Warning signs for Pemex

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Mexico’s government is siphoning off revenue from its state-run oil producer while loading it up with debt, leaving Pemex short of funds to upgrade its infrastructure. Despite this policy, investors are still buying Pemex paper. US Credit reports

There are few things as sacred as oil in Mexico. Black gold was first struck under the country’s soil in 1901 by two American speculators; two decades later, Mexico was the world’s second largest oil producer. In 1938, a state-run company was formed to manage the new national treasure: Petroleos Mexicanos, better known as Pemex.

Nowadays some market professionals view the relationship between Pemex and its sovereign authority as one where the state of Mexico gives with one hand and takes away with the other. It siphons off much of Pemex’s revenue stream, hurting the company’s financial health, but at the same time it relieves pressure on Pemex in the secondary market by implicitly backing Pemex debt.

Pemex bonds often trade at a discount to Mexico’s sovereign instruments, but in recent months spreads have tightened between the two credits as Mexico has moved further into investment-grade territory and investors have scooped up more Pemex bonds. “Spreads have tightened versus the sovereign, but there’s still a small premium,” says Rashique Rahman, an emerging markets debt strategist with HSBC Securities.

Mixed blessing

Mexico’s enormous oil reserves have been a mixed blessing for the country. Corruption over the years has drained countless dollars from the state entity; meanwhile, Pemex cashflow has long provided the federal government with a big enough fiscal cushion to maintain non-oil related tax collection at a meager 11% of gross domestic product (GDP). Tax collection in the US, by comparison, represents 25% of GDP.

Last year, as is the custom, Pemex handed over more than 60% of its $69 billion in revenue to the federal government. These taxes and royalties fund about one-third of Mexico’s annual budget. The massive payments, however, leave Pemex with net losses and severely restrict the amount of money the company can reinvest in exploration, production and even simple maintenance. The risk of scrimping on maintenance has become all too clear in recent months as a series of explosions and leaks on the company’s corroding pipelines have polluted rivers and farmland.

While front-page images of oil-soaked birds captured the nation’s attention, Pemex bonds barely budged. One reason the bonds didn’t react, analysts say, is that many consider Pemex debt to be an extension of, or alternative to, Mexico’s stable foreign currency-denominated debt. “We believe that fundamentally the credit is as good as the country,” says Alexandra Parker, who covers Latin American oil and gas companies for Moody’s Investors Service. On a stand-alone basis, however, Parker concedes that Pemex would be in the low investment-grade category, whereas the agency currently has the debt at Baa1, the same rating as Mexico’s foreign currency.

Under these parallel ratings, Pemex can access cheaper credit than if it were to present a stand-alone balance sheet, which would be considerably less attractive. “All of this is a kind of ‘funny money’ situation,” says George Baker, an analyst and publisher of the Mexico Energy Intelligence newsletter. The government skims cash off the top of Pemex’s sales, making all other expenses—including debt servicing—secondary. The logic for the confidence in both credits is circular: Mexico would likely bail Pemex out of any debt problems since Pemex is the backbone of Mexican public finances.

Mexico’s debt profile has steadily improved in recent years while that of Pemex has only gotten worse. “Pemex and the federal government are living a very complicated symbiosis,” says Gerardo Rodríguez, deputy undersecretary for public credit at Mexico’s Finance Ministry. Since being graced with investment-grade status in 2002, Mexico’s debt as a percentage of GDP has dropped to 39.4% from 41.0% and the country has taken steps to lengthen maturities and replace external obligations with debt denominated in pesos, the local currency. Meanwhile Pemex’s debt load has shot up 61% to $44.9 billion as the company attempts to raise funds for exploration and new projects. Those obligations make Pemex one of the world’s most heavily indebted oil companies.

“They’re raising debt when oil prices are high, which is usually an opportune time for oil companies to reduce debt,” says Jason Todd, an oil and gas analyst with Fitch Ratings, which has the company’s foreign currency debt at BBB-. “They wouldn’t have to borrow so much money for their projects if they were able to apply internal cashflow.”

Some see Pemex’s increased leverage as canceling out Mexico’s improving debt profile. “What you’ve seen is a transferring of the debt,” says John Padilla, director of energy consultancy IPD Latin America.

Francisco Javier Carrillo, secretary of the congressional energy commission and member of the left-leaning Democratic Revolution Party, agrees. “It’s like moving money from one pocket to the other,” he says, tapping the side pockets of his slacks. Carrillo says there is a consensus among Mexico’s political class that the Finance Ministry needs to be weaned off Pemex funds.

Dwindling resources

With oil prices high, Mexico can afford this sort of band-aid approach to its finances, but within just a few years, the Pemex cash cushion threatens to get thin. Mexico’s big payload—the Cantarell field discovered in 1976—is due to start producing less oil this year, with output dropping to 2.02 million barrels a day from 2.11 million. Cantarell represents more than 60% of Mexico’s crude output. From this fairly simple and highly profitable deposit, Pemex will be forced to move on to new projects that will require heavy investments long before they begin to yield results, and Pemex officials say that more debt won’t do the trick.

“Pemex faces a delicate financial situation,” Pemex chief executive Luis Ramírez said recently. Ramírez insists the company needs to open to private investment in order to attract the sort of money and technological know-how necessary to tap difficult deposits. Such alliances are currently impossible, though, since Mexico’s constitution bars private entities from exploiting the country’s energy resources. To get around this law, Pemex has awarded contracts that pay based on production, although some political factions are questioning the legality of such deals.

The government of President Vicente Fox has proposed a fiscal reform to make it easier for Pemex to invest in new projects, but few observers expect the measure to pass before Mexico’s 2006 presidential elections. Meanwhile, as Pemex’s leverage increases, the dynamic between the state company and Mexico’s sovereign credit will likely become more precarious. “With higher oil prices, they have basically bought themselves some time,” says Shelly Shetty, a sovereign analyst with Fitch who has Mexico’s long-term foreign currency at BBB-.

And ultimately the buck could stop with US taxpayers. “All you have to do,” says Baker from the Mexico Energy Intelligence newsletter, “is think back to the Clinton rescue package for Mexico, which was guaranteed by Pemex oil revenue, to imagine what might happen.”

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