Mexico sets sights on foreign investment through energy reform

End of PEMEX monopoly expected to give Mexico an additional 1% economic growth in 2018 and 2% more by 2025

By Cesar Hernandez, OTS International

Mexico has vast oil and gas reserves but not enough capital resources to drill for it. Consider this: In the US-controlled part of the Gulf of Mexico, more than 300,000 bbl of oil are brought up every day from the deepwater, contrary to production levels in the Mexico-controlled part. There is only one oil and gas company in Mexico, Petróleos Mexicanos (PEMEX). It has been this way since 1938, when the country was in the midst of a socialist revolution. The government took control of production and expropriated the sector from foreign oil companies.

For decades, Mexico was one of the world’s top crude producers, but not anymore. Since 2004, oil production has declined from 3.5 million bbl/day to 2.5 million bbl/day. One of the keys to turnaround is accessing the potential 50 billion bbl of oil in the Gulf of Mexico deepwater. However, deepwater drilling is highly complex and expensive. Today, PEMEX spends more than $26 billion in exploration and production. However, required investment to meet Mexico’s long-term goals and prospected activity exceeds $60 billion.

Mexico’s Energy Reform, through a strategic framework agreement, is pushing for foreign investment. The more generous it is, the more investment it will bring – but also more controversy.

The Energy Reform is a historical milestone that ends the monopoly in the energy sector. It allows the entrance of private investment for hydrocarbon exploration, production and commercialization, as well as electricity generation and distribution. It is the culmination of a process that started more than 20 years ago. The strategy framework agreement includes amendments to three constitutional articles, plus transitory articles, as well as the approval of a secondary legislation inclusive of 21 initiatives (in which nine are completely new).

On 20 December 2013, a constitutional reform was enacted. The reform represents a paradigm shift in the management of Mexico’s natural resources.  The secondary legislation, approved on 7 August 2014, modified the legal framework in order to promote a more productive and sustainable use of the country’s natural resources. After this transformation, the State will possess a flexible legal framework governed by the principles of private law; a special regime for acquisition and procurement, compensation, budget, debt, subsidiaries and affiliates; and strengthened corporate governance.

The main guiding principles of the Energy Reform include:

• Hydrocarbons: The Mexican State retains ownership and control of hydrocarbons;

• Tax regime: Third party participation in the hydrocarbon sector through various types of contracts and a new fiscal regime;

• State Productive Enterprises (SPE): PEMEX and Federal Electricity Commission (CFE).

• Strength: Restructuring of the energy sector with new entities, as well as redefined roles and the strengthening of regulatory agencies; and

• Transparency: Promotes sustainable development of the national industry and ensures transparency and accountability.

Secondary Legislation

To consolidate a new legal framework in the energy sector, the secondary legislation includes modifications to 12 existing laws and the creation of nine new statutes:

• Hydrocarbons Law: Establishes the overall framework by which the exploitation of hydrocarbons will be performed. It provides rules for the types of contracts that will be granted for exploration and production to industry operators, as well as the rules through which such contracts will be granted.

• Electric Industry Law: Oversees the regulation of the generation, transmission, distribution and commercialization of power and electricity, as well as sets requirements for industry members on issues such as clean energy, open access and supply, among others.

• Geothermal Energy Law: Regulates the exploitation of geothermal resources located in the subsoil, which includes the participation of private investors through the granting of permissions and concessions.

• National Agency for Industrial Safety and Environmental Protection in the Hydrocarbons Sector Law: Creates a decentralized agency that will regulate and monitor the industrial, operational and environmental protection related to the locations and activities of the hydrocarbons sector.

• PEMEX Law: Reorganizes PEMEX’s activities and seeks to transform PEMEX into an SPE. It provides regulations for corporate governance, as well as audit and assurance, among other changes to PEMEX’s current structure.

• CFE Law: Establishes the organization, functions and operation of the CFE, as well as provides new rules for entering into procurement contracts for leasing, services and public works.

• Coordinated Regulatory Entities in Energy Matters Law: Creates two regulatory agencies: the National Hydrocarbons Commission (CNH), for exploration and production (upstream) activities; and the Energy Regulatory Commission (CRE), for transportation, storage, distribution and retail of oil, gas and electricity (downstream) activities.

• Hydrocarbons Revenue Law: Regulates the distribution of oil and gas revenues between the government, the State Productive Enterprises and the private contractors, as well as the taxation that will apply to the new contracts entered into with private investors and the state productive entities.

• Mexican Petroleum Fund for Stabilization and Development Law: Establishes and regulates a state-owned fund that will receive, invest and manage all non-tax revenue derived from the new contracts and assignments.

Impact to Development

The Energy Reform is designed to provide Mexico with a modern legal framework so that, without privatization, it will strengthen the oil industry and increase oil revenues for the benefit of Mexicans. PEMEX and CFE will not be privatized. All petroleum and natural gas resources will continue to belong to Mexico, and private participation will be permitted in exploration, extraction, refining, petrochemicals, transport and storage.

The reform will lower the price of electricity and gas. Nearly a half-million extra jobs will be created during the present administration and 2.5 million by 2025. The oil industry will once again be an engine of economic growth in Mexico, by triggering investment in new areas.

Experts indicate that Mexico will have approximately 1% more economic growth in 2018 and approximately 2% more by 2025. The opening up of the electricity industry will allow major investments to flow into the sector. Through project selection, Mexico will decide participation conditions in order to have the necessary investment and means to extract resources in deepwater and shale fields.

There will be more resources for the  government budget and for social programs, derived from new businesses in the energy industry and by growing the country’s oil revenues. Citizens will be able to monitor operations and oil revenue derived from new contracts. All existing contracts will be audited annually. There will be more transparency and better instruments for controlling the oil industry.

A key objective of the reform is to end corruption and special privileges.  CFE and PEMEX will be strengthened to increase Mexico’s competitiveness, equipping the companies with more autonomy through efficiency, profit investment and improved corporate governance. Finally, the electricity industry will be reorganized to ensure competitive rates for households, industry and commerce.

Resolution, Bidding

In order to strengthen PEMEX and maximize its long-term value, the Ministry of Energy (SENER) prioritized PEMEX’s request for exploratory blocks and producing fields and defined their dimensions in Round Zero. The government granted 100% of the requested 2P reserves, which makes up 83% of total reserves, and 67% of the requested prospective resources, which is 21% of total prospective resources. The rationale was to sustain current output levels while holding onto strategic exploratory prospects to facilitate organic growth in the future.

The Round One proposal consists of a balanced and diversified portfolio of blocks. It encompasses currently producing areas, relatively new or scarcely explored areas, and areas with conventional resources, as well as unconventional fields with high prospective potential. Round One, previewed by SENER and the CNH, includes 109 exploration blocks and 60 extraction fields that together amount to 28,500 sq km (91% of exploration areas and 9% of extraction fields). It represents an annual investment of $8.5 billion for the next four years. If PEMEX’s associations are included, the annual investment could reach $12.6 billion on a yearly basis. This represents a 40% increase over the $30 billion annual investments planned during the next four years by PEMEX.

During the process, SENER and CNH will be in constant talks with industry players in order to receive feedback and ensure the process is carried out with transparency. SENER is assuming that most investments for Round One will come from foreigners. However, the participation of some Mexican companies is expected in selected fields where they are already participating or have certain expertise, as is the case of developing mature fields through enhanced recovery.

The aftermath of the reform constitutes a new industry environment built on technology transfer, collaboration along the entire value chain, risk-sharing, diversification, transparency, sustainability and environmental protection. In conclusion, the Energy Reform represents a game changer for Mexico’s state-owned hydrocarbon resources, as the basis to expand the types and nature of hydrocarbon investment contract models with private investors.

Additionally, it includes a full liberalization of the midstream and downstream activities within the oil and gas industry, as well as an open market for the generation of power.

This article is based on a presentation at the 2014 IADC Contracts & Risk Management Conference, 14-15 October, Houston, Texas.