Mexico Seeks Energy Reform

Roberto Eraña & Alexander P. Trueba

Mexican President Enrique Peña Nieto unveiled his energy reform on August 12 that proposes to open up the energy industry by allowing private and foreign investment in the sector.  The proposal, the cornerstone of Peña Nieto’s domestic agenda for economic growth, will structurally change the industry in an effort to position Mexico for stronger job creation, lower energy costs, and to revive an industry plagued by decreased production and high inefficiencies.

Reforms to the energy industry are a delicate subject in Mexico.  The industry has been state-owned by Petroleos Mexicanos (Pemex) since 1938, when foreign oil companies were nationalized.  It is a major source of national pride given it provided the then young country with a sense of independence from foreign interference, a feeling that persists.  The President’s challenge will be to sell the changes to the country and reverse oil’s nearly mythical image.

Key Oil & Gas Reform

The most prominent change will allow Pemex to enter into profit-sharing contracts with private companies, bringing much needed technical expertise and capital to oil, natural gas and shale projects such as deep water drilling and exploration.  The shift in policy is needed given crude oil production has dropped 26% to 2.5 million barrels a day from a peak of 3.4 million barrels a day in 2004, as production from established reserves in shallow water and inland fields has declined.

From 1979 to 2007, Mexico produced most of its oil from the giant Cantarell field, which used to be the second largest reserve in the world. The massive output from that field, and others like it, allowed Mexico to defer investment in technology or explore new reserves without repercussions.  However, production from the Cantarell field has dropped 80% from its peak, with other fields reeling from similar results.

Mexico is still a major player in the oil industry, currently the world’s 10th largest producer of crude according to OPEC. It has an estimated 14 billion barrels of proven oil reserves at its disposal, third in Latin America only to Venezuela and Brazil, in addition to possessing significant gas and shale reserves. Unfortunately, due to limited capital and low historical investment in technology, it has neither the necessary techniques nor the funds to adequately take advantage of the untapped resources. At its current pace, Mexico is slated to become a net importer of oil by 2020.

Additional Reforms

The President’s plan also calls for allowing new players in electricity generation to compete with the state-owned monopoly, CFE (Comisión Federal de Electricidad).  The President hopes that by allowing competition, new investment and market forces will lead to higher supply and lower costs.  Manufacturers in Mexico currently pay nearly double per kilowatt-hour compared to the US, and even though consumers receive subsidies, they also pay 25% higher rates than the US.

Other proposed reforms reach into gasoline refining.  While Mexico is the third largest exporter of crude to the US, they import half of its gasoline form the US.  The reforms will allow for competition in the refining, transporting and storing of gasoline, all areas that lack modernization and capacity.

Pemex and Fiscal Reform

As part of the process to open the energy industry to competition, the President’s proposal calls upon changes to Pemex itself.  Currently, Pemex sends nearly all of its profits to the federal government, with no flexibility to do otherwise.  In fact, 33% of the Mexican government’s revenues come directly from Pemex.  The proposal would allow Pemex to treat the government like a shareholder, and pay dividends when appropriate. The government would still receive significant revenues through taxes on the company, but the proposed flexibility would insure the company has much needed discretion in capital investment so that it does not continue to fall behind.  Initially the government would take in less revenue from Pemex, which would be funded by widening the base of products the value added tax (IVA) applies to, now to include food and medicine among them.  Over the long term, as production and efficiencies improve, Pemex’s contribution to the national budget is expected to increase.

Convincing Politicians, Foreign Investors

Mexico’s refusal to cede ownership of the oil reserves may prove to be a key obstacle in drawing the full attention of major oil companies.  Profit sharing arrangements do not allow investors to recognize the reserves on their balance sheets and therefore may impede share price growth. Limiting upside for investors may restrict the flow of capital. However, the proposed structure for the reforms was likely a careful decision and compromise Peña Nieto made in an effort to enact change by delivering a proposal the people could get behind and ultimately pass.

Internally, the reforms will require amendments to articles 27 and 28 of Mexico’s constitution, which grant the public sector exclusive control of the oil and gas industry. The amendments will need two-thirds support in both Mexican houses of congress to pass, followed by a majority of state legislatures. The President’s party, the Institutional Revolutionary Party (PRI) enjoys a majority in congress and is supported in this endeavor by the conservative party, the National Action Party (PAN), which proposed their own aggressive energy reform recently.  The President’s chief of staff, Aurelio Nuño Mayer, has stated that he is optimistic that the bill can be ratified before the end of the year.

To do so, it may need to overcome public sentiment, which was recently reported at 65% opposing opening the energy sector. Additionally, they should expect public demonstrations and rallies staged by the leftist opposition leader Andres Manuel Lopez Obrador, who has used similar tactics in the past.

Economic Impact

Mexican government officials approximate that the reform could add 1% of growth to the economy by 2018 and up to 2% by the year 2025.   In the short term, the most important impact would be felt via Foreign Direct Investment.  Total net annual inflows to Mexico averaged $20 billion over the last five years with the energy sector only receiving $360 million.  Investment Bank CIBC estimates this proposal could jumpstart total FDI and projects it as high as $50 billion within 10 years.

In the decade after joining NAFTA in 1994, FDI quadrupled and exports to US and Canada tripled, driving sustained economic growth.  Mexico is hoping that changes to the energy sector will promote growth in other areas, having a trickle down effect as cheaper energy supply drives investments in manufacturing, infrastructure and other projects.

For the moment, the President’s reform seems to be a good middle ground compromise, neither too radical nor too conservative. If passed, the plan’s success will hinge on how investors view the opportunity after they carefully review the details in the law and related legislation.  Nevertheless, the bold proposal is, at a minimum, a step in the right direction.

Sources: Reuters, Wall Street Journal, El Economista, Forbes, Global Post, Milenio, El Diario, LA Times, NY Times, Financial Times, CNN Mexico, McClatchy, The Globe and Mail, Investors.com.