President Pena Nieto’s yearlong effort to reform significant parts of the Mexican state floundered in September 2013 when the government produced a so-called fiscal reform that failed to live up to its name. Excitement generated over reforming labor, education, telecommunications and banking fizzled out. Instead, a degree of disappointment entered into Mexican discourse with accusations that the reforming spirit of this president was no better than his predecessors. However, on December 11 Pena Nieto published his desired constitutional amendments to reform the energy sector. On December 18, he gained the necessary approval from a majority of Mexican states. With remarkable speed, Pena Nieto has recaptured the political levers and demonstrated skill to enact a breathtaking strategic reform. Passage of the Constitutional energy reform permits Pena Nieto to catalyze his reform program and portray a government that can both introduce and implement significant modernization.
What do the constitutional changes on hydrocarbons and electrical energy entail and how significant are they? As anticipated in my article, “Mexico’s Most Critical Challenge: Energy Reform” of November 25, the law allows the Secretary of Energy (SENER) to grant licenses to private institutions, including foreign persons for all downstream activities, i.e. refining, pipelines, petrochemicals, transport and even management of gas stations. (Licenses should be distinguished from concessions in that ownership of the resource – oil and gas – occurs at the well head, not in the subsoil.) However, SENER may not grant licenses or production sharing contracts for the exploration and extraction of oil and gas. Those activities may only be awarded on a contract for profit basis. The Mexican state thus preserves its ownership of the subsoil and its contents, respecting the historical - and much venerated national ownership of the “black gold” and the gas.
In the case of electricity generation, the state owned company Confederacion Federal de Electricidad (CFE) may neither grant licenses, nor production/profit sharing contracts for the transmission and distribution of electrical energy. However, all other activities in the electricity industry are open to contracts with private entities. This article will focus on the changes to the hydrocarbons regime, leaving the reforms to this industry for a future article.
Allocated Entitlements to PEMEX
The constitutional changes to Articles 25, 27 and 28, together with 21 “transitory laws” holding constitutional effect, require that SENER, on behalf of the Mexican state manage the nation’s oil and gas reserves and identify the areas for exploration and extraction. Contracts will be awarded by the National Hydrocarbon Commission (CNH) to PEMEX and to private entities through “allocated entitlements.” PEMEX holds priority in the first round, a.k.a. “Round Zero” of entitlements to extract oil and gas from fields on condition that it can extract and operate commercially. However, “Round Zero” contracts will only be issued during a 90 day window following passage of the implementing legislation. Holding the rights to commercialize allocated in this short timeframe, PEMEX then has 3 to 5 years to develop the resource. Significant pressure will exist to deliver results.
During that time, PEMEX may chose to exploit the resource itself, or enter into joint venture with private companies for the development of fields on the basis of a contract for profit. These opportunities maybe of interest to oil service companies as well as U.S. ‘independents’ who produce 54 percent of domestic U.S. oil, 85 percent of domestic U.S. gas and drill 95 percent of domestic U.S. oil and gas wells. PEMEX willingness to enter into joint ventures with U.S. ‘independents’ could produce sophisticated technology and know-how that PEMEX presently lacks and allow it to develop half-exploited fields, known as “bitten apples.” PEMEX may also decide to develop the field itself, but later transfer the “allocated entitlement” into a new contract with private companies. Throughout this process, PEMEX remains a favored contractor, but loses its monopoly position and is subject to Mexican regulators.
Four Types of Contracts
After the 90 day “Round Zero” period, a reconstituted National Hydrocarbon Commission (CNH) can award four different types of contracts to private companies, be they Mexican or international. These are service contracts that currently exist, but are of little interest to private companies, profit sharing, production sharing and licenses. Although considerable space is devoted to discussing the exploration and extraction of oil and gas, perhaps the greatest interest to U.S. companies will lie in the mid and downstream activities, i.e. refining, transportation, pipelines and storage, as well as gas stations.
Working through the CNH, the Secretary of Energy (SENER) will establish the valuation for areas of exploration and extraction, and open them up for public auction. In those areas where PEMEX believes that it can carry out commercial and profitable extraction, PEMEX is given 3 to 5 years to develop those fields. Furthermore, SENER will allow PEMEX to participate in service contracts, production contracts and license agreements for the development of mid and downfield activities, i.e. refining, pipelines and transportation, petrochemicals, marketing and sale of gas stations. PEMEX will no longer have a monopoly in these activities, but compete with private entities to determine which can provide the greatest revenues for the Mexican state.
Regulators and the Mexican Petroleum Fund
To safeguard the revenue generated from the licenses and contracts, a new national trust fund is created, the “Mexican Petroleum Fund for Stabilization and Development.” This fund is modeled on Oljefondet, Norway’s oil fund. It will be created to ensure the long term viability of oil/gas resources both for investment in the oil sector, as well as the social sector of the Mexican state, i.e. pensions and education. The Mexican fund will be placed within the Mexican Central Bank and be responsible for receiving, administering and distributing the income derived from both the licenses and private or production contracts. Furthermore, the reconstituted CNH and a new Energy Regulatory Commission (CRE), as well as regulatory bodies to overseas industrial safety and environmental protection will be created. CNH will play the most important role. It will be responsible for issuing the contracts, publishing the terms of the agreements and ensuring that payments are made to the Mexican Petroleum Fund. PEMEX will no longer receive minimal oversight from regulators. Instead, it will be treated as an independent national oil company, subject to the new regulatory bodies and bound to publish its accounts and operations.
PEMEX to become a for-profit company
Within a period of 2 years from the passage of the law, that is December 2013, PEMEX is required to become a state owned, profitable corporation which revenue is dependent upon its own extraction and the profit contracts that it enters into. Gone are the revenue streams from all energy related activities. PEMEX faces three more challenges: it anticipates that personnel will leave PEMEX lured by the higher salaries of international oil and service companies. We could see skilled geologists and petroleum engineers moving over to the private contractors. Second, PEMEX anticipates that a generation of managers will retire within the next three to five years depleting the national oil company of its leadership team. Third, transparency will make it harder to contract with small Mexican business which supply boots, medical equipment et al. at uncompetitive prices based on sweet heart deals. Finally, PEMEX will have to operate as a for-profit company and, where necessary sell off assets to generate operating funds and pay its pension liabilities. From the privileged position of absorbing all energy related revenues, subject to minimum regulatory oversight and passing a high, but established percentage onto the Federal government, PEMEX could be short of funds and drained of talent.
The consulta nacional (referendum) on energy reform
Who will contract with PEMEX for the exploration and extraction of hydro-carbons? Both ‘majors’ and ‘independents’ may act cautiously, conscious that strong opposition remains in Mexican society to the prospect of private participation demonstrable through the consulta nacional (referendum). The PRD, on the left of the political spectrum plans to use this referendum to block the energy reform. Earlier this year, the PRD succeeded in gaining the signatures of more than 2 percent of those registered to vote so as to force a referendum in conjunction with the mid-term election in 2015. Those in favor of the energy reform must rely on the Supreme Court determining that this reform is of national transcendence thus requiring a majority vote to block the reform in both legislative bodies. The PRD may have obtained sufficient signatures to hold the referendum, but the strong majority of those favoring the reform from both the center-right PAN and the governing PRI party in both the Lower House and the Senate make it unlikely that the PRD will achieve the majority vote in Congress to block the reforms. Despite the anticipated outcome, the referendum process could provoke nervousness and a degree of uncertainty among international investors.
Mexican energy companies
Perhaps the first to take advantage of the reforms will be Mexican business owners who will form the first generation of privately held energy companies to invest in hydrocarbons. Mexican entrepreneurs hold the advantage of deep knowledge of doing business with their government. Meanwhile, the international oil industry will watch to determine the capabilities of these new private Mexican entities. Opportunities for joint ventures will abound.
Oil Service Companies
Second, the structure of the constitutional changes with licenses granted in all mid and downstream operations suggests that oil service companies may demonstrate greater interest than international oil companies in Mexican energy. Although, the majors are famed for their project management and access to capital, the nature of the contracts that will open up, as well as the allocation of licenses in the mid to downstream production streams are better suited to oil service companies. They too may enter into joint venture with Mexican corporations to develop the extensive resources throughout the energy industry. Currently, PEMEX is an investor in the Shell Deer Park Refining Company outside Houston. That joint venture will now be able to consider refining operations in Mexico. This is a win for new investment in Mexico and greater productivity in the oil and gas sectors.
Expectations for economic growth and jobs
The reform represents a paradigm shift for Mexico. Gone is the dominance of PEMEX. There exists the potential to see increased investment in the energy sector and increased production from the current 2.4 million barrels a day (mmpd), to 3 mmpd in 2018 and 3.5 mmpd in 2025. Furthermore, the Mexican government anticipates an additional one percent in GDP growth by 2018 and 2 percent by 2025, the creation of half a million jobs by 2018 and 2.5 million jobs by 2025, as well lower costs of electricity and gasoline. The prospect is exciting both for Mexico and North American energy integration.
However, the details of how the hydrocarbon fields will be valued, the bidding process, the nature of the contracts and the explicit approval of the U.S. Securities and Exchange Commission (SEC) on how international companies may book reserves in their annual accounts is yet to be defined. Given the work that has already been devoted to this reform, we can be confident that the brightest minds in Mexico will seek to resolve these issues. They will examine the work of the U.S. Energy Department in bidding, the role of private investors in the Colombian, ECOPETROL and the Norwegian management of its Oljefondet for long term savings, among others. They will draw upon best practices and then persuade the political elite and the Mexican citizens that this reform producers winners over the long term. That time frame is expected to occur after President Pena Nieto leaves office at the end of 2018, but the reforms should be sufficiently advanced that it will be economically costly to turn them back.