Mexico Moves to Open Its Energy Sector

9 MINS READDec 17, 2014 | 10:00 GMT
A ship approaches the Centenario oil rig in the Gulf of Mexico in 2013.
A ship approaches the Centenario oil rig in the Gulf of Mexico in 2013.
(OMAR TORRES/AFP/Getty Images)

Mexico has taken its first official step toward implementing the energy reform that Mexican President Enrique Pena Nieto signed into law roughly one year ago. The government recently unveiled many of the contractual terms for the first 14 shallow offshore blocks that will be auctioned off to oil companies early next year. Bidding for the blocks will end on July 15, 2015, and the results will be announced shortly thereafter.

Since Mexico City passed the energy law in December 2013, the reform process has gone according to plan, and the release of contractual terms indicates that it will continue to move forward smoothly, despite falling oil prices and other concerns that could derail the process. However, the move is just the first step in a slew of other auctions that Mexico City will be organizing for its energy sector's more lucrative and challenging oil blocks. By this time next year, foreign companies will likely be starting operations in many different areas of Mexico's upstream oil sector. 

Since 2004, Mexico's oil production has dropped from about 3.4 million barrels per day to around 2.3 million barrels per day for a number of reasons. Petroleos Mexicanos, commonly known as Pemex, has fallen significantly behind its international peers in terms of technological expertise, and high tax burdens have limited the company's exploration efforts. (Until the energy reform law was passed last year, Pemex was the only company allowed to explore and produce oil in Mexico since the country's oil industry was nationalized in 1938.) At the same time, the supergiant Cantarell Field, which was the main source of Pemex's production boom in the late 1990s and early 2000s, is quickly being depleted.

The production decline has spurred several attempts to reform Mexico's energy sector over the past 15 years. But only recently have Pena Nieto, the Institutional Revolutionary Party and the National Action Party succeeded in aligning their energy reform proposals. The ruling Institutional Revolutionary Party knew the energy sector's continued decline was economically and politically unsustainable and managed to reach a compromise with the National Action Party, which had tried to pass energy reforms numerous times throughout the previous decade when it held the presidency. Together, the two parties garnered enough political capital to push the reform through the legislature.

The Mechanics of Energy Reform

The resulting reform law was an extremely ambitious package that put an end to Pemex's domination of Mexico's oil sector. The reform allows foreign companies to invest in the country's energy sector and compete on equal footing with Pemex for blocks in many of Mexico's future auctions. But the new law does not gut Pemex completely; it will significantly cut the company's tax burden over time, and Pemex will still be able to retain all of the country's previously producing assets and as much as 83 percent of the proven and probable oil and natural gas reserves in Mexico's Round 0 blocks.

The National Hydrocarbons Commission will award production-sharing contracts, profit-sharing contracts and direct licenses for the remaining blocks — which include potentially lucrative shale and deep-water plays — during future bidding rounds. The bidding process will begin when the commission opens an auction by publishing all of the blocks' contractual terms, except for the percentage of production or profit that will go to Mexico City. Once this step has been completed, companies will have six months to evaluate the blocks up for auction and submit their bids. To limit corruption as much as possible, most of the details of the bidding process are specified in the law itself. For example, all contracts must be made public and must be awarded to the bidders offering the highest percentage of production or profit to Mexico City, though some consideration can be given to the amount of investment promised for the block itself. These anti-corruption measures are comforting for Western companies because they ensure that firms with less stringent domestic regulations against corruption (including Chinese and Russian companies) do not gain a leg up in Mexico's bidding process.

The energy reform also limits corruption through the restrictions it places on Pemex's joint ventures with foreign companies. Pemex has the right to partner with foreign companies on the blocks awarded to it during Round 0, but it cannot form partnerships on its own. Instead, the company must first inform the National Hydrocarbons Commission of its intent to migrate its contract into a joint venture for a given block. The commission would then organize a bidding process similar to those held for non-Pemex blocks in every respect except that Pemex would be given limited input in determining the pre-qualification requirements companies must meet to enter the bidding round. However, because Pemex already signed agreements to cooperate in oil and natural gas exploration with a number of major oil companies in 2014, such as ExxonMobil and Petronas, it seems unlikely that any of these companies would fail to pre-qualify for bidding on the joint venture blocks. 

The First Phase of Round One

With the architecture of the energy reform in place, Mexico has now set several plans in motion to open up its energy sector under the moniker Round One. On Dec. 11, Mexico City announced that it would auction off 14 new offshore exploration blocks. Pemex does not control these blocks, but it can attempt to qualify for and bid on the blocks like any other company, though its limited financial resources could hinder its success. Once the initial auction is complete, Mexico City will hold subsequent auctions for unclaimed deep-water offshore blocks, unconventional natural gas blocks and onshore heavy oil blocks later in 2015. Meanwhile, Pemex will be seeking joint-venture partnerships for the blocks it currently controls, including the shallow-water Bolontiku, Ek and Sinan fields; the heavy-oil Aatasil-Tekel-Utsil field; the onshore Rodador, Ogarrio and Cardenas-Mora fields; and the deep-water Kunah-Piklis, Trion and Exploratus fields.

The first 14 blocks up for auction cover a relatively small area and are only expected to collectively produce about 80,000 barrels of oil per day, but they are just the first of many blocks that Mexico will auction off. The process serves as an important benchmark that shows the energy reforms are proceeding smoothly, but even more important, the blocks' contractual terms provide insight into how contracts for more lucrative blocks will be structured in the future. Mexico City is offering 25-year production-sharing contracts for the blocks with the option to renew the agreements twice for an additional five years. Production-sharing contracts and joint ventures are boons for international oil companies because once reserves are proven, these contracts allow changes in ownership to be reported to the U.S. Securities and Exchange Commission. After offering such contracts for the first 14 blocks, it is likely that Mexico City will continue using the production-sharing contract in future auctions as well.

The terms of the tenders also include stiff rules on pre-qualification requirements for bidding companies or consortiums. To ensure that the winning bidder has the financial resources and technical expertise to develop the blocks quickly, bidders must show that they hold $1 billion in capital and have participated in multiple exploration projects over the past five years. These constraints prevent speculators, seeking to take advantage of low oil prices, from bidding on the blocks and reselling them to oil companies in the next 25 years or so. They also prevent oil companies that lack the capital needed to start oil exploration quickly from winning.

The auction rules are designed to promote healthy competition and keep any single foreign firm from gaining a stranglehold on Mexico's energy sector. For instance, supermajors are not allowed to partner with one another, and companies cannot join more than one consortium. Additionally, no consortium can bid on more than five blocks. Each of these restrictions are designed to avoid the lack of competition that plagued Brazil's first pre-salt auction in 2013, during which all of the interested parties formed a single consortium to give Brasilia the lowest share of profits possible.

Local content requirements are another significant concern for international oil companies looking to bid for block contracts because they determine companies' dependence on local wages, education levels, industrial levels and other in-country factors that could complicate projects and drive up costs. The first round of contracts contains a local content level of 13 percent during the exploration phase, which then rises to 25 percent in the development phase and to a floor of 35 percent across all blocks by 2025. However, it is very likely that Mexico City will require much lower local content minimums in the more technically challenging blocks moving forward.

Hurdles to Reform Remain

The implementation of the energy reform law has proceeded relatively smoothly thus far. However, there are a number of obstacles that will limit its success once international oil companies start moving into Mexico.

Though Mexico City has taken steps to stave off corruption, interactions with dozens of different entities — from Mexican cement companies to local police and government officials — are bound to bring companies into contact with individuals who demand kickbacks or other illegal benefits, endangering the companies' contracts. It is also unclear how capable the regulation and auditing processes in place are in enforcing the new corruption rules.

Lower oil prices add an additional layer of complexity. International oil companies may be less interested in bidding on new exploration blocks, particularly in more technically difficult fields, potentially limiting the number of bids Mexico City has to choose from. As a result, it is possible that the later bidding rounds set for the second half of 2015 will see reduced participation from foreign companies. That said, lower interest in longer-term projects like deep-water exploration is usually spurred by companies scaling back on exploration expenditures in general and is not necessarily a reflection of Mexico's attractiveness for future investment. Still, companies' differing timetables for investment in the Mexican energy sector could throw a wrench in Mexico City's goals for the swift exploration and development of its oil and natural gas resources.

Even if the government manages to limit corruption, solve its regulatory challenges and bring in foreign investment, Mexico still has other aboveground institutional problems that will be harder to fix. Pemex needs to be revamped into a company that can compete internationally, meaning it must attract significant human capital and foreign technology — a process that could easily take a decade to complete. Furthermore, Mexico's oilfield service sector remains underdeveloped, a problem that will strain international oil companies if local content requirements remain at higher levels than originally hoped for. Improving this sector will be yet another long and arduous process for Mexico City. 

Despite these challenges and constraints, Mexico's energy reform has already improved the country's oil and natural gas sector in addition to its regulatory processes. If all goes according to Mexico City's plan to reverse its recent decline in oil production, a number of international oil companies will begin significant exploration across Mexico's energy sector by 2016. There is no shortage of interest from international oil companies — particularly those based in Texas, the heart of the world's oil and natural gas industry — in getting involved in Mexico's energy sector. But the question remains as to whether their investment will come quickly enough to meet Mexico City's expectations.

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