THE Game-Changing Mexico Opportunity

What if Mexico were to privatize its state-owned oil company Pemex around the same time that the US and Mexico ended the moratorium on oil and gas production along their shared Gulf of Mexico border? Opportunities galore …

Opening up the Mexican energy sector to private investment is one of President Enrique Peña Nieto's top priorities, and we expect that reform to begin in 2013. This-coupled with the US House of Representatives' recent ratification of the US-Mexico trans-boundary oil and gas agreement--means that production could begin soon along some very lucrative Gulf of Mexico acreage. 

Getting Rid of those Institutional Icons

Peña Nieto has already demonstrated his willingness to tackle institutional icons for the sake of better governance (i.e. the arrest of Elba Esther Gordillo, the notoriously corrupt head of the teachers' union). And any political watcher would say that successful reform of the energy sector would be a historic victory and a tremendous legacy.

The potential benefit is greater competitiveness and faster GDP growth. Analysis by Mexican firm Marcos y Asociados shows that by 2020, projected GDP growth would be 2.3% higher in a scenario where Pemex accepts partnerships with outside investors than in status quo maintenance.

The downside will be political conflict; left-wing politicians in Mexico are adamantly opposed to any change in Article 27 of Mexico's constitution. And they are dead set against the privatization of Pemex. 

Yet Peña Nieto already has already opened the door a crack; and he was elected on a platform which explicitly included the "modernization" of Pemex. Current expectations inside and outside Mexico mean failure to liberalize the energy sector presents its own political challenges.

Depending on his appetite for conflict, Peña Nieto may avoid a constitutional amendment, instead setting out legislation that would explicitly interpret the state ownership of oil and gas resources as permitting downstream license agreements and joint operations.

Given the preponderance of successful public-private "hybrid" energy companies across the globe (Statoil, Petrobras, Gazprom, Sinopec, Ecopetrol), Mexico has a number of potential models to follow. Key questions will revolve around

•    the types of licensing, concessions and partnerships permitted
•    the limits on, and representation of, minority shareholders if Pemex itself opens up to outside investors, and
•    regulations, such as local-sourcing requirements or the creation of an agency dedicated to issuing and monitoring hydrocarbon concessions.

Many of the anticipated changes will happen gradually. The easiest (and therefore the first) liberalization may occur in the less profitable and less controversial downstream sectors, such as refining and petrochemical production.

Today, Pemex is running at a $10 billion annual loss on refining operations, and the expansion of a major refinery in Tula has stalled because of concerns over spending. Already this year, Mexico's Congress fully funded Pemex's current budget request for exploration and production, but only authorized one-third of the money requested for refining operations.

Though Mexico may need to swallow its pride to loosen its hold on hydrocarbon resources, advocates of the reform argue it is already a source of shame to watch idly as other companies produce oil and gas in the Gulf of Mexico and the Eagle Ford Shale formation.

By its own estimates, Mexico has 115 billion barrels of oil equivalent but much of that is in unconventional deposits that are currently out of reach for Pemex.

Mexico has the world's fourth-largest shale gas reserves. The EIA estimates it has up to 680 trillion cubic feet (tcf). And the Eagle Ford play extends south of the US border. Not only does Pemex not have the technology to tap into this shale or to pump deep-water reserves, it also doesn't have the money to focus on onshore exploration-it's all tied up offshore. And US natural gas imports are pretty cheap, so there's not enough incentive for Pemex to foot this bill or try to go it alone.

Strategic partnerships with experienced foreign companies would allow Pemex to quickly enter those markets, and would be some of the most profitable areas for investors.

Aside from the items listed above, the Mexican government and Pemex need to address other issues relating to the Pemex reform. Pemex management and the Pemex workers' union will need to deal with internal disputes over issues like an unwieldy (some say excessive) labor force and debts (including unfunded pensions) of more than $100 billion. Allegations of corruption have dogged the leader of the Pemex workers' union for years, but Carlos Romero Deschamps has held on. His precarious hold, however, may give Pemex management some leverage in negotiating the union contract this summer.

Where it does show profits, Pemex continues to be subject to an extraordinarily high tax rate. We expect any reduction in Pemex's tax obligations to be one of the slowest things to change, if it ever does. The government cannot find another source of revenue to replace or supplement oil money overnight, and would almost certainly require higher taxes somewhere else. Popular Former Mayor of DF Marcelo Ebrard (PRD) believes fiscal reform to reduce government reliance on Pemex and increasing its autonomy should be sufficient. He flatly opposes Peña Nieto's push to attract foreign investment in Mexican oil. But the President of the PRD Jesús Zambrano said he is even open to discussing a constitutional amendment. It isn't clear how the public will react to the debate on the horizon; it seems the instinct to resist change is weakening, perhaps because of successful "hybrid" oil companies elsewhere, perhaps because many Mexicans are tired of the Pemex monopoly on scarce gas stations.

The PAN and PRI together could accomplish the needed "modernization" of Pemex, but if they merely overrule PRD opposition, it would fatally undermine the "Pacto por Mexico," an agreement between the three main parties to cooperate in advancing numerous initiatives. Until last week, Peña Nieto avoided publicizing any sort of timeline. The fact that he said an energy bill would reach Congress by September 2013 means Peña Nieto's team has been busy gathering commitments to back a broad agreement.

At the end of the day it isn't only politicians who want a strong economy - regular citizens do too - and an influx of foreign investment in Mexico's gas and oil development is just the boost the country could use.

The US-Mexican Border and the Pemex Potential

The US House of Representatives on 14 June ratified the US-Mexico Hydrocarbon Transboundary Agreement (TAP), which will govern oil and gas development along the US-Mexico border. The agreement was brokered by the two sides in February 2012, and once implemented will end the moratorium on production here. Essentially, it sets up a framework for joint development of oil and gas assets on the shared border in the Gulf of Mexico by US companies and Pemex.   

About 1.5 million acres and an estimated 172 million barrels of oil and 304 billion cubic feet of natural gas are covered by the agreement. If the US House and Senate can agree on a transparency sticking point over whether US companies should have to divulge royalty and other payments made to the Mexican government, we will see leasing going on here soon.

This could be great for Pemex. The state-run company is eyeing the deep-water Perdido fold belt, which could have the potential to expand Mexico's stagnating domestic production.

Last summer, Pemex announced a major discovery of crude oil in the Perdido fold belt, with preliminary estimates that the company's Trion-1 well contained 350 million barrels of oil equivalent (proved). The well is about 39 kilometers south of US waters. And that's just one well. Overall, the area has an estimated 10 billion barrels of oil equivalent.

This report was produced by Southern Pulse exclusively for Oilprice.com.