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Mexico at the crossroads as calls for reforms grow louder

Reforms are vital if the country’s is to reverse its declining oil and gas profile – and unlock potentially vast unconventional resources. Justin Jacobs reports on how the politics are shaping up

Enrique Peña Nieto’s victory in Mexico’s July presidential election marked the return to power for the Institutional Revolutionary Party (PRI) after 12 years in opposition and has set the stage for the next round of battles over much-needed energy reforms in the country. 

State-run Pemex holds a monopoly over Mexico’s oil and gas industry – its control over the industry from field to forecourt was enshrined in the constitution after the industry’s nationalisation in 1938. It is a model that, although inefficient and long the target of calls for change, kept the oil flowing for several decades. Mexicans took great pride in their country’s ability to operate one of the world’s largest oil industries without help from abroad, and the government saw little need to share the spoils.

But calls for reforms to this model have grown louder in recent years as Pemex has proven unable to deal with the multitude of challenges facing Mexico’s oil industry. Production has fallen precipitously, a wealth of deep-water and unconventional resources remain undeveloped, the country is forced to import fuel products because of a shortage in refining capacity and accusations persist of patronage and corruption in the industry. 

Outgoing president Felipe Calderón made the first push for major reform in 2008. In the face of widespread opposition, however, Calderón decided to leave alone the issue of Pemex’s constitutionally mandated role. Instead he pushed for reforms that would allow Pemex to offer private companies per-barrel fee-based service contracts, similar to those used in Iraq, Ecuador and elsewhere. He also proposed changes to Pemex that would give it more autonomy, but did not go so far as to offer it independence from the government.

Even these limited reform proposals, though, met with stiff opposition. Many in Peña Nieto’s PRI party opposed the reforms and the opposition Party of the Democratic Revolution (PRD) drummed up public opposition to private involvement in the oil sector. 

Limited reforms

Nevertheless, Calderón did manage to pass some limited, though still unprecedented, reforms. He had hoped to push for further restructuring later in his term, but after the initial bruising debate an increasingly bloody drug war and a slowing economy scuttled hope for any new initiatives.

Most notably the 2008 reforms allowed Pemex to offer the incentive-based service contracts to private companies. It was hoped that this would prove to be attractive enough to lure the foreign capital and, more importantly, technology needed for Mexico’s increasingly challenging projects.

Four years later, however, it is clear that those reforms did not go far enough. Pemex has held two auction rounds since the 2008 reforms that offered incentive-based contracts to boost production at several mature oilfields across the country. But the rounds attracted tepid interest, mostly from service companies comfortable with the contract structure. The rounds failed to attract serious interest from Western oil majors with the technology and operation experience Mexico needs.

Now it is Peña Nieto’s turn. He has not yet detailed his reform plans, saying that he would bring together policy experts to formulate a comprehensive strategy. But he has sketched out some fundamental reforms that could revitalise Mexico’s oil industry. And the push for reforms could start soon as Peña Nieto looks to capitalise on the momentum gained through his election victory and the fact that he has an ally still in office in Calderón. He has said that he hopes to launch that effort even before he officially takes office in December, proposing that congress takes up reforms when it reconvenes in September. 

The first area of reform that Peña Nieto has said he will look at relates to changes to the constitution that would allow the government to offer contracts to foreign investors giving them a stake in Mexico’s oil reserves. Under the constitutional framework, Pemex has sole ownership over all Mexico’s hydrocarbon reserves. Foreign companies, particularly western majors, though, will need some way to book reserves under the various international regulatory standards to justify investment in the country. 

Although constitutional changes would be the industry’s preferred path for reforms, there is another option. A less ambitious deal that kept the service-contract model enabled by the 2008 reforms in place, but allowed companies to be paid in oil rather than cash, enabling them to book reserves under US Securities Exchange Commission rules, could achieve the same aim. This approach, though, could put off potential investors by signalling that Mexico is not fully committed to energy reform.

The second area of reforms will look at the structure of Pemex and its role in the Mexico’s oil business. As Juan Carlos Zepeda Molina, the head Mexico’s National Hydrocarbon’s Commission, recently pointed out, Pemex is more of a government agency than it is a company. 

“Right now, the Mexican Constitution states that Pemex is not a company, it’s a government office,” he said. “It has some technical autonomy to do its job, but many other things are constrained and controlled by the government, because technically it is a part of that government.” Reforming Pemex, then, would likely see it given much greater autonomy over its investment and operational decision-making. Peña Nieto has said that he will consider going so far as to allow a minority of shares in Pemex to be traded on the stock market, similar to the private-public model championed in Latin America by Brazil’s Petrobras and Colombia’s Ecopetrol. That would take Pemex out of the energy ministry and go a long way towards encouraging greater efficiency and transparency, making it a much more attractive partner to foreign investors.

Such fundamental reform to such an entrenched sector, however, poses an enormous political challenge. It would require unwinding a system that has been accused of fostering inefficiency, patronage and corruption.  

And Peña Nieto will likely have to try to pass reforms without a majority in either the 128-seat Senate or the 500-seat Chamber of Deputies, let alone the two-thirds vote he would need to change the country’s constitution.

“We will have a diverse Congress where no party has an absolute majority and, as a result, all the parties will be responsible for coming to agreements,” Peña Nieto said at a news conference after his election. “It is time to agree, not impose.”

One positive sign of change is that a myriad of political and industry forces appear to be lining up behind major reforms in a way not seen in the past. Keeping those forces in line, though, will require deft politicking from Peña Nieto.

It was members of Peña Nieto’s own PRI party that were some of the most vociferous opponents to reform in the past. PRI hardliners forced Calderón into tempering his ambitious plans and Peña Nieto will first have to win over those in his own party that previously opposed reforms.

If he is able to do that, Peña Nieto should find support in Calderón’s pro-business National Action Party (PAN), the largest of the opposition parties. Outgoing president Calderón said that he would work with Peña Nieto to push through the more energy reforms that he was not able to pass. “Not only will I, and the government of the Republic, cooperate (with the PRI) but we will continue to push through reforms,” Calderón said after his party lost the general election to Peña Nieto.

While PRI and PAN are likely to find common ground on energy reform, efforts to make constitutional changes could be complicated by opposition from the PRD. Led by leftist Andrés Manuel López Obrador, the PRD has voiced support for giving Pemex greater autonomy, but opposes constitutional changes to allow foreign companies to own Mexico’s oil reserves and would be unlikely to support plans to partly privatise Pemex. 

That will leave PRI and PAN looking for support from some of Mexico’s minor parties to achieve deeper energy reforms.

Backing for major reforms from Pemex itself, and the powerful oil workers union, could help sway uncertain lawmakers. Although both have in the past been loth to give up their iron grip on the lucrative industry, and some within are still opposed to opening up, continued struggles in the industry have pushed most to support the changes. “I believe (the 2008 reforms) are the first step for Mexico’s exploration and production industry... for deep water, for example, we will have to make some pretty big adjustments,” Perez Chavez from Pemex said.

Cantarell countdown

The challenges for the industry to overcome are complex and numerous, but start with the country’s falling output. Oil and natural gas liquids production has fallen by around 25%, from a peak of 3.83 million barrels a day (b/d) in 2004 to 2.98m b/d last year. And with the country’s mature fields in decline, Mexico faces further production declines unless it is able to find and develop new sources of production. 

The country’s production woes hinge on the ageing super-giant Cantarell field. Discovered in 1976 by a fisherman, for years Cantarell was the workhorse  of Mexico’s oil industry – and has contributed nearly $500 billion to the country’s treasury. Output from the field peaked at around 2.1m b/d in the early 2000s. As expected, output from the field started to decline this decade, but the fall has been far steeper than Pemex expected. The field has produced an average of just 404,000 b/d of oil through the first seven months of this year, and while production appears to have stabilised, it is showing no signs of recovering.

Since Cantarell’s decline, the nearby Ku-Maloob-Zaap (KMZ) heavy-oil complex has taken over as Mexico’s largest producing field. The government estimates that output from KMZ will rise steadily to a peak of 933,000 b/d in 2017. 

While oil production has fallen over recent years and faces an uncertain outlook, a strong economy has fuelled rising oil demand. Mexico could even become a net oil importer by the latter half of this decade, a move that would be a blow to the country’s accounts. Oil exports earned Mexico around $49.36bn last year, roughly 15% of the country’s total export earnings and contribute 1.1 trillion pesos ($72bn) to the treasury – about a third of the government’s revenue – each year. It does not have to be, though. Mexico still has a number of potentially world-class resource plays. 

Mexico’s deep-water section of the Gulf of Mexico, which has yielded multi-billion barrel finds across the border in the US, remains virtually unexplored. 

Onshore, the country is thought to hold vast shale reserves stretching from the north, where the Eagle Ford shale play straddles the US-Mexico border down the Gulf Coast. While explorers have invested billions of dollars and drilled thousands of wells in the Texas sector of the Eagle Ford shale, making it one of the most productive onshore plays in the US, the Mexican section is mostly undeveloped.

Pemex estimates that the country holds 113.9bn barrels of oil equivalent (boe) of untapped oil – 75% of which, about 85.9bn boe, is thought to be in deep-water and shale formations. The company estimates Mexico’s shale-gas reserves at 59.4bn boe, more than the 53.7bn boe the country has produced to date.  Mexico’s prospective deep-water resource is estimated at 26.5bn boe. The problem, however, is that these are technologically challenging and costly resources to develop, largely beyond Pemex’s reach. 

“Pemex has to improve its execution capabilities,” Jose Antonio Perez Chavez, a business development manager at the company, told a conference in Miami in late June. 

With the industry eager for new resource plays, reforms that gave companies a stake in Mexico’s oil and made Pemex a more attractive partner could open the door to an influx of new investors.

“It’s going to be a long process, and what we’re advocating for is just for Mexico to take the next step... and if the next step provides an avenue for ExxonMobil to participate, we will,” ExxonMobil chief executive Rex Tillerson said in June. He added, though, that his company had little interest in the service contracts that have been put on offer to date and that steps would need to be taken to allow foreign companies to take a stake in Mexico’s reserves. 

Pemex has said it hopes to hold both deep-water and shale licensing rounds in 2013, with the deep water round scheduled for the first half of the year and the shale round for the latter half. By that time the industry will likely know the state of reforms. Without action, Mexico, one of history’s energy powerhouses, could be left to watch from the sidelines as unconventional and deep-water discoveries herald a golden age for energy production across the Americas.

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