Mexico's legislation changes grow energy sector competition

With more than 6% of Mexico’s GDP coming from oil and gas, and 1.8% from the utilities sector, energy is one of the most important components of the economy. Historically, the country has been largely dependent on its oil exports, which have made up a large part of the public budget for several decades. Nonetheless, the decline in production of Petróleos Mexicanos (Pemex), the state-owned oil company, from a peak of roughly 3.4m barrels per day (bpd) to around 2.5m bpd after 2010, combined with oil price volatility, led to an approval of a profound legislative revision in 2013 following the failed reform initiatives started in 2006 and 2007. The energy reform included a series of changes at the constitutional level. In short, the move amended the state’s exclusivity over most energy-related activities, including oil production and processing, natural gas production and distribution, primary petrochemicals and most of the electricity sector.

Wide-Ranging

By the start of 2014 significant constitutional changes had been implemented. Mid-2014 saw the publication of secondary legislation for the oil and gas, and electricity sectors. Legislative changes included a package transforming government monopolies Pemex and the Federal Electricity Commission (Comisión Federal de Electricidad, CFE) into what have been defined as “productive state companies”. The remaining changes relate to rules and regulations for each subsector. With the first investment opportunities around the corner, the challenge, according to Enrique Ochoa Reza, director of the CFE, is the timely implementation and working of all new processes. “Up to now all deadlines have been achieved, but these processes will last for some years,” he told OBG.

Upstream

According to Luis Vielma Lobo, managing director of CBM Ingeniería Exploración y Produccion, a local consultancy firm specialised in hydrocarbons, “Pemex is currently in a decline phase, producing around 20% less per year. This is mostly because of the decline of Cantarell, even though Pemex has found other significantly large fields, such as Ku-Maloob-Zaap. If Pemex wants to maintain production at 2m bpd the company must increase annual production by 20-25%.”

The volatility in oil prices, especially at the beginning of 2015, has compounded the impact of decreasing output. Antonio Juárez Alvarado, partner at Marcos y Asociados, a financial and business development consultancy specialising in the Mexican energy industry, told OBG, “Due to current low oil prices many companies are having a hard time achieving their production goals and are not looking to invest. This unfortunately has an effect on Mexico and may result in a delay in the exploration and development of shale fields in the country for one or two years. The next projects are likely to be mostly a revisiting of mature oilfields.”

Zero Round

Under the radar, the first phase of the energy reform, “zero round”, was a key stage in the transformation of Pemex from state monopoly to productive company. It consisted of quantifying the country’s resources, and assessing which of those should be assigned to the national company and what should be left for an international oil company to tackle.

As Manuel Rodríguez Arregui, partner at Ainda Consultores, a financial advisory firm for oil and gas projects, told OBG, “Zero round implies that Pemex has accountability for extraction, production, recovery factors and restitution of reserves.” Most critically, the National Hydrocarbons Commission (Comisión Nacional de Hidrocarburos, CNH) will regulate all players regarding the extraction factor, meaning the amount of the resources extracted versus the amount left in the ground. During the zero round Pemex accepted commitments with regards to the amount of resources it has to extract from the fields it was assigned. “Pemex production commitments will likely bring interesting challenges to the oil company and will require strategic alliances to overcome them,” said Rodríguez Arregui. “The opportunities for working with Pemex on much more sophisticated schemes than before, such as joint ventures, will imply important opportunities for private players that have so far been widely overlooked.”

Pemex will maintain 83% of the country’s proven and probable reserves and 21% of potential reserves, the energy minister, Pedro Joaquín Coldwell, said in August 2014. From the numbers, it may be that the CNH was looking for risk reduction on Pemex’s portfolio. Vielma Lobo said that the results of this zero round were a great paradigm change, not only for Pemex but also for Mexico. “It has passed as ‘business as usual’, but it is a milestone for a country that has depended on its national oil company for more than 70 years to provide over 30% of its budget,” he said.

Round One

Starting in December 2014 the Ministry of Energy (Secretaria de Energía, SENER) tendered some of its “round one” fields. The first fields opened for contract were 14 shallow-water areas in the exploration stage, under a production-sharing contract. Five additional areas were tendered, also in shallow water and in a production-sharing agreement, but ready for extraction. By May 2015, 26 additional land-borne areas were published, offered under licence contracts. Deep-water, unconventional and extra-heavy oils were pending until further notice as of mid-2015 (see analysis).

In July 2015 the CNH awarded two shallow-water exploration blocks, falling short of the 30-50% success rate the government was aiming for. Analysts and authorities attributed this to a combination of low international oil prices and high requirements for investment and profit sharing. The winning bids were from a consortium of Talos Energy of the US, Mexico’s Sierra Oil and Gas, and the UK’s Premier Oil. The operator is expected to invest $1.3bn in each block over the next five years, with 74-88% of profits going to the state.

However, the results of the second phase of the round one auction, released in September 2015, provided cause for optimism. Nine companies competed for a block thought to hold more than 700m barrels of oil. Another block attracted five bidders. Both were among three awarded production-sharing contracts during the phase: the third block received only one bid, and the other two had no takers (see analysis).

Midstream

Many experts think that most of the opportunities lie with Mexico’s mid- and downstream segments rather than upstream. In Vielma Lobo’s opinion, Mexico is a “sleeping giant” in terms of midstream opportunities, as additional production now coming online is not going to stay on the wellhead. “Production has to be taken to a place to be measured and evaluated in order to be billed. Although Pemex has very large land- and water-borne infrastructure, more investment will be needed to get the necessary infrastructure to handle the upcoming added production,” he told OBG.

Regarding natural gas, midstream opportunities are also on the rise. Mexico’s natural gas production has been declining since 2010. This is compounded by rising domestic demand, resulting in the country importing a large amount of its gas to cover the shortfall. Pipeline projects such as Los Ramones, Chihuahua and Noroeste may increase import capacity by up to 8.3bn cu feet per day by 2030. The latter two will add the Pacific coast region to the country’s growing pipeline network. Further integration in the south-east with the Morelos, Yucatán and Salina Cruz pipelines will allow for power plant conversion to natural gas.

These opportunities go beyond the upstream sector. North of the border, in Texas, for example, the natural gas pipeline network is approximately nine times larger than the existing network in Mexico. “Mexico, as part of North America, has a huge competitive advantage: access to affordable natural gas. There are still many regions of Mexico that do not benefit from this advantage yet,” Rodríguez Arregui told OBG. “If all planned pipeline projects announced are completed, this ratio will only decrease to six to one. The energy potential in Mexico is barely tapped.”

Refining

The current refining margins and the fact that Pemex operates all the installed refining capacity are challenges for quick subsector development. Juárez Alvarado told OBG that the national refining system is only operating at 68% of its total 1.6m-bpd capacity due to operational constraints and maintenance practices. “The first step would be to look into optimising the operation of the existing refineries,” he said. “The next step would be to look at expansions.” The current labour burden on Pemex refineries, which employ high numbers of staff to make up for inefficiencies, also means it is complicated for private companies to participate directly in its existing production facilities. However, key developments are expected in the form of associations for new processes in refinery expansions and reconversion, which could alter these shortcomings.

Retail

One of the most aggressive liberalisation time-lines should be seen in fuel retail. The 11,246 service stations in Mexico are all Pemex-branded franchises. Fuel is provided by Pemex using its own logistics and infrastructure networks, while the Ministry of Finance and Public Credit controls pricing. The energy reform package will change all of that. Starting in 2016, service stations will be able to bear any brand and use their own logistics operations with Pemex products. In 2017 fuel retailers can start importing their own product, and fuel prices will be liberated as an open market in 2018.

Many changes are on the way, and the existing participants are already preparing for these, especially large groups such as Hidrosina, CorpoGAS and Petro-7. In Rodríguez Arregui’s opinion, the downstream retail and wholesale market will also undergo transformation. “The petrol and diesel retail groups in the country did not previously handle wholesale. They had uniform prices from Pemex so there were no real incentives to optimise that part of the supply chain,” he told OBG. “Under the reform, arbitrage starts at the border, with procurement and risk-management strategies set to fall on retailers and their suppliers. Procurement, hedge trading, logistics and financial requisites will all have to be taken by the retail chains, which will probably lead to alliances with more experienced groups.”

Petrochemicals

The petrochemicals subsector had been partially liberalised in 1992 by creating an artificial division between primary and secondary petrochemicals. However, the development expectations for private secondary petrochemicals were not met. The main challenge was to secure long-term raw material contracts from Pemex, the sole supplier in Mexico of commodities such as ethane gas. Roberto Bischoff, managing director of Braskem-Idesa, a joint venture between Mexican and Brazilian petrochemicals manufacturers, told OBG, “Mexico has an annual deficit of petrochemicals products in the range of $20bn. To reduce this figure, petrochemicals production companies need access to more raw materials such as ethane gas. Without access to more raw materials, Mexico will not decrease this deficit in the petrochemicals sector.”

The opening of the primary petrochemicals sector in Mexico will give players the opportunity not only to secure supply but to also look to be more competitive by replacing some imports with local production, reducing the industry’s costs. Fernando Hernández, head of country services at Clariant Mexico, a specialist in chemicals, told OBG that energy reform will lead to a decrease in raw material prices for the petrochemicals industry. He added, “Having the opportunity to boost the development of our industry is of great importance."

Electricity Reform

The impetus behind the elecmake electricity tariffs more competitive for consumers. As an integral part of the energy reform, the monopoly status of the CFE was addressed, opening the electricity sector to private investment in all subsectors. Nonetheless, it was decided that control of the transmission and distribution system would be retained by the state via the National Centre of Energy Control (Centro Nacional de Control de Energía, Cenace). The sector was divided into generation, transmission and distribution segments, and new activities such as commercialisation were added. Activities and bodies that had been state exclusive were opened for private participation. These include energy suppliers, qualified customers (customers that can buy directly from private generators or the market) and energy retailers.

“The energy reform allows the CFE to partner with private investors,” Pierre Comptdaer, the managing director of ABB Mexico, told OBG. “As such, Mexico is now on the radar of the world’s most significant electricity companies.” The rearrangement of regulating entities and their capabilities was also a key point of reform, with a redefinition of roles for SENER, the Energy Regulatory Commission (Comisión Reguladora de Energía, CRE) and the inception of Cenace. The creation of a short-term wholesale energy market and the definition of two types of users – basic and qualified – were also integrated into the legislation.

Generation

In the first quarter of 2015, the CFE reported an effective installed capacity of 54.9 GW, of which the CFE owns and operates 76.5%. The remaining 23.5% is under independent power producer (IPP) contracts and another 26 GW is generated under the self-supply scheme. Of the total CFE capacity, 72% is from fossil fuels, 22% is hydropower, 2.7% is nuclear, 1.5% is geothermal and 1% is wind, according to Ochoa.

One of the largest challenges for the CFE has been to lower generation costs, some of which – especially those related to coal- and oil-fired generation – can be uncompetitive. The sector has been gasifying the fuel mix through a combination of retrofitting plants to operate with natural gas and building more IPP combined-cycle plants. In light of current natural gas prices this set-up will likely result in a future reduction of generation costs, but not an immediate one.

Electricity generation costs in Mexico were 24% above those in the US when the reform passed, according to Rodríguez Arregui, with similar inputs. This is partly because a high percentage of generation uses fuel oil. “Considering the industrial, commercial and service tariffs, Mexico’s electricity costs were 73% higher than the US’s,” he said. Rodríguez Arregui expects the wholesale market to cut costs for market participants that will seek out the least-expensive energy to pass on savings to their consumers, supporting more efficient generators. “Mexico is striving for additional energy at lower prices,” Jimmy Delano, director-general at ATCO Mexico, told OBG. “We have already seen electricity costs reduce for the industrial sector by 40%.”

Alongside the upgrades to existing infrastructure, Mexico’s generation capacity is set to expand thanks to the construction of new facilities. There are more than 10.7 GW in the CRE permit pipeline under the grandfathered legislation, for a total investment of more than $23bn. The most important technologies are wind with 2900 MW, solar with 3500 MW, co-generation with 2200 MW and hydro with 1000 MW. These projects could be coming on-line from 2015 to 2018.

Transmission & Distribution

Although less dynamic than generation, the transmission and distribution market will undergo a series of changes in the coming years. With 57,000 km worth of transmission lines, the Mexican national transmission system ( sistema nacional de transmisión, SNT) interconnects most of the country into one single network, with the exception of Baja California and Baja California Sur. With the reform, transmission and distribution companies will operate under the supervision of Cenace. For fair competition and access, these companies cannot be related to power producers or generation companies.

A division of the CFE will start as the main transport player, since it currently owns and operates most of the assets, but an array of other opportunities will arise. As Rodríguez Arregui explained, by having an open market, arbitrage is generated between the different nodes, meaning that the price difference will probably not reflect the actual distance between the nodes. This will bring opportunities for east-west transmission line construction, since the SNT network is currently built predominantly as a north-to-south design.

One of the less publicised aspects of the energy reform has been its establishment of energy retailers, which act as brokers of energy and related services to large consumers (i.e., qualified users) or to regions. Their legal capabilities include support with permits, agreements and energy-related services, as well as the provision and acquisition of transmission and distribution services. Retailers that also hold a supplier permit have added capacity to commercialise energy to end users and the short-term wholesale market.

Renewables

Under the grandfathered legislation the renewable portfolio adds up to more than 7500 MW. The scale of investment is mostly due to a strong incentive package that was set up to attract producers to the sector. This package comprised energy banking and preferential wheeling, which serve to make renewables more cost efficient by net-metering energy and fixing a lower fee for renewable energy transmission and distribution (see analysis). However, these incentives will not be applied to future projects as the reforms envision alternative methods of structuring tariffs.

Alejandro Peraza García, head of the electric systems unit at the CRE, told OBG, “Energy banking may be substituted by the wholesale energy market, while the renewable energy wheeling fees will not apply for new projects. In the case of transmission between nodes that may be congested, the fees may include a charge calculated using the nodal price difference defined by the wholesale market.”

Wholsale & Market

Another of the pillars of the electric sector reform is the opening of the wholesale market. As of mid-2015, the specific rules and regulations were in the public consultation phase, with stakeholders having an opportunity to provide feedback. The market is planned under a locational marginal pricing system, starting with today’s 42 nodes. In a first stage the auctions will be done the day before and will subsequently become real-time. Cenace is the body in charge of operating the wholesale market, while the CRE will be in charge of regulating it. More sophisticated products such as renewable energy certificates and financial transmission rights will be added to the daily auctions in the future. Besides the spot auctions, long-term auctions will be a key part for market evolution.

Outlook

The energy reforms are expected to incentivise an otherwise slow-moving sector, especially in the case of oil and gas. In an initial phase, however, investment in oil and gas exploration and production is likely to be outrun by advancements downstream, such as retail and product logistics. The reform goals are ambitious, but if the country and its stakeholders continue to move in the same direction – and at the same speed – as they have been, Mexico is nicely poised to become one of the most dynamic energy markets in the region.