Only (Limited) Upside for Private Sector Oil Operators in Mexico

Over the medium-term there are likely to be improved opportunities for private sector firms to participate in incentivized service contracts for oil exploration and extraction in Mexico, albeit with asymmetrical contractual obligations, legal & political risks. Opportunities for more far-reaching entry into the Mexican oil sector, including asset acquisition, are viewed as less likely over the same time horizon.

Foreign investment in the Mexican oil sector has been negligible since the nationalization of the country’s oil resources in 1938, and subsequent creation of PEMEX, the state-owned oil company with an integrated upstream-to-downstream business model. ‘Resource nationalism’ has been prevalent in the intervening decades, prospects for liberalizing reforms constrained by both popular opinion and entrenched political & trade union interests.

Oil production in Mexico, one of the world’s top ten producers and one of the United States’ top three sources of imports, has fallen precipitously from its 2004 peak of 3.4m bpd to the current level below 2.6m bpd at which it appears to have stabilized.

With a small tax base, oil revenue covers one third of government revenue, declining production thus poses risks to long-term fiscal sustainability, even with relatively high crude prices.

Chronic underinvestment and lack of modern technical proficiency undermines Mexico’s ability to explore and extract more of its still significant reserves (estimated at 46bn barrels). Much of these reserves lie in as-yet-unexploited and difficult-to-extract fields under the deep water of the Gulf of Mexico. Without significant advances in extraction capacity, Mexico could become a net oil importer within a decade as reserves in mature fields such as Cantarell are depleted.

Despite attempts at reform and liberalization in 2008, little has changed in recent years, and little is expected to happen before 2013 at the earliest when a new President, potentially with a Congressional majority, may reprise the reform agenda. Even backed by such a majority however, it is likely that a new President would have to broker a political alliance to secure meaningful reform. The most likely configuration would be a PRI-PAN alliance, the PRD being more steadfastly opposed to liberalizing reforms.

A two thirds congressional super-majority, and a majority of the state legislatures, is required to amend Article 27 of Mexico’s 1917 constitution, which affords PEMEX its monopoly position by banning private ownership or part-ownership of hydrocarbons. Such an alignment must be viewed as unlikely to be brokered in the aftermath of the 2012 elections, rendering unlikely an short-to-medium term evolution towards shared asset ownership, or similar, arrangements.

Significant opportunities will likely arise, however, for private sector actors to partner with PEMEX or to engage in upstream extraction under incentive-based service contracts for government, as was foreseen by the 2008 reforms and later deemed constitutional by the Supreme Court. Although only three such contracts have been awarded to private companies, for small oil fields, a second round of contracts is set to be awarded over the coming months in respect of 22 mature oil fields representing 220m barrels in proven, possible & probable (3P) reserves. A third round of service contract awards are envisaged for late 2012. Such developments are likely to present opportunities for firms like Halliburton and Schlumberger (winner of one of the 3 first round service provision contracts).

Given constitutional and legislative constraints, an improvement in the terms of service contracts to incentivize foreign operators must be viewed as more probable than more substantive liberalization in the medium-term. Participating in such arrangements, with PEMEX as lead operator, will likely be the most significant opportunity for foreign oil companies to make money in Mexico in the coming years. With incentives linked to oil prices, on a fixed-fee per barrel plus 100% cost recovery formula, these contracts are likely to increase in prevalence as crude prices increases, and vice versa.

PEMEX’ interest is served by engaging foreign, private sector service providers at the lowest possible price, without ceding control over hydrocarbon assets, while obtaining maximum benefit in terms of know-how and knowledge transfer. The current arrangements are not attractive enough, however, to entice firms to begin extraction from fields under deep water or difficult terrain, the very fields in which PEMEX needs to develop its own exploration and extraction proficiency.

Front-running PRI presidential candidate, Enrique Peña Nieto, has spoken of the need to introduce private sector involvement into the Mexican oil industry while guaranteeing state ownership of reserves. Brazil’s Petrobras is cited as a potential model. A newly elected PRI President would face significant internal political constraints which would hinder his ability to deliver on campaign reform promises. Notable among these would be the oil workers’ trade union, traditionally part of the PRI family.

A victory for the PAN candidate, Josefina Vazquez Mota may also signal the possibility for reforms, albeit dependent on PRI support in Congress. Since late 2011, and particularly since her nomination as candidate in January 2012, she has been gaining in opinion polls, polling within 7% of Peña Nieto in one poll published this week. Further, sustained tightening in the polls increases the likelihood of another close, fractious Presidential election, undermining potential post-election cooperation on energy reforms and other issues.

An unlikely victory for the PRD candidate, AMLO, could conceivably postpone the possibility for reforms until 2019 or later, although funding issues are likely to weigh on government in advance of this if unpopular revenue raising tax reforms cannot be introduced.

Persistently high or increasing crude prices would allow some delay in the introduction of reforms – as would the acceleration of extraction from the Chicontepec field, which is expected to be included in the award of service provision contracts in late 2012 – but this is unlikely to pertain in the long-term.

Conversely, a rapid and sustained reduction in oil prices – or resumption in the decline in production levels – could accelerate the reform imperative by putting government funding under further pressure. Potentially, such a funding crisis would increase the chances of more far-reaching reforms, including constitutional changes which would allow for the floating of PEMEX shares or permitting it to engage in strategic alliances.

In February, the US and Mexico signed an agreement which clarifies the national ownership of off-shore drilling rights in border areas, and could see joint operations between US and Mexican oil companies. By providing an alternative channel through which PEMEX can acquire the know-how for exploring and extracting deep sea oil fields, this may stifle the impetus for reform.

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