Energy reform now underway in Mexico could create a new dynamic in North American energy production, offering new opportunities and risks in many sectors of the industry and expanding North America’s already burgeoning oil and gas production outlook. The result could be a more prosperous Mexico, with the energy sector helping to drive economic growth.

Mexican energy restructuring is the central proposal of President Enrique Peña Nieto, who took office in December 2012. His initiative faces steep political, economic and cultural challenges in the country where the 1938 expropriation of the foreign oil companies is still observed as a national holiday.

The reform plan, conceived as an antidote to Mexico’s declining oil production, was approved by Mexico’s Congress in December 2013. The plan is intended to inject a measure of competition and foreign investment into Mexico’s monopolistic energy industry dominated by 70-year-old state-owned Petróleos Mexicanos (Pemex).

Under the new rules, non-Mexican exploration and production companies, such as ExxonMobil, Shell or China’s CNOOC, could partner and invest with Pemex for the exploration of deepwater Gulf of Mexico prospects. This would also include Mexico’s large shale gas resources, as well as pipeline construction and even retail sales of gasoline and other petroleum products.

A 2008 less ambitious and unsuccessful effort by President Felipe Calderón offered only a possible share of profits under a fee-for-service contract concept. The new plan aims to offer expanded participation opportunities, but not outright ownership of oil and gas reserves.

The reform effort will not be easy. While there are market developments pushing Mexico toward broader-than-usual popular and political support for substantive energy reform, there are also serious challenges. Some considerations include:

• The main target of the reform effort is bringing urgently needed investment to Mexico’s oil production, which has been declining since 2004. Oil production funds a third or more of Mexico’s national budget, according to the Financial Times, and thus the status quo is fiscally unsustainable. The government hopes to boost oil production to 3 million barrels per day by 2018 from 2.5 million b/d today. At a time when the U.S. is experiencing an historic surge in oil production, it appears politically unpalatable for Mexico to be experiencing a decline, especially as Mexico is credited with substantial undeveloped resources in some of the same plays that are proving profitable for the U.S. industry.
• Mexico has a growing natural gas supply problem while the U.S. has abundant new supplies. Mexican demand is expected to grow an average of 2 percent per year over the next 25 years, while domestic supply is projected to remain static. Additional U.S. pipeline exports and foreign capital to increase Mexican production will be needed. Black & Veatch forecasts that U.S. exports of gas to Mexico will increase to 4 billion cubic feet/day (Bcf/d) in 2033 from less than 2 Bcf/d in 2013, via as many as seven new U.S.-to-Mexico pipeline projects. However, a growing natural gas dependence on the U.S. and other foreign sources is likely to prove unpopular in Mexico, which highly values its home-grown energy.
• Mexico’s retail electricity rates, though subsidized, are higher than in the U.S., and the costs for Mexican businesses have doubled since 2003 to roughly 13 cents/kilowatt hour. The new energy reform plan includes opening up of the electricity sector to dramatically reduce electricity rates.

There are numerous challenges that could derail the reform effort:

• Under the plan, Pemex continues to receive advantages that may discourage investors, such as being allowed to identify current and future fields where it retains sole development rights.
• The constitution will still bar outright concessions to foreign companies or reserve ownership, offering profit- and production-sharing contracts and “licenses” and the right to book a share of the reserves.
• Geopolitical risk will remain, as production rights will be subject to confiscation through tax and fiscal policy or by direct nationalization of the resources. Tax reform will also be needed since Pemex pays close to a 100% tax rate and such reform has not been started.
• Mexico’s highly regulated natural gas industry will require restructuring to attract investment.
• An increase in dry gas production will require market reforms allowing competition that would be tied to the incremental cost of production and non-subsidized prices.
• Pemex is Mexico’s largest single employer with 160,000 employees; competitive threats to Pemex entail risk labor and political retaliation. Though the reform measure passed the Mexican Congress, it must still be approved by the states, a process likely to be highly contentious. A referendum movement opposing it is underway, supported by the opposition political party PRD.

Shortly after his inauguration, President Peña Nieto helped to forge a consensus among the three major political parties in favor of the pro-reform “Pact for Mexico.” The initiative has already resulted in legislative passage of pro-competition education and telecom reform measures not previously expected to garner consensus.

Meanwhile, Mexico has caught up with its South American rival Brazil in some measures of economic progress, such as per capita GDP. These factors suggest that economic necessity and political realities will push Mexican energy reform with strength not seen in the past.

Published originally on Black & Veatch Solutions