Mexico’s oil reforms aim to boost revenue

Mexico’s oil reforms aim to boost revenue

President Enrique Peña Nieto’s privatization efforts are an attempt to restart revenue generation in the oil sector, which had stalled. Nieto hopes greater tax revenue from the sector may help cover federal budget deficits.

As details of Mexican energy sector reforms emerge, the goals of President Enrique Peña Nieto are also becoming clearer. The plan fits in a larger environment of reform and economic development, but those issues do not explain why Peña Nieto’s plan is moving forward only now. The mobilizing force behind the reform of state-run oil company Petróleos Mexicanos (Pemex) is lagging tax revenue due to declining oil production.

Declining production, lagging tax revenue

Although Peña Nieto’s Institutional Revolutionary Party (PRI) has been forced to evolve a great deal since it lost the presidency in 2000 – the first time in 70 years – proposing privatization of the oil industry is a new sign of party changes. It was the PRI that nationalized Pemex in 1938 and still celebrates the anniversary each year.

A combination of falling reserves, lagging investment, and mismanagement has led to Mexican oil production declining for 10 consecutive years. Part of the drop is due to a drawdown in easily reachable, conventional petroleum resources, which can only be counteracted with investment in deep-sea and shale drilling.

But another reason is mismanagement. Many of Pemex’s high-ranking officials were installed not because of expertise but rather political connections. Further, the company has not been able to sustain the capital investment required to remain competitive. Nearly 100% of the company’s profits are sent to the government as taxes (the rate was 99.7% in 2012), making up over 70% of total revenue.

At the same time oil revenues have fallen, the federal government’s deficits have ballooned to their largest levels since 1990– twenty times larger than in 2009. Oil revenue had even allowed the government to run a surplus following the 1994 financial crisis, but can no longer support government expenditures.

Peña Nieto’s reforms can be seen broadly as a reaction to falling tax revenues, and oil privatization is just one example. In October 2013, Congress increased income tax rates and junk food taxes, the latter not only raised revenue but also aimed to cut state healthcare costs. In the context of Peña Nieto’s other reforms, it becomes clear that oil privatization is aimed at reviving the oil sector to stabilize tax revenue.

PRI has also lived through the negative experience of its last wave of privatizations in the 1990s, when the banking and telecommunications industries were auctioned off. Thanks to PRI’s reforms, Carlos Slim became the world’s richest person. The shortcomings of the past have clearly informed PRI’s second round of privatization.

Senate plan kickstarts sector, protects government revenue

Allowing private oil companies into the Mexican market will allow for increased utilization of Mexico’s resources, but it comes at a cost: the federal government will be forced to accept less than 99.7% of oil profits. Peña Nieto is betting that the productivity increase will counteract the government cost of privatization.

Nevertheless, the plan endorsed by a Senate committee in July 2014 ensures the Mexican government will still receive significant revenue from the oil industry. Under the plan, 25% of labor and materials used in private oil projects must be Mexican by 2015, rising to 35% by 2025. The laws eschew expropriation of land for a leasing and profit-sharing regime, and for the first time set up a sovereign wealth fund for government oil revenue.

The government is also relying on a boom in jobs and productivity to fuel tax revenue. Pemex lost $9.3 billion in 2013, and the hope is that sector becomes much more profitable under private control. The government estimates the changes will lead to 500,000 more jobs by 2018.

Are oil reforms enough to attract foreign producers?

Given Mexico’s history of nationalizing private oil projects and lagging development of unconventional oil resources, the risks associated with entering the Mexican market may prove too much for some oil companies.

The reforms have proven unpopular with the Mexican public and leftist politicians have threatened future re-nationalization. These risks, however, may seem relatively small since the Mexican oil regime’s governance is still more transparent than many OPEC countries.

The biggest risk to foreign investment and exploration is the disconnect between the type of firm best positioned to deal with the Mexican government and the type of firm with the technology most suited to extract Mexico’s oil. In the US portion of the Gulf of Mexico, small firms have led efforts to extract unconventional oil resources. These are the technologies that will help boost Mexican production the most, but these firms are in the worst position to cross the border. Their small size and inexperience at navigating the corruption and red tape put them at a distinct disadvantage.

Perhaps the most likely situation will be that the large foreign players, like ExxonMobil and Chevron, will develop or license technologies and expand into the more advanced drilling methods that have so far been the domain of small US firms.

About Author

Alex Christensen

Alex is an Editor at Global Risk Insights, who also currently works in investment research. His work on political risk and economic policy has appeared in many forums, including Business Insider, Seeking Alpha, & The Emerging Market Investors Association. He holds a Master’s in Economics from the London School of Economics and BA from Washington University in St. Louis.