Passing Mexican Energy Reform 'Easy Part' of Process

Passing energy reform in Mexico was the easy part. Now comes the hard part as Mexico's Congress hammers out energy reform's secondary laws.

Passing the energy reform legislation in Mexico was the easy part. Next comes the hard part – forming secondary legislation, strengthening regulatory institutions and creating contract terms attractive for investment, an industry observer told attendees at a recent presentation in Houston.

Mexican President Enrique Pena Nieto signed Dec. 20, 2013 legislation that would amend Articles 25, 27 and 28 of Mexico’s Constitution, opening Mexico’s energy sector to foreign and foreign private investors. The reform of Mexico’s energy sector is one of several reforms that have taken place in Mexico, including reform of its telecommunication and education sectors. Energy reform is central to the Mexican government’s strategy of growing Mexico’s economy and reversing declines in its oil production from fields such as Cantarell; revenue from oil production is needed to fund Mexico’s social spending programs.

Despite the urgent need to reform the nation’s energy sector, the political odds were stacked against energy reform due to the widely divergent view of what that reform should look like, even among reform proponents, said Duncan Wood, director of the Mexico Institute at the Woodrow Wilson International Center for Scholars, during a presentation held by law firm Mayer Brown in Houston on energy reform. Previous attempts at reforming Mexico’s energy sector failed due to Mexico’s political system’s inability to move reform forward.

The inclusion of licensas in that reform also proved a surprise.

“We still don’t know what they are,” Wood commented.

The government said they are not concessions – concessions are prohibited under the Mexican Constitution – but the licensas look and act like concessions, which may cause some trouble.

The latest effort to reform Mexico’s energy sector differed from prior attempts in that officials with Mexico’s three main political parties – Partido Accion Nacional (PAN), Partido de la Revolution Democratica (PRD) and Partido Revolucionario Institucional (PRI), which represent 80 percent of Mexico’s voters – sat down to negotiate together.

The PRI party alone could not have passed the constitutional reform, said Gustavo Madero, president of the PAN, who gave context on the reform taking placing within Mexico, not just for energy, but in education and telecommunications. This negotiation marks a significant change from the lack of political agreements in the past, which have weakened democracy in Mexico and strengthened factualism and economic dysfunction.

In the past, Mexico’s political system has lacked the capacity to build agreements with speed, depth and cause to achieve opportunities and overcome its problems. This lack of capacity can be attributed to Mexico’s slow, difficult and delayed democratic transition over the past century that didn’t generate all the democratic institutions as in other democratic countries, causing weaknesses in its democratic formation. As a result, the country has struggled and continues to struggle with poverty, inequality, and lack of security and democracy.

“We are so careful and concerned that this not become derailed in the transitory and secondary laws,” said Madero. “We want this to be iron clad and for many of the provisions to be self-applicable so we don’t run risks in this area.”

To achieve energy reform, Mexico also had to overcome the ideology ingrained in the nation from 1929 to 2000 that Petroleos Mexicanos (PEMEX) must be a public state monopoly, Madero said.

“To criticize PEMEX went against the nationalist part of our ideology that petroleum belonged to PEMEX. In the reform, we tried to deconstruct this to create competition, transparency, and greater benefits from petroleum for the entire nation.”

Mexico experienced a divided government from 1997 to 2012, with a lack of political majority in Congress, which created an incentive among the political parties to reach agreements in order to achieve economic growth. Pena Nieto came to power at a time when the country was experiencing financial weakness and lack of dynamic inclusive economic growth.

“Bilateral agreements were not getting results, so the three parties had to sit down to negotiate. We had a situation where we asked if Mexico must continue with a divided government through 2018 at great cost to our country.”

PAN’s decision to collaborate with the other parties was strategic, and Madero said PAN views the reform’s passage as an electoral, political and cultural victory for PAN, whose ideas found their way into the reform.

Strong Regulators, Regulations Key to Bidding Success

Mexico will likely get it right in terms of forming secondary legislation, but faces potential risk in terms of launching its first bidding round too soon. However, many people in Mexico’s government are learning from the recent disastrous bidding round in Brazil in which only a few bidders participated.

“I think it’s better that they wait until they have strong regulators and regulations in place,” said Wood.

The Mexican government has 120 days from Jan. 1 to pass all secondary legislation. A conceptual map of secondary laws has already been drawn up, with over 20 laws in five groups in need of address. While passing secondary legislation will be simpler than the energy reform – with only 50 percent plus one versus two-thirds majority of Congress needed – the government wants to establish a certain sense of harmony among the political parties on the secondary legislation. This means that passing all this legislation by early May could prove challenging.

For Round Zero, PEMEX will have 90 days to identify the existing and future fields on which it will focus. The Comision Nacional de Hidrocarburos (CNH) will then have 180 days to decide what it will allocate to PEMEX and who its partners will be. Carrying out such an enormous task that hasn’t been done before within three months may be unrealistic, Wood said.

Materials on Round One are expected to be available sometime in April, but questions on how this can happen if what’s available for bidding is unknown. So much depends on the last element of regulation. While some say Round One will happen as soon as Round Zero is resolved, others say this cannot happen unless creditable regulatory agencies are in place, which may not happen until sometime in 2015, Wood noted.

Mexico has had a spotty record of autonomy of its regulatory agencies; in recent years, its federal election institute, previously a model for autonomous elections, has seen its autonomy decrease.

“Regulatory bodies need to be truly independent to provide a level playing field,” Wood commented.

Contract terms for production sharing, profit sharing and licensing will need to be determined, as well royalty rates. Private investors are expected to pay the standard corporate tax rate plus royalties.

“Mexico must make energy reform work not just for private companies and to raise production, but to ensure the government has a stable, secure source of income for social spending,” Wood noted.

In order for energy reform to be successfully implemented, Mexico’s regulatory institutions need to be strengthened in terms of personnel, financing and best practices. CNH, which will be responsible for running bidding rounds, may need to grow its staff from a handful of workers to around 500 to handle future bidding activity. Finding people qualified for these jobs and willing to work for a government salary will be challenging as human talent in the energy sector is at a premium today, said Wood.

CNH will be self-sufficient going forward, charging for its services, and will be allowed to build up a surplus of money equal to three years of its annual budget.  But the commission will be in trouble if less interest than hoped for in bidding is seen, Wood said.

Mexico’s energy ministry has been studying best practices in regulations from Norway, Canada and the United States for many years, and has an idea of what works and what doesn’t. However, this process will take time, more than the Mexican government wants to admit, Wood commented.

Mid-terms elections in 2015 could slow the timeline of bidding by private investors in Mexico’s energy sector. Despite the Mexico government’s success in passing energy reform and outsiders view of Pan Nieto as a visionary, the current president’s administration is unpopular at home, with an approval rating of less than 50 percent, Wood said.

Historically, most Mexican presidents have had an approval rating of over 65 percent; Pan Nieto’s approval rating is considered disastrous. Pan Nieto needs to boost his approval rating ahead of elections to prevent the PAN and PRD from taking control of the presidency.

Wood said that Pan Nieto should seek to bring the PRD – which left in the breakdown of the Pacto por Mexico last year – into the fold to help shape secondary legislation. Both PRD and PAN’s energy reform proposals last year offered real details and a certain amount of expertise on which the government will need to draw.

“The only way to convince the Mexican people that energy reform is good for them is to make it good for them,” Wood noted. This includes job creation and lower energy costs in the long-term, and a sovereign wealth savings mechanism.

Energy Reform Most Liberal to Date

The energy reform bill, which is the most liberal to date, presents an opportunity to end the inertia that has surrounded Mexico’s oil and gas industry for longer than necessary, said Adrian Lara, lead upstream oil and gas analyst with GlobalData, in a Jan. 6 press release.

However, the changed law does not specify which type of contract will be applicable to the different types of hydrocarbon exploration and production. Industry observers and participants therefore have to wait for the so-called secondary laws that will frame the fiscal terms for the new contracts, Lara noted

“This additional information will allow for a more rigorous test in assessing the effectiveness of the 2013 energy reform,” Lara commented. “While it is still not decided when this fine print be drafted and voted on, the second half of 2014 is viewed as the best-case scenario.”

PEMEX’s lack of experience for complex and deepwater and onshore shale plays offer ideal opportunities for private investment.

“Deepwater, shale and even shallow water areas benefit from different combinations of technology transfer, capital expenditure in E&P and managerial expertise,” Lara commented.

A crucial test of Mexico’s reforms will be the reaction of international oil companies when the first new opportunities are offered, which will depend to a great extent on what exactly is offered. In any case, Lara believes there is a long way to go before the reform materializes in new production, or has a significant effect on the wide Mexican economy through lower energy prices.