The time is ripe for a historic transformation of Mexico’s energy sector. The 2008 Reforma Energética (Energy Reform)—a congressionally-approved presidential initiative that established or modified seven laws—highlighted the significant challenges facing the Mexican oil industry and the economic implications of a decline in oil production. The problem: it didn’t resolve them.
With the exception of Andrés Manuel López Obrador of the Partido de la Revolución Democrática (Party of the Democratic Revolution—PRD), for the first time in Mexican politics the presidential candidates this year set out a series of bold institutional reforms. These included what was unthinkable years ago: turning the state-owned enterprise, Petróleos Mexicanos (PEMEX), into an autonomous firm that could issue stock shares—a model similar to the one adopted by Brazil’s Petrobras in the 1990s.
But is this wishful thinking? As with past proposals to open up Mexico’s power or oil industries, are expectations rising against all odds?
The answers will begin to emerge once the newly elected congress convenes in September and President-elect Enrique Peña Nieto takes office in December 2012. But Mexico’s incoming leadership will have to address a growing consensus about the need to modernize the energy sector.
Conventional wisdom holds that Mexico’s energy sector will not change until the country faces a severe crisis. But, at least conceptually, change is already under way. The future of Mexico will be determined by the ability of the incoming administration to turn visions of a grand redesign of the energy sector into implementable policies. To be sure, there will need to be some hard negotiation and bargaining to reach the compromises and build the agreements necessary to make this happen.
A Crack Appears
Mexico became a champion of climate concerns during the administration of President Felipe Calderón (2006–present). In April 2012, Congress approved the Ley General de Cambio Climático (Climate Change Law), the second of its kind worldwide, establishing the framework to achieve voluntary nationwide greenhouse gas (GHG) mitigation targets: 30 percent by 2020 and 50 percent by 2050. Congress also set a goal of generating 35 percent of electricity with clean technologies by 2024. Reaching these objectives will require a major transformation of an energy mix that relies heavily —93 percent—on hydrocarbons, including 60 percent in the power industry. Wind, solar and geothermal energy, all of which Mexico has in abundance, have yet to be tapped to their fullest potential.
Traditionally, the Mexican government has used the state-owned monopolies of the energy sector as instruments of public policy, either to promote fiscal policy or for industrial development. The deployment of renewable energies and clean technologies—for both internal consumption and export—opens an opportunity for developing new industries, generating employment and moving toward a green-growth economy.
Still, there is no sense of urgency when it comes to restructuring the power industry, despite a shortage of natural gas for combined-cycle generation and challenges in meeting GHG mitigation targets. Instead, even with growing opportunity for private investment, discussions are only beginning around the organizational arrangement required to meet renewable targets. Achieving these goals, while increasing national competitiveness, means that reform will eventually be necessary.
The oil and gas industry is a different story. Since 2004, oil production has been in sharp decline, going from a peak of 3.4 million barrels per day (mbd) to 2.5 mbd in the first quarter of 2012. At current rates of production, reserves are expected to last 9.5 years. At the same time, domestic demand has been rising and is expected to reach 2.3 mbd by 2015. In addition, Mexico imports close to 50 percent of its gasoline and over 40 percent of its natural gas.
The decline in production is particularly worrisome, since oil revenues are critical to the financial solvency of the government, accounting for 35 percent of government income. The sustained high level in oil prices has masked the net decline in crude exports, but a significant shift in the international oil market could result in a severe financial crisis. That fear, and the perceived need to increase oil income, drove the 2008 Energy Reform.
The government currently relies on extracting revenue from petroleum production and sales rather than taxation to finance the public budget. As a result, PEMEX’s financial condition is determined not only by the market but by the policies of the Secretariat of Finance and Public Credit—where, even under the latest fiscal regime, 70 percent of PEMEX net income goes to paying taxes and duties. Thus, despite being one of the top petroleum companies in the world, pemex is technically bankrupt, sharply curtailing the possibilities for growth and investment for innovation.
Restoring the financial health of PEMEX is critical to the oil company’s future, and that means freeing it from its status as the state cash cow. Most experts and politicians converge on the view that PEMEX needs to be structured more as a private company. As such, it should follow international best practices, be removed from the federal budget, become autonomous, have its own capital and assets, and adopt better corporate governance. Still, it’s also generally agreed that the state should continue to be the sole owner of Mexican hydrocarbon reserves.
An assessment of the 2008 Energy Reform is now under way. During the 2012 presidential campaign, different aspects of the oil and gas industry were discussed, including issues of efficiency and ownership. A more sophisticated analysis has emerged to challenge both the neoclassical view that national oil companies are inefficient and the nationalist ideology that considers any form of privatization a threat to sovereignty. This analysis identifies clear differences between the upstream business and the dismal results of the downstream subsidiaries. Still, concerns over the negative results of previous privatizations for consumers in key Mexican industries have made full-fledged privatization unlikely.
Exploration and Production: The Keys to Deeper Reform
The 2008 Energy Reform initiated the makeover of the Mexican exploration and production (E&P) industry. Crucial institutional arrangements were defined, such as the governance of PEMEX, the establishment of a regulator for E&P, the terms for procurement, and the structure of contracts.
Some of the innovations have since raised questions about their usefulness. But they opened a path toward an institutional architecture that resembles more closely the organization of the oil industry worldwide. Mexico continues to have one of the most—if not the most—closed arrangements in the petroleum industry. The lack of outside investment and input in PEMEX Exploration and Production (PEP), the crown jewel subsidiary of PEMEX, has hindered innovation and technological advancement. The limits of existing arrangements become increasingly evident as traditional areas of production decline and new opportunities, such as in the deep and ultra-deep waters of the Gulf of Mexico, are pursued under tougher conditions.
Preserving the status quo—and maintaining legal coherence—has been made more costly by the refusal to amend the Constitution to allow some degree of private participation in the energy sector—as has been done in Brazil, Norway and even Cuba. Mexico’s oil industry is accepting inefficiency while paying a high price to pretend that it can do it all on its own.
In fact, world-class service companies such as Halliburton, Schlumberger, Noble, and Baker-Hughes work closely with pemex engineers to keep the oil flowing. According to Petroleum Intelligence Weekly, PEMEX paid over $16 billion for oil field services in 2007. PEP is repeatedly the number-one client of Schlumberger.
A central element of the 2008 Energy Reform was the definition of a new incentive-based contractual framework. The model was developed to attract leading oil companies to the Mexican market while keeping the constitutional mandate intact. It relies on a fee-per-barrel rate determined in a bidding process, where ownership of hydrocarbons belongs to the Mexican state. Production, profits and risk are not shared, and there is no reserve booking for the companies.
Thus far, the new contract model has not attracted any major oil companies. It has been applied to low-risk projects where a high recovery rate is ensured. Instead of having a Petrobras or a Chevron working jointly with PEMEX in the deep waters of the Gulf of Mexico, bidding has gone to mature fields, with services companies such as the United Kingdom’s Petrofac Facilities Management winning the auction.
Against All Odds
The challenge for PEMEX is to increase reserves and oil and gas production in areas that are not part of its traditional zone of expertise. PEMEX has been outstanding at E&P in shallow waters. But its experience is mostly limited to 3,300 feet (1,000 meters) deep—far above the 8,200 to 11,500 feet (2,500 to 3,500 meters) needed in the most interesting area of the Gulf of Mexico. Going to deep and ultra-deep waters or to complex, fractured onshore fields such as Chicontepec requires new skills.
Mexico is in the process of developing regulatory and safety measures to do so. But it is not a matter of buying technology in the market, as some politicians have asserted. Particularly in the case of deepwater production, international best practices show that because of the associated complexity and high risk, no company can operate alone. The Deepwater Horizon oil spill in April 2010, when a BP-operated drilling rig exploded on the U.S. side of the Gulf of Mexico and caused a 4.9 million barrel leak, reinforces the concerns over risks. Ideally, PEMEX would enter in a joint venture with companies at the cutting edge of deepwater production, such as Chevron, Shell, Petrobras, or BP. Yet this is prohibited by the Mexican Constitution, and the new contracts are unlikely to attract those companies.
In the past decade, over 4 billion barrels were extracted on the U.S. side of the deep waters of the Gulf of Mexico. The area offers one of the richest potentials for oil and gas production. That is why the U.S., Mexico and Cuba are eager to exploit those resources, most of which lie in the deep and ultra-deep waters of the Gulf of Mexico where E&P presents great challenges and high risks. But the sophisticated technical and managerial requirements of deepwater E&P are a great challenge for Mexico.
Still, in a controversial move, PEMEX has rented three rigs to initiate deepwater drilling in the Perdido Fold Belt area in the northwestern Gulf of Mexico. The National Hydrocarbons Commission (CNH) recently approved regulations that are consistent with those in the U.S., but the newly established agency does not yet have the personnel required for the oversight; nor does it have the legal authority to force PEMEX to wait.
In the midst of this debate, PEMEX has opted to speed up the process and commit significant investment in order to try to lock in a favorable decision by the CNH. pemex has also invested heavily in acquiring the equipment to respond in case of an accident. But questions arise about whether PEMEX should instead focus on Mexico’s less risky and financially more rewarding options: enhanced oil recovery, secondary recovery and shallow water production. Choosing any of those alternatives would allow PEMEX to profit from its expertise, save financial resources and buy time so that a sustainable deepwater exploitation process can be put in place.
But, for the time being, PEMEX is already on the move.
Deepwater drilling is likely to take center stage with the signing of the U.S.–Mexico Transboundary Hydrocarbon Agreement in February 2012. The agreement, ratified by the Mexican Senate but still awaiting approval in the U.S., relieves concerns about the so-called “straw” effect, in which Mexican oil is sipped away by the U.S. as its production advances closer to the international maritime border in the Gulf of Mexico.
The agreement provides a legal framework for development of oil and gas reservoirs that cross the maritime border in the Gulf of Mexico—the first such pact for both countries. In fact, it is viewed as a dress rehearsal for negotiations the U.S. will have to undertake with Canada, Russia and even Cuba to address shared reservoir exploitation.
Implementation will require legal and institutional adjustments in Mexico and in the United States. Since it requires joint or coordinated production, the agreement possibly opens a new era of cooperation between PEMEX and international oil companies. If a transboundary field were identified, PEMEX would have to work with field operators on the U.S. side. This makes technological aptitude particularly relevant, since shared reservoirs are more likely to exist in the deep and ultra-deep waters of the Gulf of Mexico.
For sovereignty, energy security and political reasons, Mexico will go the extra mile to ensure that its hydrocarbon resources are not lost to its neighbor. This gives it a high incentive to develop the institutional architecture—including strengthening the CNH—needed to implement the agreement. Identifying and developing a joint reservoir would allow PEMEX to work in full partnership with companies at the cutting edge of ultra-deepwater production. The experience, benefits and know-how that would be gained may reduce the reluctance to undertake joint production and other strategic alliances that are banned by PEMEX bylaws. Implementation of the treaty could trigger an accelerated transformation of the regime under which deepwater resources are exploited in Mexico.
Exciting times are in sight. The incoming administration will be compelled to conduct a debate on the future of PEMEX, and the issue of constitutional reform will have to be a full part of it. The Mexican oil industry can no longer thrive on amendments to distorted schemes.