Mexican energy reform is a historic opportunity for change

President Enrique Peña Nieto’s year-long effort to reform significant parts of the Mexican state floundered in September 2013, when the government produced a so-called fiscal reform that failed to live up to its name. Excitement generated over reforming labor, education, telecommunications and banking fizzled out. Instead, a degree of disappointment entered into Mexican discourse, with accusations that the reforming spirit of this president was no better than his predecessors.

However, on Dec. 11, President Peña Nieto published his desired constitutional amendments to reform the energy sector. One week later, on December 18, he gained the necessary approval from a majority of Mexican states, Fig. 1. With remarkable speed, the president has recaptured the political levers and demonstrated skill in enacting a breathtaking strategic reform. Passage of the Constitutional energy reform permits Peña Nieto to catalyze his reform program, and portray a government that can both introduce and implement significant modernization.

Fig. 1. President Peña Nieto is driving forward reform of Mexico’s oil and gas industry. Official photograph.

What do the constitutional changes on hydrocarbons and electrical energy entail, and how significant are they? The law allows the Secretary of Energy (SENER) to grant licenses to private institutions, including foreign persons for all midstream and downstream activities, i.e. refining, pipelines, petrochemicals, transport and even management of gas stations (licenses should be distinguished from concessions in that ownership of the resource—oil and gas—occurs at the wellhead, not in the subsoil). However, SENER may not grant licenses, or production sharing contracts, for the exploration and extraction of oil and gas. Those activities may only be awarded on a contract-for-profit basis. The Mexican state has thus preserved its ownership of the subsoil, and its contents, respecting the historical—and much venerated—national ownership of the country’s “black gold” and gas.

ALLOCATED ENTITLEMENTS

The constitutional changes, to Articles 25, 27 and 28, together with 21 “transitory laws” holding constitutional effect, require that SENER, on behalf of the Mexican state, manage the nation’s oil and gas reserves, and identify areas for exploration and extraction. Contracts will be awarded by the National Hydrocarbon Commission (CNH) to PEMEX and private entities through “allocated entitlements.” PEMEX holds priority in the first round, a.k.a. “Round Zero,” of entitlements to extract oil and gas from fields, on the condition that it can extract and operate commercially.

However, “Round Zero” contracts will only be issued during a 90-day window following passage of the implementing legislation. Asserting the rights to commercialize allocated fields and wells in this short timeframe, PEMEX then has three to five years to develop the resource. Significant pressure will exist to deliver results.

During that time, PEMEX may chose to exploit the resources itself, or enter into joint ventures with private companies for the development of fields and wells. It remains unclear whether these JVs will be based on production sharing contracts, or profit sharing contracts; the former being preferable to independent oil companies and oil service firms. These opportunities may be of considerable interest to oil service companies, as well as U.S. independents. These operators produce 54% of U.S. oil and 85% of U.S. gas, and drill 95% of U.S. oil and gas wells.¹

PEMEX’s willingness to enter into joint ventures with such independents could give the NOC access to sophisticated technology and know-how, which it presently lacks, and allow it to develop half-exploited fields, known as “bitten apples.” PEMEX may also decide to continue developing the field, itself, but later transfer the “allocated entitlement” into a new contract, with private companies. Throughout this process, PEMEX remains a favored contractor, but loses its monopoly position and is subject to Mexican regulators.

FOUR TYPES OF CONTRACTS

After the initial 90-day, “Round Zero” period—which is expected to last from late April to mid-July 2014—a reconstituted CNH can award four different types of contracts to private companies, be they Mexican or international. These are service contracts that currently exist, but are of little interest to private companies; profit sharing; production sharing; and licenses to operate in exchange for the payment of royalties plus taxes. Although the new transitory laws give considerable space to discussing the exploration and extraction of oil and gas, perhaps the aspect of greatest interest to U.S. companies will lie in the mid- and downstream activities, i.e., refining, transportation, pipelines and storage, as well as the production of petrochemicals and carbon-derived plastics.

Working through the CNH, SENER will establish the valuation for areas of exploration and extraction, and open them up for public auction. In those areas, where PEMEX retains the “allocated entitlement” to develop a field, it has three to five years to operate on a commercial and profitable basis. Furthermore, SENER will allow PEMEX to participate in service contracts, production contracts and license agreements for the development of mid- and downstream activities, but it will lose its monopoly. Instead, PEMEX will become an NOC, which will have to compete with private corporations, both domestic and foreign, to provide maximum revenue for the Mexican state.

MEXICAN PETROLEUM FUND

To safeguard the revenue generated from the licenses and contracts, a new national trust fund, the “Mexican Petroleum Fund for Stabilization and Development,” is to be created. This fund will be modeled on Oljefondet, Norway’s oil fund. It will be created to ensure the long-term viability of oil and gas resources, for investment in both the oil sector and the social sector of the Mexican state, i.e., pensions and education. The new fund will be placed within the Mexican Central Bank, and be responsible for receiving, administering and distributing the income derived from both the licenses, and private or production contracts. Furthermore, the reconstituted CNH and a new Energy Regulatory Commission (CRE), as well as regulatory bodies to oversee industrial safety, environmental protection and natural gas transportation, will be created.

CNH will play the most important role. It will be responsible for issuing the contracts, publishing the terms of the agreements and ensuring that payments are made to the Mexican Petroleum Fund. PEMEX will no longer receive minimal oversight from regulators. Instead, it will be treated as an independent NOC, subject to the administrative rules of the new regulatory bodies, and bound to their transparency and anti-corruption requirements. Of concern is the financial independence, and political autonomy, of the CNH, the most important of the new regulatory bodies. Questions remain to be answered. Within a relatively short period of time, can it hire the personnel, with the appropriate skills, to carry out the valuation of fields and wells, as well as determine the capacity of PEMEX to operate on a for-profit basis?

PEMEX TO BECOME A FOR-PROFIT COMPANY

Within a period of two years from the passage of the law, in December 2013, PEMEX is to become a state-owned, profitable corporation, whose revenue is dependent upon its own extraction activities and the contracts that it enters into, Fig. 2. 

Fig. 2. West Pegasus platform in the deepwater Gulf of Mexico. Photo courtesy of Ing. José Luis Luna Cárdenas/PEMEX.

PEMEX faces a number of additional challenges: It anticipates that personnel will leave the company for the higher salaries of international oil and service companies. Skilled geologists and petroleum engineers may move to private contractors. Second, PEMEX anticipates that a generation of managers will retire within the next three to five years, thus depleting the company of its leadership team. Third, transparency will make it harder to contract with small Mexican businesses, which supply everything from tools to boots, on uncompetitive terms, often based on sweetheart deals. Finally, PEMEX will have to operate as a for-profit company and, where necessary, sell off assets to generate operating funds and pay its pension liabilities. From the privileged position of absorbing all energy-related revenues, being subject to minimum regulatory oversight and passing a high, but established, percentage onto the Federal government, PEMEX could find itself short of funds and talent.

THE REFERENDUM ON ENERGY

Who will enter into JVs with PEMEX, or bid for the exploration and extraction of hydrocarbons? Both majors and independents may act cautiously, conscious that strong opposition remains, in Mexican society, at the prospect of private participation, a fact demonstrated by the Consulta Nacional (referendum). The PRD, on the left of the political spectrum, plans to use this referendum to block the energy reform. Earlier this year, the PRD succeeded in gaining the signatures of more than 2% of those registered to vote, so as to force a referendum, in conjunction with the mid-term election in 2015.

Those in favor of the energy reform must rely on the Supreme Court determining that this reform is of national transcendence, thus requiring a majority vote to block the reform in both legislative bodies. The PRD may have obtained sufficient signatures to hold the referendum, but the strong majority of those favoring the reform, from both the center-right PAN and the governing PRI party, in both the Lower House and the Senate, make it unlikely that the PRD will achieve the majority vote in Congress to block the reforms.

Despite the anticipated outcome, the referendum process could provoke nervousness among international investors. The intervening 18 months provides an opportunity for the Mexican government to educate its citizens on the necessity for reform. In the early 1990s, the North American Free Trade Agreement was unpopular with Mexican citizens. However, the PRI government of the day engaged in a major campaign that succeeded in persuading a strong majority of citizens that the agreement was necessary for the modernization of the nation. The same effort will be needed for energy reform.

MEXICAN ENERGY COMPANIES

Perhaps the first to take advantage of the reforms will be Mexican business owners, who will form the first generation of privately-held energy companies to invest in hydrocarbons. Mexican entrepreneurs hold the advantage of having a deep-rooted knowledge of doing business with their government. Grupo Alfa is in a JV with U.S. companies, anticipating an opportunity to enter the Mexican oil industry, when passage of the implementing legislation is complete. Meanwhile, international specialists will watch to determine the capabilities of these new, private Mexican entities to enter into this new area for Mexican industry.

Second, the structure of the constitutional changes, with licenses granted in all mid- and downstream operations, suggests that oil service companies may demonstrate greater interest than IOCs in Mexican energy. Although the majors are known for their project management and access to capital, the nature of the contracts that will open up, as well as the allocation of licenses in the mid-to-downstream production streams, are better suited to oil service companies. They, too, may enter into JVs with Mexican corporations, to develop the extensive resources throughout the energy industry. Currently, PEMEX is an investor in Shell’s Deer Park Refining Company outside Houston. That JV will now be able to consider refining operations in Mexico.

EXPECTATIONS FOR ECONOMIC GROWTH AND JOBS

The reform represents a paradigm shift for Mexico. Gone is the dominance of PEMEX. There exists the potential to see increased investment in the energy sector and increased production from the current 2.4 MMbopd, to 3 MMbopd in 2018 and 3.5 MMbopd in 2025. Furthermore, the Mexican government anticipates additional 1% growth in GDP by 2018, and 2% by 2025; the creation of half-a-million jobs by 2018, and 2.5 million jobs by 2025; as well as lower costs for electricity and gasoline.2 The prospect is exciting for both Mexico and North American energy integration.

However, the details of how the hydrocarbon fields will be valued; the bidding process; the nature of the contracts; and the explicit approval of the U.S. Securities and Exchange Commission, on how international companies may book reserves in their annual accounts, is yet to be defined. Given the work that has already been devoted to this reform, the industry can be confident that the brightest minds in Mexico will seek to resolve these issues.

They will examine the work of the U.S. Energy Department in bidding; the role of private investors in Colombia’s ECOPETROL; and Norway’s management of its Oljefondet for long-term savings, among others. They will draw upon best practices, and then persuade the political elite, and the Mexican citizenry, that this reform produces winners over the long term. That time frame is expected to occur after President Peña Nieto leaves office at the end of 2018, but the reforms should be sufficiently advanced, that it will be economically costly to turn back. 

REFERENCES

1. Independent Petroleum Association of America information found at www.ipaa.org/about-ipaa/ 
2. Reforma Energetica, http://presidencia.gov.mx/reformaenergetica/assets/descargas/40_pags.pdf