AN INTERVIEW WITH JESÚS REYES HEROLES: Mexico’s PEMEX is considering joint projects in the Gulf of Mexico

QUESTION: PEMEX is a rather special case in the international oil and gas industry. In recent years, IOCs have been posting record profits while NOCs have successfully expanded beyond their national borders. Over the same period of time, PEMEX has been facing an increasingly challenging situation. Why is that?

JESÚS REYES HEROLES: I think that the institutional context in which PEMEX operates does not favor effective management and does not allow the company to capture the many opportunities emerging in the energy sector. The regulations kill initiatives, not only initiatives from within PEMEX but also initiatives from the private sector which has great difficulty in bringing good ideas and business proposals to PEMEX. The context is completely anti-business. It is really very damaging in that regard. This has had many implications. Part of the implications has to do with the difficult operational and financial situation that PEMEX is facing, while part of it also has to do with the fact that PEMEX has been losing opportunities. Other companies are running and we are not even walking. Sometimes we are really standing still.

QUESTION: The situation you describe requires great leadership to implement the kind of operational and financial change that will enable PEMEX to catch up with the rest of the industry. Do you believe that your ability to bring about the required change will rely primarily on your political or business skills?

REYES HEROLES: PEMEX is a unique company, and I think that you need a combination of political and business skills to push forward some of the changes that are needed. At the end of the day you need some kind of leadership capacity to mobilize the energy and willingness of lots of people to do good things for PEMEX. There is a lot of goodwill for PEMEX, both inside and outside the company. One of the key roles of the CEO of PEMEX is to be able to capture and mobilize that goodwill for the benefit of the company and for the benefit of the country.

When you talk about PEMEX, you talk about the country. When you talk about PEMEX, you talk about the nature of public finance, the capacity of Mexico to stay competitive, and the capacity to achieve higher rates of economic growth. Talking about PEMEX is talking about the critical challenges that Mexico faces. I would say that you require leadership and you require the capacity to mobilize all the goodwill, and the potential of change that is out there, to the benefit of PEMEX.

QUESTION: You have to deal with many different Mexican government bodies including the Office of the President, Ministry of Finance and Public Credit, Ministry of Energy, the Mexican Congress, and the Senate. Is it possible to set a long-term strategy for PEMEX while taking into account the interests of so many different parties?

REYES HEROLES: To understand what is going on with PEMEX one has to be very clear that PEMEX is only part of the many changes that are occurring in Mexico. The kind of PEMEX that we aim to devise in the next 10 to 15 years has a lot to do with the kind of country we are visualizing. PEMEX has been treated as a department of the government since the early 1980s. The period from 1976 to 1982 was the last time there was a strong vision of a growing PEMEX. Regretfully, there were many excesses within PEMEX during this period. As a result, the succeeding administrations started to adjust PEMEX, downsizing the company to make it more effective. After that, two or three different strategic plans were launched, but they were too short-term oriented and were too dependent on the people in power within the government and the company at that time.

Nowadays, we are trying to put in place a system of medium-term planning based on the grassroots in society. This strategy has to be backed by society and can therefore not be changed so quickly. In order to achieve this, we will have to be extremely transparent and frank about the current situation and our objectives. People have to buy into our ideas as well as our medium-term objectives.

I compare what happens in PEMEX with what happens in CFE, Mexico’s major electric utility. CFE has a planning system that has been in place for probably 20 to 25 years. The system seems quite boring, but it is very useful because it moves very slowly from one year to the next and has projections for the next 15 years. Obviously there are changes in direction, but the people know where the company is heading, in which regions they identify opportunities, and in which areas the company intends to develop. That system, which is public, is the basis for the budgeting of the company. If applied to PEMEX this would dramatically reduce the discretionary power of forces outside of PEMEX to do whatever they want with the budget.

QUESTION: At present the annual budget set for PEMEX defines the limits of your development strategy, as opposed to the strategy of PEMEX defining the allocated budget. Changes in the legal, regulatory, and fiscal framework are essential to give PEMEX the opportunity to optimize its strategic planning. What are the most important changes that have to be made in order to get PEMEX back on track?

REYES HEROLES: Precisely because PEMEX is operating within the public sector we have the same illnesses that other public entities have in terms of planning. We don’t have multi-year budgeting, not even of our investment program, which makes the planning and budgeting program extremely inefficient. We have to work with the budget that is set for PEMEX for this year, but I clearly want to have a completely different budget for next year. PEMEX needs a budget that is the right budget for PEMEX, according to the conviction of both people inside and outside of PEMEX. I would like to have a multi-year budget with a planning horizon that covers the rest of the term of the Calderon administration or even stretches out until 2015 or 2020. This would enable PEMEX to define its long-term goals.

You asked about the changes, what are the critical changes? First of all, PEMEX cannot keep paying as much taxes as it has been paying in the past. The numbers vary but basically the reduction in the tax payment of PEMEX has to be around 1.2% of GDP - that would be around US$10 billion to $11 billion. This variation depends on the provisions or solutions that will be put in place to take care of PEMEX’s pension liabilities. The point is that the necessary decrease in tax payment by PEMEX requires the increase in tax collection from other sources. The critical change is the tax rate.

Second, PEMEX requires changes in the rules and regulations that govern the budget. A lot of the rules and regulations that are applicable to public entities should not be applied to PEMEX. My personal view is that we should realize that there should be special conditions for productive public entities, and there are only two of them in Mexico: CFE and PEMEX. These entities require different treatment. Obviously they should be kept within the bounds of the public sector but under unique conditions. PEMEX does not present any cost to the public sector. PEMEX is actually the country’s largest taxpayer and the major provider of resources and should be treated as a productive firm. PEMEX is not a public sector entity, it is a public firm - and I underscore the word firm. That is the second change.

Another issue is caused by regulations that do not derive from the budget, but derive from other rules and regulations that apply to public sector entities. It has to do with responsibilities of the people and the risks you incur when you make decisions in a public company. The system has gone too far. I really think that the directors of public entities and public officials have lost the right to make mistakes.

When there is wrongdoing or fraud in the private sector, you apply the law and people are sent to jail. In the public sector this should apply even more so. What is not right is that people working in the public sector are required to be perfect. They cannot make mistakes, but mistakes are part of reality. If you punish mistakes in an overly excessive manner then people will refrain from making decisions. That affects the entire public sector in Mexico and particularly CFE and PEMEX.

Another chapter has to do with the internal operation of PEMEX: corporate structure, incentives, and the carrot-and-stick approach to make the company move in the right direction. This has to do with a clear and shared view of where we are heading. There will always be people who do not coincide fully with all the guidelines or routes that are established by the management, but you have to have a basic consensus that the main lines are correct. There has to be a change there.

Finally, in this new era for PEMEX we obviously have to revise labor relations. The union is very conscious about that because we are in a mood for change. We mean everybody - from the management of PEMEX to the leadership of the union.

QUESTION: The budget of the Mexican government is based on a price of US$42.80 for the Mexican crude oil basket. In many other countries with strong national oil companies making significant contributions to the budget, the budget planning is based on more modest oil price estimates, providing a more reliable basis for long-term investment planning. Do you believe that the approach taken by the Minister of Hacienda (Minister of Finance and Public Credit) is over-optimistic?

REYES HEROLES: First of all, the price estimates for the Mexican crude oil basket is not set by the Minister of Hacienda but is established by a formula that is incorporated in Mexican law. That law was created by Congress two years ago based on the fact that they thought that the Ministry of Hacienda underestimated the price of oil. The Congress assumed that the Ministry established an oil price estimate that was too low, which gave Hacienda too much leeway to discretionally move the budget. So the Congress responded and passed this law which basically states that the Ministry of Hacienda will base its price estimates for the crude basket on the formula stipulated in the law.

Is the formula going to be accurate or not? This year we expect that the forecasted US$42.80 per barrel is not out of line. It is not the same case for gas. When the budget was prepared, the futures for gas were higher than today. The price that was set in the budget, US$6.99 per MMbtu, seems to be a little bit high and we probably won’t see that as an average price throughout the year.

QUESTION: As you said before, PEMEX has to be an efficient firm with one shared vision. On the other hand, PEMEX consists of four subsidiaries that operate with substantial independence and individual objectives. Do you have any plans to integrate the four divisions into one firm again?

REYES HEROLES: Some people think we should do that. My view is that the creation of the four subsidiaries was a very good idea, because PEMEX was a black box. It was impossible to understand what was going on in PEMEX, and the division into four subsidiaries made things a lot more transparent and allowed for more financial-based decision making. The concept of having transfer pricing between the four divisions created an internal market that created visibility on the financial viability of the activities of the different subsidiaries, based on the real economic parameters. I think that has helped a lot, this was the upside.

On the downside, the creation of subsidiaries did create redundancy. Somebody obviously realized that a few years later, and PEMEX decided to concentrate several activities at the corporate level, which makes sense. However, I think that in many cases the centralization process did not eliminate a lot of the duplicated activities in the subsidiaries, it just added to the duplication and unnecessary costs. Important functions that have been centralized successfully at the corporate level include environmental issues, work security issues, legal affairs, community affairs, finance, property management, and IT.

My view is that we have to take the better of the two processes: a matrix kind of solution. This enables PEMEX to reap the benefits of having the four subsidiaries, combining transparency with the different contacts that the individual subsidiaries have with the markets.

PEMEX Exploration and Production operates as a very closed entity, except for the international trading of oil, but the other subsidiaries have contact with external markets in different degrees. PEMEX Gas actually competes with other companies in the marketplace, still with a dominant position and with growing competition. We have to use the contact between the subsidiaries and the client to redefine PEMEX as a business. Simultaneously, you have to take as much advantage as possible from the centralized control of the key processes. We are moving in that direction and both people inside and outside PEMEX are convinced that that is the way to proceed.

QUESTION: When benchmarking PEMEX against international market leaders such as ExxonMobil, there are clear differences in profitability, productivity, and efficiency. PEMEX is making significant progress in the implementation of IT, automation, and communication systems. However, the company cannot streamline the organization to take advantage of these investments in new technology. How do you expect to improve efficiency, productivity, and profitability while the labor unions prevent PEMEX from reducing its workforce to rationalize the organization?

REYES HEROLES: In many aspects one has to be very careful to always recognize that within PEMEX there are significant differences. IT is one example. One of the subsidiaries is considered to have the best application of SAP in Latin America. At the same time PEMEX has managed to do something that sounds impossible, which is to have several SAP systems that don’t talk to each other efficiently.

Another example is the maintenance of pipelines. The standards of PEMEX Gas in terms of pipeline maintenance and pipeline operation are very good - in some ways, world class. Taking advantage of this competence, PEMEX Petrochemicals has passed the management and operation of all its pipelines to PEMEX Gas. However, when you turn to the other two subsidiaries, especially PEMEX Refining, the management and operation of all the pipelines is problematic.

Internal benchmarking and the companywide application of best practices would already lead to enormous efficiency and performance improvements. We are trying to start this process by applying the standards of PEMEX Gas to the other subsidiaries, and we expect to see a very significant difference in terms of operation and cost in the next few years.

The relationship between improved operational performance and the number of workers is different, depending on whether you consider a growing PEMEX or a stagnant PEMEX. Similarly, the issue of the number of workers that PEMEX has is different, depending on whether or not PEMEX has the flexibility to move people around.

Our aim is to have a growing PEMEX with the flexibility to move people around. That would allow us to improve labor efficiency and create a more rational workforce - rational not only in the number of employees but also in terms of qualifications, age, motivation, regional distribution, and so on. We are gradually moving towards this objective. We will have a revision of our collective contract with the union this year, which will set the margin that PEMEX will have in the future to make more effective use of its labor force and to improve its efficiency.

There is another thing that is related to that. There are a lot of efficiency gains that can be obtained with some additional investment. Our first estimate of the potential cost reduction is in the neighborhood of US$1 billion, which is about 10% of our operating expenses. This is not trivial, but I think we should aim for more and we are in the process of putting together a strategy to achieve precisely that.

QUESTION: President Calderon has stated that deepwater is the future of PEMEX. What is the main constraint to going into deepwater? Is it a financial constraint or is it a technology constraint? How do you expect to deal with this?

REYES HEROLES: It is a financial constraint. PEMEX is already drilling successfully at 1,000 meters and we plan to do more deepwater drilling. Basically, that requires more resources. We can do a lot up to 1,500 meters and we are acquiring more equipment to do so. However, we are facing problems to actually get the kind of equipment that we need. The market is tight and the prices are very high.

The simple fact that the President has said very clearly that PEMEX will not be privatized has fueled a change of attitude among the foreign oil companies. We are looking for technological alliances with foreign companies, but we will cooperate within the existing legal framework. This has encouraged foreign companies to look for opportunities within the existing legal structure. The previous administration offered a lot of hope for constitutional change but never delivered, and that was very frustrating for a lot of the foreign companies. Now the foreign companies say: “Now we understand, this is not going to change. What can we do together in deeper waters without crossing the bounds of the existing constitutional and legal framework?” It is very interesting, they have changed their approach.

Nevertheless, we are not planning to go to 3,000 or 3,500 meters, because we do not need to do that now. We are planning to increase our activity in water of up to 1,500 or probably 2,000 meters, which will give us a lot of opportunities for the next few years. It is very curious because the technologies that were not available to explore at 1,000 or 1,500 meters four of five years ago are available now. When we move into deeper water three or four years from now, then probably the required technology will also be available.

The main problem of deepwater, in addition to the technological aspect, is that deepwater exploration is very costly and risky. That is a real problem. Would we like to go into deepwater by ourselves and invest US$600 million to $800 million to find out that we actually drilled four dry wells, or would we like to go in with a couple of other guys and share the risk? It is a critical issue that is not well digested yet in Mexico. However, this is an ongoing debate and the people are learning and Congress is learning about this other aspect of deepwater exploration.

QUESTION: Do you consider the technology agreement that was recently signed with Petrobras as a first step towards sharing the risk of deepwater exploration and production in the future?

REYES HEROLES: The agreement with Petrobras is still limited in that regard. We are acquiring the knowledge of deepwater exploration and production through technology agreements with different companies. We have agreements with Petrobras and Statoil, while we have been working in a cooperative way with Repsol as well as with Shell, with whom we have a partnership in terms of the Deer Park (Texas) refinery.

PEMEX has a pretty diversified portfolio of upstream projects. If we were to have more resources, then we could do more. We are not lacking projects, and we are not lacking projects of which we can handle the technological challenges. Suppose that some kind of joint project on the US side of the Gulf of Mexico emerges, we would need to actually make an assessment of that project in terms of its net present value and rate of return and put it in the ladder competing with other projects that we have within our territory and boundary of technological feasibility, which is by the way moving away from the axis as time goes by because we are learning and the technology market is opening up. What I am trying to say is that we primarily need to share risk, because access to technology is not a strong challenge. On the other side, how to split financial risk is a real issue.

QUESTION: You already mentioned the possibility of participating in projects outside your national territory, which is a worldwide trend among NOCs. Do you think that PEMEX has the competitiveness to be a desirable partner for international oil and gas firms?

REYES HEROLES: I don’t know, and let me tell you why. We have a nice portfolio of upstream investment opportunities in Mexico within our technological and financial capabilities. Up to now, we have not assessed the viability of a deepwater project outside Mexico. It is something that could be done just for the sake of doing it, but then we would have to benchmark the competitiveness of that project against our other projects.

It is good that we are not lacking upstream projects, and that is why so many companies are willing to help. It is a budgetary decision here. If we could get US$2.2 billion to $2.5 billion for exploration and another US$20 billion for investments, then we could certainly do a lot. PEMEX would be able to execute its exploration strategy without uncertainty and without endless negotiations with the treasury and other entities. If PEMEX gets this financial space, then we have the resources, or could acquire the resources, to actually keep increasing the production of oil and gas.

Last year was a great year in terms of gas production, but it was not very good in oil. At the moment, we have several projects going on that will bring new production on-stream. We have to remember: this is an oil company.