Mexico’s Energy Reform is Rolling, Albeit with Training Wheels

Published July 20, 2015

Understanding the connection between energy and economic growth, Mexico’s President Enrique Peña Nieto set out to reform his country’s energy policy and invite outside intelligence and investment to boost slumping oil output. In late 2013, he succeeded in getting the constitution amended to allow private and foreign companies to explore and produce oil and gas in Mexico—for the first time in nearly eight decades. The amendments put an end to the government monopoly. Foreign companies can now compete with, or partner with, Pemex—the national oil company. Nieto hopes his reforms will bring in $50 billion in investment by 2018.

The wheels of reform move slowly, but on July 15, the first international investors put their toes in the shallow water of Mexico’s oil prize—which could be “as big as the proven reserves of Kuwait.” The Financial Times (FT) calls Mexico’s potential 107.5 billion barrels of oil: “quite a feast.” FT adds: “The country is viewed as one of the dwindling number of opportunities to add substantial reserves to portfolios after several years when the oil majors have struggled to make big discoveries.”

Disappointing Start

Yet, despite the possibilities, Mexico’s first of three auctions expected this year, being called round 1.1, was disappointing, at best. In round 1.1, 14 shallow water blocks were offered. Only two had successful bids: block 2 off the coast of Veracruz and block 7 off of Tabasco.  The winning bidder for both blocks was Sierra Oil & Gas—a Mexican company in a consortium with U.S. company, Talos, and Britain’s Premier Oil.

Thirty-eight companies—including majors such as ExxonMobil, Chevron, and Russia’s Lukoil—qualified to participate in the auctions, though only nine participated in round 1.1. BloombergBusiness reports: “Spokesmen for Exxon and Chevron said that while they weren’t interested in the shallow-water round of bidding, they hadn’t given up on being part of Mexico’s energy reform.”

When Mexico’s energy reforms began, oil was in the $100 a barrel range, the Mexican government expected four to seven of the blocks would be sold—representing a goal of 30-50 percent. On July 15, the success rate was a less-than-expected 14 percent.

Bad Timing

Unfortunately for Nieto, the timing couldn’t have been worse. Not only are global oil prices 50 percent of what they were when the constitutional amendments passed, the week during which the auction was scheduled, turned out to be bad news for Nieto’s hopes.

First, four days before the auction took place, “El Chapo,” Mexico’s most notorious drug lord, broke out of one of the country’s highest security prisons—again. The Economist states: “The escape of El Chapo is proof that the rule of law in Mexico is still shaky.” FT echoes the sentiment: the escape shows “impunity, corruption and the weak rule of law remain the norm in Mexico rather than the exception.”

The fields up for auction on July 15 were fields with lower probabilities of success—6-54 percent, according to a FuelFix report. While smaller companies are more willing to gamble on success, they can’t afford the security or kickbacks needed to co-exist with the cartels. The Economist explains: “Disorder does not always deter investors who can afford armoured cars and bodyguards, but it puts off smaller businesses, Mexican and foreign.”

One small U.S, company told me: “Mexico’s past history is one of political instability, expropriations, quick changes in government policies, graft and corruption, inefficiencies, and socialist-style attitudes and philosophy. With abundant opportunities in the U.S., and less risk here, why invest in Mexico?”

At the same time the news of El Chapo broke, reports indicated a deal with Iran was imminent. The nuclear accord was struck the day before Mexico’s historic auction. Concerns that Iran will soon begin exporting 1.5 million barrels of oil a day, making crude prices slide further, dampened interest in new exploration.

El Chapo’s escape highlighted the risk, while the Iran deal reduced the reward. The scales didn’t tip in Mexico’s favor.

Poor Offering

While the July 15 auction wasn’t the success it was hoped to be, there is cause for optimism. Perhaps to give itself time to work out the kinks, the National Hydrocarbon Commission offered the less desirable parcels first. The New York Times (NYT) states: “the lots offered in the first round of a multiyear auction process were not among the most commercially attractive.”

The majors, which skipped the first auction, are more interested in the deep water projects—scheduled for auction in early 2016—where the risk is lower and the reward is higher.  NYT explains: “The biggest growth will probably come in deep water fields that are adjacent to bountiful American production fields and that have yet to be thoroughly explored. The fields are thought to be large and have the added advantage of being close to the vast pipeline network in the American portion of the Gulf of Mexico, as well as American refineries and the American market itself.”

Additionally, the onshore potential will be of more interest to the new Mexican oil companies—many of which previously worked for Pemex as oil-field service contractors. They have experience with drilling on land but will need foreign partners for offshore exploration. The onshore blocks are scheduled for auction in December.

Unattractive Terms

When the terms, designed to maximize Mexico’s take more than to attract investment, were first announced, they generated little interest. They have been sweetened twice since then—and will likely be revised before the next auction.

Winners, who were pre-qualified as able to meet the financial requirements, were determined by the highest amount of profit to be shared with the Mexican government and the amount of investment pledged above the required minimum—which was set by the finance ministry and kept in a sealed envelope that was opened at the auction. For the two blocks awarded in the July 15 auction, the winner offered 55.99 % for the first block and 68.99% for the second. In each case, an investment of 10% above the minimum was offered. Some of the blocks that were not awarded did receive bids, but they were below the minimum—though the Wall Street Journal (WSJ) reports: “several rejected bids fell just below the minimum.”

One of the terms of concern is the stringent guarantees required in case of a blowout such as the Deepwater Horizon. The Economist calls them: “beyond international norms” and the FT reports: “Four pre-qualified companies pulled out last week—at least one because of the guarantees” which are “essentially a blank cheque.”

Additionally, Mexico has reserved the right to rescind contracts—which reminds potential investors a bit too much of Mexico’s history of expropriation.

Pablo Medina, Latin America upstream analyst at Wood MacKenzie, said, in WSJ: “I would expect the government to incorporate what it’s learned in the next tenders.”

Cautious Optimism

Despite the various bumps in the road, many are cautiously hopeful. Juan Carlos Zepeda president of the National Hydrocarbon Commission, has, according to WSJ, “higher expectations for subsequent auctions.”

In, Richard Sanchez, IHS Petrodata’s lead Marine Market Analyst for the Americas, states: “Mexico has vast deepwater potential, comparable to oil fields found on the US side of the Gulf of Mexico.” It is too big to fail. A consultant working with the new Mexican oil companies told me: “The resources are world-class. Mexico’s energy reforms will ultimately be successful.”

“The government estimates almost half its unproven reserves lie in the deep waters of the Gulf of Mexico,” the FT reports. “In addition it holds the world’s sixth biggest technically recoverable shale gas and the eighth largest shale oil prospects.”

Jim Hoffman, an oil-and-gas training and education provider who has worked in the industry for 35 years, told me: “Over time, opening Mexico will provide a huge boost for both American producers and service companies at reduced cost. It won’t happen right away, but as the infrastructure gets built, results will become better and better.” He added: “How about jobs, for Mexicans, who won’t have to cross the border illegally? How about Americans who have the opportunity to bring new and better technology and practices to an underdeveloped industry location?  What a great opportunity.”

Mexico’s energy reform is rolling. The July 15 auction gave the country a chance to try it out and start slowly—more of an evolution than a revolution. There is enthusiasm for the future. The oil-price issue will work itself out as it will take three to five years to develop the new fields. As the training wheels come off, the terms are tweaked and the offerings are more attractive, results will become better and better—delivering a whole new industry for Mexico and fresh opportunities for American companies.