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The Future Of Mexico’s Energy Industry Is In The Air

Leftist candidate Andrés Manuel López Obrador’s victory in last July presidential election casts a shadow over the future of Mexico’s ongoing energy reform. The president-elect has not yet said whether he will continue tenders of oil assets, and during the campaign described the 2013 reform bill as “vile trick” and a “complete flop”. He also pledged to build at least one oil refinery, a proposal perceived as a “nationalist madness.” Will López Obrador find the right balance between pragmatism and ideology?

In December 2013, Mexico passed an historic energy reform bill ending state oil company Petróleos Mexicanos’s (Pemex) 80-year old monopoly and opening the door to private sector participation. Some 75 years after the expropriation and nationalization of the country’s oil industry, two-thirds of the Mexican Chamber of Deputies and Senate passed a constitutional amendment allowing private investment in every aspect of the energy sector. Since the reform began to be implemented in 2014, Mexico has awarded over 100 contracts, which could generate as much as $200 billion in investment from oil majors and Chinese firms. The reform also benefited Pemex, which reported its first profit since 2012 in May 2017, after reporting 17 consecutive quarterly losses. But these gains are now in question.

A storm is coming

In August 2013, as president Enrique Peña Nieto was about to unveil the framework of what would become the Mexican Energy Reform (or Reforma Energética), Andrés Manuel López Obrador (known popularly as AMLO) issued a warning to the ruling Institutional Revolutionary party (PRI): “Oil is the property of the nation,” López Obrador thundered. “I am convinced that privatizing petroleum (…) betrays the country. We have to call things by their name. They are traitors.”

Flash forward to 2018, and AMLO is now Mexico’s president-elect, after winning the country’s presidency in a landslide victory last July, paving the way for the most left-wing government in Mexico’s democratic history. AMLO’s political rise in Latin America’s second-biggest country echoes Peña Nieto’s abysmal approval rating. Among the many failures of the outgoing president is his perceived unwillingness to defend Mexico’s national honor and sovereignty in the face of repeated insults and threats of tariffs from US president Donald Trump. While Trump has been a thorn in the side of Peña Nieto, his antagonistic rhetoric against Mexico has been a blessing for AMLO, a veteran leftist politician, former mayor of Mexico City, who came close to winning the 2006 presidency as the candidate of the center-left Democratic Revolutionary Party (PRD).

At a time when Mexicans were looking for someone who could stand up to Trump’s bully-type behavior, AMLO tailored himself as a Messiah with a fighting spirit attitude. He ran under the aegis of Morena (National Regeneration Movement), a party formed by former PRD members in 2014, campaigning against Mexico’s widespread corruption, and denouncing the country’s slowing economy as well as the government’s soft response to Trump’s diatribes. On 1 July, he was elected with the widest margin in a presidential election since the 1980s, taking more than half the vote – 30 points ahead of his nearest rival.

Related: The Trojan Horse In Oil Markets

Among the observers who anxiously followed last July’s ballot, energy companies certainly have much to lose from an AMLO administration. Since the passage of the 2013 energy reform, a number of oil majors such as Royal Dutch Shell, BP, ExxonMobil and Total have signed multimillion-dollar contracts to explore for oil the deep waters of the Gulf of Mexico. A long-time ally of labour unions and a fervent supporter of a strong Pemex, AMLO has pledged to halt oil auctions and to build more refining capacity within Mexico. Although the designers of the energy reform argue that Pemex lacks the capital and expertise to pursue deep-water exploration or unconventional gas development, AMLO seems determined “to bring production back home” so that oil never “falls back into the hands of foreigners.” Despite the president-elect’s braggadocio, AMLO, who will take the oath of office on December 1, might catch energy players and investors on the wrong foot by opting for a pragmatic approach.

Decoding Mexico’s ‘tropical messiah’

AMLO was born in 1953 in the tropical southeastern state of Tabasco, where his parents ran a village store. He cut his teeth in politics in Mexico’s PRI in the 1970s, when he worked as a representative of Mexico’s National Indigenous Institute in his native state of Tabasco. He spent five years living in a shack, just like the ones the indigenous families lived in. He eventually became Tabasco state party president in 1983.

As a result of his upbringing, López Obrador has the principle of never spending more than you earn built into his DNA, a belief reflecting his promises of halving bureaucrats’ salaries and selling the presidential plane to fund pensions, student bursaries and apprenticeships. To this day, AMLO’s political nature is still heavily underlined by his tropic roots, his fighting-spirit and his unwavering willingness. He has made cracking down on corruption a central priority of his campaign, favors tighter state control of economic activity and is a harsh critic of the Peña Nieto administration education, tax, and labor-market reforms.

He has vowed to launch Mexico’s “fourth transformation” — referring to the country’s independence in 1821, the civil war in the mid-19th century, and the 1910 revolution — by uprooting the “mafia of power,” ending corruption like “sweeping the stairs, from top to bottom,” reducing violence (over 100,000 Mexicans were killed in incidents related to organized crime in the last six years), and rebalancing the gap between the rich and the poor.

“AMLovers” see him as a champion of Mexico’s poor and middle class — a decent man in indecent times — who will bring honesty, security and prosperity at the top of the political agenda.

AMLO’s heroes include the late Cuban revolutionary Fidel Castro and Argentine Marxist revolutionary Ernesto “Che” Guevara (he named the youngest of his four sons Jesús Ernesto as a tribute to Guevara). He is also a friend of UK Labour leader Jeremy Corbyn, with whom he reportedly spent part of his 2016 Christmas holiday.

Although AMLO promises a peaceful revolution to transform Mexico, the country’s political establishment portrays him as a clone of Venezuela’s president Nicolás Maduro, and is convinced that he will run Mexico into the ground. Some are also worried that he might undermine the political and judicial institutions. In 2006, following his narrow defeat in the presidential election, AMLO alleged fraud, declaring himself Mexico’s legitimate leader and staging a mock inauguration during which he famously said “to hell with their institutions.” He even wrote book — The Mafia That Robbed Us of the Presidency (La Mafia Nos Robo la Presidencia) — in which he bitterly retraces his failed presidential bid.

AMLO’s vision for Mexico’s energy policy

Three ideas are central to AMLO’s energy doctrine: re-inserting the state into the energy sector, passing and implementing new measures to maximize production in Mexico, and achieving energy efficiency within three years. During the campaign, López Obrador disclosed four energy proposals:

• Investing 75 billion pesos ($3.8 billion) in capital injection for state oil company Pemex, with the ultimate goal of increasing oil output from 1.9 to 2.5 million barrels per day (bpd);

• Starting the renovation work at Mexico’s six refineries, which are currently operating at just 51.1% of their total capacity, according to figures released by Pemex in 2017. Such renovations would require an additional 49 billion pesos ($2.5 billion) investment;

• Building what could be the country’s largest oil refinery, with an approximate cost of 155 billion pesos ($8 billion) and production capacity of 400,000 bpd. The project, which is expected to begin in 2019, is part of the AMLO administration’s ambition to slash Mexico’s reliance on US fuel imports, as the president-elect seeks to achieve energy self-sufficiency by half-way through the government’s six-year term. The construction of an additional refinery with a smaller capacity might also be envisaged by the administration during the same timeline;

• Rolling back the liberalization of the energy sector by putting a halt to tenders and reviewing over 100 oil contracts awarded to private investors under the 2013 energy reform.

AMLO’s energy reforms constitute an unusual combination of old and new ideas, reflecting the president-elect’s resolve to defend a nationalistic approach to energy. He has picked Rocío Nahle, a 53-year-old congresswoman and former chemical engineer, to serve as the administration’s Secretary of Energy. A fierce opponent of the Peña Nieto government’s energy reform, she shares AMLO’s vision that Mexico should turn its focus to value-added-fuels, and increase domestic crude processing capabilities to produce more gasoline and diesel at refineries owned by Pemex.

Although aligned with López Obrador’s leftist agenda, Nahle has pledged to adopt a pragmatic vision once in office. In an interview for Reuters last February, she said the new administration is “open to investment” and “to the world,” and highlighted the need to internationalize Pemex. But she also described the opening of the energy industry to foreign investors as “irresponsible,” portraying the oil auctions as “an excessive rush.” As the benefits of the 2013 energy reform in terms of job creation, fiscal revenues, economic growth and oil production have not materialized yet, many Mexicans might see those comments as very compelling.

The 2013 Energy Reform at risk

The 2013 Energy Reform ended the state monopoly established following the nationalization of the petroleum industry in 1938. It includes numerous provisions aimed at establishing a competitive tax regime level to turn Mexico into an attractive market for foreign firms. It also focuses on combating corruption within Pemex, which is widely viewed as the single most corrupt institution in Mexico.

The energy reform has already generated substantial benefits, such as contracts that could yield $200 billion in investments in the coming years, according to figures from the country’s Secretary of Energy. In January 2018, the government awarded 19 blocks in the Gulf of Mexico to a number of oil and gas companies, including Royal Dutch Shell. In March, 35 additional shallow-water oil and gas blocks were auctioned, leading to the signing of contracts with firms including Repsol, Total and Eni. The revenue raised from the auctions will be managed through a sovereign wealth fund, the Fondo Mexicano del Petróleo, as the Mexican government seeks to build a long-term savings reserve.

As mentioned above, one of AMLO’s most controversial energy proposals concerns the halt of auctions while his administration assesses the extent to which a large capital injection into Pemex might help lift production capacity. In July, the National Hydrocarbons Commission, Mexico’s oil regulator, announced that it would postpone two scheduled oil auctions and a tender to find joint venture partners for Pemex from September 2018 until February 2018.

The decision to delay the auctions until the new administration officially takes office has alarmed investors, who fear that AMLO’s planned $10.5 billion rescue plan for the oil industry will increase Pemex’s debt burden. The Mexican state oil company is already the world’s most indebted national oil company, according to ratings agency Moody’s, with more than $100 billion in debt and about the same amount in pension liabilities. On October 19, Fitch, another ratings agency, revised down Pemex’s outlook rating to negative from stable, causing the peso to fall to its lowest level in over a month.

Pemex’s disarray is evidenced by Mexico’s gargantuan oil production decline over the past two decades. According to data from the International Energy Agency (IEA), oil production fell from 3.9 million bpd in 2004 to 2.5 million bpd in 2016, and slipped even further in 2017, dropping as low as 1.9 million bpd. Oil output has fallen during most months in the first half of 2018, standing at just under 2.1 million bpd in June.

This production loss has been caused by the natural decline of Pemex’s Cantarell field, which was not offset by new discoveries. Pemex’s fall in output to a four-decade low was among the major factors that led to the so-called “Pact for Mexico” — a political coalition that brought together to PRI, the center-right National Action Party (PAN), the PRD and the Green Party — which was at the origin of the 2013 energy reform process.

The company is in dire need of partnerships with international energy players specialized in enhanced oil recovery. Such joint ventures would allow it to extract more oil from its existing fields, and to discover new fields to rejuvenate its mature portfolio. Moreover, it is crucial to that Pemex is able to pursue its current approach of generating profits, under which its oil refineries operate at half capacity, allowing the company to not produce at a loss. Adopted two years ago, this new strategy has proved its worth, as Pemex recently reported 26.8 billion pesos ($1.43 billion) of net profit for the third quarter of 2018, compared with a 101.8 billion pesos loss in the same period last year ($5 billion).

Saving Mexico’s oil output

With AMLO taking the oath of office on December 1st, the hypothesis of a roll-back of the energy reform is on everybody’s mind. Considering Pemex’s financial burden, time is not on the side of the incoming administration, as much of the company’s debt matures in 2022. Hence, the new government will have to rapidly put in place a coherent energy policy, as Pemex pays 70 per cent of its income to the state and is a fundamental pillar of the economy. As it stands, AMLO’s agenda is the exact opposite of the kind of reforms Mexico needs to pursue.

López Obrador’s set goal of increasing oil production to 2.5 million bpd by investing $3.8 billion in exploration and drilling does not strike as realistic, as this would only be achievable through a competitive footing in Mexico’s deep-water and unconventional areas — which would require Pemex to participate in joint ventures as a learning partner — an option that AMLO and Rocío Nahle have promptly rejected. As indicated in Pemex’s third quarter results, crude production remains the most urgent issue that the company has to tackle: crude output continued to decline, to 1.827 million bpd from 1.87 million bpd in the second quarter. If implemented, AMLO’s expressed determination to halt oil tenders and to reverse the 2013 reform will inevitably hurt Mexico’s oil production.

Related: U.S. Oil Production Is Set To Soar Past 12 Million Bpd

The only pragmatic policy to boost Mexico’s oil output is to ensure the continuity of the 2013 Energy Reform, as investments by international companies in the country’s oil industry will be crucial for reversing the decline in oil production. Pemex must continue to take advantage of the partnerships with the private sector promoted by the Energy Reform, especially regarding the deep waters exploration projects, which require state-of-the art technology from oil majors and a certain level of risk-sharing.

Moreover, although crude oil production has suffered a continuous decline under the Peña Nieto administration, oil ouput is forecast to rise from 2019, as recently discovered fields come online. In September 2016, Pemex announced the discovery of six oil deposits in the Gulf of Mexico containing around 200 million barrels of oil equivalent per day (boe/d). In March 2017, Eni revealed that it had discovered considerable deposits of heavy and light crude oil in its Amoca-2 well in the Bay of Campeche. In July 2017, a joint venture including Premier (UK), Talos Energy (US) and Sierra Oil and Gas (Mexico) announced a major oil discovery in the southern Gulf of Mexico.

Located 60km off the coast of the Tabasco state, the Zama well contains an estimated 1.4 billion to 2 billion barrels of light oil in place. Finally, in November 2017, Pemex made its largest onshore oil and gas discovery in 15 years — the Ixachi-1 well — in the eastern state of Veracruz. The asset could hold 350 million barrels of proven, probable and possible reserves.

Pragmatism vs. ideology

In this context, there is no economic argument justifying the potential reversal of the 2013 reform, especially if the AMLO administration is to carry out plans for social and infrastructure spending. Considering López Obrador’s ambitious social spending agenda, it will be politically costly to send taxpayer money to inject capital into Pemex rather than using funds generated through partnerships with private companies.

According to an estimate from multinational Spanish banking group BBVA, AMLO’s energy proposals would represent a cost of 0.8 per cent of gross domestic product (GDP). Similarly, plans to stop exporting oil in favor of refining production domestically could deprive the government of income worth 2 per cent of GDP, according to Moody’s Investors Service.

Moreover, AMLO’s willingness to start building a new refinery immediately after taking office smacks more of economic nationalism than a sound energy policy: Mexican refinery production in the third quarter of 2018 fell to 640,000 bpd, down from 704,000 in the second quarter. The new refinery could cause considerable damage to Pemex’s credit profile, which might eventually force it to sell off some of its assets when its debt matures in 2022.

The president-elect does not seem to consider all the downside risks associated with increased domestic refining: he recently criticized Pemex’s plan to import US light crude from refiner Phillips 66, calling it another example of “the great failure of neo-liberal economic policies.” Hardly reassuring is the fact that Octavio Romero, AMLO’s pick as the new head of Pemex, is an agronomist from his native Tabasco state, with very little experience in the sector.

The 2013 Energy Reform is rooted in Mexico’s constitution and cannot be changed by an executive order. His coalition would need to secure the two-thirds Congressional majority required to reverse constitutional reforms. However, as the auctioning process has been placed under the authority of the government, the AMLO administration will have exclusive control over the offering of private contracts for oil and gas investment.

Therefore, energy players already operating in Mexico can only hope that the new government will opt for a pragmatic approach, in the light of the many challenges it would face if it was to suspend the 2013 Energy Reform. During his time as Mexico City’s mayor from 2000 to 2005, AMLO showed that he could work with the business sector. His record as mayor includes the building of a second tier to Mexico City’s urban highways, a successful partnership with telecoms tycoon Carlos Slim to fund a large-scale renovation plan of the city’s historic center, the passing an old-age pension and an efficient fiscal management. Some of AMLO’s declarations in the margins of the campaign also constitute positive signals. During a business forum in May, the president-elect pledgedto respect investors: “We need business to get this country going, to allow us to grow.”

Outlook: The risk landscape

There is a strong chance that AMLO will pursue a populist agenda. During the campaign, the president-elect described himself as a “high-risk” politician, and his past escapades won’t contradict this statement, especially in the field of energy. In 1994, after losing the governorship of Tabasco in an allegedly fraudulent election, López Obrador called on his supporters to block Pemex’s facilities in the state, in a demonstration of civil disobedience. In 1996, he instigated another blockade of Pemex’s oilfields in Tabasco, in an attempt to obtain remuneration from the company for environmental damages.

In 2008, a coalition of left-wingers led by AMLO stormed Mexico’s national congress, protesting against president Felipe Calderon’s oil reform, which would have allowed Pemex to enter into joint-ventures with foreign firms on technically challenging projects. In 2015, López Obrador prompted Tabasco residents to stop paying their electricity bills in protest of rising retail power prices. Around 90% of customers failed to pay.

His recent decision to scrap the $13 billion project to build a new airport in Mexico City — following an unofficial referendum in which only 1 per cent of Mexico’s electorate participated — raised business concerns that the new administration may not respect long-term contracts.

Hence, AMLO’s demonstrated impulsivity could pave the way for an energy policy driven by the president’s own populist ideology rather than a pragmatic strategy.

By Global Risk Insights

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