The Heritage Foundation

Backgrounder #923 on Latin America

December 15, 1992

December 15, 1992 | Backgrounder on Latin America

Oil and Prosperity: Reforming Mexico's Petroleum Monopoly

(Archived document, may contain errors)

923 Decernier 1s; 1992 OIL AND PROSPERITY REFORMING MEXICOS PETROLEUM MONOPOLY INTRODUCTION Ever since its discovery in 1901, oil has held a s pecial place in Mexico as a symbol of the countrys sovereignty, national pride, and hope of prosperity. Nationalized in 1938, the oil in dustry was regarded as so impoitant to the nations firture that all facets of it, from explora tion to refining, were reserved exclusively for the government.

Half a century after its creation, however, Petroleos Mexicunos (PEMEX the government owned petroleum monopoly, is in disarray. Mismanagement, corruption, bmaucratic inertia insufficient investment, and a host of problems endemic to all state-owned indust r ies have un necessarily limited the growth of an industry central to Mexicos economic development. So extensive are its failings that the existence of a state-owned, exclusively Me&x.n oil industry has become a major obstacle to Mexicos true national inte rest the development of a prosper ous, modem economy.

PEMEX Under Scrutiny. As with so many other state-owned industries around the world PEMEX is undergoing an unaccustomed scrutiny. In part, this attention has been farced by the monopolys poor performanc e in the face of global economic pressures, growing indus trial demands at home, and competition from abroad. At the same time, bsident Carlos Sali nas de Gartaris efforts to ~estrucm the Mexican economy-including privatizing state owned industries and op ening the country to foreign investment-have introduced a free-mar ket outlook and approach that is at cross-purposes with the mercantilist, anticompetitive phi losophy which underlies PEMEX.

But Salinas has yet to tackle PEMEX head on. The fundamental tra nsformation of PEMEX that many observers had predicted, including even its possible privatization, has yet to materi alize. Salinas has farced a reorganization of the company, dividing it into a central holding company plus four independent secm accarding to function: exploration and production, re fining, natural gasbasic petrochemicals, and secondary petrochemicals. But most of its mo nopoly powers remain in place, and the private sector-Mexican as well as foreign-still is largely excluded from the petro leum industry.

PEMEXs resiliency owes mm to politics than to a good pdormance. The d monopoly was mated as a political symbol of Mexicos sovereignty and resistance to an imagined UNted States economic imperialism. Modeled on the state socialism pardgm whic h dominated the 19309, PEMEX was vigarously promoted as the most effective means of economic development as well as a social vehicle for sharing the wealth of the oil industry with the broad public.

PEMEX is the most prominent product of the failed politi cal and economic ideology that Salinas inherited, and is attempting to change. That legacy-the product of the quasi-socialist authoritarian governments of the past-is one of state control of the economy, hostility to pri vate business, and suspicion of th e U.S. However politically attractive this philosophy may have been in the past, its results have been disastrous for Mexico in every sector of the econ omy in whfch it was applied. The acknowledged bankruptcy of this ideological approach has allowed Salin a s to tackle successfully many of the formerly untouchable bastions of Mexicos socialist past, most notably his reform of the communal farming sector, sale of state-owned in dustries, and jettisoning of protectionism. But PEMEX remains intact, surrounded b y a politi cal minefield of entrenched interests which m prepared to resist an all-out effort to dismantle the monopoly. Among the fiercest defenders of PEMEXs privileged position is the leftist Partido Revolucionario Democratic0 (PRD and the left wing of S alinass own party-the Partido Revolucionario Institucional(PlU Destruction of Myths. Given this powefi opposition, a successful refom of PEMEX will quire extensive public education in Mexico, including exposing the political myths which surround the monop o ly. The most ingrained, and most destructive, of these myths are Myth #l: An opening of the petroleum sector will benefit foreigners primarily, to the detriment of Mexicans; and Myth #2: A state-owned oil monopoly is of significant political and economic b enefit to Mexico Myth 1. The first of these, the belief that foreign oil companies and foreign countries will be the primary beneficiaries of a dismantling of the monopoly, carries enormous emotional weight. The image of PEMEX as a protector of Mexicos oi l wealth against foreign depreda tions has a David vs. Goliath, populist political appeal that is difficult to dislodge and which is used, often quite cynically, by Mexican politicians. For example, attempts by U.S. and Ca nadian officials in the North Ame rican Free Trade Agreement (NAFIA) negotiations to ob tain a greater opening of the Mexican oil industry were used by Mexican officials to score PO litical points at home through their obstinate defense of this national resource.

It is a profound mistake, however, for either U.S. or Mexican officials to regard an opening of the oil sector as a concession to the U.S. To begin with, the liberalization of the petroleum sector need not involve foreign participation. Even a limited reform that permitted competi tion but restricted it to Mexican companies would be an improvement over current conditions.

While the U.S. indeed would derive some minor benefits from a relaxation of PEMEXs grip such as an inmase in the.expm of oil equipment and technology and a greate r diversification in the world supply of oil that increased Mexican production would bring, these pale in com parison to the benefits that Mexico itself would obtain from a more efficient petroleum indus try Myth #

2. The prominence of the issue of foreig n participation and the equating of PEMEX with Mexican nationalism obscure what should be the focus of the real debate regarding PEMEX: its heavy costs to Mexico. Far from being an economic boon, PEMEX has proved 2to be a very costly experiment for Mexico . Its monopoly powers and the resulting stifling of market forces have hobbled the development of a modem oil industry, and the resulting ineffi ciencies have heavily burdened the larger economy which depends on it. Once the worlds fourth largest exporter o f oil, Mexico will become a net importer by 2004 if current trends continue. The cause of this decline in fortunes is not to be found in dwindling oil resources Mexicos proven and probable reserves are conservatively estimated at over 160 billion bar rels and geologists are confident that vast new fields await discovery and development. In stead, responsibility for PEMEXs increasingly costly failure stems from its very nature as a state-owned monopoly, one which has been inexcusably mismanaged by politicia ns.

How Mexicos interests are advanced by this hemorrhage of resources and the continued constriction of a major industry is difficult to imagine. Economically, there is no question that it is an enormous burden on the entire economy; the historical record admits no contradiction of this. Even a wealthy country would be hard-pressed to continue this expensive indulgence and Mexico remains far from wealthy.

Thus, the sole rationale for PEMEX is a political one. The only question is whether or not the politi cal benefits are worth the economic price. That they are not is demonstrated by the Mexican governments own actions in other areas of the economy. In the NAFTA, Mexico has chosen to abandon itshpovkrishing protectionism by integrating itself into North Am e r ica. Hostility to the U.S. and the outside world in one sector of the economy and an embrace in all other sectors represent two clearly contradictory approaches. One of the two must be wrong, and logic and all available evidence point to the former. Mex i co and the Mexican peo ple as a whole do not benefit from PEMEXs monopoly; the only real beneficiaries of a state owned monopoly are those special interests that promote their own welfare at a cost to the country as a whole and which cynically disguise se lf-interest as nationalism.

Reforming PEMEX. The only effective means of reducing PEMEXs costs to the econ omy is through the introduction of market forces and it is on this that any reform of PEMEX should be concentrated. No administrative reform can acco mplish this task; what is required is the privatization of all or part of PEMEXs activities and the complete opening of the oil sector to competition by private companies. Although certain entrenched interests would suf fer from a reform of PEMEX, includi n g many with powerful political connections, Mexico and the Mexican people without question would benefit greatly from the removal of this weight from the economy be beneficial and should outweigh all other considerations. The politically sensitive issue o f foreign participation clearly is of secondary importance; even a market opening that was re stricted to Mexican companies would be a major step in the right direction. Nevertheless, the economic argument for foreign paxticipation is a strong one, given t he superior technology expertise, and available capital they possess. Should political realities require some limitation on their role, the economic costs of such a come should be made widely known.

The most effective means of building public support for a free market reform of PEMEX is through a public debate and discussion of the oil monopolys me costs and benefits to Mex ico. Until now, discussion of the issue has been dominated by leftist nationalists who have succeeded in creating an image of PEMEX as a symbol of Mexicos national sovereignty while preventing a public examination of the companys failings. Only by exposing the falla cies of the many myths which surround the monopoly can the government hope to defuse the emotionally charged arguments of t h ose who oppose real reform The need for the introduction of .market farces is such that any move in this direction would Liberalizing measures that the Mexican government could implement, in ascending order of importance, include K K Y K at Allowing perfo r mance or risk contracts. PEMEX needs to greatly expand its exploration and development of new oil fields, and risk contracts are needed to at tract foreign companies Changing legislation to allow majority foreign investment in petrochemical production In o rder to attracted badly needed investment in the petrochemical in dustry Salinas has broadened the opportunities far Mexican and foreign private companies in this fperly closed sector. But many obstacles remain. Existing ~e strictions on foreign investmen t need to be removed if foreign capital is to be farth coming Dividing PEMEX into separate, competitive companies. PEMEX recently un derwent an administrative reform which left centralized control largely intact. The companys new divisions need to be given independence if they are to become more efficient Allowing domestic and foreign competition with PEMEX. PEMEXs monopoly powers have done great damage to the Mexican petroleum industry and the Mexi can economy. If PEMEX is to remain a state-owned company, t he government should reduce its costs to the larger economy by allowing unfetted competition in all sectors Privatizing PEMEX. A privatization of PEMEX would create a dynamic and ea cient oil industry in Mexico, and mum enormous profits to the treasury TH E POLITICAL LEGACY OF MEXICAN OIL In countries around the world, natural tesources commonly are viewed not in terms of their economic utility but as a national inheritance to be jealously guarded against foreign theft While understandable, this attitude of t en has led to an unfortunate triumph of politics and emotion over economic rationality, as governments impose numerous restrictions on the ex traction and use of those nsources. Although the political benefits from such measms usu ally are given wide play , their economic costs to the country as a whole are rarely discussed.

In this, Mexico is no exception. For decades, the Mexican government has portrayed oil as a national treasure to be safeguarded from exploitation by foreigners. Mexican nationalists hav e viewed the extraction and export of Mexican oil by foreign companies as a metaphor of Spains looting of Aztec gold four centuries ago. So powerful was this image that even after the government nationalized oil production in 1938, there was considerable resistance even to selling oil to foreigners for fear that others might benefit from Mexicos black gold.

Ironically, the discovery of petroleum in Mexico and the original development of the Mexi can oil industry was the product of foreigners. Oil was discovexed first in 1901 by an Ameri can, Edward L. Doheny, in Tampico, Vera Cruz. This was followed quickly b y discoveries in other locations, and soon major oil companies such as Gulf, Standard Oil, Royal Dutch Shell and others were drilling for oil, mostly along Mexicos Gulf coast. By 1921 Mexico was pro ducing 530,000 barrels a day, or onequarter of the world s output 4 Oil and Politics. In 1910, President Porfirio Diu was overthrown, initiating a seven-year period of political turmoil and civil war known as the Mexican Revolution. The government which eventually emerged was highly nationalist and anti-foreign, particularly regarding the U.S. In addition, it was &creasingly influenced by the socialism then in its ascendancy around the world. Whereas Dim had followed a relatively tolerant policy toward foreign companies including those in the oil sector, the nati o nalists in the new government viewed the fareign oil companies as exploiters, the very symbol of a pervasive U.S. imperialism they believed they were fighting against government and the foreign oil companies over the control of the oil industry and the we a lth it produced. To a large extent, this struggle was an outgrowth of the Mexican governments nationalism and socialist economic policies which opposed the control of such an important sector of the economy by foreign companies. But it also concerned a mo re practical issue who would control the money. The Mexican government maintained that the oil companies we~e not compensating Mexico adequately for the wealth they were extracting and were in stead enriching only themselves.

The battle between the foreign companies the govemment came to a head in March 18 1938, when President Lazaro Cardenas nationalized the British and American oil companies in Mexico, citing their defamation, disobedience, and challenge. In Mexico, the measure was portrayed as a nationa l defense against foreign threats to Mexican sovereignty. A country wide effort was launched to raise the money needed to compensate the oil companies for the expropriations, enlisting even school childFen in what kame a national campaign.

Three months aft er the expropriations, the Mexican government created Petroleos Mexicu nos (PEMEX) and gave it monopoly control over the nations oil industry. The debate over whether the government-owned PEMEX should be run as a profit-oriented company or as a tool for p olitical and social ends was settled when the Oil Workers Union-which was closely tied to Mexicos ruling party, the quasi-governmental PRI-quickly gained control.

Doubled Production. Although politically attractive, union control proved economically unwork able, and oil output stagnated during the first five years after nationalization. Union of ficials in 1942 ceded control of the campany to a board of directors, which ran it on a pfit oriented basis. This strategy, along with increased oil demands from th e Allied Powers in World War 11, helped PEMEX double production during the next decade.

In the 1950s the Mexican government took increasing control over PEMEXs strategic deci sions and operations, with unfmnate results. By foregoing price increases, the go vernments policies impoverished the company and pvented it from investing in new equipment, explo ration, and refming operations. By the late 1950s, PEMEX was nearly insolvent, unable to pay its taxes or repay its loans. Corruption became widespread as th e politicians now in charge of PEMEX handed out contracts as political patronage. Under such a regime, PEMEX did not surpass its 1921 production levels until 19

72. By then, Mexico-a country with the worlds fifth largest oil reserves-was importing over lO0 ,OOO bmls a day from Venezuela hated to safeguard Mexicos oil, PEMEX had been converted by politicians into a political tool, one which was draining wealth from the country In the years following the Mexican Revolution, a long struggle began between the M e xican 1 Alan Riding, Distant Neighbors: A Portrait qfthe Mexicons (New York Alfred A. Knopf, 1985 p. 158 5 PEMEX AND THE ECONOMIC CRISIS Although oil has played a major political role in Mexico since the Revolution, its promi nence in the Mexican economy emerged only in the 1970s. Major discoveries-a 20-billion barrel field in Tabasco in 1972 and a 17-billion-barrel-field near Vera Cruz soon after-were followed by a quadrupling of the world price of oil in 19

73. As a result, Mexico became the sudden and u nexpected beneficiary of enormous and ever-increasing wealth try, seeing oil as the means to fund the modernization of Mexicos economy. Lopez-Portillo poured $15.5 billion into PEMEX with the goal of increasing production from 800,OOO bar rels per day in 1976 to 2.25 million in six years. From 1978 to 1980,28 percent of all Mexi can public expenditures were spent on PEMEX in pursuit of this goal?

Meanwhile, Mexicos proven reserves continued to grow. In 1977, offshore reserves of 34.4 billion barrels were d iscovered in the Gulf of Campeche. By 1981, Mexico ranked fifth in the world, with 72 billion barrels in proven reserves and an additional 90 billion barrels in estimated reserves. Mexico also ranked seventh in natural gas reserves, with major discover ie s constantly adding to its total in Mexico that oil was the answer to all of the countrys financial and developmental prob lems. Confident in its future income from oil exports, the Mexican government borrowed enormous sums to finance vast government spend i ng programs. International banks were eager to lend, secm in the knowledge that the price of oil would continue to inmase bling were commonplace. But in 1981 the world price of oil crashed, falling by half. One im mediate casualty was Mexicos solvency. It quickly became apparent that, cut off from addi tional barrowing and vastly overextended, Mexico would not be able to service its existing in ternational debt of nearly$90 billion, onequarter of which was owed by PEMEX alone.

Diverting Revenues. Resident Miguel de la Madrid took ofice in 1982 amid a rapidly worsening economic crisis. Desperate far cash, de la Madrid decided to use PEMEXs foreign cmncy revenues to cover the nations $16 billion in international debt obligations for 1982.

For the next five y ears, PEMEXs revenues were diverted away from investment in its own production and refeg operations toward Mexicos debt payments. The resulting loss of in vestment in PEMEX led to neglect of existing infrastructure and new production, resulting in a stead y decline in output. By 1992 PEMEX produced less than one-third of Mexicos foreign currency earnings, down from 80 percent in 19

86. Nevertheless, the government continues to extract a large partion of its revenues from taxes on PEMEX, approximately $10 billion, or one-third of all taxes collected in 19

91. Condemned to inefficiency, repeatedly exploited by the government as a source of ready income, a failure in its primary mission, PEMEX has be come a heavy burden on the economy In 1976, Jose Lopez-Porti llo became President of Mexico with ambitious plans for the coun In this heady atmosphere of seemingly unlimited wealth, a widespread perception took hold And for a time, it did. Oil prices doubled again in 1979, and predictions for yet another dou 2 Ibid p. 165 6 OPENING MEXICOS OIL INDUSTRY: THE NEED FOR DEBATE There is little doubt that dramatic changes are needed to modernize Mexicos oil industry and make it more responsive to market farces. Many issues, however, are clouded by rhetoric and there is sh a rp disagreement in Mexico over which reforms should take place. Free market reformers want to open the Mexican oil sector to greater domestic and foreign participation while leftist Mexican nationalists want to rescind even the most recent reforms of PEME X . It is clear that the political costs of liberalization could be substantial, if these issues are not properly addressed. Too often, assertions about the importance of PEMEX go unchallenged the result being to inhibit effective action by the government. T he best method for dealing with many of the myths which surround PEMEX is to expose them to a public debate and to examine the most emotionally based and politically sensitive arguments against opening Mexicos oil industry. These include Does Mexico Profi t from PEMEX When the foreign oil companies were nationalized in 1938, the governments slogan The Oil is Ours mimrred the sentiment that the profits from Mexican oil belonged to the people.

But placing oil revenues into the governments coffers does not nec essarily benefit the Mexi can people. Not included in these calculations are the substantial costs to the Mexican econ omy as a whole resulting from PEMEXs monopoly position. Its inefficiency and monopoly powers have limited the development of what should be one of Mexicos principal industries.

The thriving, world-class, private Mexican oil industry that should have developed-along with its new jobs and higher tax revenues has not materialized. Other resources such as nat ural gas are greatly underutilized PEMEX cannot deliver its surplus of natural gas in south ern Mexico to users in the industrial north, necessitating imports from the U.S. It is estimated Mexico will needlessly b ecome a net impr of oil by 2004 because PEMEX cannot de velop even existing resources, much less bring new ones into production. Already, an average of 75,000 barrels of gasoline per day must be imported because PEMEX has been unable to increase its refin ing capacity. The money used to import oil will divert resources fnrm indus trial investment within Mexico.

Some Mexicans argue that because PEMEX pays such high taxes, it benefits the national economy as a whole. To be sure, in 1991 the Mexican government t k $9.9 billion from PEMEX in taxes, representing 94 percent of PEMEXs gross profits. But this seemingly high level of tax income is illusory. For one thing, PEMEX is currently pumping only 2.6 mil lion bmls per day, but most oil experts estimate that p r oduction could be increased to 4.5 million barrels per day through more efficient operation. If taxed at the regular Mexican wr porate rate of 35 percent, this extra 1.9 million barrels per day would almost double tax reve nues. ment and a consequent decl i ne in PEMEXs infrastructure, exploration, and production. The long-term costs in foregone development in this industry alone outweigh the quickly dissi pated tax revenues, to say nothing of the resulting costs to the larger economy stemming from the hobbl i ng of one of its most promising and central sectors Y More important, this confiscation on PEMEXs earnings has resulted in severe under-invest 3 Sergio Sarmiento, The Restructuring of Pemex. El Financier0 Internafional, June 22,1992, p. 9 7 Is Mexlcos Sov e reignty Threatened by Foreign Oil Companies Since the Revolution, Mexico has labared under the illusion that its industries needed spe cial protection from foreign hats. Realizing the enormous costs to the Mexican economy re sulting from these policies, S a linas has hwn this approach overboard and moved quickly to open the economy to the outside world and attract foreign investment. But the old defensive mentality still reigns in the oil industry The hostility to the foreign oil companies stems, in part, fr o m a belief that Mexico had little control over its oil sector before 1938 and that extraardinary measures, including state owner ship, were required to create an indigenous industry. Regardless of the situation in the past however, there can no longer be a realistic fear that foreign oil companies will act as sover eign powers in Mexico; no one can credibly argue that the Mexican governments authority over the economy is too limited or that the private sector is too unrestrained.

Similarly, Mexicans need n ot fear that their own people will have little influence in a pri vate oil industry. After nationalization, a sophisticated, albeit inefficient, petroleum industry was developed, with virtually all positions fded by Mexicans. Mexican engineers, geologists accountants, lawyers, economists, managers, and technicians would be indispensable to com panies wishing to operate effectively in Mexico ist model of development with strong anti-U.S. and anti-fareign sentiment. Although politi cally useful to some inter e sts, such economic nationalism is self-destructive. As late as 1982 bsidemt Lopez-Portillo nationalized all commercial banks in Mexico, ostensibly to protect the nation from ffareign interests. The result of this and other such politically based mea sures was an economic crisis lasting a decade Mexico has paid a heavy economic price for a governing ideology which combined a social What Are the Costs of Political Control?

Although the 1938 nationalization was politically popular in Mexico, its economic cost s are still being felt. In Mexico, and in dl other countries, government intervention in the economy far political reasons always has economic costs, even if these are not widely mognized. Eco nomic nationalism often collides With economic reality. For ex a mple, in 198 1 PEMEX an nounced a $2 increase per bad in the price of its oil despite a global price drop. PEMEX jus tified the action with the nationalist argument that it would not let foreign buyers dictate the price of oil. That political decision xwe ived strong suppart inside Mexico, but cost Mexico 1 billion in lost contracts in the first month alone. PEMEX was forced to reverse its decision one month later.

Political control of an industry such as oil means that rewards m distributed not on the basi s of economic merit but according to political clout. The Mexican Oil Workers Union played a key role in supporting President Lauuo Cardenass nationalization of the industry.

Afterwards, PEMEX gave the labor union power to award up to 50 percent of all it s supply and service contracts. In many cases these contracts went to companies owned by union of cials, leading to overbidding and shoddy service. This inmased the overall cost of PEMEX operations and lowered profitability that, in turn, discouraged rein vestment. Union control also led to gross overstaffing and an abysmal productivity =cord.

In the absence of competition, management was able to run the company inefficiently and often corruptly. During President Luis aheverrias administration, PEMEX manage ment be came involved in numerous contracting schemes involving kickbacks and overbilling that di 8 verted millions of dollars in profits from the company. Under Lopez-Pdo the theft has been estimated in the billions of dollars Will Mexico Benefit by Pump ing More Oil Now?

Opponents of privatizing Mexico's oil industry attempt to put a positive spin on PEMEX's lackluster development record by arguing that Mexico benefits from keeping oil in the ground for future extraction and sale. But there is a world oil glut, and all estimates point to decades of ample world supply. The oil-producing nations of the Middle East have increased produc tion of crude oil'and expanded their =fining capacity and distribution network as part of a strategy to keep world oil pric es low and supply plentiful. If Mexico continues producing at its current rates, it will simply lose revenues. It will lose even more revenues if, as expected less expensive alternative fuels become widely available in the coming decades.

Optimal productio n for Mexico today is estimated at 4.5 million barrels, a 73 percent in crease over existing levels of 2.6 million day. At current rates of production, Mexico will not exhaust these =serves for sixty years. This estimate is actually conservative becaur it does not include possible discoveries in promising mas PEMEX has not yet explared. Tens of billions of bmls could be extracted from existing reserves with the advanced technology horizontal drilling, water injection, deep sea drilling, and seismic explora t ion-that interna tional oil companies could provide. Without foreign investment, these economic opportunities will be lost to this generation that has mare pressing and realistic problems than hypothetical ones Mexico may face in fw years LIBERALIZING THE MEXICAN OIL INDUSTRY The situation in PEMEX was only one of many problems in the economy facing Salinas upon his taking office in 19

88. Although he has successfully implemented far-reaching free market xefanns throughout the economy, his reshaping of PEM EX has been limited to modest administrative measures which are insufficient to cmt the monopoly's many failings. The greatest obstacle he faces axe the powerful political interests which view the creation of a gov ernment-owned petroleum monopoly as the m ost important accomplishment of the Mexican Revolution. These political factors inevitably distort decision-making on the economy. For ex ample, during the negotiations for the NAFTA, the Mexican government successfully ex cluded the petroleum sectur from the market-opening provisions of the agreement, and for eign investment remains all but impossible in most mas of the oil industry. This "victory however, means only that Mexico will be denied the capital and expertise needed to wive its oil sector.

These political victories, however, are purchased at considerable cost to the economy, and any government which is serious about modernizing the Mexican economy and creating con ditions for long-tern growth eventually must find a way to liberalize the petroleu m sector 4 5 The Impartance of Energy to a FreeTrade Agreement with Mexico American Petroleum Institute, Policy Analysis Department, June 1991, p 5. Joseph P. Riva, Jr Mexican Petroleum Congresshd Research Service, Library of Congress, Report No. 83-178 SP R September 8,1983, p. 30.

I 9 There are a number of steps which the government could take which would improve PEMEXs performance. In ascending order of importance, it could Allow performance or risk contracts Exploration for oil was hard-hit by the declin e in investment in the 1980s. From 1980 to 1990, proven oil reserves actually shrank by 10 percent as exploration slowed and few new wells weIe drilled. In 1990 PEMEX announced plans to raise $20 billion in investment over the next five years 8 billion of that fiom international capital markets, mostly for purposes of exploration and production6 So far PEMEX has attracted around $1.6 billion in invest ment, far short of what it needs to sustain even current production. Oil analysts estimate that it will ta k e an additional $3 billion per year far the next five years to meet rising domestic de mand for gasoline-which is increasing at 8 percent annually-and also maintain current ex port levels of 1.3 million barrels per day nomic sense, even when reform is the stated goal. Far example, PEMEX has begun awarding contracts to fmign oil companies for explaration and drilling, primarily to take advantage of these companies expertise and advanced technology. Unfortunately, PEMEX restricts these companies to fixed-fee or seMce contracts in which a set amount is paid for specific ser vices. In general, however, international oil companies prefer to operate under what are known as risk contracts. Under these contracts, oil companies use their own funds to ex plore for oi l and are compensated with a percentage of the oil they discover. Current Mexican law, however, prohibits any fmign claim to oil. Since fixed fee contracts will not attract most foreign oil companies, PEMEX has been forced to raise badly needed capital by borrowing abroad, a limited option due to PEMEXs existing heavy debt load.

Even when successful, fixed-fee Contracts are very costly for Mexico. Drilling for oil is a risky and costly business, and many dry wells are drilled before a profitable site is located.

Under fixed-fee contracts, however, PEMEX is obligated to pay companies for all wells drilled-even those that produce little or no oil. In addition, under the fixed-fee arrangement sexvice companies provide none of their own capital. An illustrative examp l e is the recent con tract between PEMEX and Triton Engineering, a U.S. oil company. PEMEX paid $20 million forTriton to drill for crude. Although not yet under production, the well is expected to pro duce only 50 barrels per day in a field that produces 5 00,000 barrels per day. With risk con tracts, U.S. companies would get only a percentage of the oil they actually find, and would not be compensated for unproductive wells. Under fixed-fee contracts, PEMEX assumes all risk and expenses.

Opponents of risk-b ased contracts claim these violate the Mexican Constitution. However Salinas could allow risk or performance-based contracts without violating the provision that only the Mexican government may own the oil. Ecuador, for instance, has a similar constitu ti o nal pmhibition; risk contracts are allowed by awarding royalties on the oil produced to for eign companies that locate and drill for it, while the actual ownership of the oil =mains with Ecuador Despite these limitations, PEMEX continues to follow practic e s which make little ecc 6 Damian Fraser, Mexican Oil Reforms Still Have a Long Way to Go, Financial Times. May 31,1991. p. 25 10 Change legislation to allow majority foreign Investment in petrochemical production The Mexican petrochemical industry is in g r eat need of foreign investment. According to the Mexican Petrochemical Commission, Mexico is becoming increasingly reliant on petro chemical imports because of shortages in domestic supply. Although Mexico today enjoys a small trade surplus in petrochemic a ls, its petrochemical plants are running at 97 percent capac ity. Mexico currently imports 50,000 to 100,OOO gallons of gasoline per day because of a shortage in its own refining capacity? The mandated introduction of unleaded gasoline in Mexico to combat air pollution will greatly increase the demand for petrochemicals used in gasoline refining. By 1995 the Commission expects petrochemical imports to reach $8.6 bil lion.

Although the Mexican constitution reserves ownership and production of oil resources to the state, it does not explicitly prohibit foreign investment in petrochemical production. Under Mexican law, petrochemicals are classified as basic (or primary secondary, and tertiary, de pending on their level of refining and processing. Under curren t restrictions, foreigners are al lowed 100 percent ownership in tertiary production and 40 percent ownership in secondary petrochemical production, but are completely excluded from producing primary petrochemi cals, which are reserved exclusively for the state.

As PEMEX's investment funds contracted in the 1980s, its investment in petrochemical production declined as well. The Mexican government attempted to compensate for this by at tracting investment from the private sector. In 1986, the government broa dened the opportuni ties far private companies by reclassifying 36 primary products as secondary petrochemicals.

This was the initial step in a strategy which hsident Salinas has since greatly expanded whereby this fonnerly closed sector of the oil indust ry has been privatized de facto by use of a low-key, administrative approach which has avoided a political backlash. In 1989, Salinas further pared the 36 primary products reserved to the state to 22 and the 700 secondary petro chemical products to 66, th ereby further opening the sector to domestic and foreign participa tion. In 1992, all but two basic petrochemicals were reclassified as secondary?

For private Mexican petrochemical companies, these reclassifications have opened import ant new opportunities . Foreign companies nevertheless still face many baniers. Particularly troublesome is Mexico's outdated fomign investment code, which severely limits foreign ownership and control of Mexican companies. Restricted to minority ownership of Mexican petrochem i cal companies, foreign concerns have been reluctant to invest large sums without management control over production decisions 8 7 8 9 Mguel Angel Sanchez and Ted Bardacke, "The Private Memoirs of petroleos Mexicanos El Financier0 International February 10 , 1992, p. 15 The Importance of Energy to a Free- Agkment with Mexico American petroleum Institute, Policy Analysis Department, June 1991, p. 7 U.S. Mexico Energy: The U.S. Reaction to Recent Reforms in Mexico's Petrochemical Industry United States General A ccounting Office, Report to the Chairman, Subcommittee on International Economic Policy and Trade, Commitfee on Foreign Affairs May 1991, p. 4 10 'Ihrough the cmtion of a Mexican "trust,ft foreign companies can acquire majority ownership ova existing seco n dary petrochemical production. However, this process--which involves the creation of a series of subsidiaries over which the foreign company has minority control at each level, but ends up with aggmgate majority ownership-is complicated and exposes the co m pany to multiple taxation liabilitia PEMEX to Relinquish Basic petrochemical production 11 Foreign petrochemical companies are also reluctant to invest in secondary and tertiary pet rochemical production because the building blocks for their products, the basic petrochemi cals are still produced and controlled by PEMEX, which is unable to guarantee a constant supply at free market prices. In addition, these companies fear that the executive decrees Sali nas has used to reclassify petrochemicals could be ea sily overturned by his successor unless they are made more secure through legislation.

Some foreign investment is taking place through joint ventures between PEMEX and pri vate companies. For example, PEMEX and Valero, a U.S. petrochemical company, have m ated a joint venture to construct and operate a plant making MTBE, a chemical additive used in the making of unleaded gas. However, joint venms alone will not bring in the estimated 5 billion to $10 billion needed to solve Mexicos shortfall in petrochemic a ls cal sector. Salinas has made enormous strides in opening this industry to private and foreign investment through the use of presidential decrees, but he may have already exhausted the possibilities of this administrative approach. A more permanent, con s titutional basis must be established for opening Mexicos petrochemical industry to the outside world if Mexico is to attract the investment that it needs It is clear that half-measures of ref= have not been sufficient to liberalize the petrochemi Divide P EMEX into separate, competitive companies.

When PEMEX was created in 1938, it was given responsibility for operating all sectors of Mexicos oil industry that had previously been controlled by seventeen foreign oil companies.

That mandate became more diffi cult as the industry diversified and began manufacturing pet rochemicals. Centralized PEMEX control over everything from exploration and. crude oil pro duction to distribution, marketing, and relining of petrochemicals has prevented these indus tries from growing efficiently.

In 1989 President Salinas initiated a modest restructuring of PEMEX, reducing the size of its bloated work farce and reorganizing the exploration and production divisions. Then, in April 1992, a series of explosions caused by a leaky PEMEX pipeline in Guadalajara killed over 200 people and devastated an entire section of the city. The resulting public outcry gave Salinas an oppurtunity to,push th~~~gh a much more thorough restructuring of PEMEX. This reorganization centered on a divis ion of the company into a central core and four independent divisions: exploration and production, refeg, natural gas and basic petrochemicals, and sec ondary petrochemicals.

Despite Salinass extensive reorganization of PEMEX, his refms are less than meets the eye. PEMEX will retain most of its former control as a holding company for these subdivi sions. Although each division will have its own bod of directors, the president of PEMEX will preside over each; these new boards will have only limited power to determine invest ment and operational plans and limited responsibility regarding finances. The holding com pany will be responsible for all taxes, will regulate prices among the various divisions, and will set strategic goals. The subsidiaries have no bud g et of their own, but instead are depen dent on PEMEX for their funding El Financier0 Internacional, August 31,1992, p. 26 12 This continued centralization will deny the subsidiaries the flexibility they quire to re spond to changes in their industry and w ill pvent them from becoming more efficient, Fur ther, the restructuring failed to remove political appointees from the operations of these divi sions, ensuring that political favoritism, not efficiency, remains the criterion for major deci sions.

It is Mi cult to know what Salinas has in mind for PEMEX. Some see this reorganization as but the first step in a more thoroughgoing privatization of the monopoly; its division into four subsidiaries could make the process mm politically palatable by allowing a fu t ure liber alization to take place one sector at a time. The industry would best be served by a complete privatization, but if the intention is to retain state control, a much more beneficial approach would be to make each division truly independent, respo n sible for its own budget and opera tions and able to determine foreign participation in its activities. Most important, each divi sion should be operated on a for-profit basis. Political interference should be curtailed by giv ing these new companies auto nomy, and the Oil Workers Union should lose its monopoly status.

By this reorganization, many of the worst characteristics of PEMEX can be ameliorated even though government ownership will ensure continued inefficiency Allow domestic and foreign competition with PEMEX.

Mexicos oil industry is in serious need of capital, management expertise, and advanced ex ploration technology, but the Mexican government does not have the necessary resources to in vest in these. Although attempting to squeeze mm efficiency out of PEMEX through mr ganimtion will produce some benefits, such gains will inevitably be limited and incxeasingly diMicult to obtain. Without question, the most effective way of achieving maxi mum gains is by privatizing the petroleum industry altogether. But even if PEMEX is to remain a state owned company, significant results can be obtained by giving PEMEX competition from the private sector.

Most of PEMEXs failings and burden on the economy stem not from the fact that it is owned by the state-although that is a serious limitation-but that it is a monopoly. It is not only foreign companies which ate bamd from most sections of the petroleum industry; Mexi can companies are excluded as well.

Wi thout competition from the private sector, PEMEX officials have had the luxury of run ning the company inefficiently without fear that competitors would pvide a better seMce at lower cost. Example: for fifty years the politically powerful Oil Workers Unio n extracted concessions from PEMEX that led to enormous inefficiency and extensive padding of the pay roll. Example: in the 1980s, falling oil prices forced PEMEX to reduce costs by cutting the size of its work force from 450,000 to around 100,0

00. Such o vermanning on the order of 400 percent is only one example of abuses which would not be possible in a private company or even in a state-owned company which was subject to market forces. Without question, even further economies are possible: Venezuelas go vernment-owned oil company uses only 30,000 employees to produce approximately the same amount of oil as PEMEX.

By removing the restrictions on the private sectors activity in the petroleum industry and allowing it to compete with PEMEX, Mexico would benef it immediately from improved ser vice and productivity. Given PEMEXs dominance of the industry and its political clout, how ever, the government would also have to create the conditions that would allow true Competi tion to take place. In addition to remo v ing PEMEXs monopoly rights, these include: creating 13 an open bidding system for all contracts and services; clearly defining property rights for com panies, including the extent and terms of drilling concessions and exploration rights; and de nying PEME X preferential treatment in the awarding of contracts or concessions tion alongside private Mexican companies. PEMEX should also be given full freedom to enter into joint ventures with foreign companies. To the limited extent this has already oc curred, th e results have been promising. The Houston-based company, Triton Engineering Inc recently drilled a well for PEMEX in the Campeche region in one-half the time it took PEMEX workers, and at less cost. And cooperation between PEMEX and several U.S. compa nie s to increase natural gas supplies in narthern Mexico has been very productive, providing the regions rapidly growing industries with clean energy resources which PEMEX had been unable to supply For maximum benefit, foreign companies should be allowed to c o mpete without discrimina 4 Privatize PEMEX Even without privatizing PEMEX, Mexico can gain enormous benefits by allowing full competition hughout the petroleum industry. In such an environment, PEMEX could con tinue as a government-owned entity, albeit a m ore efficient one. It is unlikely, however, that a truly profitable and efficient government-owned PEMEX could ever exist because of the temptation of government officials to remain involved in decision-making. Since PEMEX was created in 1938, it has been viewed more as a vehicle for political and social ends than as a profit-seeking company. Only by full privatization can the petroleum industry be freed of the constraining hands of bureaucracy and politics and be allowed to develop its potential A privati z ed petroleum sector would not only rapidly inmase its productivity but also its dynamism and service. Cumntly unused or underutilized resources-oil reserves, natural gas, pipelines, property would be efficiently developed and added to the national econ om y . Along with these would come increased employment in direct and supporting industries and greatly expanded revenues far the government. The enormous potential of the industry would attract investment capital sufficient to its long-term needs, ending clai ms on the public treasury.

Then axe many reasons to privatize PEMEX beyond the strictly economic ones. Because PEMEX is owned by the government it has been virtually immune to legal challenges from government nqplatory agencies &private individuals. Unlike a private company, PEMEX need not fear having the government llemove its license for poor performance, or even illegal actions.

This is clearly demonstrated in PEMEXs environmental red In the Chiapas region, un controlled drilling during the late 1970s r uined local water supplies. PEMEXs oil distribution system is now plagued with leaking land-based and underwater pipelines, one of which was responsible for the recent explosion in Guadalajara. These and other failings demonstrate a callous disregard for e nvironmental concerns which would not be tolerated in a private com pany One often overlooked benefit of privatizing PEMEX is the enormous opportunity cost of keeping idle the potential revenues of the companys sale. Estimates are that PEMEX could be sold for as much as $148 billion in todays market. Proceeds from such a sale would retire Mexicos entire international and domestic debt of $107 billion. Currently, annual payments on that debt are $7.5 billion in principal alone; when interest payments are in c luded, the total exceeds the tax revenues the government now receives from PEMEX. a 14 CONCLUSION For over half a century, Mexicos ail monopoly, PEMEX, has reigned over that countrys oil industry. During that time, a large and diversified petroleum indust r y has been developed and PEMEXs supporters hail its accomplishments as legitimation of the economic national ism which prompted the 1938 nationalization of the oil industry. Unmentioned by these sup porters, however, are PEMEXs extensive failings and the enormous costs at which its accom plishments have been purchased. The belief that a state-owned monopoly such as PEMEX can be cost-free or even beneficial to the wider economy is a fiction which can no longer be sus tained.

In the 1 WOs, oil took center pl ace in Mexicos national attention. The sudden wealth that poured in seemed like a windfall, but proved to be a near-disaster. The gamble of staking Mexicos economy on oil failed, and Mexico is still paying the price of such reckless deci sions. PEMEX itse l f has suffered fiom control by politicians, who have siphoned off its eam ings to support government spending in other areas. The monopoly is seriously undercapital ized; its other industries, such as petrochemicals, urgently need modernization. Unable to sup ply even current needs, PEMEXs inability to supply Mexicos future requirements is a matter of record The entire economy will suffer from the squandering of resources, the growing shortages, and the numerous deficiencies of PEMEX.

Legacy of the Past. A s well, the political benefits that PEMEX supposedly brings Mexico are illusory at best. The entire ideology upon which PEMEX rests-socialism, state control of industry, protectionism, xenophobic nationalism-all have been decisively demonstmted as failms a nd are being tossed aside all over the world. PEMEX is a legacy of the past, a prod uct of fear and of an imae;e ,of Mexico as weak and threatened. Even though they pose as fenders of Mexico, the purveyors of this image peddle a stereotypical image of Mex i co as a Third World, backward nation unable to compete in the world. Their economic leadership has been responsible for most of Mexicos economic misfortunes, yet they continue to cling stub bornly to an antiquated, regressive ideology. But far from weaken ing Mexico, the countrys political and economic sovereignty would only be strengthened by a growing and diversified economy and a dynamic petroleum sector, both of which would be advanced by demonopoliz ing the oil industry.

President Salinas has attempted to modernize Mexicos oil industry, but his reforms have been too limited to have any useful impact. More dramatic reforms are needed if PEMEX is even to approach a modicum of efficiency. Although much attention has been focused on the question of fmign p a rticipation in the oil industry, this is at best of secondary importance and plays into the hands of those who oppose any reform of PEMEX. The real need is to intro duce market forces into the petroleum industry, most of all by breaking PEMEXs strangle ho ld and allowing competition. Even Iestricting participation in the oil sector to Mexican com panies would be a substantial improvement over the current monopoly situation.

There is an important argument for allowing foreign participation as well. Foreign c ompa nies can provide the Mexican oil industry with the sophisticated financial, managerial, market ing, and capital services that are needed to inmase production and profitability. Without ques tion, the principal beneficiary of their involvement would b e Mexico 15 Open Debate Needed. Given its political volatility, the reform of Mexicos oil monopoly needs to be debated openly in Mekico. Far over half a century, discussion of PEMEX has been as monopolized by the left as the oil industry itself. Rational d i scussions of costs vs. ben efits are drowned out by impassioned appeals to nationalism, most vocally by the very groups which benefit economically from the existing situation. However, once the Mexican people are made awm of the bankruptcy of economic nat i onalism and realize the benefits of liberal ization to their own pocketbooks, opposition to reforming PEMEX is likely to give way to en thusiastic support far complete privatization. Not surprisingly, it is this debate which the ece nomic nationalists mos t fear.

Mexico has outgrown the worldview on which PEMEX is based, and the countrys new economic confidence and readiness to participate in the world make PEMEX an obstacle to the realization of Mexicos aspirations. Liberalizing the oil industry will help Mexico fulfill President Salinass definition of the new nationalism economic growth and prosperity and prepare Mexico for the opportunities of the 21st century.

Wesley R. Smith 4. Policy Analyst 16

About the Author