The Mexican Oil Dilemma: Refining PemexPublished: April 20, 2009 in Knowledge@Wharton
Mexico is running out of gas. The world's sixth largest producer of oil and America's third largest source of crude imports faces declining production at its primary oil fields, and the well may be dry in less than a decade. Meanwhile, the structure and management of Pemex (Petróleos Mexicanos), Mexico's state-owned oil monopoly, coupled with the government's historic dependence on its revenues, have limited the country's ability to bolster its reserves. And while the government celebrates the recent passage of a Pemex reform bill, the changes enacted are overly cautious. Experts predict that Mexico's reserves will run dry.
But all is not lost. The resulting turmoil may, in fact, save Mexico. The reality is that Pemex cannot simply be refined; it must evolve in the face of external pressures to remain viable and ensure Mexico's long-term energy independence. That change is coming, although it is taking an energy crisis to make it a reality.
What is causing the supply issues? According to the Ministry of Energy, Mexican oil fields are experiencing an accelerated decline. With its hands tied by the government, Pemex has been unable to allocate the necessary resources to explore new sources of oil. As a result, crude oil availability is forecast to decline from its 2003 peak of 3.5 million barrels per day to about 2 million barrels by 2016.
Conversely, demand for oil-derived products is rising -- a demand that local production is currently unable to meet. Efforts are under way to increase production capacity, but because the country lacks advanced refineries, Mexico has negative trade balances in derivatives such as gasoline and fuel oil. Ironically, although the country is rich in oil resources, Mexico exports crude oil and then re-imports refined products, losing potential value and profit to outsiders. Worse, the loss of self-sufficiency for both crude oil and refined products raises serious concerns about the nation's long-term security.
Pemex is owned and operated by the government. Company leadership changes every six years (tracking presidential term limits) and thus forces a short-term focus on profit making over long-term viability. Until the October 2008 reform, the organization was led by a board of directors consisting of members of the President's cabinet and industry union leaders. The uneasy power sharing between groups holding widely different interests has historically complicated decision making and inhibited the execution of a consistent company vision.
Tax Reform Needed
Compounding these challenges, Pemex must surrender significant amounts of taxes to the government. This means that reinvestment for growth is nearly impossible. It is estimated that the company pays four times more taxes than the average Mexican private company and three times more than other oil companies. The government relies on Pemex to supply the bulk (approximately 40%) of the fiscal budget. Company earnings are routed directly to the state, which then redistributes revenues to social projects and back to Pemex. Since social initiatives remain critical for maintaining popular approval, the Mexican government is often unwilling to pull funding away from health, education and other social initiatives in order to invest in the future of Pemex. Unfortunately, long overdue tax reforms aimed at decreasing government reliance on Pemex remain unpopular and have proven exceedingly difficult to implement.
Further muddling matters, competition -- which stimulates innovation and efficiency -- is lacking as Pemex is shielded by the nationalistic policies of the Mexican government, which awards it monopoly status within the country. Consequently, Pemex has not invested in research and development and now lacks the expertise needed to compete in a global market. For instance, deepwater drilling, which many believe is necessary to boost falling oil reserves, is beyond the Mexican company's technical capability.
Outsiders have the expertise to help, but even after the recent reform, Mexican law continues to ban foreign ownership or investment in oil exploration, production and transportation. Under the reform, Pemex expects to benefit from the expertise of outsiders by hiring them to explore and produce oil. But major oil companies may not find the proposition attractive without an ownership incentive. Thus, Pemex is structurally handicapped and, in many respects, hindered from accomplishing its goal of ensuring the energy independence of the Mexican state.
Pemex's predicament is a result of decades of mismanagement. In 1938, Mexico's oil industry was nationalized by President Lázaro Cárdenas in a populist move that redistributed wealth to citizens and affirmed the nation's sovereignty during a protracted recovery from the Mexican Revolution. The effects have been long-lasting: Energy is now defined in the Mexican constitution as a strategic sector and thus off-limits to foreigners.
The petroleum industry was expropriated by the government during modern Mexico's infancy and became a central part of its identity. Consequently, Mexicans have strong emotional ties to nationalized energy production, which is currently managed by Pemex. Ernesto Marcos, a former CFO of Pemex, describes the state-run company as "synonymous with the ultimate symbol of Mexican cultural identity: the Virgin of Guadalupe. The nationalization of petroleum is closely tied to our identity as a country and our sovereignty as an independent nation. It is almost a religious myth, an object of devotion."
Not surprisingly, a widespread belief exists that Pemex belongs to the people and should remain with the people. Many citizens believe that a public company puts food on the table and benefits the country, while a privatized company will benefit already wealthy, greedy foreigners and rob Mexicans of profits from oil. This historic backdrop framed the debate that led to the eventual passage of a weakened Pemex reform bill in late 2008, and will continue to color and restrain further initiatives to modernize the state-run organization.
In the debate over the Pemex reform bill, the country's historic relationship with oil was a critical issue. The three major parties -- the PRI (Revolutionary Institutional Party), PAN (National Action Party) and PRD (Democratic Revolution Party) -- accepted the need for reform yet struggled to agree on its execution. President Felipe Calderón's pro-business PAN party initiated the petroleum reform in hopes of making small changes that might grow into greater reforms permitting the transfer of international expertise critical for stabilizing reserves.
On the opposite end of the spectrum, the leftist-nationalist PRD has argued that any loss of sovereignty over the oil reserves would circumvent the constitution and directly violate the law. This resistance was crystallized by PRD founder Cuauhtémoc Cárdenas, whose father nationalized the industry, when he proclaimed resource availability concerns overly "alarmist" and proposed that nationalistic policies be passed to allow the necessary growth, development, and investment to come organically from within Mexico. The once-dominant PRI party stands somewhere between these two extreme positions. Many believe that this party -- swing voters during the reform debate -- hesitated to take sides in hopes of securing greater concessions from the rival parties.
Regrettably, the reform, handicapped by the country's politics and history, will not be enough to save Pemex. On the positive side, the bill approved by Congress contains several measures that will provide added flexibility and transparency to Pemex's operations. First, the reform will add independent members to the board of directors for more balanced, business-oriented, and less politicized leadership. Experts like Isidro Morales Moreno, director of government and public administration at the Technological Institute of Monterrey, believe the concept is admirable and that Pemex could certainly benefit from having experienced decision makers sit on a more balanced governing council. The reform also establishes an independent auditing system, which should permit greater transparency in spending and decision-making.
Addressing Critical Gaps
Finally, the reform grants more budgeting and management autonomy, freeing up the procurement process and adding agility to the organization. However, these changes, while improving matters, do not address critical gaps in Pemex's current structure. Weaknesses that remain unresolved include permission for limited private investment to help lower operating costs and improve performance, and a reduction in taxes paid by Pemex to allow budgeting for long-term activities such as exploration of new oil reserves. Moreover, provisions to attract the technology transfer required to stabilize reserves through deep-sea drilling were never completely addressed. Foreign companies may be hired to help and share their technologies, but may not invest in the Mexican petroleum industry. While the reform is lauded by all political parties, it remains too watered down to save Mexico from a future of energy dependency.
According to Marcos, the former CFO of Pemex, the reform leaves a lot to be desired. Each point reveals a weak compromise reflecting the controversial political climate and setbacks of previous reform attempts. For example, the "independent" members who will be added to the board of directors will be appointed by the executive branch. Not surprisingly, these experts will face the same political pressures as current Pemex leadership and suffer from the same shortsightedness, leaving one of Pemex's critical shortcomings unaddressed. In addition, the reform in its current incarnation does little to change the parasitic relationship that currently exists between the government and Pemex. The proposed reform does not relieve the inordinate tax burden on the company. Mexico's lack of tax base diversification represents a solvency risk for the government as oil fields dry up, gas prices fluctuate and exploration funds remain scarce or unpredictable.
For the Mexican people Pemex is many things: a cash cow, a revered national symbol, and a fundamental part of Mexico's sovereignty and independence. But at its core, Pemex is an oil company, and oil companies depend upon exploration to survive. As a state-run entity, the company is structurally incapable of funding the risks required to successfully explore for oil. There exist good alternatives to resolve this increasingly critical issue, but they involve the taboo of private investment. Due to Mexico's historic aversion to corporations and recent difficulties with the privatization of other industries, any arrangement between Pemex and private interests will be difficult but remains promising. If newly discovered reserves prove sufficiently large, the nation would maintain its geopolitical importance as a secure source of oil.
Understandably, the critical points of independent governance, private investment and lower taxes are contentious and unlikely to result from any further reforms undertaken in the current political environment. Thus, Pemex and Mexico are on a collision course with crisis, a scenario that independent analyst group CERA believes will be necessary to stimulate action. Paradoxically, a crisis could catalyze the political parties to bury their differences and recreate a Pemex that can truly help Mexico address a changing energy world.
According to CERA, more than just a stronger Pemex is needed to resolve the situation. The technical, investment and risk-management challenges faced by the Mexican oil industry cannot be easily solved by a single company. To survive, exploration risk must be spread among private players, and Pemex must be permitted external partnerships in order to acquire needed technologies and skills.
Mexico is already forced to import refined oil products due to its insufficient refining infrastructure. As consumption continues to outpace exploration and development, Pemex will soon become unable to supply Mexican citizens and industries with a stable supply of oil. And as oil contributions to state revenue begin to evaporate, so may Mexico´s resource-based credit rating and general investor confidence in its long-term stability. Falling oil prices may accelerate this looming crisis, creating the impetus for the cash-strapped government to implement real change and permit the organization to evolve more sustainably. A Pemex that is independently operated, funded and incentivized could become the new hallmark of the Mexican government. Just as nationalized oil solidified the base of a modern Mexican state in the early 1930s, a resilient, innovative Pemex could galvanize today's emerging Mexican democracy. Unfortunately, this prospect will likely require a crisis to unfold.
This article was written by Megan Lan, Marcelo Silva and Renzo Weber, members of the Lauder Class of 2010.