Mexico Energy: Positive Reforms

President Peña Nieto's proposed energy reform is a big step in the right direction, although incomplete, experts say.

BY ENERGY ADVISOR
Inter-American Dialogue 

Mexican President Enrique Peña Nieto on Aug. 12 presented his highly anticipated plan to overhaul the country's energy sector and break the state's monopoly on oil and gas production and electricity generation. His reforms, though not as extensive as those proposed by the National Action Party, will likely be approved by Congress, analysts say. What are the key elements of Peña Nieto's proposed energy reforms? Will they have the desired effect on Mexico's energy sector and economy overall? How should international companies and investors interpret the proposed reforms? 

Maria Jose Hernandez Medina-Mora, associate at the Eurasia Group's Latin America Practice: President Enrique Peña Nieto's proposal is a significant step to open up the energy sector in Mexico. While not as liberal as the one presented by the National Action Party (PAN), the two proposals taken together offer a political path for changing the Mexican Constitution in ways that will allow private investment in the sector—a policy revolution unthinkable even a few years ago. Peña Nieto's proposal includes constitutional amendments to articles 27 and 28 of the Constitution. He aims to remove the ban on contracts in the hydrocarbons sector, but still prohibit concessions. Moreover, he seeks to remove electricity and hydrocarbons from the list of strategic sectors, allowing private investment in related activities. Interestingly, markets last week skeptically focused on the fact that uncertainty remains. But while investors should not lose sight that negotiations will prove difficult, the risks are actually less than meet the eye. The government will only be able to secure approval with support from the PAN. And the PAN is unlikely to advance energy reform negotiations unless political reform moves forward. However, Peña Nieto is likely to cede ground on this front—he can't afford to see energy reform to fail. Ultimately, the reform's impact will depend on the contract details such as tax regime, booking of reserves and other technical details, which will emerge in secondary legislation once the constitutional changes are approved. But both the government and the PAN realize that an attractive contract scheme is necessary for the reform's success. 

Andrés Rozental, president of Rozental & Asociados in Mexico City and senior fellow at the Brookings Institution: President Peña Nieto's proposed energy reform is a big step in the right direction, but unfortunately an incomplete one. There are two key missing elements: 1) excluding a regime of concessions to private sector investors, both Mexican and foreign, who would like to participate in future hydrocarbon exploration and exploitation in deep water reserves and shale; and 2) not having explicitly allowed private-sector companies to book any reserves they find. Including both of these options would have made the proposal much more acceptable to major new investors. That said, the proposal still marks a sea change from the existing exclusionary regime. There are still many details to be worked out and publicized, many of which will be discussed when Congress takes up the reform package starting next month. Allowing profit sharing and giving the state oil company, Pemex, an early advantage through a 'zero round' should satisfy most, but not all, of the reform's strongest critics from the left. These will oppose any change to the current state of affairs, no matter how minor or major, so the government rightly decided to make this a 'transformational' effort, opening the door to further changes in the future. There are also important changes planned to the way Pemex operates and is managed, which should allow the company to compete on a more even footing with private-sector players, some of whom may choose to associate with the state-owned company rather than strike out on their own. It remains to be seen how many changes the draft legislation undergoes as it wends its way through both houses of Congress. However, it appears likely that a PRI-PAN coalition has the necessary votes to pass the constitutional changes, and that would be a major victory indeed for Peña Nieto and his government. 

Jeremy Martin, director of the energy program at the Institute of the Americas: The Aug. 12 energy reform unveiling by the Peña Nieto administration was quite a moment. Indeed, the majestic Palacio de Bellas Artes in Mexico City might have been a more appropriate site for the performance. The government's roll out was draped in history invoking the hallowed name of President Lázaro Cárdenas, but also starred the economy and a strong pocketbook argument. The administration emphasized the reform's economic importance and its potential to ignite activity, from a 1 percent boost to GDP and creation of half a million jobs to the populist promise of reduced power and natural gas prices during the Peña Nieto sexenio. Beyond economic issues, there are two additional key elements: The constitutional amendments and legislation that will allow for increased private participation in the oil and gas and power sectors. The amendments are critical to developing a new contractual framework for upstream activity, and the possible contract modality has provoked furious debate. Will the proposed profit-sharing contracts be sufficient to lure significant private investment, particularly in the costly and challenging deepwater and shale plays? Assuming the Constitution is amended, the finalization of secondary laws, as well as how Mexico develops and manages private sector bidding, will go a long way to determining companies' interest. But Mexico should garner substantial investment by companies from across the globe, many of who have been toiling on the margins for years in anticipation of a real opportunity to bring to bear their technical and financial capabilities to unleash the country's energy potential. But whether those investments will deliver the economic benefits set forth in the reform proposal—before the end of the Peña Nieto term—is not entirely clear. 

George Baker, president of Baker & Associates and publisher of Mexico Energy Intelligence: Both the PRI and the PAN propose measures to allow some degree of market forces in the oil-and-gas and electric sectors. On both, the extent of the commercial privileges remains to be seen. Attention is being given to the oil side, where the government is proposing a form of 'profit-sharing' arrangement. A distinction is made between 'cost oil' and 'profit oil.' The idea is that an international oil company (IOC) is to recover its investment by receiving a share of production (cost oil) and the company is also entitled to a profit in compensation for the risks incurred (profit oil). Peña Nieto hopes to attract oil companies by splitting the profit oil in some negotiated manner, offering the cash equivalent instead of the physical barrels. What's new is that it links payment to market prices; what's 'old' is that the legal framework is to be that which was in place in 1940, when Lázaro Cárdenas was president. On the power side, an unexpected innovation is the proposal to create an Independent System Operator which would bring public oversight and transparency to the rules by which generation from public and private operators is transmitted. This measure should reassure investors of fairness and lower the delivery price of electric power from the present high levels. The list of desired effects is long, so I will mention only those at the top of the upstream. One desired effect is that the 30 billion barrels of oil equivalent in deepwater reservoirs will be put into production by qualified companies under financially and politically affordable terms. Another desired effect is that a government agency other than Pemex take responsibility for administering contracts with IOCs. The PAN urges the Hydrocarbons Commission to take on this role; the PRI is less specific. A third desired effect is that as a side-effect of IOC investment in the upstream, Pemex E&P goes international, either as a 100 percent state company, or (preferably) as a new, stock-bearing NOC with a minority of its shares in a major exchange. 

Jonathan C. Hamilton, member of the Energy Advisor board and partner and head of Latin American arbitration at White & Case LLP: President Peña Nieto will join ministers, ambassadors and a cadre of Mexican and American CEOs for a historic 'Shared Destiny' summit in Mexico City next month, spearheaded by the U.S.-Mexico Foundation, which promotes bi-national partnerships and philanthropy. It is a time for putting momentous change in the energy sector into historical perspective. Latin America long has been marked by cycles of nationalization and privatization, including the 'Washington Consensus' toward the free market that emerged in the 1990s and the backlash in countries like Venezuela and Bolivia over the past decade or so. For many decades, and throughout two decades of the NAFTA era, the 1938 Mexican nationalization of the oil and gas sector has persisted somewhat like a fly in amber, trapped in time and immutable to change. In this context, the mere opening of the energy sector trumps most any dispute over the details. Domestically, the potential for change emerged from the unique Pacto Por México that has driven reforms throughout the year.  Economically, the government predicts a boost in investment of $10 billion a year through 2025 and the creation of up to 2.5 million jobs in the same time period. Politically, the change may bring significant social impact (including potentially on immigration), by creating massive investment flows through the free market, rather than waiting on aid that always seems insufficient. Critically, internationally, the move represents a major opportunity for increased bi-national collaboration with the United States, from private investment to philanthropy. It is indeed a shared destiny, soon to be even more so.

Republished with permission from the Inter-American Dialogue's weekly Energy Advisor