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Mexico’s reforms signal a changing oil industry

Mexico’s oil industry has entered a brave new era with the passage of landmark energy reforms

Optimism is running high in Mexico’s oil patch. The country has passed energy reform legislation that goes further in breaking the state’s 75-year monopoly over the industry than seemed possible just a few months ago. The measures, analysts and industry officials say, will help Mexico revive its moribund oil sector and could see it become an increasingly important regional and global player in the next decade.The reform package, which promises to open the sector to foreign investment and overhaul state oil monopoly Pemex, was hammered out by president Enrique Peña Nieto’s Institutional Revolutionary Party (PRI) and the conservative opposition National Action Party (PAN) and passed by the legislature on 12 December. ”Leaders of both the PRI and PAN have boldly faced the reality that Mexico’s current energy regime is failing,” says David Goldwyn, the head of Goldwyn Global Strategies, a consultancy, who wrote a report on the reforms for Washington DC-based think tank Atlantic Council.

The need for reform has been clear to many policymakers, analysts and industry players for years. Oil production plummeted from a peak of around 3.5 million barrels a day (b/d) in 2004 to around 2.55m b/d in 2013 and the country’s refining infrastructure has suffered as a result of underinvestment. Without change, Mexico, a key supplier to the US market, could become a net oil importer by the end of the decade.

Pemex has managed to slow the decline in production over the past year, but it has been clear that the company does not have the technical prowess or financial muscle to develop the deep-water and unconventional reserves that are key to reviving the industry. The country needs foreign expertise and capital to develop those fields. But it was only over the past year that the political and economic incentives aligned to make major reforms possible. Peña Nieto showed a deft political hand during his first year in office, pulling together diverse and cross-party coalitions to push through as series of major reforms. The energy sector was the last, and largest, item on Peña Nieto’s to-do list.

The first order of business for reformers was rewriting Mexico’s constitution. The state’s monopoly over Mexico’s oil was enshrined in the constitution after the industry was nationalised in 1938. The state’s dominant role in the sector has been a source of national pride ever since, and it wasn’t clear if Peña Nieto would be able to muster the support needed to make changes to the constitution needed for deep reforms. In the end, the changes to the constitution went further than most thought possible. Changes to Article 25 of the constitution give more autonomy to Pemex and encourages it to become a commercially focused enterprise. Article 27 has been revised to reverse the nationalisation of Mexico’s oil, and allows the government to enter into exploration and production contracts with private companies. Finally, changes to Article 28 of the constitution end Pemex’s monopoly over the industry, though it reserves a dominant role for the state company, establishes an oil stabilisation fund and carves out a new more powerful role for regulators.

Reforms

The constitutional changes provide the necessary and ambitious broad framework for reform. But it is in follow-on secondary legislation where technocrats will have to do the difficult work of filling in the details of the legislation. “The real heavy lifting starts now and getting these details right is what’s really going to matter,” says John Padilla, managing director at IPD Latin America, a consultancy. The secondary legislation will tackle a number of issues. The constitution has been changed, for instance, to allowing the government to enter into contracts with private companies, but it is in the secondary legislation where the details of those contracts will be decided.

In a bid to fend off criticism from oil nationalists, the government has insisted on the state’s ownership over oil in the ground and explicitly bans concessionary contracts. But this is largely a game of semantics. Oil ownership can be passed to companies at the wellhead, and authorities have made it clear that they want contracts drafted in a way that allows foreign companies to book reserves from their Mexican projects under foreign stock exchange rules. That will be a key condition of investment for international oil companies. Still, potential investors will have to wait to see what type of contracts will be offered. It is likely authorities will develop a mix of licences and profit and production-sharing contracts, then seek to match each with the risk investors are taking on at different projects.

It will be a difficult balancing act for regulators, and striking the right balance will be crucial to attracting the private investment the country needs.“The reform is only going to succeed if the contractual arrangements that are put in place are competitive on an international basis,” says Marcelo Mereles, a partner at Mexico-based energy consultancy EnergeA. After establishing the framework for foreign investment, the most urgent task for regulators will be restructuring Pemex. The company is at the heart of the industry and Mexico’s economy and even with the opening up it will remain a dominant presence. It is the jewel in the government’s crown. The company single-handedly accounts for about 9% of Mexico’s GDP and one-third of the government’s budget. But the company’s lustre has become badly tarnished. While advances have allowed the industry to open up new frontiers, Pemex has largely been left behind.

Pemex will not be part-privatised like other Latin American state oil companies such as Colombia’s Ecopetrol or Brazil’s Petrobras. That has been a successful model elsewhere, but it is still a step too far for Mexico’s oil nationalists. Pemex, though, will be given a much greater degree of financial and managerial autonomy. The company has been operated, analysts say, more like a government department than a modern oil company. It is perennially cash starved and plagued by inefficiency. “Pemex historically paid an effective tax rate exceeding 99% through daily payments to the treasury, supporting approximately one-third of the federal budget. It is commonplace for national oil companies from Baku to Riyadh to provide the lion’s share of budgetary support, but the tax regime was crushing to Pemex,” says Goldwyn.

A new board of directors will be created to improve decision-making and the company will be put on an equal financial footing with other investors, paying the same base royalty rate and corporate income tax as other companies. It will pay a special dividend to the government, but that is expected decline over time as taxes and royalties from private investors in the industry increase. It is hoped that this will free up financial resources for the company to invest in new projects as well as new technologies.

A shock to the system

Putting new rules in place will be challenging enough, but changing the company’s culture could prove even more difficult. “The reform is only going to succeed in producing [a] strong national [company] only if there are deep changes to [the company] ,” says Mereles. “It is urgent and it’s pretty worrisome because [this is an] institution used to working in a certain way, very bureaucratic and very overregulated.”

The government will also set to work re-organising the sector. Pemex has effectively run all aspects of Mexico’s oil and gas industry, from field development to the fuel pump, with little oversight from regulators. That is to change under the new constitution. New regulators will be established and tasked with awarding contracts, setting energy policy and enforcing safety and environmental rules. Setting clear mandates for each of those bodies will be essential and difficult. Bureaucratic turf battles could paralyse the industry and scare off investors. The government has given itself just a few months to develop and start implementing the crucial secondary legislation, with new contracts expected to be ready in the first half of 2014. That will keep the momentum for reform moving forward, but it is a tight timeframe for policymakers to put a host of complex legal and financial measures in place.

At the same time the secondary legislation is being drawn up, Pemex will take part in what is being called Round Zero. During the first half of the year, the company will take a comprehensive look at its portfolio and decide which assets it wants to keep and which it will relinquish. It will have to prove to regulators that it has the financial and technological capacity to develop the projects it wants to retain. Pemex will have every incentive to retain as much of its portfolio as possible, and taking a realistic view of the company’s capabilities will be an important early test of the new regulators’ technical and analytical capacity, as well as its willingness to stand up to Pemex.

The company, analysts say, will likely want to maintain complete control over its major producing fields such as Ku-Maloob-Zaap and Cantarell. But it is also expected to start negotiations with private companies for new joint ventures during this time.  The biggest opportunities for foreign companies at this stage will likely be projects at Pemex’s existing deep-water acreage, including the company’s first deep-water discoveries, which it does not have to capacity to develop on its own. It will also likely seek partners for enhanced oil recovery (EOR) projects that offer the best hope of delivering quick production gains. 

Into negotiation

This period, though, could prove tricky for potential investors as negotiations could start before all the secondary legislation is in place, forcing them to balance the need to move quickly to get the best projects with the risk of legal uncertainty. Following Round Zero and the passage of secondary legislation, most likely in mid- 2015, Mexico’s new upstream regulators will set about delineating new exploration areas and preparing the country’s first licensing rounds under the new legal framework. First bidding is expected in 2016. The government will likely hold separate rounds focused on conventional, deep-water and shale areas, probably with different contractual terms for each.

There are numerous obstacles to these reforms. Getting the contracts right will be difficult. Pemex has fallen far behind its international competitors and it will take the company time to catch up. Domestic opposition to the reforms remains stiff, and could gain support if Pemex sacks workers to increase its efficiency, as it is expected to do. Regulators face a monumental task. Billions of dollars will have to be invested before tangible gains are seen. The whole process will inevitably take longer than predicted and could be derailed. But many analysts see the changes taking place in Mexico as momentous and gaining speed. “It will be a bumpy road, but these reforms mean there is no turning back,” says Goldwyn.

The government has high hopes. It says the reforms will help to increase production by around 500,000 b/d to around 3m b/d by 2018 and 3.5m b/d by 2025 and raise its reserves replacement ratio to more than 100%. This may prove overly optimistic over the short run unless Pemex is able to rapidly ramp up EOR operations and deploy new foreign technology at its established fields, but the country’s long-term prospects are clear. Pemex reckons the country’s deep-water fields hold more than 26bn barrels of oil equivalent (boe) and its shale basins hold a further 60bn boe. The country likely holds billions more barrels in conventional reserves. “It’s hard to overstate just how large the potential is here. Mexico is probably the most underexplored market in the world outside Antarctica. Canada drilled more wells in 2012 than Mexico did between 1990 and 2012,” says IPD’s Padilla.  

That potential is expected to attract a wide range of players from across the industry. International majors such as ExxonMobil, Chevron, Shell and BP that have extensive experience in the US section of the Gulf of Mexico will be keen to take that expertise into Mexico’s part of the Gulf, if the terms are attractive. Likewise, international majors and independents working in the Eagle Ford shale in south Texas have shown an interest in developing Mexico’s section of the Eagle Ford and other shale plays in the country.

National oil companies, particularly from China and elsewhere in Asia, have been snapping up reserves around the world, and will no doubt be keen on new Mexican projects. Pemex signed an EOR deal with China National Petroleum Corporation last year, and company and government officials have worked to establish closer ties with Beijing. Oilfield service companies, especially the major players Schlumberger, Halliburton, Baker Hughes and Weatherford that already have a presence in the country, could be the biggest benefactors as drilling and seismic activity pick up. Deep-water rig providers also stand to benefit. There are around 40 floating rigs at work in the US section of the Gulf of Mexico (GoM), compared to just five in Mexico’s section of the GoM. That represents a $16bn difference in annual spending between the US and Mexican sectors of the GoM, according to Barclays. As reforms are implemented, Mexico will start to close that gap, representing a potential multi-billion dollar boon to the offshore services sector.

The reforms could also see the rise of a new crop of Mexican oil and gas companies across the upstream, transport and downstream sectors. “Starting in 2013 we’ve had a lot of Mexican companies come to us and say ‘hey, help us understand the reforms and help us understand the opportunities I have because of the reforms,’” says EnergeA’s Mereles. “There are billions and billions of capital from family-owned companies that have a long tradition of being on the outskirts of the sector, and all these companies are opening their eyes right now and are very active trying to reinvent themselves and to evolve with Mexico’s energy sector.” Working with these companies, which have a deep knowledge of the local market and experience working with the government, could be an attractive entry point for foreign investors, especially US independents, says Mereles. 

If the reforms are successful in revitalizing the industry, the effects will be felt across the region and in global oil markets. Investment is already increasing across Latin America, and the emergence of a strong Mexican oil industry will make the field all the more competitive. Governments from Bogotá to Brasilia will have to compete harder for investment dollars. “For companies seeking a stake in South and Central America, Mexico’s oil resource base offers a good comparative opportunity that is lower cost than Colombia’s heavy oil resources and Brazil’s deep-water resources,” Michael Cohen, an analyst at Barclays, an investment bank, wrote in a research note. The cost of finding and developing a barrel of oil in Mexico is about half the regional average, according to Barclays.

The Western Hemisphere is undergoing an energy renaissance, with production surging from Canada’s oil sands to US shale to Brazil’s deep waters. Mexico risked being left behind without these reforms. No longer. “[The reform] puts all eyes on Mexico. Mexico now becomes the market to watch,” says IPD’s Padilla.

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