The Dallas Morning News
Saturday, September 20, 2003

Graft, taxes, unions draining Pemex

Mexico oil monopoly must change or die, observers say

By BRENDAN M. CASE / The Dallas Morning News

First of three parts

VILLAHERMOSA, Mexico State-owned oil monopoly Petróleos Mexicanos pumps petroleum from some of the world's richest fields. It ships boatloads of crude to
the United States. It supplies every gas station in Mexico, charging nearly $2.50 a gallon.

A recipe for riches? Not as long as Mexican politicians treat their beloved company like one of the world's largest piggy banks.

After years of government pillage, Pemex is fighting to remain an anchor of the Mexican economy and a key U.S. oil supplier at a time of turmoil and uncertainty in
world oil markets. Despite embodying national pride and wealth, Pemex is turning into a $48 billion case study of Mexico's squandered economic potential.

Now, President Vicente Fox and other top officials are launching a race against time to save the troubled giant. Armed with record budgets, they're adopting new technology, seeking fresh reserves, rooting out graft and refurbishing decrepit refineries.

That's the good news.

The bad news: Pemex is caught in the grip of a political and economic straitjacket, and loosening it won't be easy. The struggle to rescue the nation's largest company pits Mr. Fox's so-called new Mexico of economic modernization against the old Mexico of inefficiency, waste and looting of national resources.

"Industrial logic points in one direction for Pemex," said George Baker, who edits a Houston-based newsletter called Mexico Energy Intelligence . "Tradition, vested interests and populism point in another."

Trouble in Pemex would spark broader economic woes for Mexico, Texas' largest trading partner. Pemex controls all hydrocarbon activity in Mexico, pumping more petroleum than all but two world oil companies. Every last gasoline station carries the red, white and green logo of an eagle shielding a drop of oil.

Pemex's future could also affect U.S. energy supplies. Mexico, the world's sixth-largest oil producer in 2002, is the No. 2 crude oil supplier to the United States behind
Saudi Arabia.

Will the rescue effort succeed?

Mexico has barred most private investment in energy for decades, despite a chronic capital shortage. A powerful labor union saddles Pemex with some of the oil
industry's least productive workers. Rampant corruption costs the company more than $1 billion a year.

Moreover, Mexican presidents have long used Pemex as a cash cow, milking a third of all federal revenue from the company. That's left Pemex with a debilitating debt
and falling oil reserves.

Such weaknesses are coming to a head. Natural gas imports are skyrocketing. Many oil fields are being exhausted. Soon, the jewel of Mexico's energy industry a
fabulous complex of oil fields called Cantarell is expected to begin declining.

"Pemex is crossing the threshold of the new millennium in the midst of a great uncertainty," wrote Mexico City energy expert David Shields in a recent book called
Pemex: An Uncertain Future, which was published in Spanish. "The problem with reserves and declining production [in some fields] puts Pemex's future in doubt."

Riches in the Gulf

High in a Pemex building in Villahermosa, a tropical city in the Mexican oil patch, engineer Vicente Ortega is peering deep into the Earth. Using supercomputers and
three-dimensional glasses, Mr. Ortega says he just struck oil deep below the azure waters of the Gulf of Mexico.

"Right there!" he said, pointing to a digital image of ground highlighted in blue, red, yellow and black. "I'm sure there are hydrocarbons there. That's where we'll drill."

It won't be the first time Pemex has drilled in that location. Mr. Ortega points out several nearby sites where engineers drilled dry holes a generation ago. Today, thanks
to 3-D imaging technology, the area could turn into pay dirt.

Such techniques, which are old hat in much of the oil industry, spotlight a transformation within Pemex. For the first time in 20 years, Mexican leaders are developing
new sources of oil instead of just squeezing Pemex for revenue.

"Pemex's first big growth phase came in the 1970s," said Adán Oviedo, a top exploration official in Villahermosa. "We're starting another right now. We've only explored
about 20 percent of this country's hydrocarbon potential. Now we're making the investments to explore more."

This year, Pemex has an investment budget of $10 billion for exploration and production its highest level in more than 20 years. The budget for exploration alone is $1
billion, compared with an annual average of $350 million in the 1990s. The company is also belatedly improving its technological capabilities horizontal drilling,
centrifugal pumping and applying digital technology to oil exploration.

"Pemex is already becoming a more sophisticated company, and it will have to get more sophisticated," said Fabio Barbosa, an energy expert with National Autonomous
University of Mexico. "That process is beginning. It's not enough, but it's a positive change."

Leading the transformation is Raúl Muñoz Leos, 63, a lean, serious, silver-haired man who has led the company since 2000.

Named to his post by Mr. Fox, Mr. Muñoz Leos found a company in decline. Oil production was rising, but reserves were falling sharply. Labor costs were soaring. And
the company's assets were tumbling.

"We were headed straight for a collapse in production," Mr. Muñoz Leos said in recent testimony before the Mexican Senate.

Hope on horizon?

Three years later, Pemex is showing signs of a turnaround.

Daily oil output recently surpassed 3.5 million barrels, an all-time high and 16 percent more than in 2000. Officials are aiming for 4 million barrels per day by 2006.

Along with rising investment budgets, Pemex has given the private sector a larger role. Service contractors, such as Schlumberger Ltd. and Houston-based Halliburton
Co., have landed major contracts. Houston-based Pride International Inc. now has 19 rigs under contract with Pemex, compared with just one in early 2002.

Reserves are also rising, for the first time in years. During the 1990s, the company's reserve replacement rate averaged just 26 percent. In other words, it discovered
new sources of oil amounting to only a quarter of current production a recipe for long-term decline.

Last year, Pemex boosted its reserve replacement rate to 40 percent. Officials are aiming for a 75 percent rate by 2005, and 100 percent by 2010.

Critics say Mr. Muñoz Leos' efforts might prove to be a case of too little, too late. By the standards of the U.S. Securities and Exchange Commission, Pemex's oil
reserves are far below those of comparable oil companies.

Production costs would probably rise well above current levels of about $5 a barrel. Mexico's days of cheap and easy oil appear to be numbered.

That's not all. Mr. Shields, the book author, says a collapse in oil and gas production is still a possibility. He warns of upcoming trouble in the offshore complex of
Cantarell.

Discovered in the 1970s at the Gulf of Mexico's southern edge, Cantarell ranks as one of the largest oil strikes of all time. It produces nearly two-thirds of Mexico's oil.
But it will begin an inexorable decline as early as next year, according to independent experts and Pemex itself.

Many other oil fields are already showing signs of exhaustion.

"The truth is that almost all Mexican fields are declining significantly," said Mr. Shields, who says he doubts Pemex can produce 4 million barrels a day by 2006. "The
changes needed to solve this problem are taking place too slowly to correct the trend and eliminate the risk of a collapse."

Two for one

That's because Pemex can't easily wriggle out of its debilitating political and economic straitjacket and the inefficiency, corruption and chronic financial woes that go
with it.

It takes two Pemex workers to produce the same amount of oil as one worker for Venezuela's state-owned oil company. Workers at oil majors such as Irving-based
ExxonMobil Corp. or London-based BP are even more productive.

Such inefficiency stems from Pemex's workforce of 141,000 and its rigid labor contracts. About half of Pemex's exploration and production employees work in fields
that yield 2 percent of production, says Luis Ramírez Corzo, the company's E&P chief.

The company's labor union is a powerful fiefdom, headed by officials who often double as lawmakers in Congress. Pemex's labor costs have risen more than 15 percent
a year since the late 1990s, according to Mr. Muñoz Leos.

Corruption skims off more than $1 billion a year, Pemex officials say, due to such things as pilfered gasoline and fraud by crooked contractors and some of the
company's own officials.

But perhaps the largest drain comes from the government's grip on Pemex.

Last year, Pemex contributed about a third of federal revenue. At about $29 billion, its tax bill amounted to 60 percent of its sales. In 2001 and 2002, Pemex's taxes
actually surpassed operating profit, forcing it to borrow money to pay the taxman.

"We can't hide the fact that both companies' economic viability has been seriously compromised," Mr. Fox said in his Sept. 1 State of the Union speech. "That puts our
country's future at risk."

Of course, oil revenue has helped pay for schools, hospitals and anti-poverty programs. But easy oil money has let politicians avoid boosting non-oil tax collection, which
is extremely low by international standards.

Lawmakers are discussing ways to increase tax collection and ease the burden on Pemex. In 2001, however, an attempt at what Mr. Fox called "integral tax reform"
achieved little success among a political class that long ago grew accustomed to easy oil money.

Fundamental change

Add up Pemex's uncertain outlook for oil reserves, its inefficiency, its financial deterioration and its gigantic tax burden, and what do you get?

Perhaps, in coming years, a new stage in Mexico's long oil history.

State control of oil has long been a pillar of modern Mexico. Schoolchildren learn that "el petróleo es nuestro" the oil is ours. Top politicians learn that oil revenues are
theirs to spend.

But such attitudes were easier to afford when Cantarell was spewing out endless quantities of black gold. Now the days of cheap and easy oil are on the wane.

Privatizing Pemex would be politically impossible. But with more autonomy from the government, Pemex could become more like an international oil company. It could
boost its productivity. It could adopt more technology. It could venture into promising but expensive deep-water exploration in the Gulf of Mexico.

Without major changes, however, the old behemoth is on a path to decline.

In the conclusion to his book, Mr. Shields wrote, "If a wholesale reform of the oil industry is not achieved in the current presidential term, we'll lose a historic opportunity
to strengthen this great but troubled national company, before its difficulties worsen and become a burden for future generations of Mexicans."