Modernizing Pemex: New Reforms Focus on Regulation

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By Juan Carlos Quiroz, Revenue Watch Policy Analyst

The Mexican Congress has recently approved seven different bills to reform some aspects of its energy sector, including the national oil company's legal regime. The new legislation is based on the idea that it is possible to modernize the state monopoly (Pemex), and reverse a declining trend in production and reserves, without liberalizing the hydrocarbon sector. The objective of this reform is to provide Pemex greater flexibility when pursuing contracts with private companies (for services, leases and procurement of materials), without losing control of strategic decisions or relinquishing ownership over reserves and production.

Background
Mexico's energy sector is the bedrock of public finances, contributing regularly over a third of total government revenue. As a producer country, Mexico benefited from the oil price spike, which has doubled Pemex gross revenue since 2003 (see table 1). However, this outstanding windfall reflects price increases, while covering a dire reality of production decline and shrinking reserves. After peaking in 2004, production has fallen sharply as production in mature oil fields began to tail off (chart 1). In particular, the offshore oil field of Cantarell, which contributes almost two thirds to total production, accelerated its decline since 2005. According to some estimates, by 2015 loss of production from Cantarell could bring total production to about 2.5 million barrels daily by 2010.¹ This would reduce oil available for exports, creating additional pressure on the public finances.

Table 1
PEMEX Financial results summary (US$ million)
		2003	2004	2005	2006	2007	2008
Total sales		55,663	68,673	86,163	97,647	104,548	96,974
	Domestic sales	34,464	39,860	46,866	50,247	54,485	47,296
	Exports	21,199	28,813	39,297	47,400	49,965	49,351
	Services income						327
Income before taxes and duties		30,241	40,774	46,959	57,725	60,642	62,890
Taxes and duties		34,037	42,108	53,873	53,566	62,327	62,384
Net income (loss)		(3,617)	(2,263)	(7,078)	4,159	(1,685)	506
EBITDA (1)		28,213	44,972	55,269	72,252	76,723	78,246
Taxes and duties/total sales		0.61	0.61	0.63	0.55	0.60	0.64
Data for 2008 covers nine months ending Sept. 30.
US dollars conversion was made at the exchange rate on last day of reporting period, nominal value.
(1) Earnings before interest, taxes, depreciation and amortization is a non US-GAAP measure, therefore PEMEX provides a reconciliation which excludes the cost of reserve for labor obligations.
Note: Numbers may not total due to rounding.

Source: PEMEX financial statements available at www.pemex.com

Pemex has stated that it has offshore and onshore projects that could compensate this decline. In August 2006, the company's then CEO stated that to maintain production levels constant, Pemex would need to invest US$18 billion annually for a period of ten years. Assuming that other programs remain unchanged, this investment target can only be financed through debt, private investment, or the government’s own income. The first option has been tapped. In recent years Pemex has financed its investment with debt, using "long-term productive infrastructure projects" or PIDIREGAS. However, this option is limited as Pemex credit rating depends on the backing of the Mexican government, while its failure to recover reserves and the scale of its pensions' liabilities hurts its financial standing.² With the option of private investment ruled out by political constraints, the only alternative left is to use public resources. Congress has moved in that direction.

In early 2006, Congress approved a new tax regime for Pemex. The previous fiscal terms for the company were simple: the Treasury got 60.8% of monthly gross revenue (and then any remaining surplus after paying expenditures, taxes and interests). This effective way of strapping the company of cash is reflected by the losses posted as net income after taxes and duties (see table 1). The new fiscal regime was supposed to give Pemex a tax relief. Congress divided the upstream and downstream activities for taxation purposes, introducing a variable tax rate for oil production (the scale varied from 78.68 to 87.81%), a windfall tax for oil prices over US$22 per barrel, and an extraordinary tax on oil exports. Refining and distribution activities would pay a regular corporate tax.³ As a result of these changes, Pemex paid taxes and duties equivalent to 55% of its gross revenue in 2006, compared with 62.5% in 2005 (table 1).⁴  Less than a year into the new administration of President Calderon, Congress acted again to supposedly reduce the company's tax burden in September 2007. Fiscal changes were estimated to produce approximately US$10 billion in tax savings for Pemex in 2008. The objective of the bill was to boost investment, create incentives to revive marginal fields, and increase exploration in deep waters.⁵

These tax breaks reflect the dominant view that Pemex's main problem is a confiscatory fiscal regime. According to this view, all the company requires is additional financial resources to expand its drilling schedule onshore (in the geologically complex area of Chicontepec), to venture into deep-water areas and to curb production decline in mature oil fields. However, there are at least three considerations that should curb celebrations of the above mentioned reforms. First, investment has increased to record-high levels in the last decade (chart 2), but emphasis has been on production recovery to maximize short-term revenue from Cantarell, not on new exploration, so there have been no substantial reserves increase from this expansion. How long government finances can sustain this effort based on public debt (see amount for PIDIREGAS on Chart 2) should be a concern.⁶ Second, tax breaks still have to translate into more cash for investment. Despite previous changes intended to reduce the company's tax obligations, the upstream fiscal burden still results in a consolidated tax rate of over 60% of its gross revenue (table 1). Third, investment needs to be accompanied by improved efficiency and managerial modernization to produce the desired outcomes. This task seems to be the objective of the last round of reforms.

Source: Pemex

Scope of the reform
While previous changes were limited to Pemex's tax regime, the new reform aims at overhauling the oil company's operation. On October 29, Congress passed seven bills that address different aspects of the institutional framework. The main features of each bill approved can be summarized as follows:

1. A reform to the Regulation of Constitutional Article 27, which strengthens the prohibition of private participation in exploration and production of hydrocarbons. This bill authorizes contracts for services, leases and procurement, while it emphatically forbids concessions, production sharing agreements or incentive-based service agreements.
2. A new Act to regulate Pemex activities, which stresses objective of keeping Pemex's monopoly over the oil sector and Pemex as a state-owned company. This Act modifies the NOC governance structure, creating a new Managing Board with four professional members that will have a large role in overseeing operations. Second, it expands managerial autonomy in an effort to cut Pemex from excessive control from the Ministry of the Treasury. Third, it specifies three methods for awarding contracts for procurement, leases or services (direct award, invitation to a limited auction, and open auctions), providing more flexibility to the company. Finally, there is a schedule for a transition for Pemex to increase its take from oil revenue that would extend for at least five years.
3. An expansion of the Energy Regulatory Commission powers, which gives the Commission authority to oversee sales of gas, fuel and petrochemicals.
4. Creation of a government Fund to finance projects in renewable energy sources and mandated to promote clean and renewable energy sources.
5. An extension of the authority of the Secretary of Energy, which increases its power to regulate and oversee Pemex, design an energy strategy, create a consultative National Council of Energy, grant Pemex licenses and permits to explore and produce hydrocarbons, set a production target, and issue regulation, among other roles.
6. Creation of a National Commission of Hydrocarbons, which will provide technical support to the Secretary of Energy's new tasks, such as evaluating exploration and production projects, concentrating geological information and overseeing Pemex's operations.
7. Creation of a National Commission of Energy Efficiency, which will promote sustainable energy technologies and energy efficiency.

Although the main criticism of this reform has been that it is limited and restrictive, it should rather be noted that its ambitious goals stand in inverse relationship to the means it provides to achieve them. The Mexican Congress was not shy about embracing new and, in some cases, worthy objectives, such as giving Pemex a new governance structure, expanding the sector agencies' powers and authority, and making energy efficiency a cornerstone of the country’s energy policy. In the years to come, this reform should be judged by its success in achieving these objectives. However, the key assumptions that it is possible to modernize a state-owned monopoly with regulation and that it is possible to improve efficiency without competition make this a very unrealistic reform without successful precedents abroad.

In recent years, countries like Brazil, Colombia and Indonesia have embarked on reforms to boost investment and improve efficiency. For comparison, it is useful to highlight some elements of these experiences. First, they eliminated the state monopoly over the upstream and downstream sectors. Second, in addition to liberalization, these governments intended to create a clear division of roles. The NOC's main role was limited to commercial operations, while policy making and regulation were trusted to the sector's ministries and new hydrocarbon directorates. Third, contracts, licenses and permits are granted by an independent government agency, forcing the NOC to compete with international oil companies for exploration and production areas. Finally, although these countries did not fully privatize their companies, Brazil and Colombia did transform their NOCs into publicly traded companies in an effort to impose commercial discipline while increasing their autonomy.

The Mexican reform has clearly borrowed some elements from these international experiences. In particular, Congress has created a new entity that has the potential to evolve into an independent regulator and licensing agency, which reflects a desire to move towards technical criteria for setting objectives for the company rather than maintaining the traditional focus on balanced budgets. This should introduce some degree of accountability into a situation where Pemex has effective ownership over the entire hydrocarbon resources of the country. A second element is the intention to provide greater autonomy over its own budget decisions to Pemex. Under the traditional arrangement, the company's only real control was the Treasury and Congress' approval of its budget. Also, by paying in advance a fixed percentage of its gross revenue, the company had to cover all its expenses with what remained. This simple arrangement avoided conflict over work plans and cost recovery that are common and often contentious in other jurisdictions. In order to make the revised requirements successful, the new and existing regulatory agencies need to take the opportunity to acquire the technical expertise and resources necessary to oversee Pemex activities effectively. Finally, the reform stresses the role of the Secretary of Energy in defining policy through a set of new consultative bodies and regulatory agencies. In theory, clarity of roles should reduce conflicts of interest, opportunities for corruption, and space for arbitrary decisions. In this case, however, the reform created a long list of objectives (including promoting renewable energy, energy security, and even providing fertilizers), where the new agencies will have to struggle to keep their roles clear.

What is missing from other experiences is very important. By maintaining a monopoly and prohibiting private investment, the country is committing itself to bear the cost of all the expenditures of future operations and assuming all the risk of oil exploration. It is likely that growing investments will pose a heavy burden on the public budget and will keep the NOC competing for limited government resources with other priorities. This already happens in the federal budget, where Pemex receives the largest allocation of resources (see chart 3). The assumption behind this reform is that regulation can improve the company's efficiency and eliminate the need for private investment. The result is that this reform piles more risk onto the already stretched government and national oil company.

Source: Secretaria de Hacienda y Credito Publico

Looking into the future
Traditionally Pemex has had two main objectives: ensure security of energy supplies and maximize revenue for the government. Production from Cantarell since the late-1970s facilitated achieving these objectives.⁷ Measured by its contribution to the treasury, Pemex has been a great success. Alas, that same success blocks the road for comprehensive reforms. Fiscal dependence on oil revenue makes it politically unfeasible to raise taxes to reduce the company's fiscal burden; the availability of short-term windfalls is an incentive for wasteful expenditure without accountability at both the federal and local level; the expedience of tapping Pemex to cover the budget holes makes it unpalatable for politicians to relinquish control; and the labor union is still a formidable source of cash, privilege and political connections that can mobilize effectively to preserve the status quo.

Some elements of the current reforms will become more important as oil production continues to decline. The emphasis on increasing transparency and accountability, and the intention to strengthen regulatory capacity and create new governance structures for Pemex are all positive steps. These reforms should be a starting point, not the end of the discussion. The future agenda should include strengthening these reforms, broadening public debate on  oil sector performance, and setting priorities for the public budget and for oil revenue expenditures by the federal, state and local governments.

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¹ "Mexico: A Shrinking Giant." Petroleum Economist, March 2005.
² See Pemex Credit Ratings reports available here.
³ Suarez-Coppel and Yepez, "Mexico adopts a new tax structure for oil, gas exploration and production." Oil and Gas Journal, June 5, 2006.
⁴ See Pemex Financial Results available at: www.pemex.com.
⁵ Liskey, "Crucial tax win claimed by Calderon." Upstream, vol. 12, week 38, 21 September 2007.
⁶ An additional reform approved on November 13, 2008 involves the Law on the Federal Budget and Fiscal Responsibility, which affects the PIDIREGAS scheme. Under the previous regime, Pemex had to negotiate its annual budget within the constraints of the federal fiscal balance and was unable to contract debt directly. The new legislation means that the Federal government assumes PIDIREGAS as sovereign debt and puts Pemex budget outside the government's balance requirement. The problem, however, remains that Pemex credit rating will depend on the company being able to retain cash after paying taxes and duties and on the size of its long-term liabilities. In essence, PIDIREGAS was an off-balance-sheet vehicle for the government to invest in Pemex. After this reform, Pemex debt will be off the government's balance sheet, but in the end it still is sovereign debt.
⁷ For a recent review of Pemex's contribution to the Mexican economy see: Ognen Stojanovski, "The Void of Governance: An Assessment of Pemex's Performance and Strategy." PESD Working Paper #73, Stanford University, April 12, 2008. Available online here.

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