Incentivised reform: A changing energy mandate spells new opportunities for hydrocarbons and electricity

Since the release of the energy reform in December 2013, the Mexican energy sector has been on the rise. Little by little the rules have been set to turn a closed sector with two state-owned giants – Petróleos Mexicanos (Pemex) and the Federal Electricity Commission (Comisión Federal de Electricidad, CFE) – into a modern-day open market.

Much Needed

Pemex production has dropped by more than 24% since reaching a peak of 3.4m barrels per day in the early 2000s. Added to that, handling the amount of work and responsibility required to control the entire oil and gas chain had turned Pemex into a slow-moving giant. This caused oil exports to decline, refined product imports to rise, and the general cost of fuels and supplies such as petrol, diesel, liquefied petroleum gas and natural gas to become uncompetitive.

On the other hand, the CFE had challenges in keeping up with the required investments for growing electricity demand in the country. Mexico’s electricity demand rose at an average of 3.3% per year from 2000 to 2013. Many of the generation projects were being built through independent power producer (IPP) contracts while the expansions required for the transmission systems were fully dependent on the state-owned giant’s budget. This translated into high electricity tariffs that affected the industrial, commercial and residential sectors alike.

Under these circumstances, change was imperative. In 2013 the political, social and economic context led to the creation of the “Pacto por México” alliance. For the first time in the country’s history, the three main political parties came to an agreement in various subjects and launched a massive reform package in finance, education, telecoms and energy. The energy reform came at the end of the pack, but in many ways had the greatest impact.

Understanding The Changes

The first step of the energy reform involved modifying the Constitution. Before the change, articles 25, 27 and 28 of the Constitution stipulated that all oil and gas resources were property of the state and all hydrocarbons extraction, production, commercialisation and related activities were to be performed exclusively by the state and its various entities.

Similar wording existed for energy generation, transmission distribution and commercialisation activities. Two major exceptions were in place: the “secondary petrochemicals” clause for hydrocarbons and the 1992 Electric Energy Public Service Law. The former stated that secondary petrochemicals processes could be performed by private entities, while the latter partially opened the electricity-generation field by opening the sector to IPPs, self-supply and small power producers.

Resources such as oil and natural gas are still the property of the state, but the reforms opened all activities, from exploration to retail in the oil and gas industry, and from generation to commercialisation in the electricity sector, to private participants.

New Laws

Once the constitutional changes were approved, the next step included the publication of a set of secondary laws regulating everything from hydrocarbons, electricity, the rearrangement of roles for regulating and productive entities, taxation, environment and even social issues. The package included nine new laws and modifications to 12 existing ones. This set of laws was approved in mid-2014, with the impact and scope highly significant.

The Mexican Oil Fund was created for the administration of income, while existing dependencies and regulation entities – such as the Ministry of Energy and Public Credit, the National Hydrocarbons Commission (Comisión Nacional de Hidrocarburos, CNH) and the Energy Regulatory Commission (Comisión Reguladora de Energía, CRE) – were strengthened and given new responsibilities.

Two new technical entities have been created in gas and electricity, namely the National Centre for Natural Gas Control and the National Centre for Energy Control. Finally, Pemex and the CFE were converted to productive state companies.

Human Capital

As part of the legislation package, a national workforce content initiative was passed with secondary laws applying to both the electric and oil and gas sectors. Such national content laws may be seen as a possible bottleneck in a country where the energy sector has been historically monopolised. Nonetheless, according to Jose Uriegas, managing director at Grupo Idesa, a local petrochemicals group, “Mexico has a workforce capable of satisfying the needs of most areas of the energy sector, which is the reason why the energy reform sets local content rules at 25-35%, depending on the sector,” he told OBG. “Mexican legislators, however, understand the country lacks capacity and knowledge in areas such as deepwater and unconventionals, where local content requisites are lower.”

The objectives of the energy reform include the creation of 500,000 jobs by 2018 and 2m by 2025, 1% additional GDP growth for 2018 and 2% by 2025, and the reduction of electricity and fuel prices for all consumers. These goals are ambitious, and not all pieces of the puzzle are fully implemented. With a strong legislative and regulation background, the reform has aroused interest from a number of stakeholders within the country and across the globe.

Hydrocarbons Advances

The most significant advances regarding the oil and gas sector is the first set of oilfields out for public tender. The tender process will be divided into different “rounds” which will include different sub-rounds divided according to each stage. These stages will be divided into phases, including exploration, extraction and Pemex partnership, and will further be classified by resource type, such as shallow water, land, deepwater and extra heavies, and unconventionals. In the first round of bidding, three have been defined, six are pending and three will not have bids at this stage. The published tenders include shallow-water exploration and extraction, and land extraction. The unpublished tenders include Pemex partnerships for shallow water, land and unconventionals. In addition, they include exploration for deepwater and unconventionals, and extraction for deepwater.

Luis Vielma Lobo, managing director of CBM Ingeniería Exploración y Produccion, a local consultancy firm specialised in hydrocarbons, told OBG that there are two types of contracts: production sharing and licences. “Production-sharing contracts are an industry learning standard, having been used in many countries. On the other hand, licences have been widely adopted in the US,” he said.

As with all such first-round bidding, the primary challenge is for Mexico to recover its former oil-producing capacities. “The energy reform was meant to have an immediate impact on the country, but the drop in oil prices and Pemex’s production decline, mixed with the time it will take independent oil companies to begin production from round-one fields, has left Mexico in a complicated position,” said Vielma Lobo. “It will take Mexico around three years or more before oilfields begin producing and one can begin talking about an increase in oil production.”

Although oil exploration and production is a long-term endeavour, the volatility of oil prices affects the bidding and tendering process. Vielma Lobo said that at $100 per barrel, investments in all field types are possible. At $80 per barrel some investments become less attractive. Today, with prices at $55-$60 per barrel, many areas have been eliminated.

“Nonetheless, Mexico has an advantage, as historically the cost of production under the Pemex regime has been between $20 and $25 per barrel, so even under a per-barrel scenario of $55-60, investments can be profitable,” Vielma Lobo told OBG. The current decline in oil prices may have been one of the reasons why the CNH decided the order of its tendering programme, with mostly conventional and some mature fields first, and leaving the heavy, unconventional and deepwater resources for later.

Electricity

Although less featured in the media, the electricity sector is developing rapidly. Alejandro Peraza García, head of the electric systems unit at the CRE, told OBG, “The electric market is a complex one, with many technical components. Currently the transformation that is happening is very fast, but we are considering a ‘soft’ transition, so some of the players will stay under grandfathered legislation. This will allow a soft landing.”

Many large investments are under way. Some of the most important are in the generation field, where natural-gas-driven combined-cycle and renewable energy generation plants will see the most movement. Added to the obvious generation infrastructure investments, the kick-off of the open wholesale energy market will point to other opportunity areas.

Manuel Rodríguez Arregui, partner at Ainda Consultores, a financial advisory company for oil and gas projects, told OBG that the operating scheme for combined-cycle plants will probably be different. “With the past legislation, a plant with excess capacity could have a difficult time selling additional generation to the CFE. Today, with the new wholesale open market opportunities for building generation capacity in places with high arbitrage will bring significant investments,” Rodríguez Arregui said. Other electricity segments will see investment as well, but the nature of these, such as transmission and distribution, will most likely translate into a longer incubating time before these come to fruition.

Enrique Ochoa Reza, director of the CFE, told OBG, “In 2014, 35 investment projects were announced and on June 22, 2015 another 24 strategic investment projects were added. The investment amount for all CFE projects out for bids – including pipelines, new plants, plant conversions, transmission lines, renewable energy and so on – exceeds $20bn.”

Looking Ahead

One of the main challenges in oil and gas will be to secure investment for sites with high extraction costs, such as deepwater and unconventional resources. This is especially the case with volatile oil prices in early 2015. The bidding process has been adjusted accordingly, and these locations will probably not be released until it makes economic sense. During the second stage of the reform process, the administrative burden to handle production-sharing contracts by the CNH may prove challenging. The stabilisation of oil prices in the $ 60-per-barrel range, however, will encourage investors, while administrative challenges are mostly a question of dealing with the inherent learning curve.

On the electricity side, the main bottleneck for development will likely be securing power purchase agreements (PPAs). One of the main concerns is that with the pending issues, such as wheeling fees and market operation, bilateral PPAs will see some lag in generating the necessary confidence with investors. Since the market is changing, consumers’ expectations will be changing as well. Nonetheless, mechanisms such as long-term auctions will come into play to help allow quick and reliable project bankability.