Mexico's Upcoming Energy Reform: Opportunities, Limitations, and Challenges

by Manatt, Phelps & Phillips, LLP

Mexico's hydrocarbons sector will not be overhauled under Mexico's new President Enrique Peña Nieto to the point of the State losing ownership and control of the resource, but reforms that offer new business opportunities are likely.  The reform effort for the oil and gas sectors is scheduled to be launched in the first year of the President's six-year term.  While the major political parties in Mexico all acknowledge the need for reform, they do not agree on the "what" and the "how." 

Oil production has been in decline, and Pemex does not have the capital or technology to fully tap into all the country's potential reserves of traditional fields or promising shale oil reserves.  Reform is complicated, as Pemex, the national symbol of the country's oil resources, is a political force as well as a business.  At least for the near term, Pemex will continue to be the cash cow for the Mexican government, providing up to 40% of the government's budget and allowing for revenue transfers to states.

Pemex's inability to fully invest in new technology and exploratory activities to more efficiently extract from its aging oil fields is seen by declining oil production since 2008, when production peaked at 3.2 million barrels per day.  The U.S. Energy Information Administration estimates that by 2020 Mexico will become an oil importer if at least moderate reforms are not implemented.  Furthermore, domestic economic growth will significantly increase Mexico's energy demands. 

The need for foreign investment in Mexico's energy sector is widely acknowledged, but political realities have and will continue to limit the extent of reform.  The Pacto Por Mexico, the new Administration's legislative road map signed by the three major political partiesthe PRI, PAN, and PRDdays after Peña's inauguration, paves the way for increased private investment in petrochemicals, hydrocarbon (pipeline) transportation, and refinery operations in Mexico, while reaffirming that Mexico's natural resources are and will continue to be the property of the State.

Oil still property of the State 
Without the option to own or partially own oil reserves, industry giants are less likely to be interested in investing in crude production.  This month's third round of incentive contracts for Chicontepec continues prior practices.  However, Pemex's need for more efficient extractive technologies will persist, and Pemex and the government will be unable to fulfill the resource (investment and technology) gap.  Reforms enacted in 2008 have allowed Pemex to enter into contracts with private firms that set a base level of production and incentivize any production above that base level.  Mexico's oil and gas reserves remain lucrative, but aging wells, deep water wells, and oil and natural gas from shale present challenges Pemex has not been able to fully address, given the company's mandate of maximizing returns.  This presents an opportunity for firms that are efficient and successful in managing these types of wells.  However, current incentive-based contracts pass the investment and operating risks to private firms, which incur losses whenever the baseline amount is not met.

Privatization of refinery operations, transportation of hydrocarbons, and petrochemicals 
Some hoped that campaign rhetoric meant a change to Mexico's Constitution that would have more fully opened up the energy sector to foreign investments and participation.  However, the Pacto Por Mexico explicitly identifies refinery operations, oil and gas transport, and petrochemicals as aspects of Pemex's operation that could be opened up for privatization.  The form and extent of these reforms is yet undefined, but the current schedule is for Congress to consider them in the second semester of 2013, with implementation by the second semester of 2014.  To date, the new Administration has taken on issues that it believes it can win, so calculations about what types of reforms will be successful come with an albeit early, but so far successful, track record.

The need for investments in these industries is clear.  In 2009 the Calderon Administration announced plans to build a refinery in Hidalgo, but regulatory and bureaucratic obstacles as well as technological, planning, and budget restraints prevented the initiation of construction.  Today Mexico imports nearly half of its refined gasoline from the U.S. due to Pemex's insufficient refining infrastructure.  Pemex currently co-owns a refinery in the U.S. and has explored buying a U.S. refinery to meet domestic demand. 

Mexico's infrastructure capacity to transport natural gas is also lagging.  Despite an abundance of cheap natural gas available in the U.S., Pemex has had to limit its gas supply to Mexican customers because of insufficient pipeline capacity.  In the last quarter of 2012, CFE, the energy agency, awarded contracts for new natural gas pipelines, but more are needed.

Mexican manufacturing has the potential to grow dramatically to meet increasing domestic demand and to be more cost-efficient with access to cheap petrochemicals and plastics, but Pemex's "cracking" capabilities (the process of extracting petrochemicals from crude oil and natural gas) requires significant investment.  With the proper infrastructure and with access to crude and natural gas (the raw materials used to produce petrochemicals), Mexico is poised to become a large-scale producer and even exporter of petrochemicals.  However, the enormous infrastructural investments required for "cracking" facilities are beyond what Pemex and the Mexican government are able to provide and will require private-public partnerships with foreign companies.  Technologically advanced companies, including many from the U.S., should have an edge in new opportunities.

Risks and Challenges 
Of course, there are and will continue to be risks associated with doing business in Mexico.  Despite Peña Nieto's reform-minded agenda, numerous competing civic and political factions in Mexicolabor unions; local, state, and national politicians; environmental groups; etc.can make doing business a challenge, especially for extractive industries.  When working with Pemex, contracts (with some exceptions) are granted through a bid system rather than negotiationsa process that is not necessarily difficult, but requires knowledge of the system.  Security continues to be an issue, though threats are declining and are by no means prohibitive to doing business in Mexico.  Inflexibility in current labor laws and union negotiations can increase the cost of doing business; however, labor reform was the final legislative victory of the prior Calderon Administration.  Yet more is needed, and further efforts as well as implementation of the reform are on the current Administration's agenda.  Overall, the risks and challenges of doing business in Mexico are much lower than in most other countries in the region and can be greatly minimized through smart, strategic market entry or expansion.

ManattJones is a strategic international consultancy that supports its clients with services that span market assessment to doing business.  We can provide competitive analysis on how government and policy support a best markets analysis; work to overcome specific regulatory and legal obstacles; help find complementary partners with aligned strategies, values, and interests; create new market spaces; and address doing-business issues on an ongoing basis.  In addition to its office in Mexico, MJGS's U.S. offices complement in-country efforts through relationships with policymakers and influencers in the region and embassies in Washington.

DISCLAIMER: Because of the generality of this update, the information provided herein may not be applicable in all situations and should not be acted upon without specific legal advice based on particular situations.

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