Energy policy looms large in Mexico election

Russell McCulley
Friday, June 1, 2012

Mexicans go to the polls 1 July to elect a new president and congress. Polls suggest big gains for the institutional Revolutionary Party which dominated post-revolutionary Mexican politics for seven decades. Will a new administration have the political will –and the support in congress – to build on the energy reforms of outgoing president Felipe Calderón? Russell McCulley reviews the issues.

Although the three major candidates hoping to succeed Calderón differ on the means, all agree that something must be done to help national oil company Pemex reverse a steep decline in production and free up the capital needed to exploit the country's considerable reserves, including those that lie in the deepwater Gulf of Mexico. Mexico's constitution prohibits Pemex from entering into production sharing contracts with foreign oil companies. Reforms pushed through congress in 2008 allowed Pemex some flexibility in contracting and in its management structure. But they fell far short of what the company needs to improve efficiency and develop the necessary technology, most observers say.

‘Pemex needs to make the leap from being a 1980s-type oil company to being a 21st century oil company.’ Duncan Wood

Frontrunner Enrique Peña Nieto, who is poised to return the Institutional Revolutionary Party (PRI) to power after a 12-year exile from the top office, has acknowledged that Pemex’s current model is unsustainable, and has called for increased E&P investment and legal reforms that would encourage more private sector involvement in the company’s operations. But his proposals have been short on specifics, says Duncan Wood, a professor of international studies at the Instituto Tecnológico Autónomo de México (ITAM) in Mexico City and a senior energy consultant with the Woodrow Wilson International Center for Scholars, in the US.

Both Peña Nieto and Josefina Vázquez Mota, the presidential candidate from Calderón’s National Action Party, or PAN, are ‘on the side of a market-oriented reform of the energy sector’, Wood says. ‘For Peña Nieto, that means opening up Pemex to the possibility of foreign investment, of private investment in the oil sector. We’re not quite sure what that means – whether it means private money coming into Pemex, or whether it means allowing Pemex to work alongside private oil companies in the Gulf of Mexico.’

‘Each of the candidates has some good ideas. But most remain wrapped around the flag.’ George Baker

Constitutional change

Either proposition would likely require a change in the constitution. The 2008 reforms went about as far as possible as current constitutional law allows for foreign participation in Mexico’s oil & gas affairs, Wood says. ‘The opinion in Mexico is, we’ve pushed it to its limit. The incentive-based contracts that were released at the end of last year were really as far as you could go under the current constitutional framework.’

Peña Nieto, the former governor of the state of Mexico, has also proposed releasing Pemex from the control of the country’s finance ministry – a ‘very, very important proposal’, Wood says, ‘that would basically allow Pemex to decide its own investment budget and reduce the tax burden on Pemex’.

Vázquez Mota, who served in the administrations of Calderón and his predecessor, Vicente Fox, has also discussed easing the tax burden on Pemex, which supplies about a third of the country’s fiscal income. She has talked more explicitly than Peña Nieto, however, about the possibility of floating Pemex shares on the Mexican stock market. Under such a scheme, the state would retain a 51% majority stake in the company.

Recent polls show Vázquez Mota in a virtual tie for a distant second place with former Mexico City mayor Andrés Manuel López Obrador of the Party of the Democratic Revolution, or PRD. López Obrador has accused his opponents of attempting to privatize Pemex and has said retaining tight state control would encourage efficiency and help his administration carry out its would-be goals of environmental sustainability, exploration and investment in new technology. ‘His preferred model is Statoil,’ Wood says, 'in the sense that it would build up a national oil industry in Mexico, that there would be some kind of sovereign wealth fund that could come out of it that would benefit Mexico. But he comes back time and time again to saying Pemex must be 100% owned by the Mexican people.’

Another widely discussed NOC is Petrobras, which both Peña Nieto and Vázquez Mota have mentioned as a possible model for Pemex to pursue. ‘Theres’s a lot of doubt in Mexico right now about whether that actually makes a lot of sense for Pemex, for a number of reasons,’ Wood says. ‘The Brazilian model is proving itself to be not nearly as market-friendly as we first thought. So maybe Brazil isn’t the model, maybe we should be looking more to a country like Colombia. I think in the next couple of months, as the debate intensifies, we’re going to see more references to Ecopetrol as an example of how to do things. But that takes it even further – that’s talking about a wholescale opening up of the oil sector.’

The fact that talk of partial privatization, once considered heresy in Mexico, has even entered the public discussion is a remarkable turn of events. But the stakes are high: oil production declined by more than 25% from a 2004 peak average of 3.9 million b/d to 2.98 million b/d in 2010. Domestic demand rose to about 2.15 million b/d in 2010, according to recent report from Rice University’s Baker Institute, suggesting that Mexico could go from being one of the world’s top oil exporters to a net importer of oil in a decade. Along with its tax take, Pemex faces considerable pension obligations and, according to the Baker Institute report, ‘lacks the full stock of human capital and technology that is needed’.

The willingness of some public officials to float the idea of partial privatization is ‘a positive sign’, says Houston energy analyst George Baker. ‘Over the past 20 years, there has been talk of making Pemex more efficient. Much more can be done on that front, but it’s still an inward-looking solution.’ Gabriel Quadri, who is running a very distant fourth place in the presidential race, has been most vocal about allowing Pemex to have international partners, Baker says. ‘That’s a very significant thing for a Mexican politician to say.’

‘Each of the candidates has some good ideas,’ he says. ‘But most remain wrapped around the flag,’ meaning that they appeal to a long-held antipathy among citizens to foreign involvement in Mexico’s rich natural resources base.

Legal framework

In February this year, Mexico and the US signed the Transboundary Hydrocarbons Agreement, which intends to establish a legal framework to settle disputes over any possible discoveries, onshore and offshore, that straddle the border between the two nations. ‘The legal certainty created by the agreement will enable US companies to explore new business opportunities and carry out collaborative projects with Pemex,’ according to a US State Department fact sheet. ‘The agreement also provides for joint inspections teams to ensure compliance with applicable laws and regulations. Both governments will review all plans for the development of any transboundary reservoirs.’

Pemex is courting international bidders in the second lease sale to be held since the introduction of integrated service contracts under the 2008 reforms. The lease sale includes the offshore Arenque and Atún areas in Pemex’s northern jurisdiction, and more favorable terms this time around – including a provision whereby companies can recover 100% of their exploration costs, compared to 75% in the first round – have drawn some interest from foreign operators, Baker says. ‘Pemex’s strategy is to find the oil first, then create farm-out blocks,’ he says. But further reforms will probably be needed to draw more than interest from the majors.

Less than two months before the vote, Peña Nieto held a roughly 20-point lead in polls over his two closest rivals. ‘The key issue here now is whether or not the PRI gets a majority in congress, how big a majority it gets, and whether it is able to push through meaningful reforms,’ says Wood. If the likely new president proposes reforms that require a change in the constitution, he’ll need a two-thirds majority in congress to push them through. Keeping all members of PRI on the same page is a task in itself, Wood says; a likely scenario would be an attempt to form a coalition with the PAN, whose proposed reforms are similar to Peña Nieto’s. But PAN leaders may be reluctant to let Peña Nieto take credit for the reforms.

‘The stakes are huge,’ he says. ‘Production has gone from 3.4 million barrels to 2.5 million barrels a day over the past six or seven years. There are enormous quantities of oil to be discovered in the deepwater Gulf of Mexico, but we can’t get to them. Massive investment needs to be taken in Pemex in order to turn it around, not only in terms of its production and reserves but also in terms of its pension liabilities, which are basically bankrupting the firm right now. There needs to be heavy negotiations with the unions on pensions, wages and productivity increases.

Tax burden

‘Pemex needs to make the leap from being a 1980s-type oil company to being a 21st century oil company,’ Wood continues.

Despite good leadership over the past several years ‘there are just too many barriers to turn Pemex around. And a major one is what the candidates have correctly identified: that Pemex is strangled by a tax burden that has pushed it into the red almost every recent year. That’s something any one of the candidates will have to deal with.’

Tax relief for Pemex would mean that the revenue would have to be made up elsewhere – a politically difficult situation that would most likely have to be addressed early in the next president’s six-year term, before the honeymoon wears off.

‘It is a priority for Peña Nieto and his team,’ Wood says of energy reform. ‘Assuming that they win the election, upon being sworn in as president in December the first thing that they’re going to put on the agenda for January is going to be energy reform. The question is whether that will be alone, or whether it will be with some kind of fiscal reform as well. Because there are key structural reforms that need to take place in Mexico, and those two would be the key drivers of it.’ OE

Categories: Energy North America Regulations

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