For the majority of people, the emotion engendered by a UFO landing on Earth is fear. For others, it is a confirmation of a hope – that there are alternative realities to the beliefs the majority currently hold. Confirming the reality of a UFO landing on Earth opens up vast possibilities that people had heretofore thought impossible.

Currently, Mexico has a UFO. It is not an Unidentified Flying Object. It is an Unequivocal Failing Organization. The name of the UFO is Pemex or Petróleos Mexicanos. Pemex is the largest taxpayer in Mexico, its largest company, and one of the largest companies in Latin America. It is a vital strategic national asset. It currently employs an estimated 124,000 people and supports 107,000 pensioners. At the outset of 2020, the reinvigoration of Pemex was declared as a central pillar in the strategic platform of Mexico's President Andres Manuel Lopez Obrador (AMLO). This strategy has now morphed into a challenge nobody had ever imagined.

Consider for a moment, that you encounter a UFO. You pull your car over to the side of the road, step out and gaze upon the unimaginable. You have several thoughts that ricochet through your mind. These include:

  • Disbelief – As you rub your eyes, one thought predominates your mind; “this can’t be true.” Yet, the reality is unequivocally present before you.
  • The Unexpected – “Never, in my lifetime, did I ever expect to be in this position.”
  • Misguided – “How did we fail to imagine this reality?”
  • Beyond – “Now, what the hell are we going to do? How will this reality change the path for our future?”

I think we can all agree that confronting the reality of a UFO would produce a state of being dumbfounded in us. Dumbfounded is described as a state of speechlessness, amazement and astonishment. The state of being dumbfounded produces several reactions in human beings. These include:

  • Paralysis – For many, being dumbfounded causes us to simply shelter in place.
  • Run – For others, they simply reverse course and run from the emergence of this new, frightening reality, seeking immediate safety.
  • Opportunity – What happens now?
  • Denial – Finally, some succumb to denying the existence of a new reality; choosing to maintain a course for the future without taking the implications of the new reality into consideration.

The significance of the emergence of the reality of a UFO is that it prods us to reconsider what we thought we knew. Yes, we may all experience reactions of paralysis, running from the reality, pondering opportunity, and denial that a new reality is now upon us. However, what all UFO’s do is prod us to move beyond being dumbfounded and embrace the realistic possibilities now present before us. Mexico is currently confronting this challenge. The reality of the emergence of Pemex as an Unequivocally Failing Organization during 2020 has dumbfounded many. This reality has prodded strategically important audiences across the globe and within Mexico to revisit what we thought we knew.

Mexico’s UFO. What we know

I have written extensively about Pemex over the last 24 months. Like any organization, business failure is a process. It is an unraveling that typically takes time. The difference between an unidentified flying object and an unequivocal failing organization is tangible. For the mysterious UFO’s that populate the internet and movies, we are limited to stories and strange images and videos. However, for unequivocal failing organizations, we can actually touch and measure the composition, behavior and dimensions of these entities. So, what do we now know about Mexico’s UFO?

  • In September 2020, Jonathan Heath, deputy governor of Mexico’s central bank referred to the fear that Pemex may become Mexico’s “incurable cancer.”
  • The 2020 budget for Pemex is to produce approximately 1.86 million barrels of crude per day. In July 2020, this figure came in at 1.595 million barrels a day… the poorest monthly production since October 1979.
  • In September 2020, there is a buzz in the financial sector that further bond rating agency downgrades for both Pemex and the sovereign credit rating of Mexico may be forthcoming in Q-4 2020.
  • In July 2020, Mexico’s President López Obrador stated that energy reform, which opened up the energy sector to private and foreign companies in 2013, might need to be reversed to save Pemex. For many observers, AMLO’s position is a maligned and militant denial of the current reality.
  • According to the Financial Times at the end of July 2020: “Mexico’s economy contracted 17.3 per cent in the second quarter compared with the previous three months, putting it on course to be one of the biggest emerging market casualties of the coronavirus pandemic. It is the fifth quarterly contraction in a row, dampening hopes of a speedy, V-shaped recovery. Compared with the same period last year, the decline was 18.9 per cent, the biggest drop on record, according to preliminary data from the state statistics office Inegi.”
  • In April 2020, Pemex auditors KPMG issued a written “going concern” opinion about its future, based upon their audit of their operations and annual report dated 12-31-2019. KPMG stated there is “substantial doubt as to the ability of Pemex to continue as a viable company."
  • In the first 3 months of 2020, the Pemex operating loss was US$ 23 bn.
  • For the quarter ending June 30, 2020 Pemex sales were approximately half of the same quarter in 2019 and added another $10 billion in losses.
  • Pemex’s debt (the highest in the world for an oil company) is US $106 billion, $70+ billion in unfunded pension liabilities, forestalling payments to suppliers and subcontractors etc.

Recent remarks from industry analysts from several publications include the following in respect to the above:

“The company is bleeding cash like crazy.”
“The pension fund is being depleted and may be at zero by the end of the year.”
“This is unsustainable.”

Now what? An interview with the experts:

As I have written previously: “First, AMLO must discard the illusions that have inhabited his Pemex strategy since he took office. AMLO did not create this fiction of a company. He inherited it. Yet, it is his opportunity to reimagine for the future of the nation of Mexico. This will not be accomplished through stubbornly embracing an old reality that has been replaced with the new. It will require humility, creativity, courage and leadership; a recognition that embedded within the tangled web of the coils of this current crisis - is a tremendous opportunity.” Yet, what do I know? So, I asked the experts.

One of the options AMLO and his advisors must consider is a formal financial and strategic reorganization of Pemex. What might this look like? Is a formal financial restructuring – akin to a Chapter 11 reorganization - a possibility for Pemex? What are the challenges? What are the benefits? What financial liabilities and debt service might Pemex be able to discharge? What about the unfunded pension liabilities? Is there an appetite for a major player in the global petroleum industry to step in and assist Mexico as a strategic partner moving forward?

Edgar Cruz Borges is Chief Analyst for BBVA Bancomer SA de CV in the Global Strategy & Research - Credit Research unit. Rogelio Lopez-Velarde is an Attorney, Counselor at Law, and Partner at Denton’s - a global law firm. His office is in Mexico City. From 1988 to 1993, his experience included numerous positions at Pemex including In-House Counsel in Houston, Texas, In-House Counsel in New York, N.Y. and Head of the International Legal Department of Pemex. Currently, he is regarded as one of the top energy lawyers in the world by Euromoney, Chambers and Latin Lawyer – among others.

Here are the expert responses to my interview questions:

In your legal view, is a formal Chapter 11 filing in the U.S. (and Mexico – I, the author, am unfamiliar with this process in Mexico) a reasonable alternative that should be considered to assist in restructuring and revitalizing Pemex?

Rogelio Lopez-Velarde: I ignore whether Pemex, as a State-owned company of the federal government of Mexico (which is considered a foreign public instrumentality under the US Foreign Sovereign Immunity Act) could be eligible for the protections afforded under Chapter XI. However, in Mexico, Pemex should be able to request such protection under Mexico’s insolvency laws. One of the benefits of the 2013 energy reform, is that Pemex is now subject to commercial laws like any other company (except for the rules specifically established under the 2014 Pemex Law). Nonetheless, it would seem to be difficult that Pemex or its creditors would request the insolvency and its reorganization, before the federal government decides to step in and bail out the company. As a result of the energy reform, Pemex now is a State Productive Company, not a federal public instrumentality of the federal public administration (organismo público descentralizado) which rules prevented Pemex before to be subject to Mexico’s Bankruptcy Law. Pemex, as State Productive Company, continues not to have shares of stock and its control and management continues to be established by law in favor of the federal government of Mexico, and therefore, Pemex can only be legally transformed (and dissolved) by Congress action. While Pemex should now be eligible to request the suspension of payments under a regular insolvency proceeding in Mexico, this possibility seems to be remote.

How might a Chapter 11 filing assist in reorganizing Pemex?

Edgar Cruz Borges: Reorganizing Pemex should include a drastic reduction to tax burden in order the company has enough resources to invest them to efficient operations and increase production and reserves. Mexico’s fiscal dependency on Pemex would make it hard to reduce tax burden in our opinion. Additionally, since the country by the Ministry of Energy and Pemex do not have an asset monetization strategy to rapidly reduce debt. I do not see Chapter 11 as an option.

What are the complications for a bankruptcy filing by Pemex?)

Edgar Cruz Borges: In my opinion, the main problem to implement a Chapter 11 is that oil reserves are Mexico’s property. Pemex is a company owned by Mexico that is assigned to develop and produce over Mexico’s reserves and those reserves are in Mexico’s territory. Another potential complication is to lockdown transfers from the company to Mexico, and due to the country dependency to that revenue it could generate fiscal complications, probably an event that Mexico is not ready to accept.

What are the prospects for restricting/restructuring the unfunded pension obligations for Pemex?

Rogelio Lopez-Velarde: This seems to be difficult to happen since Pemex is owned and controlled by the federal government which, for legal and for other different reasons, have historically funded the pension and other monetary obligations of all State owned companies and other type of public instrumentalities such as Pemex.

What about the treatment of unpaid bills due to suppliers, workers and contractors?

Rogelio Lopez-Velarde: Same situation. In this case, as it is happening right now, Pemex will try to renegotiate contracts, suspend payments, and even resist litigation with those that decide not to accept the new payment terms.

What about the treatment of current contracts with foreign entities for exploration, services etc.?

Rogelio Lopez-Velarde: The current 117 exploration and production contracts (such as License and Production Sharing Contracts) were signed with the National Hydrocarbons Commission (known by its Spanish acronym as CNH) and not with Pemex, so Pemex financial condition is not a matter of concern with these contracts, except for a number of farm-outs and other Joint Operating Agreements that Pemex has signed with other foreign companies, which E&P (Exploration and Production) contracts were awarded by the CNH under the bid rounds which were successfully organized by the previous administration. In these cases, Pemex creditworthiness, as a partner and contractor, has become relevant in light of Pemex decreasing credit capability. With respect to Pemex Service Contracts, please see answer 4B above.

What are the prospects for arranging essential debtors in possession financing for Pemex?

Edgar Cruz Borges: Since Mexico is doing just enough to support Pemex liquidity. The company does not need to use that type of financing. In my opinion, Pemex could be open to various forms of financing, potentially DIP financing. However, the strict regulation and covenants from this type of financing might not be in the terms Mexico and Pemex want to be involved, in my opinion.

Might the filing in the US also have to be accompanied by a filing in Mexico?

Edgar Cruz Borges: Probably not. If Pemex enters in a Chapter 11 it would probably be to negotiate with USD-bond holders however since Pemex assets are in Mexico and since this event would require the participation of Pemex main shareholder, the filling would probably be accompanied by a filling in Mexico. It would also be likely to link Mexico to Pemex in order to respond to the company's debt obligations.

According to recent reporting by Bloomberg and El Financiero, AMLO appears to be dedicated to more state control over Mexico’s energy sector (both petroleum and electricity). What are the current practical legal hurdles his administration faces in their attempts to do so?

Rogelio Lopez-Velarde: International treaties (FTAs), the Constitution and a number of federal statutes that were enacted as result of the 2013 Energy Reform. Under these laws Pemex monopoly was repealed, and the industry is now subject to competition.

Do you believe interest from foreign strategic partners to assist Mexico (whereby the investment capital required to revamp the company ) with restructuring Pemex are out there - and willing to assist – under mutually agreeable terms and conditions?

Rogelio Lopez-Velarde: Indeed there is interest provided the rule of law is observed by the federal government, which entails that the energy reform continues to be applied and enforced by the federal government. If the Mexican government would like to change the rules of the game (which de facto, it has done) this would probably require a Constitutional amendment.

Edgar Cruz Borges: During the previous administration we noted interest by many companies to participate with Pemex, as a partnership to develop reserves. However, during this administration, these partnerships have stopped, and it would be unlikely to become a strategy, in my opinion.

Might Chapter 11 filing in the US also have to be accompanied by a filing in Mexico?

Edgar Cruz Borges: If Pemex enters into a Chapter 11 it would probably be to negotiate with USD bond holders. However, since Pemex assets are in Mexico and this event would require the participation of Pemex main shareholder, the filling would probably be accompanied by a filling in Mexico. It would also be likely to link Mexico to Pemex in order to respond to the company's debt obligations.

Do you believe the Pemex bond rating will be downgraded further by 12-31-2020 by the major rating agencies? What about the sovereign rating of Mexico by 12-31-2020?

Rogelio Lopez-Velarde: There is a strong possibility that could happen, unfortunately.

If you were the CEO of Pemex today, what would be the four elements of a strategic plan you would advise President AMLO to consider immediately to reposition the company for a return to profitability and viability over the next 5-10 years?

Rogelio Lopez-Velarde: Immediately stop the construction of the Dos Bocas refinery, request the Ministry of Energy the continuation of CNH bid rounds and Pemex’ farm outs, entertain joint ventures to complete the reconfiguration and modernization of the existing 6 refineries of Pemex, and take advantage of all the benefits that the energy reform provides for Pemex, including the possibility to incorporate companies or joint venture companies that would eventually become listed in Mexico’s stock exchange market.

Conclusion

Pemex is Mexico’s UFO. Unfortunately, the current federal government leadership of Mexico remains dumbfounded by this reality. The company is likely to continue to disintegrate unless, and until, a new strategy is imagined and implemented to reverse the current course. New alternatives must be deliberated.

Unfortunately, we have current examples of what happens to countries that nationalize their petroleum industries. On January 1, 1976 Venezuela made this decision and created Petróleos de Venezuela S.A. (PDVSA). Today, after decades of Mexico’s mismanagement, corruption and failure to make the essential financial investment in Pemex, the outlook is akin to that of Venezuela. The conclusion that Robert Rapier shared in Forbes (Charting the Decline of Venezuela’s Oil Industry – Jan. 2019) about the future prospects for Venezuela’s national oil company, are pertinent for Mexico and Pemex today:

I do believe that a country should use its natural resources to benefit its citizens, but you have to be willing to make the investments needed to keep the respective industries in good shape. The problem with Venezuela's approach was that it extracted too much from the industry, which sacrificed its ability to continue to grow its production. It's hard to imagine that Venezuela's oil industry can recover without significant reinvestment. Whether by a change in government, or the current government striking deals with countries that are desperate for oil (e.g., China), the status quo in Venezuela can be expected to continue the ruin of the country's oil industry.

The confirmation of the reality of the presence of a UFO in Mexico demands a new strategic response commensurate with the threat, and/or the opportunity. Stumbling dumbfounded into the future just won’t cut it.