US oil and gas companies are whistling a little James Taylor following Mexico’s historic energy reform legislation in December 2013, particularly that line about “It sounds so simple, I just got to go.”

No doubt opportunity abounds in a market that could witness a quadrupling of oil and gas investment to US $80 billion annually by 2020 – with roughly half of that originating from foreign investment – according to oil services analysts at Barclay’s Capital.

North of Mexico’s border the main question centers on how fast that opportunity unfolds for US-based energy companies. It may be a case of properly managing expectations.

“We estimate it could easily take two or three years to really see the first business opportunity materialize under this new framework,” said Alexandra Leon, Mexico City-based associate director for IHS’s Latin America-Downstream Oil. Leon does not expect any rise in Mexican oil production from the reform package before 2018.

“It is not just a matter of the opening and allowing for private investment,” Leon said. “It is how and under which conditions.”

Certainly when new production comes, it will entail international implications.

“The reform is really quite breathtaking in its scope and its ambition,” said David Goldwyn, president for Goldwyn Global Strategies LLC, at a February 2014 Houston conference on Mexico’s energy reform. “If it succeeds it will move Mexico to be a strategic supplier of oil by 2022. If you look at [International Energy Agency] projections, they expect non-Opec will peak by about 2022 – and they are not counting increased production from Mexico’s reform – so really good timing for the rest of the world.”

Like university students facing last-minute spring break choices, the issue for the oil and gas industry will be getting there.

If all goes well, oil services firms could see movement toward increased Mexican business volumes in the latter half of 2015, though the timeframe is likely the latter part of the decade for US-based oil and gas operators. In the meantime, US producers may find an indirect economic opportunity in exporting excess domestic gas into the Mexican market for power generation or industrial use under the new and independent pipeline system operator that reform creates.

Reform impacts

There has been a flood of seminars, white papers, and analyses on Mexico’s energy reform in early 2014. At least two have included discussions that energy reform would provide a $1 trillion boost to the Mexican economy over a 10-year period.

The Mexican government is downplaying estimates of that magnitude since they often apply US-centric metrics and fail to account for differences in exchange rates, labor rates, and other cross-border tangible and intangible factors.

“It is not the type of numbers we are discussing in Mexico,” said Dr. Maria de Lourdes Melgar Palacios, Mexico’s undersecretary of hydrocarbons, during a press conference following a Houston presentation on Mexico’s energy reforms in February 2014. “We do see significant potential for the entire reform. We are talking about $10 billion per year, in round numbers, but we are talking for the entire country and not for a specific area.”

Lourdes Melgar said energy reform will provide an increase of 1% to Mexico’s $1.17 trillion GDP by 2015, or about $11.7 billion, and 2.5% of GDP by 2025.
Still, by any metrics, energy reform in Mexico is massive in scope and patterned in many ways on energy reform in Norway that created both a national stabilization fund and spun off the state-owned oil and gas firm into an independently operated Statoil. Furthermore, momentum south of the border is real. Energy reform, though not without controversy, follows federal reformation and liberalization in education, fiscal matters, and telecommunications. Adding energy to other sector reforms will place Mexico among the more significant geopolitical and economic players in Latin America this decade.

“In the hemisphere, if this works, Mexico is in the pole position,” Goldwyn said. “Only Colombia has a more competitive framework. Colombia is working; Mexico is on paper. Brazil, Venezuela, Bolivia – and everybody else – had better watch out because this is a huge opportunity close to market, close to infrastructure, close to export capacity. It is huge.”

Why do it?

Mexican oil production has been on a steady downward trend for a decade, dropping from 3.4 MMb/d of oil in 2004 to 2.5 MMb/d of oil currently despite significant investment. At the same time, natural gas imports are rising after natural gas production peaked in 2009 and rolled over. Lourdes Melgar noted that almost half of Mexico’s electrical generation is tied to natural gas, which is also in high demand for the nation’s manufacturing sector. Finally, Mexico imports and subsidizes 49% of its gasoline, while petrochemical imports have grown from 41% of chemicals in 1997 to 66% currently.

But while the focus in the US has been on upstream oil and gas, the main focus in Mexico is electrical generation.

“Our electricity rates are noncompetitive,” Lourdes Melgar said. “It creates difficulties not just for the domestic population but hampers Mexico’s economic competitiveness. Residential and agricultural rates are 25% higher than comparable rates in the United States,” despite subsidies that keep rates 73% lower than nonsubsidized market rates. Mexico’s industrial users are paying electrical rates 84% higher than in the US.

Lourdes Melgar said electrical rate subsidies for residential customers and agriculture consume 0.75% of GDP, while as much as 20% of electricity is not paid for.
“What is happening is companies are beginning to wonder whether to come to the United States or go to Mexico, and of course with the abundance of cheap energy, some are making the decision to come to this side of the border [Houston],” Lourdes Melgar said.

What will it mean in practice?

That’s the background. The transition still faces significant challenges. First up are the secondary laws, which should be finalized in April 2014. These will govern the types of contracts such as profit and production sharing, service contracts and licenses, and the technical aspects of how each contract operates. Each must be tailored to encompass specific types of fields, whether deepwater, tight formation, or mature conventional fields, and be broad enough to encourage development in a market where commodity prices can vary widely.

What’s next?

Next up is what Pemex will retain during Round Zero as it moves to become an independent state-productive enterprise. Those nominations will be known at the end of March 2014. Early indications are that Pemex will retain deepwater assets, where it can partner with international oil companies and access technical and operational expertise, and Mexico’s conventional mature basins, where an influx of capital can reverse production declines and generate quick cash. Whether Pemex wants to retain access to tight formation gas in the northern part of Mexico is debated both ways by observers. Additionally, Pemex will retain exploration entitlements for three to five years in areas where it has made commercial discoveries or exploration investments.

The Comisión Nacional de Hidrocarburos will make the determination by Sept. 17, 2014, on which entitlements Pemex will retain based in part on what Pemex can develop technically before opening the process to external bidding in the second half of 2015.

Second, and perhaps more challenging, is creation of the regulatory framework to guarantee transparency in contract awards and a level playing field in energy. The regulatory agency will be independent and budgeted separately from the energy sector, but it must first hire and train technical staff within a tight timeframe.

Third, security goes without saying, particularly in northern Mexico within the arc of Eagle Ford shale geology. But, according to Peter Schecther, director of the Adrienne Arsht Latin America Center for the Atlantic Council, the perception of challenging security issues should be tempered by the fact that US financial rating agencies raised Mexico’s credit rating to the coveted A3 grade from Baa1 in February 2014.

“Mexico is going to strengthen a North American energy market that is going to reduce long-term dependence on the Middle East,” Schechter said during a February 2014 conference on Mexico energy reform in Houston. “That, in Washington, is a political statement that really garners a lot of interest, not to mention the fact it is going to reduce a lot of pressure areas such as immigration because, as Mexico’s economy improves, there is going to be a lot less migration to the United States. Mexicans are going to want to stay in Mexico.”

The advice for oil and gas companies who want access to oil and gas development in Mexico is to take time now to understand the massive arc of change in Mexico’s legal oil and gas framework and work to establish cross-border relationships in preparation for opening the energy sector in the second half of the decade.

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