Investors Believe in Mexican Oilfield Service Opportunities

The first months of 2011 marked the announcement of the new business ventures of two former Pemex CEOs who joined forces with private equity firms to pursue investment opportunities in the energy sector. Luís Ramírez Corzo, who ran Pemex from November 2004 to December 2006, was recruited by Integradora de Servicios Petroleros Oro Negro to take up the position of Executive President, while his successor as the head of Pemex, Jesús Reyes Heroles, who ran Pemex until he was replaced by current CEO Juan José Suárez Coppel in September 2009, teamed up with Morgan Stanley Private Equity to capitalize on the investment opportunities in the energy sector.

Strong fundamentals

“That visibility of long-term investment, and the inelastic nature of this investment, creates a very compelling environment when you compare the Mexican oil and gas industry to almost any other sector anywhere in the world,” says Gonzalo Gil White, co-CEO of Oro Negro. “It is a simple arithmetic calculation. Pemex’s approximate cost of exploration is around US$15 per barrel and its cost of development is roughly US$18 per barrel. Pemex has a policy objective of achieving 100% reserves replacement and produces over 1 billion Boe which means that to produce and replenish this production volume requires an investment of roughly US$33 billion per year. The current production and reserve replenishment policies are always subject to change, and that could mean diminished investment in the future; however, we see that as highly unlikely given the importance of the sector in the Mexican economy and the healthy return on investment. The oil sector is the most profitable investment opportunity that the government has across the board. Through Pemex, the government is spending US$30-US$33 to generate an asset that it is selling at over US$100 at current market prices. Moreover, Pemex is not only aiming to maintain current production levels; it has a stated goal of reaching crude oil production of 3 million bbl/day by 2017, an increase of 20% over current production levels. This gives us comfort that the projected levels of investment will be achieved over the coming years.”

Current need for asset financing

The majority of this investment will be channeled through service contracts. The more value driven approach that Pemex is now employing to assign contracts makes it almost a pre-requisite for service providers to have the capability to access state of the art technology. Outdated technology endured when contact assignment followed a single criterion – lowest unit cost of service – and will tend to disappear as the obsolescence of the existing plant is laid to bare in an environment that requires immediate results and efficiency. “Some of these assets are not necessarily commodities in the marketplace so there’s a barrier to entry associated with the asset itself. Sometimes the only way to be competitive is to have the ability to own the asset and amortize it over a longer period of time,” explains Gil White. Many service companies do not have the financial wherewithal to make those investments and Pemex cannot afford to delay its investment programme. “We recognize that the receptiveness to equity investment opportunities among the incumbents is very high because they recognize that their permanence in this industry as a relevant service provider is a perishable condition if they don’t have the financial capability to invest in the assets, which are in most cases the critical factor that determines contract assignment,” says Gil White.

Based on years of experience providing structured lending to service providers in the oil and gas industry as CEO of Navix, Gil White believes that there are many instances where debt capital is insufficient or ill suited to underwrite growth initiatives of incumbents. When service providers have to make investments in capital goods with a long amortization profile, debt would over lever these companies. “Companies have a certain amount of leverage on their balance sheets and in order to replenish assets or obtain better financing terms for the working capital requirements, they require a better capital structure. This is where we believe Oro Negro plays a strategic role,” explains Gil White.

Industry partner or financial partner?

To develop technological and execution capabilities, equity investment and joint ventures are not mutually exclusive. Many industry leaders argue that if Pemex migrates to more integrated service contracts, the formation of joint ventures to assemble portfolios of capabilities that the NOC is looking for in its service providers will become increasingly important for long-term success. While companies can acquire the required expertise through joint ventures, they are also confronted with significant initial investments and working capital requirements. This creates a necessity to raise sufficient capital, both to participate in tenders and align their execution capability and financial muscle with their joint venture partners. “These are two sides of the same coin: you have to be financially solvent in order to meet the requirements that Pemex can now incorporate in its tender guidelines and to invest in working capital (or in assets, as the case may be), to perform these services, and you must prove the technical capabilities and track record to be eligible. I think those two issues converge.”

Private equity investment priorities

Oro Negro will focus on segments of the oil and gas industry with the strongest growth potential in the foreseeable future, both in the medium to long term, but there is always risk associated with such investments and this is no exception. Weighting those risks and measuring the probability of contract roll-over are critical success factors, because some of these assets will be amortized over a longer period of time than the initial contract. The company is primarily focused on upstream activities, but does not rule out other opportunities in the midstream or downstream markets, and sees particular opportunities in direct and indirect drilling services. “We see a substantial increase in the demand for drilling assets, as well as the need to upgrade an aging fleet that is currently in place. Also, we see opportunities in offshore logistical services for exploration and production activities as Pemex moves into deeper waters. Current infrastructure that is designed to serve shallow water infrastructure has no scalability as exploration and production migrate to deep and ultra-deep reservoirs. Ultimately our activity is opportunistic, so we look not only at sectors but specific merits that transactions have in order to determine the capital allocation process,” explains Gil White. This also opens the door for equity investment in operators of the new integrated service contracts (ISCs). “These contracts are an enhanced version of a traditional service and offer a higher potential return with a higher risk involved. If we see opportunities that meet our criteria for return on investment, level of risk involved, and the operator’s execution capabilities and track record, then this is something that we will definitely be interested in,” says Gil White, before confirming his firm’s interest in cooperating with Mexican companies that are participating in the upcoming second ISC contracting round.

Competitive portfolios

Oro Negro welcomes healthy competition with Morgan Stanley Private Equity and other investors with a focus on

the energy sector. “This is very positive for the industry since the overall capital requirements are significant. Every sector that has strong fundamentals is going to attract participants and competition is always helpful: it forces you to be the best you can be, so we welcome it rather than frown on it. There are more than ample opportunities for our effort and other efforts to succeed since the opportunity set is orders of magnitude larger than the available capital to invest and that’s a very favorable dynamic to be in.”

Rather than trying to develop a large portfolio of small investments, Oro Negro will focus on areas where the investment on a stand-alone basis is considerable and capital itself is a barrier to entry. Since asset acquisition in the oil and gas industry can be very effectively leveraged, the company will strive to achieve a significant leverage multiple by structuring the acquisition of assets effectively. “The purchasing power of our equity capital can be up to four or five times the nominal amount,” says Gil White. “The fact that investments do not necessarily follow a single recipe increases the potential investment pool. We can invest in the capital structure of an existing operating company, or we can invest in an asset that we operate through a joint venture with an existing operating company, both of which can be appealing to Oro Negro depending on the situation. Ultimately our capital will be finite and substantially inferior to the Pemex annual CAPEX programme and so, back to my earlier point, we have the opportunity to be very selective.”