Change is in the air: Wide-ranging energy reform could redefine the sector and more

There is no part of the Mexican energy industry that will not be changed by 2013’s reform. The reform will open the nationalised oil industry to foreign investment, allow for open competition in the electricity market, enable private companies to build natural gas pipelines with more freedom, and will give producers of clean energy better access to customers. The constitutional amendments that serve as the reform’s foundation were passed in December 2013. In April 2014, the proposals for the secondary laws, which are needed to implement the reform, were published. These proposed laws are expected to be passed, virtually unchanged, in June. Then the reform’s measures, as spelled out in the secondary laws, will be implemented over the course of the following year.

Content

The most talked about and important consequence of the reform is the opening of the oil industry. Ever since Mexican oil was nationalised in 1938, Petróleos Mexicanos (Pemex), the state-owned oil company, has had a vertically integrated monopoly. It has also been a cash cow for the state, funding 30% of the federal budget. The siphoning off of Pemex’s earnings and the lack of competition it faces have led to declining production and challenges to the management of resources. The energy reform, if implemented properly, will help to address these problems.

Pemex is not the only energy monopoly in Mexico. The other, less-known one is the Federal Electricity Commission (Comisión Federal de Electricidad, CFE), the state electricity company, which, like Pemex, wields complete control over its industry. For decades, it has controlled the grid and virtually all electricity production. Today, electricity in Mexico is expensive to produce and much of it is used up in transport via the country’s large infrastructure network. The reform will break up CFE’s monopoly, opening the market to private investment and enabling free competition.

National gas infrastructure will also open to private investment. Today, Mexico has limited access to cheap natural gas, despite being just across the border from the centre of the US natural gas industry in Texas. The problem is an inadequate network of pipelines whose capacity barely meets half of the country’s demand. Like much of the energy industry in Mexico, natural gas infrastructure has been largely closed off to private investment. The reform will change this, providing the opportunity to import more cheap gas from the north. Finally, renewable energy sources will also benefit. The opening of the electricity market will eliminate restrictions on setting up electricity generation businesses and will grant producers of clean energy easier access to customers.

Politics

The energy reform is the most ambitious piece of President Enrique Peña Nieto’s wide-ranging reform agenda that is supporting the longer-term Pact for Mexico, or “Pacto por México” in Spanish. Given the history of oil in Mexico, it is remarkable that the Peña Nieto government was able to pass it.

Indeed, the 1938 nationalisation of the oil industry was such a proud moment in Mexican history that it was commemorated with a federal holiday. Today, Mexican ownership and control of its own oil is an important element of national pride and identity. For this reason any attempts to liberalise the oil industry over the past two decades have been met with howls of protest. The political sensitivity to the question of oil explains why all previous attempts at reform have been timid and ineffective.

New Urgency

However, during the past 10 years, the imperative to change the oil industry became stronger than it had ever been before.

Pemex’s production of crude peaked in 2004 at 3.4m barrels per day. Since then, production has been in decline, falling to 2.6m bpd in 2013. The production slowdown could have spelled financial disaster for Mexico since the government depends on revenue from Pemex to balance the budget. But, in the same decade that Pemex’s production fell by a quarter, oil prices doubled, allowing the government to keep budgets balanced. This, however, was not sustainable. Pemex was becoming less productive every year and Mexico could not count on buoyant crude prices bailing out the state indefinitely.

Untapping Reserves

Despite Pemex’s flagging production, Mexico remains the world’s ninth-biggest oil producer. It also possesses substantial reserves. According to the US Energy Information tion, Mexico had reserves of 10.3bn barrels of oil in 2013 and natural gas reserves of 17.2trn cu feet. The country is also believed to have substantial deep-water reserves in the Gulf of Mexico. However, Pemex Administra-cannot access much of this, as the state body operates almost exclusively in onshore and shallow water fields. It has made only one significant deepwater find, and it has minimal shale operations.

Pemex on its own is not capable of turning around the country’s oil production. Every year, it gives up 75% of its income to government levies, leaving little for investment in exploration and research and development. As a result, Pemex has fallen behind private oil majors in terms of technology and technical capability. Further, it has exploited much of the country’s easily accessed oil, leaving reserves that are geologically more complex, technologically more demanding and less profitable to exploit.

The Chicontepec Case

The only solution is to bring in foreign capital and know-how. Several attempts have been made to do this without fully opening the industry, but these attempts have failed. Notably, in 2013, Pemex held an auction looking for operators to work in six blocs in the Chicontepec field: this field contains a large portion of Mexico’s reserves that Pemex has never been able to adequately exploit due to the geological complexity of the area. The hope was that foreign groups would be more successful.

What was offered to attract foreign companies was not a licence or concession, as this would have been unconstitutional – the 1938 nationalisation, like most Mexican legislation, is laid out in amendments to the Constitution. Instead, Pemex offered a fee of $6.50 per extracted barrel plus reimbursement for operating expenses, terms that are not desirable for oil majors who want to control the oil they produce.

The auction was thus unsuccessful. Two oil majors, BP and Royal Dutch Shell (RDS), bought project specifications, but neither submitted a bid. Several oil services providers, including Halliburton and Grupo Diavaz, of Mexico, did participate, but they only bid on the smaller three of the six available blocks. Each company was assigned one of these blocks. The three bigger fields were not assigned in the auction and two of them did not receive a single bid.

The result should not have been surprising. The terms of the auctioned contracts were much less attractive than those offered to oil majors in countries such as Colombia, Brazil and Norway. But Pemex could not have offered much more even if it had wanted to. The legal framework of Mexico’s nationalisation precluded the offering of modern licensing terms that might have attracted real interest. That is why the reform was so badly needed.

Opening

It was clear that the oil industry needed to be opened to other actors. The question was what mechanism should be used to do this.

A 2008 reform gave Pemex the ability to offer services contracts to private companies – this measure allowed Pemex to hold the 2013 Chicontepec auction. However, services contracts are the most limited method of involving private firms in oil operations. At the opposite end of the spectrum are concessions, or licences in modern parlance. But concessions in Mexico are unconstitutional (the reform has not changed this), and, politically, a concessions regime would have been impossible to implement.

In the early proposals of the energy reform, Peña Nieto’s government staked out the middle ground by proposing profit-sharing or production-sharing contracts. In the case of profit-sharing contracts, a company is granted the right to operate in a particular field. The oil it extracts is sold, usually by the government or a third party, and a portion of the profits is returned to the company. For production-sharing, the oil company hands over a portion of the oil to the government and keeps the rest. These types of contracts are more attractive to oil companies than services contracts, but they generally do not grant oil companies the operational autonomy or upside they need to engage in riskier projects such as deepwater drilling. According to the Instituto Mexicano para la Competividad (IMCO), a Mexico City-based non-governmental organisation, profit- and production-sharing contracts would not be enough to attract oil majors to invest heavily in Mexico.

The National Action Party, the main opposition party, agreed with IMCO’s position and convinced the government that more attractive contracts, whose terms would resemble those of concessions, should be included in the reforms. These contracts were ultimately included under the name of “licence contracts”. The government found this name politically expedient because it has allowed the president to maintain that only “contracts” will be offered to oil companies. In fact, the overall terms stipulated under these licence contracts are indistinguishable from those of licences or concessions. Under the terms of the licence contracts, oil companies will be able to operate autonomously in fields assigned to them by the government, as they are accustomed to doing in countries such as Colombia and Norway. They will pay royalties based on their productivity and they will be able to keep the oil they extract. These are the kinds of terms that will be needed to attract investment in high-risk operations, such as deepwater drilling, and low-margin ones, such as shale.

Zero Round

The energy reform charges the National Hydrocarbons Commission (Comisión Nacional de Hidrocarburos, CNH) with responsibility of running the auctions of contracts. Today, Pemex, by default, has the right to exploit any and all oil and gas reserves in Mexico. So, the CNH’s first job is to determine which blocks Pemex will keep and which will be made available to private companies. This first selection process is called the zero round, or “ronda cero”.

As of mid-2014, work on the zero round was ongoing. In March, Pemex submitted its list of requests of fields it would like to keep to the Ministry of Energy (Secretaría de Energia, SENER).

By mid-September, the SENER must either grant or reject Pemex’s requests on a case-by-case basis. Energy analysts expect that the SENER will allow Pemex to keep all fields that are currently productive as well as exploratory fields that it has the technological capacity and know-how to exploit. This would include onshore and shallow water fields. Pemex has also expressed its desire to maintain several deepwater fields. It is unclear if the state will acquiesce to these requests. “I do not expect Pemex to get everything it asks for,” Montserrat Ramiro X, director of energy projects at IMCO, told OBG.

Additionally, Pemex will be required to exploit any field it keeps within a timeline. It will have two years to develop fields. At the end of two years, it will have the right to ask for a three-year extension. After five years, Pemex’s fields must achieve certain levels of productivity or they will be made available to private companies through auctions.

Bidding

Any fields not assigned to Pemex in the zero round may become eligible for auction. In these auctions, the CNH will be able to offer any of the four kinds of contracts covered in the reform: services contracts, production-sharing contracts, profit-sharing contracts and licence contracts. In auctions the CNH will specify the fields being offered and under what type of contract. Licence contracts are expected to predominate, with the possibility of some production-sharing contracts for conventional fields. “I do not see many profit-sharing contracts being used, since they are rarely used elsewhere,” Ramiro X. told OBG. Companies’ bids will compete based on fiscal regimes and scopes of work, with the CNH expected to make assignations based on the best terms to the state. The first round of auctions is expected in 2015.

Refined

The reform opens up the Mexican market beyond foreign firms and grants Pemex far more flexibility than it has had in the past. The prohibition against foreign investment in the Mexican oil industry has effectively isolated Pemex and forced it to become vertically integrated within the country. As a result, today Pemex has its hands in a large number of different operations, ranging from petrochemicals processing to drilling for crude and from building pipelines to exploring for shale (see analysis).

Still, it has not been able to do everything on its own. For big projects, such as the construction and operation of refineries, it has needed to partner with oil majors, which has meant going abroad. One of Pemex’s biggest refineries, for example, is a facility in Texas which it jointly owns and operates with RDS. As a result, Pemex exports its crude to the US for refining and then imports it as gasoline – or other products – before bringing it to market. Once the reform is implemented, Pemex will no longer be forced to venture abroad to partner with foreign firms and it will be able to enter into partnerships on Mexican soil.

A Productive Company

One of the reform’s goals is to turn Pemex, which will remain state-owned, into a modern, oil company that can compete with other firms unassisted. Under the reform, Pemex will become a “productive company of the state”. A number of measures will be taken to achieve this: Pemex’s board of directors will be restructured, the tax burden placed on it will be lessened, and knowledge transfer from foreign companies to Pemex will be encouraged.

Today, Pemex’s board consists of five members of the oil sector labour union, four independent advisors and six members of the government including the minister of energy, the minister of finance, the minister of the economy and three undersecretaries. As a consequence of this composition, the board is a battleground of competing interests, many of which have little to do with the extraction of oil. Based on the proposed secondary laws, the newly constituted board of Pemex will not include members of the union, but will still include the minister of finance, as well as the minister of energy and independent advisers. The fact that a seat will be maintained for the minister of finance, who has no specific oil expertise, reflects the fact that the state cannot afford to let Pemex too far off its leash. The state’s dependence on the company is likely the primary obstacle to Pemex becoming a more independent and competitive company.

Indeed, according to the proposed secondary laws, the taxes charged to Pemex will decrease by only six points, from 75% to 69%. Luis Serra, senior researcher at the Centro de Investigación para el Desarrollo (CIDAC), an independent think tank, said that the state is expected to maintain close control over Pemex.

Knowledge Transfer

Besides lowering the fiscal burden on Pemex, the reform is also aimed at making the company more competitive by encouraging transfer of specialised knowledge, particularly with respect to deepwater drilling. Partially to serve this objective, the proposed secondary laws establish a goal of 25% national content in oil production in Mexico. This percentage is an average applied to the entire industry, allowing for Pemex to have 0-100% participation in any given project.

The great bulk of this national content will come from Pemex’s existing operations onshore and in shallow waters. Another piece will come from small and medium Mexican companies that provide services to the industry. The last, and crucial, part will come from Pemex’s participation in new projects, especially in deepwater, as a partner of oil majors. It is in these projects that it is hoped Pemex will acquire the specialised knowledge it needs to compete on its own.

The extent to which Pemex will get this opportunity is not yet clear. The state-owned group will be able to join oil majors as a partner in bids for deepwater fields, but Pemex has little to offer such partners, since it has limited deepwater experience.

The group’s value as a partner in these bids will be determined, for the most part, by the government’s priorities, specifically whether the latter will allow for preferential treatment to a bid that bears Pemex’s name, or if rather it always makes assignations purely on the basis of competition. “That question depends on the government’s decision on whether to let Pemex survive or not,” Antonio de la Cuesta, chief researcher in policy at CIDAC, told OBG.

Doubts remain about Pemex’s ability to evolve or, put another way, about the government’s willingness to allow it to change. Critics of the reform alleged that Pemex had “five years to live” when the five-year timeline for its development of zero round assignations was made public. This was melodrama, but it is true that Pemex’s prospects for the future are uncertain.

Public Finance

In 2015, new investment in oil operations may begin flowing into the country, but these investments will not significantly add to government revenue. It will take years of exploration and infrastructure development before companies begin extracting large quantities of oil. Throughout this process, the state will remain dependent on Pemex.

The new revenue will build gradually over time. Conventional fields will throw off revenue first, perhaps as soon as 2016. It will likely take at least five years for shale to produce significant revenue. In deepwater, which may, in the long term, be the greatest new source of revenue, the government will not begin collecting royalties on big quantities of oil for seven to 10 years. Deepwater revenue will likely grow from the 10-year mark onward, as deepwater royalties are usually calculated on a sliding scale that increases over time. As a result, the greatest benefits to public finances will not occur for, perhaps, 15 years.

Even after this 15-year period, it is difficult to envision a Mexican state that is no longer dependent, at least to some extent, on Pemex. The state will never be able to charge independent companies royalties even close to as high as those currently paid by Pemex, so it would be difficult to replace the revenue that would be lost if Pemex floundered.

Electricity

Like the oil industry, the electricity market will be opened to investment and competition as a consequence of the reform. Today, the CFE produces approximately 70% of electricity consumed in Mexico and controls almost all production (see analysis). Private companies are able to enter the market only after receiving a request for service from CFE, so there is little competition and energy costs are high.

The reform will open the market ultimately by breaking CFE’s monopoly. Private companies will be allowed to enter without CFE’s blessing and will be able to contract directly with customers. The grid will remain the property of CFE, but its management will pass to a separate regulatory agency. This agency, the National Centre of Energy Control (Centro Nacional de Control de la Energía, Cenace) will be specifically charged with making the grid available to as much of Mexico as possible, among other responsibilities. The transfer of the grid will also eliminate conflicts of interest that could arise from CFE operating the infrastructure that its new competitors will rely on.

As new players enter the market, the government hopes that competition will drive down the uncompetitive electricity prices that Mexican industry pays.

Pipelines

The reform has established the legal framework for the electricity industry to become more competitive, but this will not be possible without increasing the supply of natural gas.

In Mexico, demand for natural gas far outstrips supply due to Pemex’s low levels of natural gas production and insufficient pipelines to import gas from the US. The reform may enable the private sector to address this second issue. “As the sector opens up, we expect Pemex to intensify the modernisation of its operating facilities and raise the safety standards with it,” Horacio Fájer Cardona, president of safety and fire prevention group Kidde, told OBG.

Today, Pemex wields almost complete control over Mexico’s pipelines. Once the reform is implemented, a natural gas regulatory agency will be in charge and private companies will have more leeway to design and construct pipeline projects independently. A clear opportunity exists here for infrastructure companies. If they succeed in increasing the country’s capacity to import cheap natural gas from the north, significant benefits will accrue to Mexican industry, especially petrochemicals producers (see analysis).

Renewables

In 2012, Mexico passed a law that stipulates that by 2024 electricity production from fossil fuels must be capped at 65% of the national total. Mexico is likely to derive almost all of the remaining 35% from big hydroelectric plants, which accounted for 11% of electricity production in 2013. However, the government has also established incentives to promote the growth of true clean energy projects, a category that big hydro is generally excluded from.

The two most important of these incentives are preferential wheeling (transmission) and accelerated depreciation. Wheeling costs in Mexico are highly variable and expensive for conventional producers. Renewable energy producers are charged a low subsidised rate that is constant, which eliminates a potential risk of establishing wind or solar farms in rural areas that might otherwise be subject to high wheeling costs. The second incentive is that investments in renewable energy instalments can be depreciated completely in one year. This tax benefit is compelling enough that large Mexican corporations have built renewable energy plants as an accounting strategy.

These incentives have succeeded in stimulating growth. In 2013, energy from geothermal, biomass, wind and solar accounted for about 3% of Mexican electricity production. This figure will rise as new projects begin operation.

Wind is perhaps the fastest-growing part of the renewables sector. The planes of Oaxaca in the south of the country have favourable conditions for wind farms and substantial capacity is already installed there – Oaxaca II, III and IV, three phases of a single project, began operating in 2012.

Another two phases, Oaxaca I and La Venta III, are expected to come online in 2014 and 2015. Each phase has slightly more than 100 MW of capacity. In Baja California, the first phase of the Energía Sierra Juárez wind farm is expected to be completed in 2014. The first phase accounts for about 10% of the planned total capacity of 1.2 GW. These projects would represent a substantial increase over the national installed capacity of about 2 GW at the end of 2013.

Solar is smaller but is growing quickly. A total of 70 MW of solar capacity were installed in Mexico in 2013, according to Álvaro Lentz Herrera, president of the National Association of Solar Energy, nearly tripling overall installed capacity. Lentz expects another 120 MW to be installed in 2014.

Geothermal electricity, although not technically renewable, may be the most promising of Mexico’s clean energy industries. According to SENER, Mexico is the fourth-largest producer of geothermal electricity in the world, with about 840 MW of installed capacity. The country has potential capacity of 10 GW and it sits on large untapped reserves. The government appears committed to developing the industry: one of the 21 proposed secondary laws of the energy reform deals specifically with promoting the development of geothermal energy in the country.

Apart from the geothermal law, the energy reform has little to say specifically about renewables. However, there are two potential consequences of the reform that may affect the sector.

There is some concern among renewable energy associations and operators that as electricity regulations are rewritten, the incentives for renewables could be eliminated. The wheeling incentive is currently in limbo as the Cenace develops a new wheeling charge regime. There is no guarantee that the special treatment currently afforded to renewables will be maintained. The other consequence is clearer, and beneficial: the breaking up of CFE’s monopoly will lower barriers to entering the electricity market and make it easier to gain access to customers.

Economic Impact

While the government has said that the energy reform will add between 0.5% and 1% to GDP each year between 2014 and 2018 (the end of the current administration), this is a politically motivated estimate, which overstates the short-term impact of the reform. The reform will not have a significant impact on the economy in 2014 and only a modest one in 2015 when new investments first start flowing into the country. The economic benefits should steadily increase thereafter, however. According to an IMCO estimate, the energy reform will boost the economy by 1.5% to 1.7% on average per year from 2017 to 2030, with a lesser benefit in the early years of this period and a larger one later on.

In the early years, the benefits will derive predominantly from changes in the electricity industry and from distribution and transport of gas, as these are the two areas that will change most quickly as the reform is implemented. The greater benefits will take longer to develop as big oil projects come online.

Notwithstanding, benefits will accrue to other parts of the economy as well. Indeed, as investment in pipelines increases, the price of natural gas will decrease, rendering Mexican industry more competitive and boosting employment.

The reform has also added security to Mexico’s long-term fiscal situation. The ratings agencies Moody’s and Standard & Poor’s (S&P) cited the energy reform in their explanations of their respective upgrades of Mexico’s debt in recent months.

In its statement, S&P noted, “Tapping into Mexico’s vast oil potential should energise investment and growth throughout the economy, but we also believe that we will not see its tangible effects on economic activity for a number of years.”

Outlook

The government has largely accomplished its objectives with the energy reform legislation, as it is outlined in the proposed secondary laws. As Ernesto Marcos, managing partner of Marcos y Asociados, a local energy-focused consultancy group, told OBG, “The goal of the hydrocarbons reform comprises four axes: strengthening PEMEX as a productive company in a competitive environment; reinforcing the capacity of the industry’s regulators to supervise both PEMEX and the new private players; encouraging the regulated involvement of private companies along the entire hydrocarbons value chain to promote competitiveness; and lastly, promoting the development of national providers, an increase in national content and a boost for Mexican technology.”

In electricity and gas infrastructure, the legislation appears to have also accomplished its goals by opening the sectors to competition and investment and taking crucial infrastructure out of the hands of monopolies. However, energy reform is still in its early stages. While the changes have created a well-planned and carefully designed legal framework, at the moment, that is all it is, a blueprint for a more competitive and more productive future for Mexican energy. The reform will likely succeed or fail over the course of the next year during implementation. It is widely hoped that the current government can handle that process as deftly as it has managed the lawmaking.