FSO Editorials: Mexico. Oil's Next Basket Case by Bill Powers, 09.30.2003

FSO Editorials

Mexico. Oil's Next Basket Case
by Bill Powers, Editor
Canadian Energy Viewpoint
September 30, 2003

One reason we are likely to see oil prices continue to escalate is the little known fact that Mexico�s oil industry is deteriorating in slow motion. Despite valiant efforts by President Vincente Fox to turn Pemex (Mexico�s national oil company) into a more efficient Western style oil company, Pemex remains a bloated, inefficient enterprise that is dominated by unions. The company ceased being an oil company a long time ago and is now a political entity unlike any other in Mexico.

Pemex was created in 1938 after the nationalization of British and American oil interests in Mexico. Some time after, Mexico�s ruling party, the Institutional Revolutionary Party or PRI, changed the country�s Constitution to bar foreign investment in underground oil and gas. �Expropriation Day� is still celebrated as a national holiday in Mexico each year.

Graft and corruption have been a large part of Pemex�s history right from the start. The company currently has 139,000 employees, up from 121,000 in 1996. To produce only slightly more oil and gas than Venezuela, Pemex employs three and a half times as many people as Venezuela's PdVSA. Over 90% of Pemex employees belong to the Oil Workers Coalition whose longtime boss, Joaquin Hern�ndez Galicia, served seven years in prison for weapons violations.

Another black eye for Mexico�s oil industry involves the former director of Pemex, Rogelio Montemayor, and the head of its union, Carlos Romero Deschamps. It is alleged that both gentlemen, who are very involved in the PRI party that was defeated by Fox in 2000, stole tens of millions of dollars from Pemex to help fund the campaign of Fox�s opponent. The investigation into the theft is running into significant roadblocks because Mr. Deschamps holds a seat in Congress and is free from prosecution and Mr. Montemayor is fighting extradition from Houston.

Despite its virtual monopoly over the oil industry in Mexico, Pemex continues to lose money year after year. The government of Mexico views Pemex as a quasi-governmental piggy bank since it relies on taxes from Pemex for 40% of its revenue. High taxes and corruption (estimated to be over $1US billion annually) have caused the firm to lose several billion dollars a year for several years running. These deficits have severely inhibited Pemex�s efforts to develop new oil and gas fields and to upgrade its refineries. The six refineries owned and operated by Pemex are in such a horrific state of disrepair that Mexico now imports 25% of its gasoline.

While Pemex has many managerial and financial problems, its biggest challenge is maintaining and increasing its oil and gas production. Today, Pemex produces 3.3 million barrels of oil a day (mmbod) and exports 1.8 mmbod (1.5 mmbod to the US). The company has proven reserves of 20 billion barrels of equivalent (boe) (86% oil and 14% natural gas). It should be noted that this reserve figure has been reduced several times over the years and may still be overstated. The 20 billion boe of reserves represents less than a 15-year reserve life and is a major cause of concern for both Pemex and Mexican officials. Pemex has stated that its goal is to replace 100% of production with new reserves by 2006, however the firm is not making the capital expenditures needed to attain this goal. While Mexico�s oil production has been on the upswing lately due to a considerable increase in spending, I see production declining relatively soon.

A great deal of Pemex�s exploration and production spending has been directed to its offshore Cantarell field in the Bay of Campeche. Cantarell is world�s second largest oilfield, behind Ghawar in Saudi Arabia, having produced an average of 1.9 mmbod in 2002. Recent production is up significantly from 1996 when the field produced only 1 mmbod. Much of this increased production is a result of aggressive drilling and a significant nitrogen injection program that was completed in 2001. While Pemex has had significant success in maximizing production from Cantarell, it is having difficulty keeping production stable elsewhere in the country. It is estimated that from 1996 to 2002, production outside of Cantarell fell a whopping 600,000 barrels a day (18% of current production).

Growing domestic consumption of oil is going to become a much larger concern for the country in the future. To put some numbers behind this statement, consider the following facts: Mexico�s current domestic consumption is 1.5 mmbod and is growing at 2.5% a year. While this might not seem like rapid consumption growth, it is nearly double the country�s oil production growth rate.

President Fox has had some success in reforming Pemex during his tenure in office. One of his larger successes was the avoidance of an oil workers strike last October. Fox convinced Pemex�s rank and file to support his wage increases against the advice of union leaders. While it is encouraging to see Fox have some success in turning around Pemex, I believe his efforts are too limited and too late. It is unlikely that Fox will be able to make the key changes required, such as allowing foreign participation in the oil industry, to keep Mexico from becoming an oil importing country before the end of this decade.

Mexico’s demise as an oil exporting country could not come at a worse time for oil importing nations. Unless a significant discovery is made within the next 12 months, expect declining exports from Mexico within the next three years. As Mexico makes the journey from oil exporter to oil importer, look for oil prices to head much higher.

Bank of Canada Lowers Rates Again

On September 3^rd, the Bank of Canada lowered its key overnight lending rate by one quarter of a point to 2.75%. The BOC gave plenty of ridiculous reasons for their action. The announcement sighted Mad Cow disease, SARS, the forest fires in British Columbia as well as the blackout in Ontario as reasons for lowering rates.

I find the drop in the Canadian overnight lending rate a thinly veiled effort to not let the Canadian dollar appreciate too rapidly against the US dollar. The Bank of Canada has certainly done its best to print money this year. Doug Noland, the Prudent Bear�s outstanding credit analyst, noted that Canada�s broad money supply (M3) expanded at a 10.2% annualized rate since the beginning of 2003.

Try as BOC Governor David Dodge may, his actions are no match for the problems facing the US dollar. With the US dollar straining under the enormous weight of a strikingly large federal deficit, a gaping trade deficit and mounting US debt, look for the Canadian dollar to resume its march to parity with the US dollar.

Will the US Reach 3 TCF?

One the biggest debates among North American energy observers concerns whether the US will have 3 trillion cubic feet (tcf) of natural gas in storage by November 1^st. Some argue that after this summer�s very large injections, we will easily reach the magical 3-tcf mark and natural gas prices will decline into the low $4.00US range. I believe we have already witnessed the bottom for natural gas prices this year and are about to see prices head much higher as we head into the winter heating season. Here is why.

The record injections experienced during the spring and summer months were the result of demand destruction rather than new supplies of natural gas becoming available. Many utilities were spared from operating their natural gas fired peaking units for extended periods this summer due to the mild summer weather in some of the largest natural gas consuming metropolitan areas. Weather related demand destruction is very fickle and cannot be relied upon for expended periods of time.

Industrial demand destruction also played a significant role during the 2003 injection season. Dow Chemical, for instance, slashed production of chlor-alkali, a petrochemical used to make products such as compact discs, at its Plaquemine, La., plant near Baton Rouge. Dow transferred production to a region not normally known for its low costs � Europe. One of North America's largest fertilizer manufacturers, Potash Corp. of Saskatchewan Inc., drastically cut production of potash and urea this past summer. To take advantage of high natural gas prices, the company decided to limit its fertilizer production and sell some of its natural gas futures contracts.

Investors should try not to focus too much on the short-term storage numbers and keep the bigger picture in mind. Even at today�s prices, we are seeing only a moderate drilling response and natural gas production continues to fall in the US and Canada. Unless we see a significant pick up in drilling activity with in the next couple months, 2004 will be the third consecutive year of falling natural gas production in the US. Despite the recent large injection numbers in the US, I expect US natural gas prices to spike to over $10US this winter as we see demand pick up and production continue to fall.

US Oil Imports Hit Record Levels

In the US Energy Information Agency�s weekly petroleum report, the agency announced that the US imported a record 10.8 million barrels of oil per day in the week ending September 12th. Below is a quote from the report:

�U.S. crude oil imports averaged nearly 10.8 million barrels per day last week, the highest weekly average ever, and up by over 1.1 million barrels per day from the previous week. Crude oil imports have averaged 10.2 million barrels per day over the last four weeks, 944,000 barrels per day more than averaged over the same period last year.�

While massive imports have done a lot to keep US inventory levels from dropping further, we are still heading into the demand heavy winter heating season at inventory levels that are below average. The following is also from the EIA weekly report:

�With imports reaching record levels last week, U.S. commercial crude oil inventories (excluding those in the Strategic Petroleum Reserve) rose by 3.1 million barrels. At 279.3 million barrels, they are 23.0 million barrels less than the 5-year average for this time of year. Distillate fuel inventories rose by 2.9 million barrels, with high-sulfur distillate fuel (heating oil) increasing by 2.2 million barrels, with the rest of the increase in low-sulfur distillate fuel (diesel fuel). Motor gasoline inventories rose by 2.7 million barrels, and as of September 12 are at 195.3 million barrels. Total commercial inventories are 73.9 million barrels less than the 5-year average for this time of year.� (Emphasis added)

Investors should consider increased US dependence on foreign oil as very bullish. With the world�s largest economy and consumer of oil forced to depend on foreign countries to ship it oil in return for rapidly declining dollars, there is little doubt that the price of oil will soon be much higher.

Contact Information
Bill Powers
773-271-7574
Email | Website

Information presented in this newsletter was obtained from sources believed to be reliable, but accuracy and completeness and opinions based on this information are not guaranteed. Under no circumstances is this an offer to sell or a solicitation to buy securities suggested herein. The editor may have an interest in the companies mentioned. All data and information and opinions expressed are subject to change without notice.