The Opening of Mexico’s Energy Sector

Dr. Wood is the moderator of the ‘ The North American Energy Advantage’ panel at the upcoming North American Competitiveness and Innovation Conference – NACIC 2014, held later this month in Toronto, featuring Gary Doer, Canadian Ambassador to the United States and Jordy Herrera, Mexico’s former Minister of Energy and former President of Pemex, among others. The following piece is a modified version of a speech given last month at the Canadian Council for the Americas panel on Mexico’s energy reform.

When considering why the Mexican energy reform, which was signed into law in August, is such an important development, there are a large number of reasons to see this as a momentous change for Mexico and for North America. The reasons range from the political to the economic to the psychological, and include elements of both scale and content. What we are witnessing in Mexico is nothing more than both a paradigm shift in energy policy, and a revolution in the energy sector that rivals the nationalization of 1938 in terms of impact.

‘An extraordinarily fast process’

The first reason why the reform is such an enormous deal in Mexico is because of the paradigm shift. After 75 years of being closed, during which time so many expert opinions said that it would never change; it could not change in our lifetimes; it is impossible; public opinion is too ingrained against it; all of a sudden it became possible. How did such a transformation take place?

It became possible because of the unique conjunction of certain political and economic factors that took place beginning in 2012. That political shift was fundamental in actually shifting the public debate over energy reform. A number of different actors played a role in that, including think tanks such as the Wilson Center, IMCO and CIDAC who put out papers that were taken up in the legislative debate. It really was extraordinary and an extraordinarily fast process that took place. Even though there were delays along the way and we thought that maybe the secondary legislation would have been passed earlier on in 2014 than it actually was, if you think about what we was involved, we are talking about a complete opening of a system that for 75 years had been completely closed. That’s an extraordinary turnabout in a period of about 12 months from the time the government introduced its reform proposal in August 2013.

What’s on offer

The second reason why this matters I think is because of the energy that is on offer and the energy implications. For investors, it is the size of these resources I think that is the most attractive thing. That is what I hear most often when I talk to oil and gas companies. And when I talk to electricity companies that is what they are telling me. They say ‘the size of the resource and the size of the market is what really interest us.’

To date, Mexico has produced 54.7 billion barrels through the entire history of the Mexican oil industry. That’s a lot of oil, but it is only a fraction of what remains under Mexican territory. Well over 140 billion barrels of crude oil may remain in Mexican reserves. That’s an awful lot of oil. When we speak to folks in the oil industry, we said ‘Where else in the world can you find a play like this that is so untapped?’ and they say ‘Apart from the Arctic, nowhere” and we all know how controversial Arctic E&P is. This is an extraordinary, extraordinary opportunity , because we really don’t have another play that is an unexplored as the Mexican side of the Gulf.

In addition to deep-waters, I would like to point out two other plays that are of major interest. First, we should consider the abandoned, mature and declining fields that exist in Mexico, many of which have been sealed and left by Pemex over the years as it moved its limited resources to focus on more productive and profitable fields. With the opening of the system, private companies have the opportunity to tap those fields, using new technologies and techniques that Pemex has not employed before. Although these fields will not produce the hundreds of thousands of new barrels of oil that we expect to see from deep water, they will be a considerable element in the overall picture, and will generate significant value for specialized cooperators.

Secondly, we should consider the complicated and complex geological fields like Chicontepec, which has been an ongoing headache for Pemex as it tries to figure out how to get the oil out of the ground. Pemex has been trying for years and years, has been using field laboratories in recent years there, but has not cracked the nut. To give an idea of the opportunity, there are between 60 and 100 billion barrels of oil in Chicontepec. However, the oil is contained in small pockets in non-porous rock so it has proven very expensive to get it out. The operations in Chicontepec are also very land-use intensive, causing concerns about social conflict with local communities. But at some point someone is going to develop the technology that is going to make that oil economically recoverable. So there is huge potential here.

We tend to focus on oil, but of course there is the natural gas side to consider. Mexico has considerable natural gas reserves that is has not been exploiting for a number of reasons, including price factors, and the traditional focus by Pemex on producing crude. But Mexico also possesses, according to the EIA, the world’s sixth largest reserves of shale gas and, apart from some exploratory well, has barely touched them. The potential is clearly there, particularly in the North of the country where the Eagle Ford formation crosses over in the Burgos fields. And Mexico suffers from natural gas shortages, which are proving to be a drag on economic competitiveness by driving up electricity prices. In the medium- to long-term, the shale plays in Mexico will prove to be a source of enormous economic activity and prosperity.

Electricity rates

Thus the natural gas picture casts a shadow directly onto the electricity industry and with the reform there we begin to see what is possible. With industrial electricity prices at around 45 percent more expensive than in the U.S., Mexican industry is crying out for cheaper energy prices. The possibility of lowering electricity rates in Mexico for industrial consumers would have a huge impact of course in terms of economic competitiveness. In the past five years we have seen a couple of examples of major firms who have abandoned their Mexican operations and moved to Texas or to other parts of the United States because electricity had become the major cost for them of doing business in Mexico. This is particularly important when we remember that Mexico is trying to project itself now as a country where its major competitive factor is not cheap labour, but rather value-added, so it really does have to make sure that its fuel sources are at a competitive rate.

This element of competitiveness is what feeds most obviously, of course, into the whole program of economic reforms and structural reforms that the government has undertaken. This reform, as it is ‘La madre de todas las reformas’, the mother of all reforms, should actually be the major driver for boosting economic growth in Mexico over the next 12 months to five years. But it goes way beyond just energy pricing. The externalities of the oil boom and electricity transformation that we will see will provide much-needed employment, technical training and technology transfer, and will be a source of huge economic opportunity for services providers, steel and cement producers, and a wide range of components manufacturers. Beyond that, the opportunities for legal and consulting firms, and for millions who live in oil-rich areas, would appear to be enormous.

The path to reform

Looking ahead, it is worth taking a moment to reflect on how the government has handled the reform process to date, and what it has done right. iIn addition to making that decision to go for a major reform, which involved a high level of political risk, the process that the government adopted along the way, gives us great hope for the future. The government understood the importance of including the private sector throughout the reform process, and listened to and included key voices. Through both formal and informal channels, the government indicated that it was receptive to feedback from the private sector, and from industry experts. Oil firms, electricity providers, and regulatory experts, all engaged with the government, giving their feedback, ensuring a decision making process that benefited from international expertise.

Traditionally, that would have been a process which would be difficult to talk about in the Mexican context; because Mexicans have traditionally guarded the energy sector jealously , seeing public control as essential to protecting national sovereignty, direct private involvement in the policy process has been seen as an abomination by many people. But this government has tried, and has shown that it is possible, to overcome that prejudice. Throughout the reform process, both in the constitutional reforms, in the secondary legislation and now that we are in the phase of actually drawing up the regulations, the Peña Nieto government has understood the importance of working with the private sector.

The government has also understood the fundamental principle of political inclusion. Although the Mexican political left announced early on that it couldn’t be part of this process of reform because it went against too many of its basic, fundamental principles, the Peña Nieto administration tried to include the Mexican left by offering benefits in the broader reform process, such as taking decisions on issues such as fiscal reform that jeopardized other interests and coalitions. Ultimately it failed to convince the left to come on board on the energy reform, but what the government succeeded in doing was to find a modus vivendi with the Partido Accion Nacional (PAN), the centre right party that was previously in government. It was PAN support that was crucial in getting the two thirds majority needed in both Chambers of Congress to get the constitutional reform passed, and then to get the 50 percent-plus-one votes needed for the secondary legislation.

Implementation and Rounds Zero and One

The reforms themselves are being implemented very well. Not just in terms of the content but in terms of the speed with which the government is enacting them. It truly is bewildering how the administration managed to do so much in 12 months, including the delays that happened on the political side in the Congress. Now that the reforms are exclusively in the hands of the Executive Branch, the government is moving at breakneck speed. It is really quite extraordinary.

Perhaps the best example of this is what happened when the government announced the results on Round Zero, which determined the resources that Pemex got to keep. During the process, Pemex asked for 83 percent of 2P reserves and asked for 31 percent of the nation´s prospective reserves. The decision was supposed to be made on Round Zero by the middle of September, but the government announced the results within a few days of the approval of the secondary legislation, in mid-August, a month earlier than expected.

When the government announced the result of Round Zero, Pemex was awarded 83 percent of 2P reserves and 21 percent of the prospective reserves. The immediate reaction from the private sector was less than positive, essentially criticizing the government for reserving so much of the nation´s reserves. However, the very same day the government announced what would be on offer for Round One, namely the first competitive bidding round, which will take place in 2015.

The unveiling of the Round One prospects was intriguing. First, there are 169 blocks on offer. Most analysts were expecting maybe 30 blocks, with 169 blocks on offer in Round One, it is a considerable prospect. Combined, the blocks add up to over 18 billion barrels in prospective reserves, which has certainly attracted the attention of the private sector. Now some private oil companies are complaining about the quality and size of the individual fields, but they recognize that this is the beginning of a longer process that will lead to bigger and ¨juicier¨fields coming available. Moreover, as the government has now begun to promote the Round One bidding process in conferences and events in Mexico and abroad, the overwhelming reaction from private firms has been that the government, Pemex and the regulatory bodies are professional and well-prepared.

And so it is clear that the Peña Nieto administration has handled this politically very, very well. The government understood that if you are going to reserve so much of the nation´s oil wealth for Pemex, then the private sector needs to be reassured that it will have access to considerable resources too, to make sure that key players remain interested. Essentially, the administration has shown that it is very savvy about the politics of the opening, both advancing the interests of the national oil company at the same time as providing prospects for the private sector.

When we examine the decision made on Round Zero, we can see that it was essential to make Pemex a sustainable business concern. Pemex now has assets which it has never officially controlled before because Pemex wasn’t a real national oil company, but rather was a decentralized agency of the state. As a result of the reform process, Pemex is transitioning to a productive state enterprise, and as a national oil company it needs to have assets. By controlling such considerable reserves, Pemex will be able to use to raise capital and most importantly it makes it a very, very attractive partner for the private sector. And that is indeed what we are seeing. At oil conferences across the world, many major IOCs and NOCs are courting Pemex.

This very smart combination of decisions from the government, was further enhanced in September with the announcement that the Pemex would be looking for partners for it prospects from Round Zero at the same time as Round One bidding takes place. These joint ventures and farmouts offer a very attractive prospect for generating value from a wide range of operators and services providers, guaranteeing that 2015 will really be a ¨big bang¨ for Mexico´s newly-opened oil and gas industry.

Bumpy road ahead?

In terms of the challenges which lay ahead, there are several which are considerable and must be brought into the equation. First of all, is the question of regulation and it must be said that the task is daunting. The government is not only creating an entirely new regulator which is the Industrial Safety and Environmental Protection Regulator, the ANSIPA, but it is having to strengthen the energy regulatory commission, the CRE, and the National Hydrocarbons Commission, the CNH, because neither of those organizations and certainly not the ANSIPA have ever had to regulate and supervise an open energy sector before. The CRE has just dealt primarily with a small number of electricity generators, mainly the CFE, the national electricity company, and the CNH has only dealt with Pemex before. Pemex essentially regulated itself before this. Now you have got to create an entire regulatory system that regulates an open market. That is a daunting prospect, particularly when one considers that by the summer of next year you are going to have 169 blocks assigned to oil firms, many of whom are new to Mexico, and on top of that there will be the joint ventures and farmouts from Round Zero to consider. This amounts to an entirely new regulatory universe and a large number of new actors coming in.

When we examine the regulatory agencies, we see a major challenge ahead in term in human resources. The National Hydrocarbons Commission, for example, has around 120 people working there today, with plans to expand to 270 by the Fall of 2015. Some experts are arguing that the CNH may need around 500 people to be hired to police the system adequately. That is a real challenge. Where are these people to be found? How do you train them? How do you bring them up to speed in time for this reform? The CRE is talking about a similar number of staff and at the ANSIPA will hire around 500 as well (many of whom will come from Semarnat, the nation´s environmental ministry). But the ANSIPA could probably use 1,000 as they consider the scale of the task in front of them, both onshore and offshore. Compare this with the telecoms industry in Mexico, where the regulator has just been strengthened because the government is also increasing competition in the sector. There are 1,000 people just working in the telecoms regulator. Oil and gas is a much bigger business than this, and will be much more complicated, so we are likely to need a similar number of regulators there.

On the human capital side, not just in terms of training regulators, but actually satisfying the demand for engineers, petroleum engineers, energy managers, lawyers, from the private sector , no one has a clear idea of from where we are going to find all these people. The government is working on a study, to make sure they actually know what the needs are but we don’t actually have any conception of how we are going to satisfy that demand in the short term. And of course that is talking about the highly skilled people, but the skills gap in Mexico (and in North America more broadly-speaking), involves a wide range of trades and vocational skills that are currently in short supply, including welders, electricians, plumbers, and construction workers. To meet the demand will require a whole re-working of the Mexican education system, at primary, elementary and higher levels. Despite its study and the 2013 education reform, it is unclear whether the government really has a clear handle on how the education system can be reformed and modernized to meet the needs of the modern economy. International cooperation is clearly going to be fundamental in that, as well as bringing the private sector into the process.

The next challenge will be the terms of the contracts. When the contracts are actually released in February of next year we are going to see whether or not the government has got the language right, and whether or not the government has got the fiscal terms right. There is good reason to be quite hopeful about that. The government seems to have a very clear idea of what is required by the private sector and the inclusion of the private sector in the policy making process up to this point has been excellent.

Then there is the political challenge. A lot of people ask ‘So is this going to stick? Is it going to hold?’ Most people point to the fact that the left wing party, the PRD, has announced it is going to hold a consulta popular, a referendum, around the time of next year’s midterm elections in Mexico. Everybody recognizes that in the eyes of the Mexican public these reforms are not particularly popular.

It is true that to date they haven’t been popular. But when Mexicans are asked if they approve of the energy reform, the responses show a 40 percent rejection rate, and only a 27 percent acceptance rate. This is not particularly encouraging. But there is an underlying trend at work here. Six years ago, when Mexicans were asked ‘Do you agree with an opening of your energy sector?’ 80 percent of Mexicans would say ‘No.’ Last year, when presented with the reform agenda, only 60 percent of Mexican said they did not approve. Now that the energy reform has passed, that rejection rate is only 40 percent. Is that 40 percent enough to actually win a public referendum, a national referendum, on overturning the energy reform?

There are a number of reasons to think that that’s not going to happen. At some point next year, it is possible that either PRD changes course and backs away from that consulta popular, or we are going to see that the government engages in a very high octane public relations campaign, continue what it did this year, to try and convince the public that this is not a bad reform. If there is one political party that knows how to get people out to vote, it is the PRI, the ruling party in Mexico. They have their entire machine ready to mobilize people and to get them out there, as the party has done in so many elections in the past.

A challenge that is often brought up in discussions of the reform is that of public security. Is security a major concern in Mexico for oil and gas investors and for electricity companies? Of course it’s a concern, but it is questionable as to whether it will be a deterrent . For while Mexico offers quite a different public security to South Texas or Alberta, it is much better than many countries in the developing world where oil companies regularly to business. There are clearly issues that oil companies will have to deal with in Mexico that they don’t have to deal with in the United States and Canada, but the companies who already operate there under service contracts actually know how to handle it and they recognize it is more of a molestia, it’s a bother, rather than a business deterrent.

Lastly there is the question of corruption. This is going to be a factor that national and foreign companies have to take into account. Mexico faces serious challenges with corruption and transparency, and they will no disappear overnight. While the current government is taking some important steps to reduce corruption and enhance transparency, the current culture is deeply ingrained and will take many years to reduce to acceptable levels. So this will certainly remain a drag on the competitiveness of the energy sector in particular and the economy more generally for years to come.

The change in Mexico that we are fortunate enough to be witnessing at the present time is an extraordinary and profound transformation of the energy sector. It has the potential to radically alter both the industry and the Mexican economy more generally. The impressive steps taken by the Peña Nieto administration to produce an effective and business-friendly transition, at the same time as strengthening both Pemex and the nation’s regulators, offers us hope that the reform will benefit both national and particular interests.

This piece was published in partnership with the Wilson Center’s Mexico Institute.