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Mexican reforms break state monopoly of energy sector

The reforms were passed in December last year and will be crucial for the country's energy prospects

After more than 70 years of isolation, Mexico's energy business is opening to the world. Passed into law in December 2013, the package of reforms introduced by President Enrique Pena Nieto to break the state monopoly on the energy sector mark the most important moment for Mexico's energy business since the industry was nationalised in 1938. 

It was a bold and risky move for Pena Nieto. Tinkering around the edges of the industry the deficiency of previous reform efforts - would have been the safer political bet. Oil nationalism runs deep in Mexico's body politic, and in many quarters the opening is seen as a betrayal. But Pena Nieto and the reformers recognised that righting the industry's problems needed profound change. That started with constitutional reforms to break the state's monopoly over the oil business and a slew of subsequent regulatory changes that have fundamentally altered Mexico's energy landscape.

The changes have been needed for years. As Mexico's energy business sank further into the morass, it became clear that state-run Pemex did not have the financial or technical capacity to stop the industry's inexorable decline on its own.

Mexico remains a major oil producer, but output has fallen steeply over the past decade and the country has lost ground on its neighbours and regional rivals. Crude production was 3.48m barrels a day (b/d) in 2004, but has fallen by 1m b/d in the decade since to 2.48m b/d in 2014. Despite potentially huge gas deposits, Mexico now also relies on liquefied natural gas (LNG) and pipeline imports. 

Customer becomes supplier

That the decline took place during an unprecedented boom in oil prices that fuelled investment and production growth around world, and especially across the Americas, made it all the more painful. Over the past decade, Mexico could only watch as an oil bonanza arrived in the US, turning its most important customer into a global oil powerhouse. A decade ago, Canada's oil output was 1m b/d less than Mexico's. Today, thanks to a surge of investment in the oil sands, it produces 1m b/d more than Mexico. Regional rival Brazil is set to overtake Mexico this year thanks to its pre-salt development. While the neighbours have thrived, Mexico's struggles have cost it tens of billions of dollars in revenues and investment.    

Pena Nieto's answer has been to throw open the door to foreign companies, capital and expertise. Immense amounts of cash and new technologies have been key to spurring oil growth elsewhere, and Pena Nieto wants the same for Mexico. That is opening new and enticing opportunities for foreign and private Mexican companies. 

The jewel in the crown of Mexico's opening is the country's upstream. Mexico has potentially world beating offshore and onshore oil reserves. The deep-water Gulf of Mexico (GoM) in the US has long been a premier oil province. For decades, companies have pushed out from the near shore, going ever deeper and finding ever greater reserves of oil. 

But nearly all that activity comes to an abrupt halt at the maritime border with Mexico, even though the same oil-rich geology almost certainly extends across the frontier. Pemex reckons Mexico's deep waters could hold around 27bn barrels of untapped crude. It has acquired more than 124,000 square km of 3-D data and drilled around 30 deep-water wells, but it will take much more exploration to nail down more precise figures.

There are plenty of reasons for optimism. For one, the sort of international oil majors that Mexico hopes to lure into the GoM - ExxonMobil, Shell, BP, Chevron and others - are already significant players in the US and know the region well. They know the geology and have the technical expertise to deal with the GoM's unique challenges, including difficult sea conditions and yearly hurricanes. Many companies also hope that they will be able to tie discoveries in Mexico back across the border into their well-developed infrastructure on the US side, which would reduce costs. 

Initial focus will likely be on the well-known fields that are thought to straddle the border. Pemex, for instance, has started to explore the Mexican section of the Perdido oilfield, at 8,000 feet one of the world's deepest developments. On the US side, the field has been developed by operator Shell and its partners Chevron and BP, and produces 100,000 b/d. Pemex could look to bring in one or all of those companies to help develop and finance the Mexican section of the field, unlocking billions more barrels. 

Equally enticing, but more difficult, will be tapping into Mexico's shale oil and gas deposits. In the same way the deep-water GoM geology doesn't stop at the US-Mexico boundary, neither does some of the US' most prolific shale geology. The oil-rich Eagle Ford shale in southern Texas has been one of the largest and most economically attractive producers in the US and it is thought to extend across the border into northern Mexico's Burgos basin. In the past four years, production from the US section of the Eagle Ford has gone from just 200,000 b/d to around 1.75m b/d. 

Many of those companies responsible for the Eagle Ford's booming production will no doubt be looking across the border to what is possible in Mexico. The Energy Information Administration (EIA) has said the Burgos basin holds 6.3bn barrels of oil and 343 trillion cubic feet (cf) of gas, making it the most attractive in Mexico. Other shale plays stretch down Mexico's Gulf Coast, and the EIA has said that Mexico has the world's eighth largest recoverable shale-oil resources at 13bn barrels and the sixth largest shale-gas deposits at 545 trillion cubic feet. 

Pemex has drilled a few wells to test its shale potential, but its focus has remained mostly on Mexico's deep-water frontier and maintaining output at existing fields, indicating shale is likely to take a back seat in Mexico's oil opening. Just four shale wells were drilled in Mexico last year, according to data from regulators, and only 18 wells in total have been drilled.

There are a number of reasons for the caution. For one, shale development will be complex, requiring a large number of operators and service companies, financing arrangements and significant new infrastructure to get the oil and gas to markets. Shale development is further complicated because many of the most promising shales happen to lie under areas where Mexico's ruthless drugs cartels are most active. 

While Mexico's shale and deep-water fields offer the largest prizes, the country's mature shallow-water and conventional onshore fields are also being opened up. These fields won't offer the same huge reserves potential, but could prove attractive to smaller upstart Mexican firms and Latin America-focused independents seeking low cost projects that could deliver new production relatively quickly. 

It is these shallow-water fields that foreign investors will get the first crack at. Mexico's regulators have already kicked off Round 1, a multi-phase bid round that will take place throughout the year. 

The first phase has seen 14 shallow-water blocks in a relatively well-explored section of the GoM put up for auction. The blocks are each thought to hold reserves of 50m to 200m barrels with relatively low levels of exploration risk. Mexican officials have said that costs for shallow water fields are less than $20 per barrel, making them attractive even at lower oil prices. More than 30 international companies, including Shell, Chevron, ExxonMobil, have paid to visit the data room for the acreage, which officials say is an indication of strong interest. Final bids for the highly anticipated round are due on 15 July, and will offer the first gauge of interest in Mexico's oil opening. 

That will be followed by the second phase of Round 1 in which five more shallow-water fields off Tabasco and Campeche states are being auctioned. The second phase fields are higher potential but also higher risk, with some blocks thought to hold as much 500m barrels. Results for that phase will be announced on 30 September.

Subsequent rounds later in the year will put up the highly sought after deep-water fields, though regulators haven't yet provided a timeline. In total 169 blocks covering shallow water, deep water and onshore conventional and shale are expected to be put up for auction this year as part of the Round 1 process. Round 2, offering a new set of blocks is expected next year as the opening gathers pace.

Mexico's energy secretary, Pedro Joaqua­n Coldwell, said in March that he expects the initial steps of the reforms to spur more than $62bn in new investment and create 212,000 new jobs. 

It will take time for that investment to result in new production. But when it does, the result should be dramatic. The US' EIA last year sharply revised up its long-term outlook for Mexico's oil production, seeing output recovering to just over 3m b/d by 2025, compared with earlier forecasts suggesting it would fall below 2m b/d by 2025. By 2040, production could reach around 3.7m b/d, the EIA said, 75% higher than its previous 2040 forecast of 2.1m b/d.

But Mexico's oil opening still has a long way to go. Most immediately, the steep fall in the oil price has complicated the reform effort. Pulling investors in to new high-cost deep-water projects at a time of industry austerity will be tricky. It could be even more difficult to attract smaller and mid-size players that don't have the financial firepower to spend through the downturn. 

Improved flexibility

Mexico's officials have been responsive to concerns about the fiscal regime, releasing updated and more investor-friendly terms in early March. And they have vowed to be flexible in the face of a volatile market. The updated terms, for instance, now allow for a higher internal rate of return before the operator's share of profits starts to decline. 

However, the country may need to do more. Will Cargill, a senior analyst at GlobalData, has said the revised terms still do not offer producers enough upside potential if the market's direction changes. He argues that although the regime is relatively attractive at lower oil prices, because royalties and the government's share of profit oil rises sharply as oil prices go up, operators will see little benefit if the oil price increases. It may dissuade some companies from investing, he says. 

Mexico's precarious security situation is also a worry. The risk will be most pronounced for onshore projects, but new pipeline and terminal infrastructure for offshore projects could also be vulnerable. Pemex workers have been targeted by the cartels seeking ransom, and employees at cash-rich foreign firms could be attractive targets. Oil and gas pipelines have also been targets for sophisticated siphoning operations, which are thought to often have inside help from Pemex employees. Extortion and intimidation of oil workers is rife.

Foreign companies that have worked in Mexico say they have been forced to beef up security at their sites and avoid moving personnel and equipment at night. The measures will increase costs, by as much as 30% according to one company, but the industry is used to working in difficult security environments and although Mexico poses a unique security threat, experts say it is manageable.

Nonetheless, the general thrust of Mexico's opening remains positive. Above all, the country's policymakers appear determined to do what it takes to make the reforms work. Impressive levels of transparency have characterised the process and the government has responded when investors have raised concerns. Backing up the efforts are world-class reserves, access to which the industry has been seeking for years. 

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