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with Adrian Lajous Vargas, former PEMEX CEO, PEMEX

09.09.2011 / Energyboardroom

When we first interviewed you in 2006 we discussed the future of Mexico and the importance of exploring and discovering new fields in order to improve the country’s energy sector. Since then it seems that not many things have changed. 2008 was a very important year with the passing of the Energy Reform bill which carried high expectations for revolutionizing Mexico’s hydrocarbons industry. Three years after its ratification, what positive aspects has the reform brought about for the sector?

I believe it is a failed reform. The government was guided more by what was feasible than what was actually necessary, given the positions of the major political parties. By doing this it never gave a clear sense of direction to the change needed in the oil industry. Additionally, the proposed reform only dealt with oil and did not address wider energy sector issues.

It is a failed reform in many respects. The effort pushed in the wrong direction as it did not recognize the need for change in oil industry governance. Instead it attributed to the Board of Directors regulatory functions that normally belong to government, while at the same maintaining practically all its powers to manage and control PEMEX from the outside. This created a confusing situation in which the roles of management and of the Board are not clear. There is also much confusion about the role of the government itself, both in terms of regulation and policy design.

The Ministry of Energy wanted to centralize its power over the oil industry. This explains, in part, why the new upstream regulator created by the reform, the Comisión Nacional de Hidrocarburos (CNH), is institutionally weak. It does not have the necessary human and financial resources, it is not independent nor was it given a mandate to effectively regulate PEMEX. The main regulatory powers remain in the Ministry of Energy and key policy instruments remain under the jurisdiction of the Ministry of Finance.

From a governance point of view, the reform process did not clarify the roles of the major stakeholders in the Mexican oil industry. The spheres of management, the regulator, policy makers and owner’s representative are inadequately defined and are imprecise.

Within the 2008 Reform one of the big highlights was allowing PEMEX to start the incentive-based contracts scheme, which came out this March. What do you see as the main benefits of these contracts and what are your expectations on their impact in the industry?

For reasons that are difficult for me to understand, PEMEX and the government first developed a generic contractual model and then tried to identify specific projects to which it could be applied. Initially it was thought that the new incentivized service contract could be used in deepwater exploration and development projects. This option was abandoned once they realized their complexity and the legal constraints that they faced. Later, PEMEX concluded that they were better suited for the development of the Chicontepec area. When this project failed, they focused on smallish projects in mature marginal fields. In a certain sense, PEMEX had a contract in search of a project, thus inverting what is the normal sequence. The projects that were put to bid have little materiality and are overburdened by a complex contractual framework.
As it stands today, it is unlikely that these contracts will prove to be successful. Large oil companies remain uninterested and I don’t see any important independents joining in. The international service companies will shy away from them because there is too much complexity and risk for relatively modest projects. They will prefer to work for the oil companies involved in these projects.

Industry players have become cynical or are frustrated by the current situation in Mexico. There has been much talk for quite a while but little has actually happened. The loss of credibility and the erosion of the official discourse have taken their toll.

To sum up it seems that we are in a real controversial situation since Mexico didn’t really know how to administrate its rich oil endowments. In this context is it a far-fetched idea for the country to recover its position as a leading oil producer?

Many people in Mexico would like to see PEMEX regain the levels of production that prevailed in 2004. The government still believes that this can be achieved by 2025. However, we must distinguish our aspirations from what is more likely. In every oil province production expands, reaches a peak and then declines. This happens even to the best families: just look at decline rates in Alaska and the North Sea. Mexico’s currently producing oil provinces have matured and are now in their declining phase. Only major hydrocarbon discoveries can stop this decline.

However, a series of large discoveries are not a frequent event, especially after a 100 year Mexican production history. The main potential for discoveries is where we have not explored in the past, which is in deep and ultra-deepwater in the Gulf of Mexico. This is more a recognition of our ignorance than any specific knowledge of what may be discovered or where. Clearly there is still a large amount of oil to be produced in Mexico and much more can be recovered from known fields. What I question is our capacity to expand current capacity significantly.

One topic we cannot miss covering is the controversial Estrategia Nacional de Energía. Some of our interviewees have talked about the unfeasibility of achieving some of its aims and the inconsistency in its numbers. Today Mexico produces around 2.5 million barrels of oil per day. The Estrategia Nacional de Energía aims to raise that number up to 3.3 million by 2025, representing 0.8 million more barrels per day in 14 years. With the current weak circumstances that E&P is facing in the country is this really feasible?

I recently published an article on this topic, criticizing the government’s production and reserve replacement forecasts. I did not make many friends with this publication. What the government is saying is that over a normal exploration and development cycle -15 years, more than ⅔ of production in 2025 is going to come from fields that have not yet been discovered. They are clearly betting on some very big discoveries. However, it is doubtful that even if they were eventually made in deepwater they would have the desired effect by 2025.

The recent past is not a good guide to the desired future. Proved reserve replacement is mainly the result of revisions and field development. Discoveries have played a minor role in replenishing the stock of reserves. This is also the case of unproven reserves. Deepwater exploration has only yielded one significant gas field, many dry holes and no oil. The government’s forecasts are not based on hard data but on uncertain assumptions with respect to the transformation of resource estimates to reserves and then to production.

Now that the “easy oil era” is over, future oil discoveries will become even harder and more costly under challenging operational circumstances. Is PEMEX ready for the changing times and new era ahead?

Reform did not improve the governance of the industry and managerial changes inside PEMEX are difficult to appraise. There is no evidence yet that the company’s capacity to execute large scale complex has improved.

When you were the CEO of PEMEX did you have the impetus to initiate change from within? Taking into account the complexity of its organization, can somebody actually move it forward and implement the required changes?

I certainly did everything that I could, but clearly it was not enough. In terms of upstream challenges, the projects that I launched managed to effectively increase oil production by 1 Mbd and non-associated gas by 1 Bcfd. What was very frustrating is that even successful initiatives never became self- sustaining. This meant that if you ever let go, if you were at all distracted, things tended to revert to a previous low-level equilibrium. Clearly there was a major governance problem. However, one should be careful not over-criticize PEMEX upstream capabilities.

Although total oil production has declined, mainly due to the collapse of the Cantarell field, production in the rest of Mexico has increased substantially in the last 8 years. I must also say that the challenges that the industry faces today are even more demanding that the ones I had to deal with during my watch.

Given the circumstances of declining oil production in Mexico and the global trend to secure more energy sources, it can be risky for Mexico to continue to depend on hydrocarbon-based energy. How important is for the country to diversify its energy portfolio and increase the usage of other energy sources?

In the short term we should focus on managing demand and rely less on the costly expansion of oil and natural gas supply. Unless there are significant discoveries in the immediate future, emphasis should be on containing the growth in demand. This is a prudent strategy both in economic and in environmental terms. There are many things that can also be done with respect to renewable sources of energy. The recent success with wind power in the South of Mexico is a good example. There are good prospects for solar, particularly in the north of the country. Unfortunately, all these efforts will not really reduce our dependence on hydrocarbons over the next twenty years, at least.

The current situation facing Mexico’s oil sector seems very clear. Could you tell us more about the country’s gas sector and offer us your perspective on its future development?

The gas sector is in even worse shape than oil. Mexico is a significant exporter of crude oil, but a net importer of gas. Import data is unreliable and is not accessible in a timely manner. Private parties import gas directly by pipeline from the U.S., and we also import LNG on both the Gulf and West coasts. Current imports are above the 1 Bcfd threshold.

The reserves and production of non-associated gas have been dropping dramatically and places in northern Mexico today have reserve-to-production ratios of only 3 ½ years. In that respect, overall production of crude oil is declining and barring any major new discoveries the prospects to increase the production of associated gas in the short-term are poor. Longer term, production of offshore non-associated gas should start in 2014 or 2015. Also, PEMEX might be able to produce shale gas and other non-conventional gas sources in the North of Mexico. The Eagle Ford play widens as it crosses the South Texas border. However, it is still too early to appraise these prospects.

To sum up, what is your outlook for the oil and gas sectors here in Mexico?

Mexico is going through a phase of declining production. In the next two or three years we should see production stabilize at around 2.5 million barrels per day; achieving that stability is an important accomplishment. But in the longer term, production will continue to decline unless we are blessed again with major discoveries. Up until now, PEMEX’s exploratory efforts in deepwater have not been successful. On the gas front it is not yet possible to confirm PEMEX’s assertion that a new mega gas province has been discovered in deepwater, close to Coatzacoalcos.

Indeed, as you said, apart from the new incentive-based contracts PEMEX is really looking forward to explore in deep waters. If I understand correctly you are not a very big supporter of Mexico entering into these kinds of contracts. Why do you hold such a position and what are the risks associated with those operations? What should be PEMEX’s E&P strategy be?

PEMEX and the Mexican government are not adequately prepared for a major, effective and safe effort in ultra-deepwater. We do not have the managerial expertise and the pool of specialized talent that is required. We lack a credible regulatory framework, and the regulator lacks the necessary instruments to implement basic rules and inspection procedures.

The BP catastrophic accident in the Gulf has provided ample evidence of the complexities involved in developing, managing and regulating deepwater resources. The coordination of a large number of contractors poses a major managerial challenge. The oil industry has been rethinking the safety and emergency preparedness specifically required in deepwater. Mexico has not participated actively in this process nor has it critically reviewed its true capabilities in this area. Regulation is, for practical purposes, inexistent in the Mexican sector of the Gulf. These are some of the issues why I have called for a moratorium on ultra-deepwater drilling in my country.

Deepwater exploration requires sophisticated risk-management skills in a very exacting environment. PEMEX does not have real expertise in this domain. It does not possess the science, the art and the experience of managing large-scale, complex, high-risk projects in ultra-deepwater.

Mexico must also deal with the fact that it plans to drill very close to the U.S Gulf sector. This implies much greater coordination with U.S regulators in regard to safety and environmental standards that must eventually converge.

On the more personal note, you have been in the Mexican oil and gas industry for many years. What makes you so passionate about this industry?

I have been in the industry for my entire professional life. What I found fascinating was that, in all the positions that I held, it was necessary to deal with abstract policy issues and, at the same time, manage very tangible and concrete problems. Traveling from one end to the other on a daily basis was very exciting and required total commitment.

What would be your final message to our readers, and what is the lesson that other countries could learn from the Mexican oil and gas sector?

Mexico must do a lot of work internally before it can open its upstream oil industry to private investors, both domestic and international. Any major restructuring of the industry would require the development of a regulatory regime – not only a regulatory framework, but also strong independent regulatory institutions. We are obligated to learn from the major privatizations of the 1990’s. They were carried out under inadequate and weak regulatory regimes. Two examples are illuminating. In the telecommunications sector the transition was from a state monopoly to a de facto private monopoly. In commercial banking, privatization eventually implied de-nationalization. In that respect Mexico is unique among OECD countries: with one exception, all the large banks are foreign-owned. In both cases we can see the consequences of opening key sectors without first having an appropriate regulation. We will certainly regret this in the long-term.

Many people fear that we run similar risks in opening the oil industry to private investment. If we are to move in that direction we must previously build a modern regulatory regime, we have to strengthen the governance structures and processes of the industry and we must strengthen PEMEX itself, by investing in its human capital and by providing it with adequate financial resources. Otherwise, we run the risk of de-nationalizing the oil industry and giving monopoly powers to private parties.

I strongly believe that we must identify the prerequisites of restructuring and to ensure that they are in place before we actually make any serious move to open Mexican oil and gas to private investors.



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