Mexico's energy sector regulatory overhaul helps to boost private investment

With the impact of reform permeating all corners of the energy sector, Mexico’s economy is undergoing a rapid transformation. The extensive regulatory changes that began in December 2013 are helping to attract large volumes of foreign and domestic investment into hydrocarbons exploration, downstream fuel distribution and renewable energy generation. Private oil and gas producers, virtually barred from operating freely in the country since the nationalisation of Mexico’s hydrocarbons industry in the 1930s, have now returned in force, prompting a series of new discoveries of hydrocarbons reserves.

Despite the positive effects of reform, the fastpaced changes have exposed the institutional obstacles that still need to be overcome. Infrastructure in key energy subsectors remains constricted by a lack of investment, something that will need to be addressed in order for the benefits of the reform to be fully felt across the broader economy.

Mexico has seen the strength of its oil and gas extraction industry dwindle over the years, partly due to a lack of investment in exploration and competitiveness. The collapse of international oil prices in 2014 further exposed the fragility of a centralised and monopolistic energy industry. State-owned companies such as Petróleos Mexicanos (Pemex), in charge of hydrocarbons exploration and production, and the Federal Electricity Commission (Comisión Federal de Electricidad, CFE), the country’s electricity utility, have long constituted the backbone of the sector. Changing the way these two firms operate, and exposing them to additional competition, has been an important aspect of the initiatives being put in place to overhaul the industry.

Sector Weight

A key goal of reforms has been to counter stagnation. The weight of oil exports in the country’s economy has seen a significant reduction, from 8.7% of GDP in 2011 to an estimated 3.3% in 2017. This was partly caused by a steady reduction in oil and gas production over the years, but aggravated by the steep fall in international oil prices in 2014. As a result, the proportion of government income resulting from oil exports went from 40% of total government revenues in 2012 to 17% by 2017, according to figures from the Ministry of Finance (Secretaría de Hacienda y Crédito Público, SHCP). The loss of oil export revenues was partially mitigated by the government’s ability to accelerate regulatory reforms of its tax system from 2013 onwards, allowing the state to improve tax administration and collection.

Oil & Hydrocarbons

Even before the steep decrease in oil prices, however, hydrocarbons production had already been gradually falling. According to the International Energy Agency (IEA), Oil production dropped by roughly one-third between 2004 and 2016, from 3.8m barrels per day (bpd) to 2.5m bpd, the agency stated in its “Energy Policies Beyond IEA Countries: Mexico 2017” report. Pemex has estimated that by the end of 2018 oil production will be 1.9m bpd, unchanged from end-2017 levels. Related gas output has also come down over the years, leading to an increase in gas imports from the neighbouring US, which now supplies over half of Mexico’s natural gas consumption.

As of January 2018 Mexico had reserves of 8.5bn barrels of oil equivalent (boe), a 7.6% decrease year-on-year, according to statistics released by the National Hydrocarbons Commission (Comisión Nacional de Hidrocarburos, CNH) . At the current rate of extraction, and barring any further exploration or development of new sources, Mexican reserves would last until approximately 2028, according to information shared at the CNH meeting. This underlines the importance of the exploration and development efforts under way following sector reforms.

The energy reforms have already spurred some progress in this regard. An evaluation of the country’s hydrocarbons reserves in 2017 highlighted that two foreign companies – Italy’s Eni and Argentina-based entity Pan American Energy – put forward volumes of reserves for the first time in the country’s history, with the combined crude oil contributions of the two firms exceeding those of Pemex. Despite these contributions, hydrocarbons production continues to fall, largely driven by Pemex’s inability to adequately invest in either the development of new oil fields, or the extension of the lifespan of its mature oil assets. This underlines one of the key aspects of the reform, which aside from allowing private firms to compete with Pemex and the CFE, also aims to transform the two firms into “state productive companies”. According to the IEA, this is expected to maximise efficiencies and allow the two entities to better compete with other players in the newly liberalised hydrocarbons market.

Changing Tune

Mexico’s energy reform began with constitutional modifications implemented in 2013. A set of fundamental goals underlined the regulatory overhaul: the need to open energy activities to market competition, attract foreign investors to participate in the sector and reverse the decrease in hydrocarbons production. Making electricity generation more cost effective and environmentally sustainable were also key priorities. The reform includes the transformation of the sector’s existing regulatory and institutional framework to strengthen the independence and operational transparency of regulatory bodies. New market mechanisms are being put in place to increase the participation of the private sector and attract foreign investors. However, some stakeholders suggest that more needs to be done. “There are many challenges that remain in Mexico’s energy regulatory framework, regardless of its well-intentioned design,” Adrián Morales, CEO of energy provider Group MD, told OBG. “Mexico does not have the experience to design a comprehensive framework to account for private international actors.”

For its part, the IEA stated in its 2017 report that concrete steps to “increase transparency and rule of law, (and) improve energy security and strengthen the environmental sustainability of the energy sector” had already been implemented.

These improvements could help to counter the potential economic cost the country would likely endure if the status quo were maintained; according to 2016 figures from the IEA, failure to reform the energy sector could result in a cumulative $1trn, or 4%, reduction in GDP by 2040. “There was a monopoly structured around Pemex and the CFE, and this situation was already damaging the country,” Arturo García Bello, partner for energy and natural resources at Deloitte México, told OBG. “One of the indications that the reform is making good progress is the influx of capital that it has brought,” he added.

Investment

At a press conference in February 2018 the minster of energy, Pedro Joaquín Coldwell, stated that by the time the President Enrique Peña Nieto administration concludes in late 2018, the total committed investment into Mexico’s energy sector since the reform will amount to $200bn. A large proportion of this has come through the auctioning of hydrocarbons exploration and production concessions, as well as through a number of tenders and contracts to establish new opportunities for renewable energy generation capacity.

Restructuring a Giant

The ongoing reform is a watershed moment for Pemex, as it restructures process transforming the way it has operated since its inception following the 1938 hydrocarbons nationalisation process. However, the need to reform the company, alongside Mexico’s broader energy sector, had become increasingly clear in recent years. According to international media sources, in 2014 the state-owned firm produced 16 barrels of crude oil per worker each day, much less than either Brazil’s state-owned oil company Petrobras or the UK’s BP, which registered a daily output of 33 and 25 barrels of crude oil per worker, respectively.

As the reform opens up several of the firm’s markets to private competition, Pemex is looking to focus on a more limited array of activities. “We are concentrating our efforts on those businesses that offer a better return and allow for an efficient use of our resources,” Carlos Treviño Medina, CEO of Pemex, told OBG. The partnerships it has signed with major oil firms should help Pemex overcome technical and financial limitations, and profit from the resources it was allocated during the hydrocarbons auction. This will be critical as production from more mature fields continues to decline, and following the company’s $17.9bn reported net loss in 2017.

Though access to the country’s hydrocarbons resources were granted to private firms, an initial bidding round, known as Round Zero, allowed Pemex to secure 83% of proven and probable reserves, in addition to 21% of potential reserves. This left the state-owned firm with an allocation of 20.6bn boe in this round. Importantly, the reserves are largely located in shallow waters, where the company has the majority of its experience.

Investment Instruments

Despite the starting advantage obtained in Round Zero, carried out in 2014, Pemex’s precarious financial situation will likely prevent it from committing the necessary resources for the development of all of the production and explorations areas it now controls. Part of this will be overcome through partnerships with incoming private operators, but Pemex is also likely to generate some additional financial resources through the monetisation of some of its assets, via new investment instruments called fideicomisos de inversión en energía y infraestructura, or FIBRA E.

These investment trusts, mirroring those used in the real estate sector, could allow the firm to free up resources and channel them towards exploration of new fields (see Capital Markets chapter). According to estimates from the Mexican Securities Industry Association, new FIBRA E listings could channel up to $70bn into infrastructure development by 2020.

Making the Rounds

In the years since Round Zero, auctions have advanced swiftly. Between July 2015 and January 2018 a total of eight oil and gas licensing auctions took place, directed by the CNH through two different rounds. These resulted in the allocation of 88 out of a total of 118 onshore and offshore hydrocarbons blocks, and promising initial finds (see analysis). “Part of the reform’s success has resulted from the transparency involved with tenders,” Manuel Ortiz Monasterio, director-general at Environmental Resources Management, told OBG. “This was the only way to generate credibility.” Further licensing rounds are expected, and over the first half of 2018 the authorities seemed to be expediting these in light of the presidential elections scheduled for July of that same year.

According to the five-year plan for the oil and gas sector developed by the Ministry of Energy ( Secretaría de Energía, SENER), Mexico will put a total of 914 hydrocarbons blocks up for auction during the 2015-19 period, representing an estimated 104.8bn boe of hydrocarbons resources.

Foreign Players

The first farmout agreement allowing Pemex to capitalise on foreign experience and capacity resulted from the fourth phase of the initial licensing round in late 2016. The Mexican oil producer partnered with Australian firm BHP Billiton to develop the deepwater Trion field in the Gulf of Mexico, expected to contain 485m barrels of oil, according to estimates from Pemex.

The project will require $11bn of investment over the course of its 35-year joint operating agreement, with plans to drill at least one exploration well between October 2018 and January 2019. The same auction enlisted the participation of Statoil, which has since rebranded to Equinor; ExxonMobil; Compañía de Nitrógeno de Cantarell, a local affiliate of Poland’s Linde Group; and BP, which were all allocated blocks, bringing technical expertise from some of the biggest oil companies into Mexico’s emerging deepwater segment. In February 2017 Pemex signed a deepwater exploration deal with US-based energy giant Chevron and Japanese oil firm Inpex to evaluate the potential of Block 3 of the Perdido Foldbelt in the Trion field.

In the onshore segment, the company inked a deal with Cairo-based oil firm Cheiron Holdings in October 2017 to develop the Cardenas-Mora field, located in the state of Tabasco, which is estimated to contain proven, probable and possible (PPP) reserves of up to 93m boe. The same bidding round gave Pemex another strategic partnership, this time with Germany’s DEA Deutsche Erdoel, which signed up to develop the nearby Ogarrio onshore field, which holds an estimated 54m boe of PPP reserves.

Natural Gas

Whereas oil production has waned in recent years, the role of natural gas in Mexico’s energy mix has grown significantly. CFE has transitioned a large part of its generation capacity to gas-fired, combined-cycle power plants, with as much as 57% of the country’s electricity production fuelled by natural gas, Juan Carlos Zepeda, president commissioner of the CNH, told international media in mid-2017. Growing demand has been driven in large part by the manufacturing sector, especially in the northern part of the country. Daily natural gas consumption increased from approximately 3.7bn standard cu feet (scf) in 1998 to 8bn scf in 2017, according to statistics from the oil and gas industry bulletin released by SENER in January 2018.

While Mexico’s PPP gas reserves stood at 54.9trn scf as of January 2015, according to figures from Pemex, the firm’s limited financial resources and the availability of cheap gas from the US have prevented higher volumes of domestic production, which fell from 3.5bn scf per day (scfd) in 1998 to around 3.1bn scfd in 2017. “Dependence on cheap US natural gas is convenient for us, allowing us to focus investment on the reform, and to attract sophisticated technology and new infrastructure,” Bulmaro Rojas, managing director of global power generator supplier Generac, told OBG.

To cover rising consumption, imports have increased exponentially, with 70% of local demand now supplied from abroad. Imports jumped from roughly 1bn scfd in 2010 to as much as 4.9bn scfd in 2017, according to SENER. Besides liquefied natural gas imports, Mexico has been depending heavily on shale gas from Texas. Government plans to auction access to shale gas reserves in the north of the country, however, are likely to increase domestic production in the near term (see analysis).

Pipelines

Despite its dependence on imports, the gas-based model has worked well for Mexico, supporting the expansion of manufacturing in the north and east of the country. The challenge now will be to effectively expand gas supply into other regions. “This will create competitive industrial hubs across the country. Some areas are still not fully connected, but these gaps are being filled by the new pipeline projects,” Bello told OBG. Sector liberalisation is attracting investment into the expansion of pipeline networks, not only to increase connections between the US and Mexico, but also to better integrate existing pipeline networks in different regions. In mid-2017 private operators were working on projects to add an extra 6450 km of gas pipelines to the existing 11,300-km network that has traditionally operated under the management of the state through Pemex.

Downstream Development

Extending pipeline infrastructure will also support growth in the downstream side of the business, which is being reshaped by price liberalisation. The measures aim to ensure that prices are more in tune with international markets and production costs. The first move to free up of retail prices came in late 2016, when the SHCP announced that average petrol prices would increase by 20.1% at the start of 2017. The abrupt rise led to protests across the country, which blocked roads and motorways. Petrol price increases were seen as especially burdensome because they added to the inflationary pressure experienced throughout most of 2017, spurred by a depreciation of the Mexican peso. By late 2017 retailers across the country were free to set their own prices.

Despite initial pushback, Mexican consumers have been adapting to the new reality. However, in an April 2018 media appearance, Miguel Messmascher, the deputy minister of finance and public credit, signalled that further hikes were possible, linked to the rising price of oil and the weaker Mexican peso. In the short-term, high logistics costs, caused by insufficient infrastructure, are likely to contribute to higher petrol prices, although ongoing investment by private energy infrastructure operators should counter the logistics aspect of the price equation in the medium term. To feed expanding distribution networks, government authorities required Pemex to open spare capacity in its pipeline network to interested bidders, as part of the so-called Temporada Abierta (Open Season), which allowed companies to apply for fuel import permits.

Liberalisation has been quickly attracting new firms to the downstream sector. By late 2017 control of 18.5% of the country’s more than 11,700 petrol stations had shifted from Pemex to other brands, and as much as $12bn of private investment was expected in the broader downstream segment, according to estimates from the Energy Regulatory Commission (Comisión Reguladora de Energía, CRE).

Refining Capacity

Although the country has plentiful energy resources and expanding distribution infrastructure, a large proportion of the petrol sold in Mexico still comes from abroad. The country’s refining muscle is distributed across six refineries, all owned by Pemex Transformación Industrial, a subsidiary of the state-owned oil giant, but their ability to function at optimum capacity has been hindered by a lack of investment. The firm also holds a 50% stake in the Deer Park refinery in Texas, part of a joint-venture agreement with Shell established in 1993. In August 2016 Pemex announced that it would look at establishing more partnerships to improve its refining capacity, given ongoing financial difficulties. Mexico’s refineries registered a combined processing capacity of 1.6m bpd in 2017; however, utilisation rates have progressively declined over the years, falling to 48% in 2017, the lowest figure since records were introduced in the 1990s.

Accumulated years of underinvestment in refining capacity have put added pressure on Mexico’s balance of payments. Imports of refined products went up from $1.2bn in 1995 to a peak $27.8bn in 2011, before coming down to $19.8bn by 2015. Furthermore, a lack of modernisation in existing refineries has encouraged Mexico to send a large volume of its crude oil to be refined in the US.

“It may seem uneconomical to sell the product cheaply and import it expensively, but you have to look at the overall business context,” Bello told OBG. “Building a new refinery is a significant investment. At the moment I think it is better to improve domestic refining efficiency,” he added.

Electricity

Meanwhile, in Mexico’s electricity generation, transmission and distribution system, the impact of reform is being felt, as in much of the rest of the sector. Existing infrastructure currently allows for 97% of the population to access electricity. The growth of the Mexican economy, however, is bringing the expansion of both its manufacturing sector, as well as the country’s urban population, adding to generation requirements.

In the 15 years to 2031 power consumption is expected to rise by an average annual rate of 3.5%. Over the same period, investment in new installed generation capacity is projected to total $125bn, with an extra 60 GW of generation capacity to be added. Most of the increases will take place through the electricity auctions included in the energy reform package. In March 2016 the Mexican authorities launched three successful long-term electricity auctions, allowing for private investors to commit to electricity generation projects involving a combined investment value of roughly $9bn. The third of these auctions, completed in November 2017, allowed for the participation of other electricity buyers besides the CFE (see analysis). A key component of power sector reform has been the new wholesale electricity market, launched by authorities in January 2016. Requirements for a fourth, long-term electricity auction were published by the CRE in March 2018, with the process expected to be completed by the following November.

Renewable Energies

Part of the overarching objectives of these auctions is to raise the participation of clean energy generation capacity in Mexico from 21% in 2017 to 35% by 2024. Although the government has a broad classification for what it considers clean energy sources – which include renewables, but also nuclear energy – the long-term electricity auctions have underlined the part that solar and wind generation are set to play in the country’s future energy mix.

The three initial long-term electricity auctions that took place in 2016 and 2017 have seen the commissioning of roughly 22 GW of new electricity generation capacity, with the three developments set to attract a total of $9bn in investment.

From 2017 to 2031, 63% of the proposed 55.8 GW that will be added to Mexico’s grid will come from clean energy sources, and 37% will be sourced through conventional generation technologies, the majority of which will consist of combined-cycle power generation. Wind will account for 24% of all new generation capacity added during that period; solar energy sources will make up 14%; geothermal and biothermal technologies will add 5%; and hydropower will contribute 3%.

“The renewable energy market has a promising future in Mexico, with solar and wind power usage growing exponentially,” Felipe Vila, CEO of local investment fund Fondo de Fondos, told OBG. “However, while this transition is carried out, it is important for Mexico to retain its energy production through non-renewables as a back-up.”

Transmission

Although regulations have kept electricity transmission and distribution responsibilities in the hands of the CFE, they have also opened up the sector to private sector partnerships in order to carry out these services. In April 2017 SENER announced that up to five transmission projects would be launched over the coming years, with combined investment set to reach $6.6bn. On the eastern coast of the country, SENER has also announced plans to build a transmission line between the island of Cozumel and the state of Quintana Roo. As a result, a handful of transmission-related tenders were expected to take place in 2018. In January 2018 Coldwell announced the launch of the first tender for the more than $1.1bn, 1400-km transmission line set to connect Hermosillo in Sonora with Mexicali in the Baja California peninsula, with a capacity of 1500 MW. The following month, the CFE also published the initial clarification sheet to begin the tender process for the 1660-km Mexico City-to-Oaxaca transmission line project, expected to generate $1.7bn in investment. The projects are scheduled to begin operating in early and late 2021, respectively. The former tender will be the first time in a number of decades that interested private firms will be invited to participate in the transmission sector in Mexico, with interested proposals to be submitted in July 2018, and the winner set to be announced later that same year. The Baja California-Sonora line will allow the region’s electricity grid to better absorb the expected generation capacity increases.

SENER’s 2017-31 National Electric System Development Programme will also additional developments to the segment. Approximately 6200 MW of combined-cycle generation capacity will be built in Baja California, Sinaloa and Sonora over the course of the programme. Additionally, 700 MW of wind generation capacity and 1000 MW of solar will be built in Baja California and Sonora, respectively.

Whether or not the upcoming transmission projects will attract as much interest as other segments of the energy sector remains to be seen. According to some sector sources, a number of conditions involved in these tenders might make them ultimately less appetising for private investors.

“We are in the process of fully understanding the structure of the transmission line tenders,” Tania Ortiz, executive vice-president of business development at Mexican energy infrastructure developer IE nova, told OBG. “You build it and operate it for 25 years, but you can’t own the asset. These projects also have the added risk of being linear developments, spread across several kilometres, as opposed to being concentrated in a specific place,” she added.

Outlook

As several important segments of the country’s energy industry open up for competition, widespread energy reform is leading to significant changes that go well beyond the sector. New investments and private operators are helping to change the economic structure of the country, in a sector with often highlighted for its significant potential.

This will inevitably signify a steep shift for the sector’s state-owned companies. But recent developments have shown that the benefits of adding competition largely outweigh the costs of to such a critical sector of the economy.

The reform is also an opportunity for Mexico to implement the structural changes that will allow it to develop cleaner and more efficient energy generation. In this regard, the country’s renewable energy potential is already being tapped by large volumes of private investment.

Nonetheless, ensuring that the correct incentives are kept in place will be critical for the long-term success of the country’s transition towards a greater degree of renewable generation capacity.

The energy sector is well positioned to receive additional private investment and technical knowhow for its future development, but for ongoing reforms to be successful in the long term, continuity of the regulatory framework will be an essential component, independent of any changes that might emerge after the July 2018 presidential elections.

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The Report: Mexico 2018

Energy & Utilities chapter from The Report: Mexico 2018

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