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Mexico’s legislature recently passed historic energy reforms designed to attract desperately-needed foreign direct investment to the inefficient nationalized energy sector for the first time since 1938. This was when then-President Lázaro Cárdenas seized fields from U.S. and British companies and made oil at all stages of production, refining and distribution constitutionally guaranteed legal property of the Mexican people. The oil industry is not only of strategic importance to Mexico, it has been important in the country’s economic development and formative in Mexico’s distinct sense of nationalism. This move marks Mexico’s first major economic reform since the NAFTA Agreement in 1994 and will allow private international energy companies to develop unexplored oil and gas resources.

Mexico is under-exploiting its energy riches and requires both investment and technology to fully develop the oil and gas business and help reverse a nearly decade-long crude oil production decline. Moreover, this reform has the potential to transform Mexico’s economy by translating into surging inflows of foreign direct investment and generating sustainable economic growth.

In this regard, Emilio Lozoya Austin, CEO of PEMEX, offers his perspective on the big challenge of Mexico’s energy sector in the World Economic Forum’s latest “Global Energy Architecture Performance Index Report 2014”: ”[W]hile the country has vast hydrocarbon resources, the cost of energy to the economy is relatively high, affecting investment opportunities and productivity growth. Energy reform can (…) play a major role in creating the conditions for sustained economic growth. Over the past decade, North America’s oil and gas industry has experienced a veritable revolution. Deep-water production and shale gas and oil have drastically reduced US dependence on imported oil (…) joining North America’s energy revolution is an opportunity the country cannot afford to miss. (…) To make the most of this opportunity, both [PEMEX and the oil industry] must improve productivity throughout the industry’s value chain, from exploration and production to refining, petrochemicals and distribution and logistics.” Furthermore, Mr. Lozoya Austin estimates that “Mexico’s oil and gas industry has a US$60 billion a year potential for profitable investment.“

And this is exactly the crux of the matter. How profitable investment in the Mexican oil and gas sector can be is very much dependent on follow-up regulations. Here a difficult balancing act needs to be struck: Mexico has to offer international oil companies attractive enough returns on capital employed to make them willing partners in developing it’s oil and gas wealth while retaining good enough “equity stakes” in joint projects to benefit and placate Mexicans. This secondary legislation to implement the opening of the energy sector and thereby spelling out the terms and conditions for foreign international oil companies to explore and develop Mexico’s deep-water and shale riches is expected to go before the Congress of Mexico in early 2014.

It is about time to tackle the inefficiencies in the Mexican energy sector: Mexico’s already subsidized electricity tariffs are still much higher than in the U.S. or most Western countries. Marco Oviedo at Barclays is quoted in the Financial Times as saying that the “Mexican industry [in 2013] has paid 45 per cent more for its electricity than factories in the U.S.” Mexico had to step up imports of liquefied natural gas (LNG) as rising industrial demand, falling domestic output from conventional gas fields and limits to pipeline capacity for cheap U.S. shale gas imports forced it to pay multiples more for incremental natural gas supplies.

Earlier last year, in what was Mexico’s biggest ever tender issued to procure LNG cargoes to be delivered to its Manzanillo import terminal on the Pacific Coast through 2014, state-run power monopoly CFE in conjunction with PEMEX, the state oil and gas monopoly, eventually secured 17 cargoes to be delivered in 2013 and 12 in 2014. According to data from the U.S. EIA, Mexico’s LNG imports averaged about 0.4 Bcf/d in 2012, representing about 20% of its overall natural gas imports. What an anomaly given the fact that Mexico’s has vast untapped deposits of gas in domestic shale rock formations. However, it will take years for the country to unlock those reserves while facing a severe natural gas shortage in the meantime. Consequently, at least for the medium term new pipeline capacity will be needed. PEMEX is currently building the Los Ramones natural gas pipeline, planned to link the prolific Eagle Ford shale formation – which extends into Mexico – in south Texas to central Mexico’s industrial heartland. By the time it is fully operational, however, domestic natural gas demand will have already outstripped the pipeline’s capacity. Mexico would do well to keep importing cheap US shale gas via pipeline in order to bolster its competitive edge in manufacturing. Labor costs in Mexico are even more competitive than those in China. Overall, cheaper electricity prices would improve Mexico’s competitiveness in a major way due to the fact that lower energy prices are key drivers of economic growth.

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Source: Mexican Energy Ministry, Energy Information System, 2013; from presentation by Mexican Undersecretary of Energy Enrique Ochoa Reza at the Atlantic Council, Washington, D.C

At the same time, Mexican domestic crude oil production has been falling for nearly 10 years, to about 2.5 million barrels per day from 3.4 million barrels per day in 2004. One reason Mexican crude production has fallen so fast is the precipitous decline of the Cantarell field in the Gulf of Mexico, where output has fallen 75% from its 2004 peak to just 500,000 barrels per day in 2011, according to U.S. EIA data. This is a great challenge for Mexico because not only did this field provide such a large share of Mexico’s total oil output but there are no other fields capable of replacing it in the short term. Reforms that will give international oil companies new access to Mexican oil fields are supposed to change this overall trend. The government says it will increase oil production to as much as 4 million barrels per day by 2025.

However, it is one thing to allow private international oil companies to develop unexplored oil and gas fields. It is quite another to increase nationwide production significantly as a result. Even in Mexico the era of ‘easy oil’ is over. Technical assistance and foreign investment is sought from private international oil companies to exploit difficult-to-access reserves such as deep-water deposits in the Gulf of Mexico. This has to be differentiated from offshore energy production in shallow water where PEMEX has a proven track record. In addition, PEMEX is reeling under large financial losses while still funding about one third of the government’s budget through taxes.

Mexico’s Crude Oil Production, 2004 – 2013

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Source: Energy Information System, Petroleos Mexicanos; from Atlantic Council report “Mexico Rising: Comprehensive Energy Reform at Last?” by David Goldwyn.

New infrastructure costs, availability of alternative projects – e.g. opportunities all over the U.S. – for interested companies on a worldwide basis, the prevailing oil market price at the time of negotiations and, above all, the terms of the development process such as standards for booking proven reserves and royalty as well as tax structures will eventually determine the pace of any increase in Mexican oil production. Currently, Mexico has an estimated 10.26 billion barrels of proven oil reserves, as well as one of the world’s largest shale gas resource bases according to the CIA World Factbook. PEMEX itself estimates that with adequate investment and technology exploring deep-water reserves could add as much as 27 billion barrels of oil to Mexico’s proven reserves. This may be the big prize alongside substantial technically-recoverable shale gas and shale oil reserves. However, note that deep-water and shale production are costly as well as risky endeavors and medium- to longer-term prospects.

According to Diana Villiers Negroponte of the Brookings Institution, the Mexican Department of Energy (SENER) “may not grant licenses or production sharing contracts for the exploration and extraction of oil and gas. Those [upstream] activities may only be awarded on a contract for profit basis. The Mexican state thus preserves its ownership of the subsoil and its contents (…).” From a commercial point of view, this contractual structure resembles the fee-for-service contracts that are the basis for the profitable business models of companies like Halliburton. However, given that it stops short of owning oil beneath the ground, it will make it more difficult for conservative, privately-owned oil companies like ExxonMobil to take on the often required greater risk. The business models of major international oil companies, as Steve Coll points out in his book “Private Empire – ExxonMobil and American Power”, depend in part on “booked reserves” that they legally control under contract similar to property rights and which they can exploit for sale in future years. Note, the distinct feature of the oil and gas industry is its depleting asset base and need for replacement through drilling and acquisition. The Mexican government will eventually have to sweeten the deal a bit to compensate properly for greater risk and needed expertise foreign international oil companies have to offer.

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Source: World Rating of Oil and Gas Terms; PFC Energy, Van Meurs Corporation and Roger Oil & Gas Consulting. Production: Oil and Gas Journal (crude oil); from presentation by Mexican Undersecretary of Energy Enrique Ochoa Reza at the Atlantic Council, Washington, D.C

U.S. major oil producers in particular should take the opportunity to use Mexican energy reform as an argument for the repeal of the export restrictions that have prohibited most overseas sales of American crude oil for decades. The primary laws prohibiting crude exports are the Mineral Leasing Act of 1920, the Energy Policy and Conservation Act of 1975, and the Export Administration Act of 1979, as Blake Clayton at the Council on Foreign Relations points out. Exxon said in its annual global energy forecast that the revolution in shale formation drilling will allow North America to join the ranks of the world’s crude oil exporting continents by 2040. According to the U.S. EIA, U.S. crude production will expand to 9.5 million barrels per day in 2016, the highest since the nation’s peak in 1970. Therefore, it is Mexico that has to get the incentives right in a timely manner in order to get costly and risky deep-water and shale plays under way to improve its energy architecture and, at the same time, become one of the most promising areas for expansion in the oil and gas industry worldwide. In the short term, PEMEX may only be successful in finding partners for over-budget, long-delayed projects, for half-exploited fields with difficult geology requiring the assistance of specific producers experienced in handling such fields, and oil and gas fields that extend from the U.S. across the border.