Drilling potential abounds in Mexico, but so does uncertainty

Pace of reforms going faster than expected, leading to optimism as industry waits for Round 1 bidding

By Joanne Liou, Associate Editor

The tides are turning in Mexico after the government ended PEMEX’s 76-year monopoly over the country’s oil and gas market. On 20 December 2013, Mexico’s energy reform bill became a law. Then, on 11 August, the government enacted secondary legislation that addresses the legal framework to promote a more productive and sustainable use of the country’s natural resources. Based on the government’s timeline, the industry will see publication of Round One bidding terms within Q1 2015. “By the summer, we expect there to be contracts signed,” Duncan Wood, Director of the Mexico Institute at the Wilson Center, said.

Reform has been playing out much faster than the world expected. “Once the legislation was approved by the Congress, the government has moved ahead even faster than we thought it would. The government is trying to show the industry that it’s serious about this.”

As a result of the progress in Mexico’s reforms, the US Energy Information Administration (EIA) on 25 August revised its expectations for long-term growth in the country’s oil production. In 2013, the EIA’s International Energy Outlook projected Mexico’s production to continue its decline from 3 million bbl/day in 2010 to 1.8 million bbl/day in 2025. Revised numbers in the 2014 outlook reflect an approximately 75% increase, projecting production to reach and stabilize at 2.9 million bbl/day by 2020 and then rise to 3.7 million by 2040.

The first round of auctions expected in Q1 2015 will give private, foreign investors control of certain oil and gas properties. It will be another year or two for the companies to assess the properties and develop exploration and development plans. “In terms of when we’ll see rig count really affected is probably going to be sometime after mid-2016 to 2017,” John Spears, President of Spears & Associates, said.

Meanwhile, new upstream projects in Mexico have come to a virtual halt as PEMEX works to comply with the reforms. “In about two years, we’re going to see both onshore and offshore drilling activity begin to rise in Mexico in response to the reforms that they’ve adopted this year.” Analysts and industry players are still uncertain how much of an increase that will entail. “We just don’t know which fields are going to end up in the hands of what operators,” Mr Spears explained, adding that more clarity is expected in 2015. “We’ll have a much better idea as that situation gets sorted out.”

An increase in onshore drilling, especially in horizontal drilling programs, could lead to newbuild rig orders and/or a migration of advanced-technology rigs. “There could be an increase in rig building that accompanies these changes in the Mexican sector,” Mr Spears said. Existing rigs leaving the US for Mexico could also lead to newbuilds in the US market, he added.

If the US market is in a downturn as Mexico picks up, it’s more likely that rigs will be pulled out and redeployed, stated Tom Horton, Trinidad Drilling VP of Business Development and Contracts – US and International. He expects dayrates onshore Mexico to increase simply because PEMEX is now requesting better, newer rigs. “They’re calling for higher-spec rigs than they’ve ever asked for. The specifications for rigs in Mexico now matches what we are using in the US in the 1,500-hp rig market. Mexico is increasing the technology on all their rig needs.”

Through integrated project agreements, Trinidad Drilling had three rigs in Mexico on a five-year contract, which ended this year. “PEMEX had gone through a tendering process for multiple projects down in Mexico through integrated service companies,” Mr Horton explained. “The rig specs changed, and those rigs didn’t meet the revised rig specifications. We made a strategic decision to move them out and put them back into Canada, where they’ll begin working this winter.”

Trinidad Drilling currently has four newbuilds under construction for Mexican operations around Villahermosa through a joint venture with Halliburton that was put into place before the energy reforms. The rigs are being constructed at Trinidad’s yard in Houston and are expected for delivery in late 2014 or early 2015. The 3,600-hp, AC-drive, walking rigs will feature 2,400-hp quintuplex pumps with 7,500-psi circulating capability. All will operate under three-year contracts with an optional one-year extension.

Newbuild boom or migration?

Mr Spears believes a migration of existing rigs will come before new rigs are built for Mexico. He pointed to the opening of other countries, such as Argentina, where US rigs migrated to handle horizontal drilling. “It’s been the older rigs that have made the move,” he said. “That’s the fastest way to get a rig.  I’m sure there will be some operators in the US that are looking to do that to get established in the Mexican market.”

Mexico is not the first country in Latin America to open its oil and gas market to foreign and private companies, so it has the advantage of being able to learn from others. Argentina and Venezuela opened their markets to private companies in the early 1990s, followed by Bolivia in 1996 and Brazil in 1997.

Brazil’s Petroleum Act in 1997 ended Petrobras’ monopoly. “Following a constitutional change, Brazil had its Round 0, much like PEMEX is expected to have its Round 0.5 shortly,” said Joe Amador, Managing Director
at Tudor, Pickering, Holt & Co, an energy investment and merchant bank. In Mexico’s Round 0 held in August this year, the Ministry of Energy prioritized PEMEX’s request for exploratory blocks and producing fields, in which PEMEX could choose to exploit or enter into joint ventures. PEMEX was granted 83% the country’s so-called 2P reserves – proven and probable – and 21% of the country’s prospective resources. Companies can propose partnerships with PEMEX before the first full-fledged round of bidding begins next year.

In Round 1, Mexico’s National Hydrocarbon Commission is expected to auction 169 blocks, of which 109 are exploration and 60 are production, covering approximately 28,500 sq km. “There are opportunities in all the key provinces. You have opportunities for unconventionals in the north, deepwater, shallow-water and mature fields toward the south,” Mr Amador explained at the King & Spalding Energy Forum on 24 September in Houston. “You will also have some heavy oil opportunities. There’s something there for everybody.”

Offshore drilling contractors are looking to Mexico to help alleviate some of the rig surplus, but nobody’s sure when that will happen. “There will be a lot of demand driven from Mexico, which will absolve some of the new deepwater rigs in the market,” said Michael Mortensen, Senior Director and Head of Deepwater for Maersk Drilling. “(Mexico) is putting these licenses out for sale for the international (companies), but when that’s going to happen and how long it’s going to be before the prospects are actually matured, that is really difficult to say.”

Mexico’s opportunities will require significant investment to realize, Mr Amador stated. “The way to attract that investment is to be competitive. Mexico will need to compete with opportunities in its backyard,” he said, referring to US resource plays such as the Permian, Eagle Ford and Marcellus. “It’s going to take an incentive to get companies to move down to Mexico.”

While the industry and Mexico’s President Enrique Peña Nieto, who is with the Institutional Revolutionary Party (PRI), have shown support for Mexico’s energy reform, there are still opposing political parties and doubts among the public about opening the E&P market. The Party of the Democratic Revolution (PRD) is still hoping to halt the reform through a referendum around the time of the mid-term elections in July 2015.

“The outcome of that is not clear at all,” Mr Wood at the Mexico Institute noted. “A majority of Mexicans still disapprove of the energy reform, but that number has fallen dramatically. Five years ago, 80% of Mexicans said that they didn’t want to see liberalization of the energy sector. Then, during the energy reform process, a poll suggested 60% of Mexicans didn’t want the reform. Now it’s only 40%. The gap has narrowed so dramatically, and there are so many undecided on this that I don’t think the outcome of a referendum is guaranteed.”

The uncertainty of oil prices poses another challenge, as much of the reform depends on having relatively high oil prices to encourage international interest and investment. “If the oil price falls significantly, and we have seen some instability in the oil price in recent weeks, then that could be a factor that dampens interest,” Mr Wood stated.

With instability in the Middle East and unrest in Eastern Europe, Mr Wood said, he believes oil prices will fall. “With ISIS and the news stories about them using oil revenue to fund activities, I think that we could expect that there is going to be more instability in the Middle East, rather than less.” He believes that rising supply and slowing demand, especially from Asia, will drive prices down in the short term.

Spears & Associates estimates spot Brent prices will average $106.40/bbl in 2014 – down 2% from 2013 – and $90/bbl in 2015, down 15%, as supply growth outpaces demand growth.

Mexico has a long way to go before making a global impact on commodity prices. However, the reforms are expected to have significant impact on the Mexican natural gas sector, which Mr Spears said has been neglected by PEMEX. “Gas is one particular area where private investors could make a real difference in terms of production, but again, all these things take time. It takes a while to find the reserves and develop them and commercialize it. It won’t be until sometime toward the end of the decade that we really start to see a substantial change on the gas sector in Mexico.”

Analysts predict that oil from projects brought about by the reforms will begin to flow in 2018 or perhaps a bit earlier. “2018 to 2020 is when we’ll be able to see significant amounts of new oil flowing,” Mr Wood said. “There’s no doubt that there’s plenty of oil to be had in Mexico. The question is, can you mobilize the resources that you need to make that happen?”

Yet another challenge in Mexico is that parts of the reform still lack clarity, such as what regulations and regulatory bodies will look like, but foreign entities and governments are helping. The Alberta Energy Regulator (AER), for example, established a memorandum of understanding with SENER, Mexico’s Energy Regulation Commission, in June 2014. The goal is to help SENER “develop best practice regulations and monitoring methods, particularly in the areas of shale gas development, water management, enhanced oil recovery and venting and flaring,” AER stated in a news release.

Mexico has also been conversing with Texas regulators and the Norwegian government about their regulations, Mr Wood said. “Mexico is working very closely with foreign regulators and with experts in the industry to try and define what competent but competitive regulation looks like. I have a lot of confidence in them because they’ve shown that they’re willing to listen to those who know.”

The other part of the equation is the people who will make up the regulatory bodies. “We don’t know if they’re going to be adequately staffed – the number of regulators they’ll have and the quality of the regulators,” Mr Wood continued. A lack of demand in the recent past means there’s not a surplus of qualified individuals ready to step in. “We’ve also been seeing cooperation in the formation of human capital, where Mexicans are being trained in places like the Northern Alberta Institute of Technology. There’s a number of universities in the US that have energy law programs and energy regulation programs that are talking to the Mexican government to get Mexicans trained in time.”

In September, operators including BHP Billiton and ONGC signed MOUs with PEMEX to exchange technical knowledge, information, experiences and practices. “We see considerable opportunity in Mexico following the recent economic reforms, and we are excited about the deepwater and the extension of the Paleogene play into the Perdido play,” BHP Billiton President Tim Cutt stated in a news release. Transocean’s Deepwater Invictus drillship this year began three-year contract with BHP Billiton in the Gulf of Mexico, after being delivered in May. “What we can offer is absolute focus as Mexico seeks partners to help develop its enormous petroleum resources,” Mr Cutt said.

Implementation of the reforms and ensuing operations will be key to Mexico’s ultimate success. “We’re very focused today on the current (contract) migration, JVs and the licensing rounds, but in order to drill your first well, you’re going to need environmental permits,” Mr Amador cautioned. “There are social issues that you’re going to need to resolve – look at what’s happened in other countries. Hopefully, Mexico will take those lessons to account when it’s implementing its reform.”