Special Comment January 2003 Contact Phone New York Alexandra S. Parker 1.212.553.1653 John Diaz Thomas Coleman Petroleos Mexicanos (PEMEX): Lack of Fiscal Autonomy Constrains Production Growth and Raises Financial Leverage Summary Opinion Petroleos Mexicanos (PEMEX) is Mexico s national oil company. It is 100% owned by the Mexican government and accounts for about one-third of the government s income through taxes and dividends. PEMEX maintains sizable hydrocarbon reserves, despite recent negative reserve adjustments. However, its oil and gas production has remained relatively flat. Unlike its private international oil company peers, PEMEX does not have the flexibility to adjust its annual capital budget to reflect changes in international oil and oil product prices. It must also contribute a substantial portion of its annual revenues to government coffers, reducing free cash flow available for long-term investment in upstream and downstream oil and gas projects. In order to accommodate rising energy demand in Mexico, the government has approved increases in PEMEX s capital budget. However, due to its high tax burden, the company has been forced to depend increasingly on debt to finance its capital projects, either directly or through other means. Moody s stable outlook for PEMEX s Baa1 global local currency and Baa1 foreign currency ratings assumes its free cash flow will rise as projects are completed over the next several years. PEMEX s rating may be pressured over time if these projects do not generate sufficient cash flow to mitigate rising indebtedness, particularly if oil prices were to decline significantly from today s lofty levels.
Introduction Created in 1938, Petroleos Mexicanos (PEMEX) is Mexico s national oil company. It is a decentralized public entity, 100% owned by the Mexican government, and is responsible for the central planning and strategic management of Mexico s petroleum industry. It is the third largest producer of crude oil and condensates in the world, accounting for about 8% of global oil production in 2001. PEMEX s operations are fully integrated, with four operating units: E&P, Refining, Natural Gas and Basic Petrochemicals, and Petrochemicals. The company is Mexico s sole marketer of refined products, with domestic sales representing about 70% of total revenues. This special comment focuses on the factors that constrain PEMEX s ability to rely on internal cash flow to finance its growth, the financing strategies employed by the company to fund projects external to its annual budget, and the effects of such financings on its credit quality. SIZABLE RESERVES DESPITE WRITE-DOWNS PEMEX has had a relatively poor reserve replacement record. Over the past five years, its proven reserves have declined mainly as a result of external reserve audits by independent petroleum engineers. More recently, in 2002, in order to comply with the SEC s definition of proven reserves, the company reclassified approximately 8.9 billion barrels of oil equivalent (BOE) in the Chicontepec area in northern Mexico from undeveloped proven reserves to probable reserves for the year 2000. This reclassification decreased its total proven reserves to approximately 21.8 billion BOE from 30.8 billion BOE (see Chart 1). The reserve impairment did not affect PEMEX s estimates of future production, as it had not included any expected future production from the reclassified reserves in its estimates of discounted future net cash flows. On the other hand, Moody s notes that the reclassification was primarily related to national budgetary constraints imposed on PEMEX, which limited its ability to determine with a high degree of certainty the timing of its investments in the Chicontepec area. Chart 1 PEMEX Total Proven Reserves Million BOE 70,000 60,000 50,000 40,000 30,000 20,000 10,000 0 1997 1998 1999 2000 2001 Total Proven Reserves BOE: 5,200 cubic feet of natural gas is 1 barrel of oil equivalent Source: Petroleos Mexicanos Notwithstanding the declining reserve trend discussed above, PEMEX s proven hydrocarbon reserves remain substantial when compared to those of its international peers (see Chart 2). The company s ratio of reserves to annual production also remains high, albeit lower than in previous years, as evidenced by 2001 reserve life indexes of 14.7 years for oil and 14.4 years for natural gas. As a result, PEMEX will need to rely less on future reserve discoveries or acquisitions to maintain its hydrocarbon production at current levels as compared to companies with shorter reserve lives. However, the company will still need to pursue exploration drilling to achieve its goal of increasing the production of more valuable lighter crudes for export. About 36% of PEMEX s current production comprises lighter crudes, as compared to management s target of 50%. PEMEX has not made significant investments in exploration since the late 1970 s. The company plans to spend up to US$1.5 billion on exploration projects in 2003. The exploration program will include drilling in deeper waters. PEMEX will need to invest in deepwater technology to develop these reserves, as most of its offshore production in the Gulf of Mexico occurs in relatively shallow water. 2 Moody s Special Comment
Chart 2: Worldwide BOE Reserves (Million BOE) Company 2001 Petroleos Mexicanos 21,893 Exxon Mobil Corporation 20,815 Royal Dutch/Shell Group of Companies 18,774 BP plc 16,072 ChevronTexaco Corporation 11,759 Total Fina Elf S.A. 10,616 ENI S.p.A. 7,008 Repsol YPF S.A. 5,394 Phillips Petroleum Company 5,132 Conoco Inc. 3,578 Amerada Hess Corporation 1,435 Marathon Oil Corporation 1,046 Source: US SEC MODEST PRODUCTION GROWTH IN THE FACE OF RISING DEMAND Despite its sizable reserve base, PEMEX has not been successful in growing its oil and gas production. Its liquids production has remained essentially unchanged for the past five years (see Chart 3). PEMEX was subject to crude export constraints based on agreements between the Mexican government and OPEC, which may have reduced the company s revenues during 2001 and 2002, but these constraints appear not to have had a material effect on the company s production. Moody s also notes that the export reductions (100 thousand barrels per day to a limit of 1.66 million barrels per day in 2002) represent a small fraction of PEMEX s total daily crude oil production of over 3 million barrels per day. The company recently agreed to increase its exports to 1.88 million barrels per day. MMBoe Chart 3 1,400 1,200 1,000 800 600 400 200 0 PEMEX Hydrocarbon Production 1997 1998 1999 2000 2001 Liquids Natural Gas Source: Petroleos Mexicanos Mexico s natural gas production has also remained fairly flat (see Chart 3 above). PEMEX will need to increase its natural gas production in order to meet growing demand in Mexico, which is expected to rise at a rate of 9-10% p.a. over the next ten years. Growth in non-associated domestic gas production would reduce the need for more expensive imports and would also improve PEMEX s production flexibility, as approximately 70% of Mexico s natural gas production is associated natural gas that depends on crude oil production. With additional investment, Mexico could also become an important supplier of natural gas or LNG to the US. The company has stated that it has the potential to produce 6.7 billion cubic feet per day by 2006. PEMEX has introduced long-term Multiple Service Contracts as a means for foreign and domestic companies to provide financing to increase Mexico s natural gas production through the exploitation and development of certain hydrocarbon reserves. PEMEX intends to solicit bids from contractors in the first half of 2003. Winning bidders will provide a variety of high-technology services, including drilling of development wells and seismic services. The first contracts to be awarded will be in the Burgos Basin, located adjacent to the US border. Although winning bidders will Moody s Special Comment 3
carry out planning and production, because PEMEX has to approve their annual plan, it will retain contol over the production from the Burgos fields. ANNUAL CAPITAL BUDGET SUBJECT TO GOVERNMENT CONTROLS PEMEX s annual budget and financing program is part of the Mexican government s annual budget, which must be approved by the Mexican Congress. The PEMEX capital expenditures included in the annual budget are separate from the government s PIDIREGAS program, which designates certain of PEMEX s largest capital expenditures as long-term productive infrastructure projects (see Chart 4). Chart 4: Capital Expenditures In billions of Pesos Year Non-PIDIREGAS PIDIREGAS TOTAL 1997 28.9 4.8 33.8 1998 31.3 19.5 50.8 1999 25.5 27.3 52.8 2000 31.6 42.4 74.0 2001 32.5 36.6 69.1 2002E 37.5 59.4 96.9 2003E 38.0* 76.3 114.3 *Subject to approval by the Mexican Congress Source: Petroleos Mexicanos Because it is government owned and controlled, PEMEX lacks the flexibility to adjust its annual budget to reflect changes in market conditions. During the past three years, the average annual oil price assumptions embedded in PEMEX s budget have been below actual prices (see Chart 5). However, PEMEX s budget was not increased to reflect the additional revenue generated by higher than expected market prices. While the Mexican congress allowed the company to increase substantially its 2002 non-pidiregas capital budget from 2001 levels, it is likely that the actual average price of Mexican crudes will again exceed the budgeted average price. There is also a risk that PEMEX s non- PIDIREGAS budget may be cut if oil prices decline. Moody s notes that PEMEX often does not spend its entire budget due to bureaucratic delays in obtaining approvals for projects above a certain amount. Moody s believes PEMEX is not likely to achieve budgetary autonomy in the foreseeable future. Chart 5 Capital Expenditures vs. Oil Prices $4,000 $3,000 $2,000 $1,000 $0 1997 1998 1999 2000 2001 2002E 2003E $30.00 $20.00 $10.00 $0.00 Non-PIDIREGAS Capital Expenditures (Million US$) Actual Average Price of Mexican Oil Mix (US$/B) Budgeted Average Price of Mexican Oil Mix (US$/B) 2002 Actual Average Price of Mexican Oil Mix estimated by Moody s 2003 Non-PIDIREGAS CAPEX subject to approval by Mexican Congress. Source: Petroleos Mexicanos, Moody s 4 Moody s Special Comment
HIGH TAX BURDEN LIMITS CASH FLOW AVAILABLE FOR INVESTMENT PEMEX is obligated to pay hydrocarbon extraction duties and other taxes to the Mexican government based on annual revenues. These taxes have accounted for about 49% of the company s revenues (excluding the IEPS tax 1 ), on average, over the past five years (see Chart 6). PEMEX must also pay minimum guarenteed dividends, but these have not been material as a percentage of annual cash flow. While PEMEX continues to generate positive pre-tax profits, it continues to generate after-tax losses. Under US GAAP, such net losses totaled 25.4 billion pesos in 2001, as compared to 16.7 billion pesos in 2000. The company s high tax burden also absorbs discretionary cash flow (cash flow from operations after dividends) that would otherwise be available to finance growth investments. PEMEX s attempts to change its fiscal regime have been unsuccessful due to political opposition. Chart 6 450,000 400,000 350,000 300,000 250,000 200,000 150,000 100,000 50,000 0 Tax Burden 1997 1998 1999 2000 2001 60% 50% 40% 30% 20% 10% 0% Total Revenues (MM Pesos)* Hydrocarbon Tax as a % of Revenue * Net of Special Tax on Production and Services (IEPS) Source: Petroleos Mexicanos, Moody s PEMEX may be able to enhance its discretionary cash flow by reducing its operating expenses. As a percentage of net sales, PEMEX s operating expenses have remained high, averaging 54.6% over the past three years (excluding the IEPS tax). The completion of all four of PEMEX s current refinery upgrade projects (Cadereyta, Madero, Tula, and Salamanca) in 2002/2003 should increase the capacity utilization of the company s refineries and improve their profitability by lowering their unit costs. Reducing labor costs, on the other hand, will be more challenging, as layoffs may be politically unacceptable. Approximately 79% of PEMEX s employees belong to the Petroleum Workers Union of the Mexican Republic. These employees have a collective bargaining agreement that is renegotiated every two years, with no firm expiration date. PEMEX recently agreed to a 5.5% increase in wages after the union threatened to strike. DEBT-FINANCED PIDIREGAS PROJECTS INCREASE FINANCIAL LEVERAGE Increased capital expenditures (including PIDIREGAS projects) have led to higher financial leverage, as PEMEX has been relying increasingly on debt to finance its upstream and downstream capital projects. The company s interest coverage 2 declined from 10.3 times in 2000 to 7.2 times in 2001, and its retained cash flow 3 as a percentage of adjusted debt 4 declined from 9.4% to 7.5% over this period (see Chart 7). Lower oil prices and higher operating costs also contributed to weaker debt service coverage measures during 2001. PEMEX s book equity has been eroded by net losses incurred over the past four years; the company had an equity deficit (US GAAP) of approximately US$4.6 billion at the end of 2001. Moody s expects PEMEX s financial leverage to rise further in 2002, based on a reported increase in its total debt through September to approximately US$19.1 billion (Mexican GAAP, excluding accrued interest) from US$17. 2 billion at the end of 2001 (see Chart 8). 1. The IEPS tax is levied against gasoline, diesel and natural gas sales for automotive use. It is excluded from net sales under US GAAP (it is paid to the government, and thus has no effect on PEMEX). 2. Operating income divided by gross interest expense (US GAAP). 3. Cash flow from operations less dividends (US GAAP). 4. Total debt plus accounts receivable sales plus pension liabilities plus off-balance sheet debt and contingencies (US GAAP). Moody s Special Comment 5
Chart 7 12 10 8 Coverage Measures Weaken 30.0% 25.0% 20.0% Chart 8 $20 $15 PEMEX Total Debt Rises 6 4 2 0 1999 2000 2001 15.0% 10.0% 5.0% 0.0% $10 $5 $0 1999 2000 2001 Operating Income to Gross Interest Retained Cash Flow to Adjusted Debt Retained Cash Flow to Total Debt Total Debt ($US Billions) Note: US GAAP Source: Petroleos Mexicanos, Moody s Note: Mexican GAAP Source: Petroleos Mexicanos, Moody s In order to finance its non-pidiregas capital projects, PEMEX has relied mainly on internal cash flow, and to a lesser degree, on debt financing. In contrast, it has financed PIDIREGAS projects primarily through direct borrowings, as well as through Pemex Finance (rated Baa1) and Pemex Project Funding Master Trust (rated Baa1). Pemex Finance is a Cayman Islands limited liability company that raises financing and uses the proceeds to purchase export receivables for Maya crude oil indirectly from PEMEX (through PMI and P.M.I. Services B.V.). In turn, PEMEX uses the proceeds from the sale of receivables to finance PIDIREGAS projects. As of September 30, 2002, Pemex Finance had long-term debt outstanding of approximately US$4.4 billion. Pemex Project Funding Master Trust is a Delaware master trust established by PEMEX in 1998 that also secures financings for PIDIREGAS projects, makes payments to contractors of PIDIREGAS projects, and repays these financings. PEMEX guarantees the Trust s debt and retains the obligation to pay the Trust all amounts necessary to service the Trust s obligations. In turn, three of PEMEX s subsidiaries (PEMEX Exploracion y Produccion, Pemex Refinacion, and Pemex Gas y Petroquimica Basica), under a separate guarantee agreement with PEMEX, are jointly and severally liable for PEMEX s payment obligations under its guarantee of the Trust s debt. These subsidiaries account for the bulk of PEMEX s earnings and cash flow. The Trust had total debt outstanding of US$11.1 billion at September 30, 2002. Moody s expects that PEMEX will continue to finance PIDIREGAS capital expenditures, which are expected to increase significantly in 2002 (see Chart 4 above), primarily with debt. The company plans to spend over US$30 billion on PIDIREGAS projects during 2003-2006. PEMEX has also relied on financing provided by construction contractors to fund PIDIREGAS projects, as in the case of its Cadereyta and Madero refinery upgrade projects, both of which have been completed. While these types of transactions are considered off-budget initially, they are eventually included in PEMEX s annual budget and in its balance sheet debt obligations as the projects are completed and the related debt is assumed or refinanced by PEMEX. At December 31, 2001, PEMEX had total commitments to contractors of approximately US$5 billion. Conclusion Moody s stable outlook for PEMEX s Baa1 global local currency and Baa1 foreign currency ratings assumes its free cash flow will rise as projects are completed over the next several years. Insufficient growth in internal cash flow to mitigate higher debt levels might pressure PEMEX s ratings over time. In the coming years, PEMEX will need to generate sufficient volume growth and/or profitability improvements to achieve reasonable debt service coverage, particularly during periods of low international oil prices. 6 Moody s Special Comment
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To order reprints of this report (100 copies minimum), please call 1.212.553.1658. Report Number: 77084 Author Senior Associate Senior Production Associate Alexandra S. Parker Gretchen S. French Cara Rosen Copyright 2003, Moody s Investors Service, Inc. and/or its licensors including Moody s Assurance Company, Inc. (together, MOODY S ). All rights reserved. ALL INFORMATION CON- TAINED HEREIN IS PROTECTED BY COPYRIGHT LAW AND NONE OF SUCH INFORMATION MAY BE COPIED OR OTHERWISE REPRODUCED, REPACKAGED, FURTHER TRANSMIT- TED, TRANSFERRED, DISSEMINATED, REDISTRIBUTED OR RESOLD, OR STORED FOR SUBSEQUENT USE FOR ANY SUCH PURPOSE, IN WHOLE OR IN PART, IN ANY FORM OR MANNER OR BY ANY MEANS WHATSOEVER, BY ANY PERSON WITHOUT MOODY S PRIOR WRITTEN CONSENT. All information contained herein is obtained by MOODY S from sources believed by it to be accurate and reliable. Because of the possibility of human or mechanical error as well as other factors, however, such information is provided as is without warranty of any kind and MOODY S, in particular, makes no representation or warranty, express or implied, as to the accuracy, timeliness, completeness, merchantability or fitness for any particular purpose of any such information. Under no circumstances shall MOODY S have any liability to any person or entity for (a) any loss or damage in whole or in part caused by, resulting from, or relating to, any error (negligent or otherwise) or other circumstance or contingency within or outside the control of MOODY S or any of its directors, officers, employees or agents in connection with the procurement, collection, compilation, analysis, interpretation, communication, publication or delivery of any such information, or (b) any direct, indirect, special, consequential, compensatory or incidental damages whatsoever (including without limitation, lost profits), even if MOODY S is advised in advance of the possibility of such damages, resulting from the use of or inability to use, any such information. The credit ratings, if any, constituting part of the information contained herein are, and must be construed solely as, statements of opinion and not statements of fact or recommendations to purchase, sell or hold any securities. NO WARRANTY, EXPRESS OR IMPLIED, AS TO THE ACCURACY, TIMELINESS, COMPLETE- NESS, MERCHANTABILITY OR FITNESS FOR ANY PARTICULAR PURPOSE OF ANY SUCH RATING OR OTHER OPINION OR INFORMATION IS GIVEN OR MADE BY MOODY S IN ANY FORM OR MANNER WHATSOEVER. Each rating or other opinion must be weighed solely as one factor in any investment decision made by or on behalf of any user of the information contained herein, and each such user must accordingly make its own study and evaluation of each security and of each issuer and guarantor of, and each provider of credit support for, each security that it may consider purchasing, holding or selling. Pursuant to Section 17(b) of the Securities Act of 1933, MOODY S hereby discloses that most issuers of debt securities (including corporate and municipal bonds, debentures, notes and commercial paper) and preferred stock rated by MOODY S have, prior to assignment of any rating, agreed to pay to MOODY S for appraisal and rating services rendered by it fees ranging from $1,500 to $1,500,000. 8 Moody s Special Comment