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May 11, 2017 | 09:15 GMT

10 mins read

The Shifting Tides of Energy Reform in Mexico and Brazil

(OMAR TORRES/AFP/Getty Images)
Forecast Highlights

  • Energy policy in Mexico and Brazil will continue to vacillate between resource nationalism and market-friendly reforms as the popularity of left-wing populist movements fluctuates.
  • But regardless of politics, both countries will have logistical and economic incentives to continue liberalizing their oil industries.
  • Neither country will be able to reclaim full control of its energy resources without jeopardizing the development of its oil sector and that of its economy. 

Energy firms from around the world have gathered in Houston, Texas, each year since 1969 for the Offshore Technology Conference. The event, the industry's largest annual exhibition, offers interested parties a chance to explore new opportunities for offshore oil exploration. With that in mind, representatives and officials from Brazil and Mexico flocked to this year's conference, which took place May 1-4, in hopes of drumming up interest in their energy prospects. The countries, which are among Latin America's top three oil producers, both are looking to attract more international investment to their offshore industries as they try to develop challenging deep-water resources. Mexico completed its first deep-water block auction in December 2016, and Brazil is preparing for its second round of bidding on its offshore pre-salt, a geological formation that accumulated on the continental shelves before the salt layer, around 160 million years ago. Both nations, as they intended, drew significant interest at the conference. Even so, international oil companies lamented the shortcomings in Brazil's energy sector, such as its fragmented regulatory structure, while praising Mexico's oil and gas industry, which has overcome those issues, at least for now.

The situation marks a reversal from just a decade ago. Brazil had achieved such success liberalizing its oil and gas sector, an endeavor it launched in 1995, that it had become the gold standard for energy reform. Mexico, on the other hand, was struggling to push through measures that would enable its oil industry to keep growing. But in the ensuing years, the Brazilian government took a sharp turn toward resource nationalism as Mexico City made strides toward liberalizing its own energy sector. And the tables could turn yet again, perhaps as soon as 2018, when Mexico will hold its next presidential election. International oil companies have watched the tides of leftism, nationalism and protectionism ebb and flow in Latin America over the years, and this cycle will continue to play out in the region's leading oil producers.

Protecting National Interests

Until the 1990s, Brazil and Mexico each pursued its own version of import substitution and resource nationalism. Mexico's government nationalized its oil industry in 1938, giving state-owned oil company Petroleos Mexicanos (Pemex), established later that year, a constitutionally enshrined monopoly over the country's energy resources. Over the next seven decades, Pemex became the linchpin of Mexico's industrial and development policy, providing an important source of revenue and jobs. The company participated in numerous state-building projects over the years, including several initiatives outside the oil and gas sector.

Brazil, likewise, has long strived to ensure national control of its oil resources under the famous slogan, "O petroleo e nosso," or "The oil is ours." Compared with that of the Mexican oil industry, though, the development of Brazil's energy sector was slower going. Oil production in the country was negligible when the government created state oil firm Petroleo Brasileiro (Petrobras) in 1953. In fact, the country was a net crude oil importer until the mid-2000s (and still is, if petroleum products are taken into account). Petrobras' main objective for the first 40 years of its existence was merely to mitigate the expense of importing the oil necessary to fuel Brazil's industrialization. The company focused first on building a robust refining sector before gradually expanding its exploration activities.

But after the Latin American debt crisis in the late 1970s and early 1980s, Brazil had to adjust course. The country returned to a democratic form of government and adopted more market-friendly economic policies. The reforms eventually reached the energy sector as well. A constitutional amendment introduced in 1997 stripped Petrobras of its monopoly over the country's oil industry. At the same time, the government partially privatized the firm, by then a competitive oil company, listing shares on international stock exchanges. Brazil even moved toward a framework under which international oil companies could invest in the energy sector and take on projects without Petrobras' participation. The new approach appealed to foreign firms; between 1999 and 2006, Brazil held seven licensing rounds that drew interest from international oil companies including BG Group, Exxon Mobil Corp., Chevron Corp., Royal Dutch/Shell and Anadarko Petroleum Corp.

In Mexico, too, the debt crisis ushered in a new era of economic liberalization. Nonetheless, the government in Mexico City maintained its strict control over the country's energy industry. Pemex had discovered several shallow-water oil fields throughout the 1970s — including the supergiant Cantarell field, which helped boost production from 500,000 barrels per day in 1972 to 3 million bpd a decade later. And since the fields were simple and cheap to exploit, Mexico City had little incentive to break up Pemex's dominance to seek help from foreign firms.

A Change of Course

The mid-2000s, however, brought a sea change to the Mexican and Brazilian oil industries. Mexico's crude oil production peaked in 2004 at 3.4 million bpd — roughly two-thirds of which came from the Cantarell field alone — and has since fallen to 2 million bpd as production from the field has dropped. In an effort to revive the industry, the Mexican government turned at last to reform. President Felipe Calderon and his right-wing National Action Party (PAN) reached a compromise with the centrist Institutional Revolutionary Party (PRI) to retool the oil sector, although Pemex retained its monopoly for several years. It wasn't until 2013 that the PRI, under the guidance of President Enrique Pena Nieto, agreed to the constitutional changes necessary to overhaul the energy sector. Pena Nieto and the PAN-dominated Congress passed amendments and legislation to enable Pemex, with help from more experienced and better-funded foreign firms, to drill in the deep waters of the Gulf of Mexico and reinvigorate production.

Brazil, meanwhile, returned to resource nationalism after Petrobras came across the Tupi field, one of the largest offshore fields discovered to date, in a pre-salt formation in 2006. President Luiz Inacio Lula da Silva, for whom the field was later renamed, dubbed the field Brazil's "second independence." (The revelation even gave rise to an updated take on the oil industry's motto: "O pre-sal tem que ser nosso," or "The pre-salt has to be ours.") Almost immediately after Petrobras confirmed its discovery, the government in Brasilia shifted its policy, pulling 41 offshore pre-salt blocks from the licensing round then underway. Da Silva's administration also introduced production-sharing contracts for pre-salt blocks, though the existing framework stayed in place for non-pre-salt fields, and a requirement that Petrobras operate them with at least a 30 percent stake. The new arrangement tightened the bond between the firm and the government, while also giving Petrobras a new mandate to ramp up production and exports to support the administration. The company no longer had the option to choose which discovery blocks to participate in based on its corporate interests.

Mexican and Brazilian Oil Production

Today, pre-salt accounts for 1.5 million bpd of Brazil's oil production. But the boom has come at a cost for the country, both economically and politically. The pre-salt layer's complex system of deep-water reservoirs requires immense amounts of capital to bring production online; Petrobras set a target of $237 billion in its 2012-16 investment plan. To reach that goal, the company took on a hefty debt burden, just in time for global oil prices to plummet and for the Brazilian Federal Police to launch a corruption investigation against the firm. Petrobras and da Silva's Brazilian Workers' Party — along with the rest of the country's political establishment — have since been embroiled in scandal. By 2015, moreover, Petrobras had become the most indebted company among the emerging market countries, with $170 billion in obligations. The firm embarked on a $35 billion divestment plan that year to pay down its debts by 2018. 

By contrast, Mexico's revised energy policies are starting to pay off. Since Pemex lost its preferential access to the country's oil resources, the Mexican government has adopted new contract models, including production-sharing agreements, to entice foreign oil companies to invest in the sector. It has also worked with international oil firms to hammer out issues not addressed in statute to ensure a smooth and successful bidding process. Mexico surpassed its own expectations for its first deep-water auction in December 2016, awarding eight of the 10 blocks on offer — twice as many as the country's energy minister had hoped. And a few months later, Italian energy firm Eni, the first international oil company to drill in Mexico since the reforms took effect, announced that it had struck oil.

Turning the Tides

Despite the praise Mexico's energy sector has received for its reform initiatives — and the problems that have beset Brazil's oil industry — the tides could turn once more. In the wake of former President Dilma Roussef's impeachment, her successor, Michel Temer, has worked to reverse some of the Workers' Party's protectionist energy policies. The government, for example, has discarded laws regulating pre-salt production, such as the measure requiring Petrobras to operate blocks, and instituted more liberal mechanisms. (The state-owned oil company, however, still enjoys privileged access to pre-salt blocks.) In addition, Temer's administration has promised to reduce his country's notorious local content restrictions, which stipulate that Brazilian companies and employees must perform a certain percentage of work on a given project. Whether the energy sector continues down its current path will depend in large part on the results of the country's next presidential election, slated for 2018. Da Silva has so far led the polls, and if he wins, Brasilia may well return to a more hands-on role in the energy sector.

Mexico, too, is gearing up for a presidential vote in 2018 that could change the course of its oil industry. Leftist populist candidate Andres Manuel Lopez Obrador has emerged as a frontrunner in the race. An outspoken critic of Pena Nieto's energy reforms, Lopez Obrador has promised to hold a public referendum on the measures if elected and to roll them back should the public vote against them. If recent developments in Mexico are any indication, that outcome may not be so far-fetched. Protests broke out in the country in January after Mexico City raised fuel prices by 20 percent as part of its energy liberalization campaign. Then in April, the government had to back off its attempts to reform fuel transport procedures when the Mexican oil workers union prevented private businesses from loading gasoline at Pemex terminals. 

Even if he wins the presidency, though, Lopez Obrador probably won't win the support of Mexico's national legislature. Consequently, he will struggle to pass the bills — not to mention the constitutional amendments — that would be required to undo his predecessors' energy reforms. But short of taking legislative action, Lopez Obrador could still interfere with the oil industry, for instance by canceling scheduled licensing rounds or increasing minimum bid requirements. The Energy Ministry's regulatory flexibility is currently one of the Mexican oil industry's biggest selling points for foreign investors, and that could change after next year's election.

Of course, regardless of politics, the Mexican and Brazilian governments each will have incentives to keep pursuing reform. Pemex needs the expertise and financial support of international oil companies to take full advantage of its deep-water resources. Brazil, meanwhile, has learned the limitations of a nationalized oil industry the hard way. But as long as populism is alive and well in the countries, their energy sectors, and the foreign firms hoping to invest there, will have to weather policy fluctuations.

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