Mexico’s Pemex: An ailing giant, but still a giant

Pemex reported a mind-boggling $23 billion loss for the first quarter of 2020, cementing its position as the world’s most indebted company. While the coronavirus-induced oil price collapse is partly to blame, Pemex has been a troubled company for a long time, but understanding it purely through a profit-driven lens misses much of what the company does in Mexico’s political economy

Scott McKnight – May 1st, 2020

Petróleos Mexicanos, Mexico’s oil giant better known as Pemex, reported a mind-boggling $23 billion loss for the first quarter of 2020. The loss, which equals just over 2% of Mexico’s GDP or a loss of about $7.85m in losses every hour for the quarter, is almost incomprehensible, even in a global oil market in which no company is spared the bloodshed.

But Pemex has been hurting for a while. Its troubles are many and well-known. The company’s oil production and proved reserves have been declining steadily for the last fifteen years. Its debt, at nearly $105 billion, makes it the most indebted company in the world. Part of the reason is that Pemex, as one of the main financial pillars of the Mexican state, suffers under an asphyxiating tax structure. Other reasons include the company’s massive payrolls and crippling pension obligations of US$77.3 billion. Likewise, as a particularly insular national oil company (NOC), the company is chronically vulnerable to political interference and suffers corruption throughout its ranks.

This set of problems led credit agencies like Moody’s and Fitch over the past several months to downgrade Pemex’s bonds to ‘junk’ status. This change has compelled active fund managers and passive funds linked to those indexes to dump some $3.5-5bn of Pemex bonds into the market, since these funds can only investment-grade securities. Pemex bonds have lost almost a third of their value in the past four months.

The Pemex refinery at Cadereyta, just outside Monterrey, Mexico. Source: Reuters/Daniel Becerril

But Pemex, although massively indebted and deeply dysfunctional, isn’t just another oil company and shouldn’t be understood only by using market-oriented metrics. Instead, Pemex is a throwback to the inward-looking, quasi-government agency that is only peripherally concerned with profits and losses. Moreover, the company is a symbol of Mexican sovereignty and widely popular—despite its well-known defects—and as such is politically protected, especially so under the populist government of Andres Manuel Lopez Obrador, popularly known as AMLO. This article identifies both the more recent as well as more deep-seated causes of its troubles.

Explaining the dismal results: The immediate causes

The most obvious and significant explanation for Pemex’s staggering $23 billion loss for the first quarter of 2020 is the coronavirus-driven crash in oil demand, something made worse by the oil price war but only incompletely addressed by the Easter weekend production cuts, to which Mexico committed to a meager production cut of 100,000 bpd in the eleventh hour of the OPEC+ meeting.

The coronavirus-induced travel and work restrictions led to a drop of over 60% in Mexican gasoline demand (the collapse in diesel demand was about 30%, as rural areas depend on diesel for product transport and agricultural machinery). The problem was that this deluge of fuel imports arrived to Pemex’s inventories that were already near capacity, as the company anticipated strong demand from heavy travel during the Semana de Pascua (Easter) holidays when families drive and fly to the beach and tourist spots.

So, by mid-April, Mexico had too much gasoline and no place to put it. Some 60 tankers carrying a combined 18 million barrels lingered off the coasts of Mexico, outside the major ports of Pajaritos, Tuxpan, Altamira and Dos Bocas. This led to Pemex racking up hefty fines (known as demurrage), costing the company about $1.5m per day. This squeeze finally led PMI, Pemex’s trading arm, to take the extreme measure and declare force majeure, something reserved for an unexpected external event that renders one party unable to fulfill its contractual obligations.

Some of this could have been avoided. Although Mexico was late to feel the oil demand hit (AMLO, the Mexican president, initially refused to implement strict travel and work restrictions), Pemex’s room for manoeuvre was nevertheless constrained the company’s commitments under long-term purchasing contracts. For decades, Pemex opted to buy nearly half of its fuel imports from the spot market. However, after AMLO took power in January 2018, Pemex changed its business model, leaving PMI with less flexibility to adapt, in this case to the pandemic-induced price collapse. This has also led to the late-April decision to halt crude production at newly drilled oilfields while boosting national refining with the goal of refining 1 million bpd by May.

Explaining the dismal results: The underlying causes

Pemex has been losing money for a while. Thursday’s cataclysmic quarterly earnings report were twice the $18.3 billion in net losses reported in 2019, which in turn doubled the losses Pemex reported for 2018. There are a multitude of reasons why Pemex has failed to function as a profit-oriented oil company.

First, Pemex has been financially constrained by the Mexican state for decades. Second, Pemex isn’t a publicly traded firm; its only shareholder is the Mexican state, who mobilizes the company in service of the Patria. Third, since its creation in 1938 until some five years ago, the company was constitutionally prohibited from collaborating with foreign oil companies, which thus deprived the company of the productive partnerships needed for technically challenging and high-cost projects as well as updating the NOC’s army of technicians.

A series of platforms at the Ku Maloob Zaap (or KMZ) fields, which together produce some 860,000 bpd. Source: Reuters

These three reasons help explain Pemex’s unfortunate fifteen-year streak of declining oil production and proven reserves, a trend the company is almost helpless to reverse under the prevailing conditions. After a peak production of 3.4m bpd and crude exports of 1.622m bpd in 2004, Pemex has been unable to replace the sunsetting ‘supergiant’ of Cantarell, which was discovered in the mid-1970s but whose rates of output fell off sharply in the mid-2000s. This decline in output has only been partially offset by the nearby fields known as ‘KMZ’, while disappointment continued onshore, in particular from the geographically dispersed Chicontepec fields, which turned into a black hole of money and hopes for the company. Pemex’s crude oil production averaged 1.68m bpd in 2019, down 7% from its 2018 levels.

Fuel theft, now run by some of Mexico’s biggest criminal organizations, stole

12.9m litres, costing the government more than $3bn in 2017 from

some 12,500 secret taps in the national pipeline network

The recent downgrading of Pemex’s bonds to junk status will only worsen this situation, as the loss of coveted ‘investment grade’ status increases the company’s costs of borrowing and reduces the company’s borrowing possibilities.

Another source of trouble has been years of systematic fuel theft from the company. Known playfully as ‘huachicoleo’, a phenomenon covered in Ana Lilia Perez’s superb book on Pemex, fuel theft has become a severe problem in recent years since the racket was taken over by Mexico’s big and sophisticated organized criminal syndicates. These mafias siphon gasoline and diesel from some 12,500 secret taps in the national pipeline network as well as from within refineries and storage installations. In early 2018, this amount increased from 477,000 litres a decade ago to some 12.9m litres (or 80,000 barrels), costing the federal government more than $3bn in 2017.

Fuel theft also related to other aspects of the AMLO government’s agenda, since the illicit trade feeds on factors such as poverty in the transit regions, the lack of a state presence in Mexico’s vast interior, and an untold number of Pemex employees on-the-take in these schemes. The problem gained national attention when a pipeline, compromised by the huachicoleros, exploded in January 2019, killing more than 130 people.

Starting in late December 2018, the AMLO administration deployed federal security forces to patrol particularly vulnerable Pemex installations and areas of the pipeline network. As a result, fuel theft fell by 95% to some 64,000 gallons per day for a savings of more than $600m while also earning the government a windfall of political capital in the process.

Another burden on Pemex is the company’s crushing payroll which employs some 125,000, well beyond necessity (it has recently asked employees to take voluntary pay cuts of 25% until December), as well as its massive pension obligations. At over $77b, this is mostly a leftover of Pemex’s quasi-welfare state function and the powerful union that first helped stabilize Mexico’s oil industry after the traumatic nationalization order in 1938. The oil workers’ union became a key pillar of the PRI’s political monopoly, in what became derisively known as ‘perfect dictatorship’ and lasted from the 1930s to 2000.

Reviving the giant: AMLO to save Pemex

AMLO made no secret of his goal to revive Pemex, the beleaguered symbol of national sovereignty. This effort centered on Mexico again achieving oil self-sufficiency, thus ending Mexico’s growing dependence on fuel imports while also lowering fuel prices for Mexican consumers. In recent decades, Mexico has come to sell its heavy crude (marketed as Maya, with an API between 21 and 22 degrees) to the US Gulf coast refineries, while Mexico imported gasoline, much which is of the ‘boutique’ variety, meaning it features specific limits on benzene and aromatics. Some 65% of Mexico’s domestic fuel demand is satisfied by imports, 500,000 bpd of which came from the United States in 2019, thus making Mexico the largest destination of US gasoline exports. Meanwhile, Mexico’s six ageing refineries processed a mere 580,000 bpd in February, functioning below 30% capacity, crippled by years of underinvestment, neglect and corruption. This quasi-colonial exchange was unacceptable for the nationalist-minded AMLO government, while also putting needless stress on Mexico’s fragile balance-of-payments situation and its anemic financial situation.

A map of much of Mexico’s oil infrastructure. Source: https://www.argusmedia.com/en/news/1718024-proposed-mexico-refinery-sites-lack-ports-pipelines

The centerpiece of AMLO’s plan to revive Pemex was the mega-refinery at Dos Bocas, in the Gulf coastal state of Veracruz. After skepticism and pushback from private industry experts that estimated the refinery’s costs at a whopping $10-12bn with the earliest completion date being 2023, AMLO instead decided to hand the project to Pemex and the Energy Ministry (known as Sener by its Spanish acronym), which claimed the cost would be $8bn and be ready by 2022.

The gargantuan refinery is the most expensive of the several infrastructure megaprojects undertaken by the new government. Others include the building of a second airport in Mexico City (this being handled by the military) as well as a rail to circle the poverty-stricken Yucatán Peninsula (this one opposed vehemently by indigenous and environmental groups).

Closing thoughts

The wisdom of entrusting Pemex, a company already grappling with declining oil production and a debt load over $100bn, is questionable. But more importantly, the decision captures the way in which Pemex is a special vehicle within the Mexican political economy. The commitment to revive Pemex, including reversing years of underinvestment in Pemex as well as the deep-cutting energy reforms of 2013-14, was made possible by the prevailing disgust of the Mexican electorate for the country’s traditional ruling class, largely embodied in the two dominant parties of the PRI and the conservative PAN (which governed from 2000 to 2012). With this strong mandate for change, the AMLO government is attempting to reinvigorate Pemex as an important instrument in creating jobs and stimulating industry.