COMMENT RESERVES DISPUTE POINTS TO NEED FOR U.S.-MEXICO COOPERATION ON OIL E&D

March 9, 1992
George Baker Consultant Berkeley, Calif. Will the incentives of a free trade agreement (FTA) be sufficient for Mexico to open the state oil sector to private investment? Or are the forces of policy traditionalism too strong for the otherwise irrepressible administration led by President Carlos Salinas de Gortari? Those are policy questions that take as their logical point of departure the existence of large scale, commercially recoverable petroleum reserves in Mexico. How large are those

George Baker
Consultant
Berkeley, Calif.

Will the incentives of a free trade agreement (FTA) be sufficient for Mexico to open the state oil sector to private investment?

Or are the forces of policy traditionalism too strong for the otherwise irrepressible administration led by President Carlos Salinas de Gortari?

Those are policy questions that take as their logical point of departure the existence of large scale, commercially recoverable petroleum reserves in Mexico. How large are those reserves, and what will it take in terms of capital, technology, and know-how to move them to market?

Those questions are important because to a large extent Mexico's economic recovery and foreign debt service depend on the continued steady flow of foreign exchange associated with crude oil exports. A frequently heard observation is that the rate of increase in Mexico's domestic demand for petroleum products will in the next 7-10 years overtake the surplus of crude oil currently being exported.

The measures to be taken to avoid the point at which demand consumes all of production is where analysts and policymakers differ.

RESERVES CONTROVERSY

In a highly critical, almost inflammatory, interview published in the Mexican weekly journal Proceso last Dec. 9, retired Petroleos Mexicanos engineer Francisco Inguanzo Suarez rekindled the 15 year old debate about Mexico's true petroleum endowment.

Among several controversial claims, Inguanzo insisted Mexico's proved petroleum reserves are not 65.5 billion bbl, as Pemex had reported, but 29.9 billion bbl. The same day the article appeared, Pemex reiterated the claim of 65.6 billion bbl and said they could support consumption for 50 years.

First, there are problems with terminology to consider.

Mexico is one of the few countries in the world that calculates a single figure for petroleum representing the sum of oil, natural gas, and natural gas liquids. In addition, Pemex uses a nonstandard conversion factor that has the effect of overstating the volume of gas in the oil equivalent reserves total. Where the U.S. converts 30 Mcf of natural gas to 5 bbl of oil equivalent (BOE), Pemex reports six BOE.

While academic and government analysts also had questioned Mexico's reserve figures, Inguanzo's views command unique authority. During 1964-76 he was Pemex's vice-president of exploration and production. It was during his tenure that Mexico imported crude oil (1972-73). It was also under his leadership that the great Reforma fields were discovered and substantially developed.

Further, Inguanzo claimed that in first half 1988 he had been commissioned by Pemex General Manager Francisco Rojas to cam out a review of Mexico's petroleum reserve statistics. The Proceso article quotes from an unpublished 100 page document in which the findings of Inguanzo and Francisco Alonso Gonzalez are reported.

Some Mexican petroleum geologists told me, "Inguanzo is absolutely right," while others dismissed his conclusions.

Inguanzo's most important conclusion is that Pemex must cut production and cease oil exports by 1998--perhaps sooner. Otherwise, Mexico would be importing more than 700,000 b/d of crude oil by 2000, he predicts.

Inguanzo also takes strong exception to the major articles of faith of the current Pemex administration in matters of contracting.

He contends no drilling contractor, Mexican or foreign, could deliver better, quicker, or cheaper results than those obtainable by Pemex using union employees.

He notes a 1991 contract awarded to a unit of Houston contractor Triton Engineering Inc., the first U.S. drilling contractor to win a Pemex drilling contract in 3 decades. Inguanzo suggests favorable media coverage of the Triton job, which cited Pemex statements in which an offshore well was completed in about half the time it typically takes Pemex for an offshore well, was overstated.

THE EARLY PERIOD

The controversy that Inguanzo hoped to spark over the size of Mexico's petroleum reserves-and by implication the direction of national petroleum policy-has antecedents that go back to the turn of the century.

Not enough is known about the views of early foreign geologists and engineers to quantify the size of what they believed to be Mexico's ultimate recoverable petroleum resource.

We know that in the early 1920s, oil companies strongly opposed the government approach to grandfathering subsoil mineral rights.

In the case of Texas Oil Co. in 1921, the Mexican Supreme Court ruled that ownership of petroleum rights under the 1909 mining code was not vested until some positive act had been taken to possess the subsoil deposits.

The government therefore proposed that only company properties on which "positive acts" of development had been started would be sheltered from the effects of Article 27-state ownership of subsoil mineral rights of the Constitution of 1917.

Had the companies accepted this ruling, they would have secured only their rights to properties then producing but would have lost other properties that could have been as much as nine tenths of the total acreage under mineral rights legally acquired prior to 1917.

Among other concerns, companies believed nothing short of a formal treaty between the Mexican government and the governments of the countries in which the oil companies were based, mainly the U.K. and U.S., could be relied on for purposes of long term investment planning in Mexico. The companies thus continued to pressure their governments to insist on full recognition of their property rights in Mexico.

When it became clear, as early as 1923, that the hoped for treaty foreign oil companies wanted would never come, they began to shift their investment out of Mexico and into new prospective areas in Venezuela and Saudi Arabia. As a result, Mexican oil production began to fall.

With expropriation in 1938, not only did the personnel and operating capital of foreign companies leave Mexico, but many of the well logs, maps, and other data on Mexican petroleum geology were lost. It's no wonder, then, that starting with so little in the way of information, the new nationalized company had a narrow vision of Mexico's oil potential.

For Pemex and the Mexican government, the official view of domestic oil reserves was allowed to diminish until 1972-73, when it became necessary to import crude oil to cover domestic demand.

Beginning in 1976, with the appointment of Jorge Diaz Serrano as head of Pemex the official picture of Mexican oil reserves began to change-at least in Mexico.

Inguanzo claims that Pemex then began to falsify reserve figures. In December 1976, Pemex estimated total petroleum reserves at 16 billion BOE. Inguanzo contends, having then just left a 12 year assignment as Pemex's chief explorationist, he knew they were actually about 6.38 billion BOE.

A decade later, analysts agreeing with the spirit of Inguanzo's complaint would say the sudden rise in Mexican official oil reserves was powered by the promise of massive if ill advised-foreign loans as much as by the progress of exploratory wells.

CURRENT ESTIMATES

There is a broad divergence of views on Mexico's current proved petroleum reserves.

The very similar estimates of total hydrocarbon reserves by Pemex and the U.S. Geological Survey in October 1991 include the values for oil, gas, and gas liquids reported by Pemex in 1978 for the intractable, nonproducing Chicontepec complex. USGS included Chicontepec data as "indicated reserves." Chicontepec, likely to produce only about 100 b/d/well, would require 10,000 wells for full development.

By removing Chicontepec values from the category of total proved hydrocarbon reserves, the range would be about 18 billion BOE less than Pemex and October 1991 USGS estimates.

Inguanzo, however, subtracts another 18 billion BOE from the official Pemex figures, but the Proceso interview does not elaborate on that point. Regarding Chicontepec, Inguanzo allows only 1 billion BOE vs. Pemex's estimate of 17.6 billion BOE. However, a retired Pemex production manager told me commercial production there is not feasible at all.

As to crude reserves, Pemex and USGS in October estimated the volume at 45 billion bbl vs. Inguanzo and other analysts' estimates of 20-26 billion bbl.

What my research and field interviews in Mexico have suggested is a new question that is not addressed explicitly by other analysts: What is the size of Mexico's currently producing reserves? In relation to this question petroleum engineers in Mexico have told me current oil production is sitting on a base that is less than 20 billion bbl of oil.

It's likely then, that Inguanzo's estimate of 20.9 billion bbl of crude oil reserves refers not to future cumulative production but to the underlying reserves that support current production. Thus if no other known or undiscovered reservoirs were ever brought into production, Mexico's reserves life would be about 20 years, not 50 years.

POLICY QUESTIONS

This discrepancy points to what's at stake in Inguanzo's challenge to the official status quo at Pemex.

If no new reserves were added and production efficiency staved static, most observers would side with Inguanzo. Their reasons for so doing, however, would differ. Only a minority of Mexican critics would agree with Inguanzo that Mexico's solution is to turn the clock back to the time when he was vice-president of exploration and production in Pemex. Few people in Mexico would buy an "all-Mexico solution" to the bottlenecks in Mexico's petroleum industry.

U.S. oil industry observers believe that only with a dramatic upgrading of Pemex's exploration and production abilities can the country hope to bring to market the sizable volumes of undiscovered oil and gas that lie in waters deeper than the 60 m in which Pemex is currently exploring and producing.

While U.S. and Canadian oil field service companies believe they can provide Pemex upgraded technology and drilling and reservoir management techniques, representatives from the producing companies from these countries are skeptical.

As one operating company official put it recently, "A service contractor wants the most revenue per contract, while we want the most oil per dollar invested. In this light, who has the greater incentive for downhole efficiency?

"Pemex is mistaken in its belief it can buy the equivalent efficiency with service companies. Our efficiency is available to Mexico only on some form of an incentive basis."

The producer companies ask: Will Mexico have the raw capital and technological horsepower to exploit known nonproducing fields as well as undiscovered resources needed to supply future domestic energy needs and its crude export clients?

U.S. and Canadian oil producers want the opportunity to apply their capital and expertise to Mexico's undiscovered resources. In their view, Mexico does not vet realize that the basic precept of Article 27 is a commonplace truth in the developing world.

As the CEO of a major U.S. oil company commented, "In Indonesia, the matter of who owns the oil is never discussed. Everyone understands that the people and the government of Indonesia own the oil. We are there not to be owners but businessmen.

"What Mexico does not seem to understand is that the ownership question is a nonissue. What we do expect is to be rewarded in one way or another according to our success."

Much of the direction-and acceptability-of an FTA with Mexico depends on the outcome of the debate over the liberalization of Mexico's oil policy.

As the Industry Sector Advisory Committee on Energy for Trade Policy Matters wrote to the U.S. Special Trade Representative, Carla Hills:

"If Mexican authorities are interested in obtaining outside participation in upstream activities, contractual arrangements could be developed which would meet their constitutional requirements, assure Mexico favorable investment returns, and provide U.S. companies with incentives necessary for participation.

"Liberalization of its laws and regulations in Mexico would increase the value of its hydrocarbon resource base and contribute to efficient reserve additions."

But even an early effort at this sort of cooperation apparently has run afoul of election year politics.

Late last September, the U.S. Export-Import Bank approved loan guarantees to support almost $1.3 billion in U.S. exports to Pemex for four projects in Campeche Sound (OGJ, Sept. 23, 1991, Newsletter). But that application has been hung up since late November because of red tape that has overtones of political pressures associated with the FTA. Accordingly, sources at Pemex think the money won't come at all in 1992.

DEBATE OVER PEMEX

For his part, Inguanzo would have nothing to do with foreign contractors, much less investors.

As far as he's concerned, Pemex is the best source of labor, management, and technology for development of Mexico's petroleum reservoirs.

There are many careerists in Pemex and the oil union who, rightly or wrongly, agree with him. As one retired production manager told me Feb. 14, "I hope the government will not decide to change our basic framework. It would not be to our advantage to have private exploration or production companies operating here because they would not place Mexico's national interests first."

Others would disagree.

Two new debate issues have emerged.

One concerns the role of the oil industry in the long term economic recovery of Mexico. Several Mexican observers, some of them present and former government officials, believe the oil industry should be placed center stage in any economic recovery strategy. As one of those observers told me recently, "We need the revenue of Mexican oil production at the level of 4-5 million b/d. The best, easiest way to achieve such production levels is through association contracts with American companies."

The other debate issue concerns Pemex's technological fitness in exploration and production. Critics say Pemex's problem cannot be reduced to a lack of equipment. "They have more instruments that we do," said one manager of a major producing company.

Pemex's technology problem in reality seems to be a management problem: shortcomings concerning organization of work and inventory management. From this perspective, Pemex's efforts toward implementing the 198991 recommendations of consultants McKinsey & Co.-downscaling, reorganizing along business lines, establishing transfer prices, among others-are not likely to have any appreciable effect on efficiencies in the field.

PRIVATIZATION, FTA

At its most senior level, Mexican government officials are believed to be hard at work building scenarios that include progressive privatization of the state oil sector.

For them, timing is as important as substance. Because it would be unseemly to take such steps in ways that could be misinterpreted as responses to U.S. pressure, they are likely to be postponed until after completion of a U.S.-Mexican FTA. Unfortunately, from their perspective, conclusion of an FTA may depend on their taking unilateral action before a vote in the U.S. Senate.

The proposed FTA also will be affected by the U.S. presidential elections in 1992. During bilateral meetings in Washington in December 1991 representatives of the Mexican government were not given any assurance that such a treaty, if negotiated, could be submitted to the U.S. Congress for ratification prior to the elections of 1992.

The Inguanzos of Mexico would have the federal government scrap such scenarios of progressive privatization without further consideration. It will take unprecedented political courage and financial realism for policymakers to do otherwise. In the event the forces of traditionalism win the policy debate over oil, Inguanzo's gloomy forecast of 1991 is likely to be a self-fulfilling prophecy.

Policymakers in the U.S. and Canada should work with officials in Pemex as well as with those in the treasury, commerce, and energy ministries to quantify options to maintain Mexican oil reserves and production well ahead of domestic demand.

The prospects that oil exports should cease or significantly be curtailed is anything but a trivial matter.

It would be worthwhile undertaking a cost-benefit study of alternative scenarios for partial or progressive privatization of the oil sector. What counts is that the Mexican state continues to set the rules for performance and efficiency and collect agreed-upon taxes.

One operating company official said, "We could work with Pemex on a sliding scale. The more efficient we become, the greater Pemex's share of production."

If it takes collaboration of a U.S. or Canadian oil producer to complement Pemex's efforts in exploration or production, it would be irresponsible of Mexican policymakers to pretend that such an option did not exist.

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