantarell. Recently, efforts have been underway to increase production at various other oilfields, namely Ku Maloob Zaap (KMZ), to offset the loss from Cantarell, but the decline at Cantarell far exceeds the increase in output from new, less promising oilfields.

KMZ accounts for 63 % of the total increase in production from other oilfields, producing 183,000 bpd in the first seven months of 2009. However, the amount of money that would come from such a quantity of oil does not seem to be enough to make up for this year's loss alone of an estimated $ 5.1 bn drop in revenue.
There is no denying that a key solution in solving Mexico's oil problem both now and in the long term is investing in oilfields outside of Cantarell. When the massive offshore oilfield was discovered in the 1970s, it may have been reasonable to overlook the threat of it running dry, rather than properly maintaining the invaluable facility, but as time goes on it becomes increasingly crucial for Mexico to take steps to find alternative sources outside of Cantarell.

New oil discoveries by the US undeniably prove that there are still valuable oil deposits in the region. On September 2, BP announced they had made one of the largest oil discoveries in US drilling history, when it drilled the world's largest exploration well in the Gulf of Mexico off the coast of Houston.
The well is estimated to hold more than 3 bn barrels of oil. Although drilling the well remains several years down the road, the discovery highlights the minimal effort Mexico has put into exploration and development of new oilfields.

According to analysts, at this point, it would be a wise long-term strategy for Mexico to heavily invest in oil deposits in the Gulf of Mexico. The country is believed to hold roughly 30 bn barrels of oil in deep waters; accounting for nearly half of Mexico's potential oil deposits. Such a large amount of oil would be the equivalent of supplying the US with oil for four years.
President Felipe Calderon himself has said, "It's likely we have similar [oil] wealth, but we don't have, whether you like to admit it, the technology or the organizational and operational capacity to do it by ourselves."

Pemex cites the lack of technology required to operate in deepwater drilling as the reason for its lack of involvement in new discoveries; at the same time, the country has failed to invest in those technologies that would bring the augmented profits so badly needed to boost the economy.
However, as a result of Mexico's current economic situation, amassing funds for future oilfield exploration is nearly an unattainable political feat. Given the technology and equipment necessary to begin drilling in the Gulf of Mexico, it would be nearly a decade until the country would be able to reap the rewards of such ventures. By that time, the problem of declining oil revenues will be much worse. Unfortunately for Mexico, Pemex put off necessary exploration for too long, frivolously spent funds elsewhere, and is now suffering from its thoughtless negligence.

Mexico's Energy Secretary Georgina Kessel Martinez has said that the country needs to look into alternatives, and she believes that Mexico "can do much more progressive stuff." In particular, she believes that Mexico should look at Brazil and its national oil company, Petrobras, as a model for potential changes to the Mexican oil sector. Brazil allows Petrobras to collaborate with foreign companies for domestic and international exploration, as well as to lease concessions to operate oil blocks in national waters.
Last October, steps were taken to have Pemex open itself up to business agreements with private companies. In an effort to grant Pemex greater independence, Congress approved seven issues of an energy reform bill proposed by the Federal Government.

The reform was designed toallow Pemex to recruit international oil contractors as limited associates in new explorations and production endeavours. Although this reform has significant potential, Mexico's constitution prohibits joint ventures where partners would be sharing in oil production schedules or profits.
Pemex will need to propose a creative scheme if it wants to find private oil companies willing to partner up with it, which could be difficult given the existing restrictions. Perhaps even greater revisions to the constitution will be needed in order to improve incentives for public and private partnerships.

Response to issue
President Calderon recently stated that Mexico "must take profound [reforms] and move quickly." Pemex appears to have responded with all due seriousness to President Calderon's recent statement; the company is in the process of redirecting its strategy.
On September 7, in a move that many companies make when their numbers look bleak, the company announced the dismissal of Chief Executive Officer and former PRI minister Jesus Reyes Heroles; his appointed replacement is Juan José Suarez Coppel. Suarez Coppel is expected to take drastic steps to curb Pemex's losses, and as President Calderon declared, "transform Pemex profoundly, to its roots." Having served as the Chief Financial Officer for the oil company from 2001 to 2006, Suarez Coppel is no novice to Pemex's financial issues and knows the company's facts and figures quite well.

Regardless of the fact that this experience might give him a bit of an edge when trying to turn around the company's losses, there is no guarantee that Suarez Coppel will be able to make more profound changes than the previous CEO. Suarez Coppel is bound to face challenges in his attempt to turn Pemex's fortune around, the primary reason being that the state corporation does not in fact operate autonomously: its budget and spending schedule are not determined by the company's governing directive, but rather by Congress and the finance and energy ministries.
Suarez Coppel also has no say when it comes to the appointment of chiefs of exploration and refining for Pemex, a decision made by President Calderon.

Perhaps, the decision to change the executives of Pemex could be explained by the president's desire for the company to attract private investments and participate in profit sharing. The company's future is less certain now that the PRI, which is in favour of keeping Pemex an exclusively national entity, controls Congress.
The PRI is likely to fight many of the proposed changes made by President Calderon and it will be Calderon who will be losing the battles, especially when it comes to changes in the nation's oil industry.

What other solutions has the Mexican government come up with to remedy the problem?
One solution that the Mexican government has placed on the table is the construction of a new oil refinery. In August, Pemex announced the location of the future refinery, named Bicentario to honour Mexico's 200th anniversary of its independence, a year after President Calderon promised a new refinery and after months of a slow and bitter struggle among the political parties to decide the location for its construction.
Bicentario, the first new refinery in Mexico in 30 years, is set to cost an estimated $ 9 bn and is scheduled to open in 2015. It is designed to produce 300,000 barrels of petroleum per day.

Currently, Pemex imports 340,000 bpd of petroleum products; a new refinery would allow Mexico to reduce the amount of petroleum imported since it would now have somewhere to refine its surplus crude oil. President Calderon announced that the city of Tula, located in the state of Hidalgo was his choice of location for the new refinery. His choice to build the refinery in Tula instead of in Guanajuato came as a shock to many, as Hidalgo is controlled by the opposition PRI party, while Guanajuato is controlled by Calderon's own Partido Accion Nacional (PAN).
Although Guanajuato was not chosen as the location for the new refinery, in consolation the Salamanca refinery in Guanajuato would be expanded and receive a $ 3 bn upgrade.

Although the decision to locate the new refinery in Hidalgo seems like a minor issue, it foreshadows the fact that the PRI is once again beginning to project a greater influence. The PRI can now be counted on to make it difficult for President Calderon to enact far-reaching legislative changes, especially over the issue of oil. This expansion project is necessary for Mexico's oil industry, but it also raises the question: where is Pemex going to find the funds necessary for such an expensive project when it lost major amounts of revenues in 2008 and 2009, and does not appear to be able to make up for them?
Pemex is billions of dollars in debt, but if it ever wants to see an increase in revenue, it is vital for it to invest funds on projects that promise to bring enhanced earnings for both Pemex and the country in the future.

Pemex announced on September 7 that the oil company hadawarded the French-owned geo-physics surveying company, CGG Veritas Services de Mexico, one of the largest private survey contracts in Mexican history. Pemex has a contract with the company that will remain in effect from October 2009 until 2013. It reportedly paid CGG Veritas $ 465 mm for the acquisition and processing of three-dimensional seismic data of Mexican offshore oilfields. However, preliminary exploration and drilling is at least 3 to 4 years away.
The BP discovery of a large new oil deposit in the Gulf of Mexico was cause for concern to Mexican officials that a "drinking straw" effect might occur, where oil extractions on the US side of the boundary line could tap into the reserves that lie under both countries.

What does this mean for Mexico?
Declining oil production makes it increasingly obvious that Mexico must find another primary revenue source and move away from its dependence on oil. If the country continues to rely primarily on oil, the only thing that it will see in the future is plummeting revenues.
Pemex undoubtedly must develop oilfields outside of Cantarell and it has shown that it is making a responsible attempt at this by updating one oilfield and constructing another. This effort will more than likely not be enough to raise sufficient revenue in the near future, but hopefully will help to stabilize the national oil company in the long run. As for now, the government will have to wait and see what happens with the Bicentario refinery, both in terms of production increases and political consequences. Will the decision to put the new refinery in a PRI-controlled state have as large an impact on oil issues as anticipated?

President Calderon and the PRI-controlled Congress would need to work together to amend Mexican constitutional provisions that would allow Pemex to join with outside companies to help with the development and production of its oil and resources. Until this happens, Mexico will have a hard time catching up with the rest of the world's oil production. There will more than likely be a challenge on this front: it was PRI which originally nationalized Pemex and is sure to fight any attempts to change existing laws that keeps Pemex from working with outside companies.
If the PRI and President Calderon can come up with new initiatives that work for both parties, Pemex will be in a better position to make the necessary modifications that will help both the company and the Mexican economy.

This analysis was prepared by The Council on Hemispheric Affairs (COHA) Research Associate Nancy Cruz. COHA is a nationally renowned independent research and information organization. The editors not necessarily share these views.

Source / COHA
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