How Mexico plans to revitalize its energy industry through privatization

For the past 78 years, Mexico’s energy industry has been closed off to private investment. The constitution Mexico adopted in 1917 bestowed sole ownership of country’s subsurface resources to the government.  The Mexican government also maintains the exclusive right to develop the resource through its state-owned oil corporation PEMEX. This has not always been the case, prior to 1938 production rested largely with a select group of large multinationals. Upwards of 90 per cent of Mexican production through the 1920’s and 30’s was divided between Royal Dutch Shell at 60 percent, with the remaining 30 percent split between Standard Oil’s progeny, Jersey Oil (later rebranded as Exxon) and Standard Oil of California (SOCAL later to become Chevron).

Shell, Jersey, and SOCAL’s management were unnerved by the fact that with the adoption of the 1917 constitution, the multinationals’ investments were no longer afforded legal protection. The Anglo-American firms, acting in concert with their respective home Governments, pressured the Mexicans to provide reassurances on the companies’ right to their Mexican assets. The friction this created between United-States and Mexico government was relieved momentarily with the signing of the Calles-Morrow treaty. The treaty was intended to reaffirm the multinationals’ control of the oil assets the companies developed prior to 1917. The fix was only temporary.

Although, Mexico was the world’s second largest oil producer during the 1920’s, the country’s industry was hard hit with the onset of the Great Depression. The economic fallout exacerbated long standing labour grievances among the nation’s oil workers. The workers’ grievances came to a head in 1937 when an industry-wide strike took hold. In a desperate last ditch effort, the Mexican government tried to mediate between management and the striking workforce, but it was to no avail.

Under mounting domestic pressure, the Mexican government was forced to act. In early 1938, the country’s lawmakers moved to expropriate all the multinationals’ Mexican assets. The resulting diplomatic row would see Britain and the United-States face off against Lazaro Cardenas’ PNR (Institutional Revolution Party) Government.

 
The affected oil companies imposed an embargo against the Mexican government, which had the unintended consequence of driving Mexico to become Nazi Germany’s largest crude supplier. The Americans, fearing that they could lose Mexico to the Axis camp, eventually settled the dispute between the Mexican government and American energy firms in 1942. The settlement saw the Mexican government pay a grand total of US$29 million in compensation for expropriated energy assets. Britain, on the other hand, took a much harder line with the Mexicans going so far as to completely sever diplomatic relations. English persistence eventually paid off. In 1947, Mexico finally settled with Britain agreeing to pay US$130 million in compensation.

Although the trade spat was formally settled, Mexican constitutional restrictions have remained to the present. The US Government tried to negotiate for readmission of American investment into the Mexican energy industry up to 1950; but with no progress, and the presentations of new opportunities in Venezuela and Saudi Arabia, the Americans cut their losses. That was until a dramatic development in December 2013 saw the Mexican government pass a constitutional amendment.

The amendment lifts PEMEX’s monopoly on production of the country’s energy resources. Prior to this amendment, contracts with private entities for the production of Mexican oil and gas were forbidden. The Mexican government is hopeful this change will foster an energy renaissance for the nation’s now stagnant oil and gas industry. With this amendment, private firms will also be allowed to invest in “oil refining and in the transportation, storage, and distribution of oil, natural gas, gasoline, and diesel fuel. Private companies will be allowed to participate in the generation and commercialization of electric energy as well.”

The sector’s opening comes after more than a decade of steady decline in Mexican crude output. National production peaked in 2004 at 3.8 mb/d, but has since stagnated and fallen to just 2.5 mb/d. The dramatic fall in output is largely attributable to a lack of investment and natural decline in the country’s oilfields. Mexican leaders believe the introduction of private initiative into the sector will encourage the application of modern technologies and processes to the extraction of Mexican energy resources, attract more foreign investment, and promote a leaner more business-oriented PEMEX.

PEMEX reported a net loss of US$30 billion for fiscal 2015/2016 and carries nearly US$80 billion in debt. A new Chief Executive was installed this past February, and given a mandate to modernize the operation of company. PEMEX management was also given greater autonomy over operation of the company as part of the 2013 energy reforms. This move will be critical to the resilience of the firm over the coming years. We can already see that change has started to take hold. The company slashed its budget by US$9.6 billion over the course of the last two years, with even deeper cuts expected for 2017. PEMEX has trimmed its workforce by 10 percent and transferred some of its pension liabilities to the federal government.

Weak demand and oversupply have caused pain for almost all oil producers. However, the stagnation of Mexican production is a more deeply rooted problem. As the country’s energy assets mature, Mexico will need to train a new technically skilled workforce, and it will have to implement modern practices and technology into the industry if it hopes to tap new virgin sources of oil.

One measure included as part of the energy market reforms was the creation of a fair and transparent energy lease auctioning system. Policy makers hope to attract foreign investment. They also expect the resulting partnerships between PEMEX and foreign firms will facilitate the transfer of technical expertise. This expertise will help build a skilled native workforce with the technical understanding on how to tap new oil fields previously inaccessible to PEMEX.

The most recent example is PEMEX’s announcement in June that it’s seeking to form partnerships with private firms to jointly develop offshore deep-well oil and gas fields. This will be PEMEX’s first foray into deep-well offshore project. The final phase of the federal energy ministry’s first round auctions to develop these resource blocks, consisting of both onshore and offshore leases, will open in early December.  Mexican authorities estimate these auctions alone should generate up to $7 billion in private investment.

Even though some of the energy reforms have already started to show progress, it will still take years before the full impact is truly felt. The International Energy Agency (IEA) projects that Mexican production will hit its trough at just under 2 mb/d some time before 2020, with production expected to gradually rise reaching 3.4 mb/d by 2040.

 
The lion’s share of new production will be derived from three different sources. The first portion of  new production will come with the application of enhanced recovery techniques to shallow offshore fields, which currently account for the most of Mexico’s crude output. Second, significant new volumes will be brought online through PEMEX and private firms ventures into Mexican offshore deep-well production. Third, we can expect to see new streams of production stemming from onshore tight oil formations, and from the previously difficult to access Chicontapec field. Mexico will also need a significant amount investment to re-establish the full capacity of its downstream assets such its aging, under performing refineries.

Liberalization should also act to give Mexican natural gas production and electricity generation a shot in the arm. Mexico sits atop a wealth of natural gas reserves. The prospect for developing of this resource has been stunted by cheap natural gas imports from the Southern US. The IEA analysis predicts that there may be a strong case for tapping these reserves post-2020 when gas prices rebound.  Private capital and know-how will be vital to these efforts. Additionally, private investment will help Mexico meet the coming 85 per cent increase in electricity demand by 2035.

According to the IEA if Mexico holds to it reform efforts, it stands to add over US$1 trillion to the national GDP by 2040. As the old world struggles to prop up its failing common market experiment, North American nations are incrementally introducing market-oriented energy reforms. Breaking down trade barriers and harmonizing regulations within North American energy markets should generate a windfall for its consumers. North America has all the making of an energy superpower through its vast resource wealth, pool of privately owned hardware (i.e. drill rigs), skilled work force, and a more entrepreneurial approach to resource management (especially in Canada and the United States).

Mexico’s reforms are hopefully just the first step on the path to realizing the full potential of North America’s energy wealth.