Energy reform in Mexico still presents risks

Energy reform in Mexico still presents risks

Mexico’s energy reforms are necessary to revitalize the sector. If the reform process is any indication, however, foreign firms will be wise to enter with caution.

So dear to Mexican society is the legacy of Lázaro Cárdenas’s 1938 expropriation of the country’s oil sector that it is still celebrated annually as a national holiday. Perhaps it is no surprise, then, that new liberalizing constitutional reforms of the sector, which promise to reopen the sector to foreign investment, have been controversial.

Petróleos Mexicanos (Pemex), the Mexican national oil company, was given a monopoly over the sector subsequent to the expropriations. Mexico’s oil has historically been in conventional, easy to access reservoirs and, as such, Pemex has proven relatively stable, if inefficient, in its production of such resources.

Over the years, however, Mexico’s conventional reserves have begun to taper off, and parasitic state intervention in the company’s finances have limited reinvestment into the firm. As of 2013, 71.5% of the company’s revenues were directed straight into Mexico’s treasury.

Coupled with limited investment in the sector, proven oil reserves in the country have dropped to just above 10 billion barrels, from a high of more than 55 billion in the 1990s.

While Mexico very likely has shale gas and oil, as well as offshore reserves, Pemex is in no shape to recover it. Its limited ability to invest in itself could ultimately make it obsolete. The company’s production numbers have fallen every year since 2004, and without major reforms, its downward slide is likely to continue.

The reforms, spearheaded by President Enrique Peña Nieto and the Institutional Revolutionary Party (PRI), and supported by the conservative National Action Party (PAN), will allow the reentry of the international oil companies (IOCs), to explore and produce oil.

Mr. Nieto signed the initial stages of the reforms into law in late December 2013. The initial legislation lays the groundwork for the reforms; they open the sector to private investment, develop a series of possible exploration and production (E&P) contracts, and provide increased operational autonomy for Pemex.

Secondary reforms, which will clarify the terms of the production sharing and profit-sharing contracts, guidelines for foreign private investment in the sector, and the level of autonomy that Pemex will be granted, are currently under development and are expected to be passed this summer.

Risky business?

So, how excited should foreign E&P firms be at the prospect of investing in Mexico? Jesús Zambrano, President of Mexico’s leftist Democratic Revolutionary Party (PRD), would have you believe that investors and IOCs are better off staying home. Potential for popular opinion to swing against the reforms, according to Mr. Zambrano, creates risk for investors. Within the decade, Mr. Zambrano believes the reforms could be overturned, leaving extensive foreign investment sunk into the country, in addition to the legal fees associated with oil companies’ potential exit.

This is the message Mr. Zambrano is spreading this week on a tour of the US, during which he is meeting with businessmen, investors, analysts, and lawmakers. Should his party make its way into power in coming years, Mr. Zambrano says, it will make counter-reform central to its agenda.

In the shorter term, the PRD is attempting to put the reforms to public referendum before signing them into law. The referendum, which would have a higher chance of rejecting the law than Mexico’s congress or executive, could be a liability for the reform’s future—unfortunately for Mr. Zambrano and his colleagues, Mexico’s supreme court is likely to keep the law under the president’s purview.

Unconventional reserves, conventional reservations

Mr. Zambrano is probably overstating the risks that foreign investors face in Mexico’s hydrocarbon reform. The PRD is unlikely to get enough public support to overturn the reforms. Pemex will remain visible as a state champion, even as foreign investors join the market, and if foreign firms can successfully find and extract shale gas and offshore oil, the market’s establishment will remain firmly pro-reform.

The real risks companies will face are more mundane. Mexico’s lack of transparency and bureaucratic inefficiency are likely to create challenges for international oil companies. The sector has been run centrally for decades, with leadership positions in Pemex often filled by partisans and politicians, and with blurred lines between Pemex and the state regulatory bodies. This culture this has fostered is unlikely to change as quickly as reform legislation can be passed. IOCs, then, will enter a market unfamiliar with competition, best practice, or bureaucratic or technical efficiency.

The current ‘round zero’ oil field auctions, whereby Pemex and oil regulators are deciding what fields to keep state control over, are already fielding criticism for their opacity. The talks are behind closed doors; it is unclear who is even participating in the meetings, let alone the substance of the negotiations.

Potential investors are also frustrated at delays in passing the secondary reforms. Mexico’s congressmen do not seem bothered—in a telling show of Mexico legislative vigor to pass the reforms, some congressmen recently called to postpone deliberations until after the World Cup. Scheduled sessions conflict, apparently, with World Cup matches that the congressmen really want to watch. Even without World Cup delays, the controversial nature of the reforms mean that deliberation is likely to be drawn out, possibly as late as September.

Big, influential oil majors can handle bureaucratic inefficiency—they operate in much more difficult environments than Mexico. But the small, independent firms that have developed expertise in shale oil and gas in the US are probably less suited to dealing with the opacity, corruption, and bureaucratic challenges they will encounter upon entry of the Mexican market.

Mexico needs the investment, and is unlikely to repeat a Cárdenas-like expropriation of IOC assets. However, given the risk already present in Mexico’s geology—IOCs will bid largely for unproven reserves in shale formations and deep offshore—even Mexico’s mundane manifestations of political risk may be enough to convince IOCs to stay north of the border.

About Author

Brady Jewett

Brady has spent the past two years in the Kurdistan Region of Iraq, analyzing investment and business in the region, and is currently based in Washington, DC. Brady holds a BA from UC Santa Barbara and an MSc from the London School of Economics.