OREANDA-NEWS. Fitch Ratings has assigned a rating of 'BBB+' to Petroleos Mexicanos (Pemex) EUR1 billion notes issuance due 2022 and EUR1.25 billion notes issuance due 2027.

The debt issuances are guaranteed by PEMEX-Exploracion y Produccion, PEMEX-Refinacion, and PEMEX-Gas y Petroquimica Basica. The company expects to use the proceeds from the issuances to finance its capital investment program and, working capital requirements, or to refinance its indebtedness.

KEY RATING DRIVERS

Pemex's ratings reflect its close linkage to the government of Mexico and the company's fiscal importance to the sovereign. Pemex's ratings also reflect the company's solid pretax income, export-oriented profile, sizable hydrocarbon reserves and its strong domestic market position. The ratings are constrained by Pemex's significant unfunded pension liabilities, substantial tax burden, large capital investment requirements, negative equity and exposure to political interference risk.

Strong Linkage to the Government

Pemex is Mexico's largest company and one of its major sources of funds. During the past five years, Pemex's transfers to the government have averaged 52.6% of sales, or 108.4% of operating income, and contributions to the government from taxes and duties have averaged 30% to 40% of government revenues. As a result, Pemex's balance sheet has weakened, which was illustrated by a negative equity balance sheet account at the end of 2014. Despite pari passu treatment with sovereign debt in the past, Pemex's debt lacks an explicit guarantee.

Oil production has stabilized at around 2.4 million barrels per day (bpd), after a precipitous fall during the last decade. This is mostly the result of a more intensive use of technology in the Cantarell field, improvements in operations, and increased production from a diversified number of fields. During recent months, Pemex's production has shown declining signs, which are expected to change the negative trend in the long term as the company increases investments and cooperation with third parties.

The diversification of the oil production asset base, with Cantarell representing less than 20% of oil production, reduces the risk of large production declines in the future. The company's goal is to increase total crude production to 2.8 million bpd in the medium- to long-term, which likely will prove challenging as the company's capital spending capacity is constrained by a high tax burden.

Approved Energy Reform; Long-term Positive for Pemex

Although Pemex's credit ratings will continue to be highly linked to those of the sovereign, the reform would likely give the company financial flexibility through budgetary independence. Up to now, the company has had to obtain budgetary approval from congress on an annual basis, which, coupled with a high tax burden, has hindered the company's investment flexibility. Also, the company would benefit by being able to partner with oil and gas companies in order to share exploration risk.

The overall impact of the reform for Pemex will be positive but gradual, and the company will continue to face a heavy tax burden in the medium term. Despite possible long-term positive implications of the ongoing energy reform, company financials continue to be significantly affected by the high level of unfunded pension liabilities as long as appropriate measures are not put in place to resolve the situation. Pension obligations amounted to approximately USD100.2 billion at the end of 2014.

Negative Free Cash Flow Due to Transfers to Government

Fitch expects Pemex to present negative free cash flow (FCF) over the next two to three years, considering Fitch's price deck and as Pemex continues to transfer a significant amount of funds to the central government in the form of duties and implement capital investments to sustain and potentially increase current production volumes. The company's historical significant tax burden has limited its access to internally generated funds, forcing a growing reliance on borrowings. The introduction of new energy and tax reforms should help mitigate Pemex's tax burden, freeing operating resources that could be used to increase investments.

Fitch expects this to be the case only in the long term, as over the next three to five years the company most likely will continue being a significant source of funding for the central government as it seeks to maintain revenues from oil and gas constant at 4.7% of GDP. At the end of 2014, Pemex's funds from operations (FFO) were approximately USD4.8 billion and cash from operations USD6.8 billion, which compared with cash capital expenditures of USD17.3 billion, resulting in negative FCF.

Strong Pre-tax Credit Metrics

At the end of 2014, Pemex's EBITDA (operating income plus depreciation plus other income) was approximately USD57.1 billion. Credit metrics were solid with EBITDA-to-fixed charges at 14.8x. Leverage as measured by total debt-to-EBITDA was low at 1.4x. Pre-tax credit metrics will weaken during 2015, should current oil prices be sustained for the reminder of the year.

Pemex cash flow metrics are weak due to the company's high cash transfers to the government in the form of taxes and production duties. Pemex's FFO leverage was 9.2x at the end of 2014. During the last five years, the high tax and production duties burden were on average USD63 billion, which has resulted in an average net loss of approximately USD9 billion and has hindered Pemex's investment ability.

At the end of 2014, total debt was USD77.7 billion and the unfunded pension liabilities were USD100.2 billion. Positively, Pemex has adequate liquidity of USD8 billion as of Dec. 31, 2014, enhanced by committed revolving credit lines for USD2.5 billion and MXN23.5 billion. The company's debt is well-structured, with manageable short-term debt maturities.

As Mexico's state oil and gas company, Pemex is the nation's largest company and ranks among the world's largest vertically integrated petroleum enterprises. As of December 2014, it reported total crude oil production of 2.4 million bpd and a refining capacity of 1.69 million bpd. The company reported hydrocarbon proved reserves of 13.4 billion boe as of Jan. 1, 2014. Pemex's proved reserves life was 10 years, and its reserve replacement rate declined to 67.8% at Jan. 1, 2014 from 104.3%. This was due mainly to lower development activity in the Chicontepec region.

RATING SENSITIVITIES

An upgrade of Pemex could result from an upgrade of the sovereign coupled with a continued strong operating and financial performance and/or a material reduction in Pemex's tax burden. Negative rating action could be triggered by a downgrade of the sovereign's rating, the perception of a lower degree of linkage between Pemex and the sovereign, and/or a substantial deterioration in Pemex's credit metrics.