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Jun 20, 2013 | 10:30 GMT

9 mins read

Mexico Readies for Energy Sector Reform

Mexico's Upcoming Energy Reform
(ALFREDO ESTRELLA/AFP/Getty Images)
Summary

In August or September 2013, Mexico will unveil the most ambitious of its legislative packages to date — comprehensive reform of its energy sector. The reform is expected to include incremental improvements, such as tax, pension and subsidy reforms, and will focus on more long-term structural issues, such as changing the constitution to allow for improved partnership models that will increase foreign investment. For a number of economic and political reasons, this attempt at energy reform will be Mexico's best chance in decades to solve some of the sector's most pressing challenges.

By most metrics, Mexico's energy sector is performing poorly. Between 2004 and 2012, crude oil output fell by 25 percent, from 3.4 million barrels per day to 2.5 million barrels per day. Crude oil exports by volume declined 32 percent, from 1.9 million barrels per day to 1.3 million barrels per day over the same period. Natural gas output has been steadily declining since 2009, causing imports to spike. Over the past decade, proven reserves of crude oil have fallen 37 percent. Roughly a decade after nitrogen injection temporarily boosted production, output at Mexico's two most important fields, Cantarell and Ku-Maloob-Zaap, is either already declining or is expected to peak soon as the fields enter their natural decline phase.

Mexico's Main Oil and Natural Gas Regions

Mexico's Main Oil and Natural Gas Regions

As the output of cheaply produced crude oil from the Bay of Campeche drops, state-owned energy company Petroleos Mexicanos' profitability will also decline. To maintain production levels, Petroleos Mexicanos, better known as Pemex, needs to look beyond the shallow offshore areas, either into the deeper waters of the Gulf of Mexico or into unconventional exploration and production. This would require a massive upfront investment of money that Pemex simply does not have due to its unprofitable downstream sector and high tax burden. To solve this problem, Pemex must improve its tax, pension and subsidy liabilities and gain access to increased levels of capital, either from private domestic sources or foreign investors. 

When low-cost oil and natural gas was readily available, Mexico did not need to confront the nationalist regulatory structure put in place in the first half of the 20th century that limited foreign ownership and investment. However, since the low-cost options (namely, oil produced at below $10 per barrel) are now in decline, decision-makers in Mexico are compelled to substantially rethink the regulatory framework. 

Nationalization and Reform

The current regulatory framework was formulated at three historical moments. In the immediate aftermath of the Mexican Revolution in 1917, Mexican leaders drafted a new constitution in which Article 27 declared subsurface mineral rights to be the inalienable property of the Mexican nation. Then in 1938, then-President Lazaro Cardenas nationalized the energy sector, expropriating foreign interests and creating Pemex, which would monopolize the entire Mexican oil industry. Most recently, the Petroleum Law of 1958 eliminated private oil mineral interests and extended Pemex's monopoly downstream to include all activities along the production chain.

Since 1999, successive administrations have attempted to reform the energy sector. In 1999, 2002 and 2008, former Presidents Ernesto Zedillo, Vicente Fox and Felipe Calderon each scored some minor victories — including adding a degree of transparency and flexibility to Pemex and improving the company's ability to contract foreign firms — but the issue of private investment was never definitively resolved. 

In each of these three attempts, the timing was only partially conducive to success. Zedillo attempted to pass a reform bill near the end of his term when he was already a lame-duck president; Fox attempted just before midterm elections, while the energy sector and Pemex were still relatively healthy; and Calderon tried to reform the sector just after winning a close and contested election. Additionally, the Institutional Revolutionary Party's 12 years out of power from 2000 to 2012 after dominating Mexican politics for decades was characterized by political ill will and non-cooperation. By contrast, the situation facing current President Enrique Pena Nieto is categorically different and much more conducive to success. The Mexican economy is growing, it is still early in Pena Nieto's term and there is broad political consensus for the need for serious reform.

Reform Options

Because the ruling Institutional Revolutionary Party does not control enough seats in either house of Mexico's Congress to pass an energy reform package on its own, let alone one that requires a constitutional amendment, any legislation will require the support of at least one of Mexico's two other major political parties. The National Action Party is the most likely partner, since it has been in favor of energy reform for the previous two administrations when it held the presidency and it sided with the Institutional Revolutionary Party in the recently passed Pact for Mexico reforms

There are three major problems in the energy sector that can be fixed without amending the constitution. First, Mexico subsidizes the gasoline, diesel and liquid petroleum gas used in most Mexican homes, which has placed considerable stress on Pemex. In 2011, Pemex — and by extension the Mexican government — spent 1 percent of gross domestic product (or $12.5 billion) subsidizing fuel. Cutting these subsidies would be highly unpopular but would improve the bottom line of Pemex's downstream activities. To reduce these outlays without sparking social unrest, Mexico has already been gradually increasing the price of fuel over the past decade. 

Second, the Mexican government relies on Pemex for 30 to 40 percent of its total fiscal revenues. Because it is a national oil company, Pemex has a tax regime and pension liabilities that are much greater than those of private firms. The Institutional Revolutionary Party needs to find a way to maintain public spending while reducing Pemex's tax burden. It is for this reason that the Pena Nieto administration may try to tackle energy and tax reform in tandem. It also explains why the government is trying to increase royalties on other sectors such as mining. However, diversifying streams of fiscal revenue is difficult, and potential alternatives, such as a value-added tax on things like food and medicine, are already prompting considerable social opposition.

Third, Pemex's pension fund is in need of reform. Under the current system, Pemex employees can retire at 55 with a pension worth their full salary. Currently, Pemex employs some 150,000 workers and pays full benefits to another 70,000 retirees. Knowing that pension reform is absolutely imperative, Pemex and the powerful oil workers' union are currently in negotiations with the government. While the details of the negotiation are unclear, there are two possible options: raising the retirement age to 65 or changing to a defined contribution model.

These reforms would certainly modernize Pemex and improve its efficiency but would not address Pemex and Mexico's main strategic imperative — to pursue deep-water and unconventional exploration and production. With an estimated 30 billion to 50 billion barrels of oil in the deep waters of the Gulf of Mexico, and with an estimated 15.4 trillion cubic meters of shale gas and 13 billion barrels of shale oil resources, if Mexico is serious about expanding energy production, it must change the regulatory framework to allow for deeper partnerships with foreign companies. Exploiting these reserves is extremely capital intensive, and while Pemex could theoretically do it alone, it would be difficult to exploit the offshore and unconventional plays in a timely manner without outside support.

It has become increasingly clear over the past decade that in order to breathe life into the energy sector, international oil companies must be incentivized to invest money and technology into Mexico. However, because the 1958 Petroleum Law prohibited private ownership of mineral rights, the only types of partnerships that Pemex is allowed to enter into are service and leasing agreements. This model has failed to attract sufficient investor interest because no percentage of production, sales or profits can be used as a basis for compensation. Unable to book even a small percentage of reserves, these energy companies are unwilling to make expensive and risky investments. The most recent attempt, in 2008, to stimulate investment without touching the regulatory framework resulted in the Pemex Exploration and Production-model contract, which is a fee-based system with a potential for a bonus payment if production exceeds expectations. Nevertheless, because firms cannot book reserves under the existing model, few companies have responded enthusiastically.

Some new information about the secretly negotiated reform effort has recently been released. According to several high-level Mexican officials speaking with The Wall Street Journal, the new energy reform is expected to grant 25-year contracts in specific deep-water areas, develop a mechanism to allow foreign firms to book reserves and create a national petroleum agency that will administer the new partnership model. Pena Nieto has said that the reform will be made public in the next three months and will include "the constitutional changes needed to give private investors certainty." As a means to placate nationalistic sentiment, the government may try to devise a way to retain ownership over the oil reserves and pay oil firms in cash. This will certainly deter some investors, but the Mexican government is anticipating that the new terms will be attractive enough to sufficiently stimulate upstream investment. While the "Petrobras model" has been referred to as a point of reference, Mexico's energy reform will most likely be a case-specific solution that addresses Mexico's own unique priorities and constraints.

Finding Common Ground

The main issues holding Mexico's energy sector back have been known and acknowledged for years, but this does not mean that the major players will agree upon a solution. Unlike the National Action Party, the Institutional Revolutionary Party is first and foremost a corporatist political entity. Its longevity in government is due to its ability to get a wide array of actors with seemingly divergent interests to agree to a common political program. Hence, the Institutional Revolutionary Party first needed to get its own house in order. Creating a reform bill that satisfies both the interests of the oil workers' union and those of the company's management is just one issue that the government has had to manage.

Once Pena Nieto gets the Institutional Revolutionary Party on board, he must strike an agreement with one of its rival political parties. The National Action Party is in many respects the most logical partner, since it has been trying to pass comprehensive energy reform for the past 12 years and would welcome the opportunity to pass it now, even if it cannot take sole credit for its passage. That said, the National Action Party knows it is indispensible to the reform's success, so it will try to exact as many concessions as possible. The leftist Democratic Revolutionary Party will flirt with the idea of energy reform but is unlikely to support a reform effort that would increase foreign or private participation in the energy sector. It may even use the energy issue to try to foment social unrest.

Mexico now has a better opportunity to enact comprehensive energy reform than at any point in recent decades. Ultimately, the success of that effort will depend on how successful the Institutional Revolutionary Party is at bringing in a rival political party without disturbing the careful balance of interests within its own ranks.

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