Tue, May 19, 2015

Will Mexico’s Energy Reforms Provide Risk or Opportunity?

As Mexico moves forward with its historic energy reform, state monopolies Petroleos Mexicanos (Pemex) and the Federal Electrical Commission (CFE) are gradually being forced to compete with Mexican and foreign companies for access to resources and licenses to distribute. After two years of constitutional amendments, legislation and restructuring of state agencies, the Mexican government has begun its first round of bids for exploration and production blocks of oil resources.

Now that the public has an idea of the structure of agreements and resources that will be offered, it is a good time to take another look at where the opportunities and risks are likely to lie for future investors, both Mexican and foreign. To do so, it is worth considering three broad factors that are shaping these opportunities and risks.

Political, business and social climate

Beginning with the most complex of these factors, Mexico has for many years suffered from deep-seated issues of corruption and, in several areas of the country, elevated levels of criminal violence. These issues are closely related, and to a great deal stem from the inadequacy of government institutions at federal, state and municipal levels to provide the law enforcement, rule of law and transparent governance that a country of this size and complexity demands. For years, the dealings of Pemex and CFE have been perceived as rife with conflicts of interest and corruption. Significant efforts are being made, particularly by Pemex, to improve its governance, but it is a massive, complex organization with entrenched entitlements for its managers and unions.

The 75 years during which Pemex was the virtual owner of Mexico’s oil sector, and acted almost as a sovereign body, has left its imprint on the Mexican oil services companies that served it. They have been limited in their capabilities and beholden to the Pemex and government officials who doled out billions of dollars of business. With the recent opening of the sector to private investment, new investors will have to deal with companies who have a long track record of doing business with Pemex and may not yet be ready to give up the practices that made them so successful in the past. Even the newer companies in the sector have sought success by hiring the talent and experience of former Pemex and government officials. They (and their partners) need to carefully assess the track records and relationships of their new leaders.

Recent events have focused media and public attention on issues of conflict of interest and improper conduct. These include the cancellation of a high-speed rail project when it became public that the Mexican President’s wife had a house built and financed by one of the companies in the winning consortium, and the revelation of massive fraud schemes by oil services companies with the use of Pemex invoices involving a U.S.-owned bank. In this climate of suspicion and concern, the potential for damage to a company and its investors, from even a perception of dubious dealings, has grown significantly in the last year or two.

In the meantime, the Mexican legislature has struggled to develop anti-corruption and transparency measures to ensure better supervision and public scrutiny of public contracts. A no less critical factor in the success of energy investments is the assurance of certainty and justice in the adjudication of the many disputes that will undoubtedly arise. The inadequacy of Mexico’s judicial system to deal effectively and efficiently with commercial, civil and criminal conflicts is well acknowledged and will be an important and growing risk issue for investors and for civil society.

Market factors

Global market factors are also having a substantial effect on the potential benefits and risks of investments in the oil sector. Reduced prices are shifting investment interest away from the more expensive opportunities such as deep-water and shale resources toward shallow-water and onshore resources. Many of these nearer-term opportunities (83% of proven resources) are still in the hands of Pemex, and are therefore most accessible through farm-out agreements with the state company agreements that may not be supervised by the newly fortified regulatory agencies. These resources also require significant on-shore infrastructure and more dealings with local municipal and state governments, which are often less transparent and less subject to oversight.

The demand for cheaper electrical energy, driven by an expanding manufacturing sector in Central Mexico and by a substantial price differential in gas and energy prices between the Mexican and U.S. side of the border, is behind the more than USD 3 billion in gas pipeline and distribution networks across the country being put to bid by the government. The pipelines are being built and operated by consortia which include Pemex, the CFE and various foreign and Mexican companies. The oversight of these networks will be in the hands of a new regulatory agency, CENAGAS, and the gas will be used by both private energy generators and CFE under a marketing scheme that has not yet been tested. From the perspective of security and corruption risks, the construction of the pipelines goes through some of the most challenging parts of the country in terms of security concerns and weak government institutions.

The demand for energy and restructuring of the energy markets are also behind significant investments in wind and solar energy being built in difficult areas of the country.

The structure of the reforms

Finally, there are aspects of the energy reform which raise both opportunity and risk for investors. For instance, the rules around the bidding for oil and gas resources require certain levels of national content 25% for exploration of conventional resources, increasing to 35% in development and production. They also require proven experience in exploring and developing the type of resource in question and restrict the ability to choose different partners for different bids. And only one single large oil company (including Pemex) can be a part of each consortium. These rules enhance the opportunities for both foreign and Mexican companies requiring the bidding consortia to include members with local presence and with international experience. At the same time, they mean that each investor, Mexican and foreign, will need to choose its partners very carefully. The risks that a partner brings to the table cannot be easily diluted by other partners.

Some investors are looking to avoid these restrictions by focusing on winning contracts with Pemex to explore and develop the resources that the state company managed to retain. Such contracts offer more certainty, but still carry some doubts about the nature of the agreements with Pemex and the risks described above of working with the state-owned enterprise with a long history of difficulties.

Mexico’s energy reform also includes significant restructuring of the government departments and regulatory agencies which will oversee every aspect of exploration and development. The powers and individuals that make up these bodies are yet to be clearly defined and tested. The types of contracts that are being offered to explore and develop resources production-sharing and profit-sharing agreements and licenses (resource concessions are still prohibited by the constitution) are mostly untested. Additionally, the circumstances and mechanisms under which agreements may be vacated are still a concern to potential investors.

Altogether, this is an exciting time for potential investors in the oil, gas and energy sectors. The excitement has been a little dampened by the decline in oil prices and resulting cuts in investment plans (not least by Pemex itself), but there is still a great deal of optimism about the future of Mexico’s energy sectors. Many of the potential investors in these sectors are new to Mexico or new to oil, gas and energy investments. The most successful investors will be those that carefully consider the diversity of opportunities that are being presented, and also carefully assess and address the complex risks that those opportunities bring with them.


Intelligence, Transactions and Due Diligence

When organizations worldwide need intelligence, insight and clarity to take decisive action, they rely on Kroll.