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AMLO's to Overhaul Pemex, but....


Map of Mexico's oil coast

- Mexico's leftist president promised to restore the state-owned oil giant to its iconic status.
But the markets—and some citizens—aren't satisfied. 

By Ami Stillman and Justin Villamil / Bloomberg

Petroleumworld 12 02 2019

In a small office at the run-down hotel his family owns in Poza Rica, Mexico, Guillermo Salinas recalls how his country's oil dreams imploded, along with many of his own hopes for a brighter future. A light flickers overhead. The air smells of chlorine, though hardly anyone uses the hotel's blue-tiled pool anymore.

On this muggy day in September, some of the few guests at the once-thriving Hotel Salinas are a dozen or so federal police sent to the area to protect pipelines from thieves who siphon off gasoline to sell on the black market. Having federales as paying customers is a mixed blessing: The sight of a bunch of guys in the lobby with rifles slung over their shoulders doesn't exactly help lure tourists.

Nowadays any paying customer is welcome here. Poza Rica, a city in the Gulf Coast state of Veracruz, lies on the edge of the vast onshore Chicontepec oil basin. About a decade ago, Petróleos Mexicanos , the state-owned oil giant that has iconic status in Mexico, was investing billions of dollars in Chicontepec. Salinas and other entrepreneurs rushed here to open restaurants, hotels, and oil service businesses.

It looked like Poza Rica was going to be a boomtown. But the boom has become a bust. Joblessness is rampant—even some drug cartels that once terrorized the town have gone elsewhere because there's not enough money to be made.

So, like a lot of Mexicans, Salinas, who manages the hotel day to day, feels let down. “The government told businesses to prepare ourselves by creating new infrastructure and services for Pemex,” he says. “That didn't last, and now a lot of investment has stopped. Many of us in the hotel business are fighting to survive.”

The same could be said of Pemex. Ratings companies are sounding the alarm over the world's most indebted oil company, with one already cutting its bonds to high-yield, high-risk junk. The biggest risk of all is that the state company's distress will drag down the Mexican economy.

Any hope of preventing that and of revitalizing such places as Poza Rica now rests with President Andrés Manuel López Obrador. When he took office in December 2018, one of his signature promises was to return Pemex to its glory days.

AMLO, as the president is known, has placed Pemex at the heart of his ambitions to upend three decades of neoliberal policies. So while he's pledged much-needed investment to revive the company, he's dialing back moves that had ended Pemex's monopoly on crude production and provided a whiff of modern management practices where do-little jobs-for-life weren't uncommon.

Pemex is now saddled with a mandate that looks a lot like a job creation program, including the construction of a refinery in AMLO's home state that most industry analysts say isn't needed. This populist prescription for saving Pemex, whose debt load is more than $100 billion, is exactly what disturbs ratings companies. The press offices for Pemex and López Obrador didn't respond to requests for comment.

In retrospect it seems clear the president was always headed in this direction. Early in the López Obrador administration, Pemex added the motto “For the Recovery of Sovereignty” to its logo—lest anyone mistake it for a more typical energy producer focused simply on drilling for oil and gas.

And that's where AMLO's troubles began.

QuickTake: How AMLO's Plans to Transform Mexico Ran Into Reality

When he became president, López Obrador had at least appeared to have the bona fides for revitalizing Pemex. As mayor of Mexico City from December 2000 to July 2005, he successfully juggled wildly divergent constituencies. What's more, he was a child of the oilpatch: He spent his early years in Tepetitán, an off-the-beaten-path village with a couple of wells sunk into the ground.

But the Pemex of AMLO's childhood was vastly more successful than it is today. In 1953, the year he was born, the oil industry was booming in his home state of Tabasco. Nationwide, production had almost doubled over the previous 15 years. By 1968 it had doubled again.

There were always concerns that Mexicans at the bottom of society weren't getting a fair share of oil wealth, however. López Obrador, who'd worked as a bureaucrat and a college professor, latched on to that anger as he began his political career. After losing a controversial 1994 election for the state governorship—his opponent's campaign spending came under scrutiny—he joined activists who blockaded Pemex wells and rose to prominence when he appeared on television covered in blood following a clash with police.

In 2000, when he won Mexico City's mayoral election, López Obrador positioned himself as a pragmatic leftist. While he expanded social programs for senior citizens, single mothers, and the disabled, he was also willing to work with billionaire Carlos Slim on development projects and former New York Mayor Rudy Giuliani on crime-fighting initiatives.

AMLO used the job as a launchpad, running for president in 2006 on a left-wing agenda that included protecting Pemex from what he saw as efforts to privatize the company. He lost to center-right candidate Felipe Calderón by less than 1 percentage point, according to the official count, but claimed fraud and didn't accept the results. He and his supporters formed a symbolic shadow government and shut down the heart of the capital city with weeks of protests.

In the following years, as Calderón took steps toward modernizing Pemex, López Obrador led the resistance, packing arenas with angry citizens for hourslong rallies. He told his followers to close down airports, oil facilities, and highways to publicize their objections to Calderón's plans. “The country's oil belongs to the people, even the most humble,” López Obrador told protesters outside Pemex's Mexico City headquarters in 2008. “We must defend this historic conquest.”

As Calderón's single six-year term was ending in 2012, López Obrador ran again for president. This time he lost by a much wider margin to another center-right politician, Enrique Peña Nieto.

Peña Nieto's administration finally achieved the cherished goal of the Mexican right: opening Mexico's energy industry to foreign investment. Although the timing wasn't ideal—the ink on the reforms was barely dry before the 2014-15 oil price crash—Mexican fields were attractive to international players such as BP, Chevron, Exxon Mobil, and Royal Dutch Shell.

In the end, Peña Nieto's government got bogged down in corruption allegations and the public's perception that the president and his wife, a former telenovela star, were disconnected from the realities of everyday life. That opened up space for López Obrador to run once again as a reformer in the July 2018 presidential election.

AMLO's National Regeneration Movement (Morena) promised something new: a government that would focus on fighting poverty and putting ordinary workers over the entrenched business interests that many believed were coddled by previous administrations. He pledged to revive Pemex, shield it from foreign interference, and make it a company of the people again.

At home and abroad, business executives and investors blanched at what they heard; the peso, bonds, and stocks all suffered heavy losses in the lead-up to the vote. But much of the citizenry embraced it, sending AMLO to a resounding victory. In his ascent, pundits inevitably heard echoes of Donald Trump, Brazil's Jair Bolsonaro, and other unconventional politicians gaining ground around the world.

Now, more than a year after the election, the problems plaguing Pemex are coming to a head, and its investors are increasingly restless.

Production plummeted to 1.68 million barrels a day on average in the first nine months of 2019, half what it was in 2004, and Mexico's most lucrative fields are drying up quickly. Investment is desperately needed, but the cash-strapped company dedicated about $2.5 billion to capital expenditures in the first nine months of the year, just 28% of its $9 billion target for the full year. That target was already not even half of Pemex's capital expenditures during some of Calderón's years in power.

While Pemex is profitable—earnings before interest, tax, depreciation, and amortization in the first nine months of the year reached $17 billion—most of that was wiped out by taxes and duties that totaled $13.9 billion in that span. “The issue is that the government takes all of that away,” says Lucas Aristizabal, Latin America senior director at Fitch Ratings Inc. in Chicago.

AMLO's critics say his government has no realistic strategy to fix what's wrong. They dismiss the centerpiece of López Obrador's investment plan for Pemex—an $8 billion refinery in his home state—as a boondoggle, or worse. They say Pemex has no need for it, the business of turning crude into fuels is best left to someone else, and the project will divert attention away from its core business of drilling.

Construction hasn't yet started on the 340,000-barrel-a-day plant, though bulldozers are preparing the land for what's to come. It will siphon off more than 4 of every 5 pesos in additional funds the government allocated to Pemex from 2020 to 2022 as part of its five-year business plan.

Never mind that existing refineries were operating at only 40% of their potential in September because of underinvestment and a lack of light crude for processing, or that the plants lose more money as they produce more, according to analysts. “It's cheaper for Pemex to buy gasoline [from abroad] rather than refine it in the country,” says Ixchel Castro, an oil and refining markets manager for Latin America at Wood Mackenzie Ltd.

Even so, López Obrador's notion that another refinery will help curtail foreign involvement and influence in Mexico's oil business resonates with large swaths of the population that have long equated Pemex with national sovereignty.

PEMEX grew out of Mexico's expropriation of foreign companies' oil interests in 1938, a time when units of Royal Dutch Shell and Standard Oil Co. were dominant players. Mexican schoolchildren learn from their history books that citizens lined up outside the Palacio de Bellas Artes in Mexico City to donate silver, gold, and even chickens to pay for the takeovers. More than 80 years later, the Día de la Expropiación Petrolera is celebrated across the country on March 18, especially in oil regions.

López Obrador's detractors argue that his policies, rather than rescuing Pemex, could push it into insolvency. That would be devastating for the economy and for government revenue. Oil revenue accounted for about 18% of federal government income in the second quarter of 2019, whereas oil and gas contributed just 3.4% of Mexico's gross domestic product last year, less than half the level of 25 years ago. López Obrador's budget for next year depends in part on Pemex boosting production by about 16%, a rate of growth unseen in almost four decades.

Mexico needs to ditch the “pipe dream” of building refineries and integrate its energy industry with its northern neighbor's, says James Barrineau, a money manager at Schroders Plc, the third-largest holder of Pemex's peso-denominated debt. The failure to do so, he says, “is really the core reason why people have been cautious about AMLO.”

In June, Fitch Ratings downgraded Pemex's bonds to junk, citing the company's falling oil production and ballooning debt, and cut Mexico's sovereign debt rating, because of the government's close ties to the company. Moody's Investors Service Inc. and S&P Global Ratings have raised similar concerns.

Swaps traders are paying more to buy insurance against a default, with the cost of five-year contracts up more than 40% since the end of 2017. Bond buyers are demanding more than 4 percentage points of extra yield to hold Pemex's 10-year notes instead of similar-maturity U.S. Treasuries, almost three times the premium investors get on Mexico sovereigns.

López Obrador, meanwhile, has belittled the credit rating companies and ignored their recommendations to plow more funds into Pemex's oil production and exploration business, sell off non-core assets, and welcome private investment. “As soon as we arrived they started talking about how they were going to lower the rating,” he said at a press conference in August. “I hope they are more careful in their analysis, more professional, more objective.”

Recent government measures to shore up Pemex have helped keep the ratings companies at bay. In September the government pumped $5 billion into Pemex to help ease its debt burden, and the company sold $7.5 billion in bonds to refinance short-term debt. Pemex had already received $1.3 billion as part of the budget approved in December 2018. It's also gotten $1.5 billion in tax breaks and $1.8 billion in assistance with its pension obligations. In the first nine months of 2019, Pemex says, it saved $1.22 billion by reducing fuel theft and an additional $375 million or so by trimming its payroll of 124,000 and interest payments on its debt.

All that money isn't nearly enough to fund Pemex's needs, according to Andrés Moreno, chief investment officer of Afore Sura, Mexico's third-largest pension fund, which holds Pemex bonds. He says the company needs $10 billion to $15 billion a year in cash flow to reverse oil production declines, so the government support is just “a plug-in.” “They are removing the emergency for the next two years, but it doesn't solve anything,” Moreno says. “What is missing in Pemex's case is awareness of the emergency and willingness to put ideology in a drawer.”

As an example of how things could work better, analysts and money managers point to Brazil's state-controlled oil company, Petróleo Brasileiro SA. To be sure, it's had plenty of problems of its own, including corruption and an enormous debt load of about $83 billion. But it does some things right: For two decades it's worked with foreign oil majors to develop vast reserves in deep-water fields off its coasts, allowing it to tap outside expertise as it gained experience in the highly technical drilling required there.

López Obrador's strategy to increase oil production by focusing on onshore and shallow-water fields is shortsighted, according to these analysts and money managers; it also fails to acknowledge the huge promise of Mexico's deep-water and unconventional acreage, which have much higher production potential but require foreign expertise and private investment.

“The current administration has made revamping Pemex—as we call it, ‘making Pemex great again'—a priority,” says Pablo Goldberg, a portfolio manager at BlackRock Inc., which owns Pemex debt. “Eventually, what we need to be seeing is the production capacity of Pemex going up. Some of this financial assistance [from the government] should give Pemex capital to invest. Now we have to see whether it's well done.”

On the outskirts of Poza Rica, dried-up wells stretch into the distance, pockmarking surrounding citrus plantations. Chicontepec is estimated to hold about one-fifth of Mexico's oil and gas reserves. In the early 2000s—after the gigantic shallow-water field Cantarell, discovered in the 1970s, started to decline at an accelerated pace—government officials promised Chicontepec would be a boon to Mexico's production.

Pemex drilled thousands of wells over the following decade. In 2010 it contracted global firms, including Baker Hughes Co. and Halliburton Co., to develop top-of-the-line production-enhancing techniques at five new field laboratories. That attracted transport and logistics companies, equipment and service providers—all to meet the needs of Pemex and its contractors.

The black-gold rush didn't last long. The drilling proved far more complicated and expensive than Pemex anticipated. At its peak in 2012, Chicontepec contributed fewer than 70,000 of the nation's 2.5 million barrels in average daily output. The failure cemented Pemex's reputation for incompetence after executives squandered billions of dollars on it, financed mostly with debt.

During Peña Nieto's administration, Pemex officials acknowledged that Chicontepec was a failure, and the company drastically reduced its investment in the field. Poza Ricans, believing new oil investment was coming their way, supported López Obrador at the ballot box. Pemex's 2020 budget does call for doubling annual investment in Chicontepec to $319 million. But for the time being, Pemex's operations in the region have continued their steady decline.

Building a refinery in his home state hasn't helped AMLO's cause in Poza Rica (population: about 200,000). “It's disappointing that we voted for him and all the support in the energy sector has gone elsewhere,” says Paola Ostos, operations manager of Poza Rica-based Transervices Energy, which shuttles workers and equipment to oil installations. “As a businesswoman, I feel that we've been forgotten. We were the principal oil zone of Mexico for many years, and now all the activity is being concentrated in the south.”

Every March 18, Poza Rica still celebrates the Día de la Expropiación Petrolera . But life in the oilpatch isn't what it used to be. Residents say the festivities—which used to span several days and include a carnival—have lost much of their luster.

On the outskirts of Poza Rica at 9:30 a.m. on a late summer's day, the sun is already turning the sheet-metal homes in squatter communities into ovens. Overhead, plumes from a Pemex processing plant streak the sky. Day after day, the installation burns natural gas that seeps from Pemex's oil wells.

Salvador Reséndiz, president of the Business Coordinating Council for the northern region of Veracruz, says López Obrador promised Poza Rica a new plant during his presidential campaign. Although Pemex's 2020 business plan includes rehabbing the facility, Reséndiz worries that Poza Rica will be forgotten—and that the refinery in the president's home state will take precedence.

“It's very clear that in these first three years of the new government, all of the investment in Pemex is going south, south, south,” he says. “When will it come north? When are they going to put money in Poza Rica?”

—With Sydney Maki, Eric Martin, and Nacha Cattan

Stillman covers energy. Villamil covers emerging markets. They are based in Mexico City.

Story by Ami Stillman and Justin Villamil from Bloomberg 12 01 2019


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