In a landmark reform since 2013, Mexico has revised its constitution and created structural changes that allow for private investment in the energy sector for the first time in more than 70 years.

The leading political party, the Institutional Revolutionary Party (PRI), in power through 2018, is driving the energy sector reform. Key goals are to increase national production (arrest the decline), drive significant capital investment ($12 billion per annum per round), improve the efficiency of Pemex and lower regionally high power prices (via natural gas generation replacement of oil burn).

The Finance Ministry’s goal is to raise production from 2.5 million barrels per day (MMbbl/d) to 3 million daily by 2018 with
$30 billion of additional and annual private investments. Energy reform is THE key element of this administration, which we believe will drive rational and competitive terms. Overall, the political ambitions aim to improve national productivity, finances and economic growth. The U.S. provides certain elements for the reform template, given the clear and apparent economic success in the U.S. from unconventional resources.

This past August, Mexico launched the beginning of the first licensing round, which includes two primary sets of opportunities: first, 11 joint-venture (JV) opportunities with Pemex (termed Round 0.5); and second, standalone exploration and development opportunities (termed Round 1.0). Despite the sequential terming, we believe both Rounds 0.5 and 1.0 will be made in rolling and simultaneous bid rounds, grouped by asset type, with deepwater JVs and exploration, the Mexican crown jewels, offered last, in November 2015.

Mexico has 42 billion barrels of 3P resources and 111 billion barrels of oil equivalent of conventional and unconventional prospective resources. Mexico has vast undeveloped potential of unconventional and deepwater opportunities.

Mexico's crude production has since fallen off since the mid-2000s.

This is a very large offering, and over time, 67% of Pemex’s 11 billion barrels of oil equivalent (Bboe) (Pemex numbers) could ultimately be opened for private investment opportunities. We expect the diversity of the offering will attract a wide array of local and international energy companies, which could ultimately drive capex to more than double by 2020 from $25 billion annually today.

We expect a rolling series of investment rounds and JV opportunities with Pemex (that will determine price) beginning in February 2015, with awards announced from May to December 2015.

Significant headlines in 2015 could follow this general timeline: November 2014, industry feedback on assets offered, a release of the preliminary contracts and further detail on 2015 timeline; February 2015, feedback on preliminary contracts; May 2015, close mature assets offerings; June 2015, close extra-heavy and unconventional asset offerings (offerings might be split in two months); September 2015, close deepwater exploration offerings; and December 2015, close on all JVs. The JV awards will occur contemporaneously with the standalone opportunities and we expect a template for additional rounds in subsequent years to become clearer in 2015.

Pemex will require large amounts of service work to stimulate its assets that have weak production.

Service opportunities

Oil service companies should benefit from participation of local players and accelerated efforts to bring back neglected fields. The rich selection of acreage offered in Mexico is likely more than established oil companies are able or willing to develop. The fields left alone by established international players are attracting interest from smaller, less-experienced exploration and production (E&P) companies and private-equity firms from Mexico and the rest of Latin America. While unable to assess impact for E&Ps or integrated oils at this point, we view this as a boon for service majors (the Big 4), as these smaller, less-experienced E&Ps are likely to require a much higher degree of integrated work.

Pemex is also placing priority on developing its large portfolio of mature and underproducing onshore fields in mature basins, for which bidding will start in first-half 2015, ahead of the deepwater. Out of Pemex’s roughly 250 producing assets, more than 200 are producing below 10,000 barrels per day (bbl/d), and more than 100 are producing below 1,000 bbl/d.

In order to stimulate production, we might see a series of integrated incentive-based contracts awarded to service companies. This strategy has been successful at Shushufindi Field in Ecuador, where Schlumberger was able to boost production by 30% in 2013, after two decades of declines. We view Schlumberger as the major beneficiary in Mexico, alongside the other service majors and Tenaris.

There will also be opportunity for offshore drillers. Mexico accounts for some 10% of global jackup demand, and we model for the region to see the largest growth through the end of the decade. While offshore fields are likely to be bid on later in 2015, Pemex was already seeking to double its jackup units from 40 in 2013 to over 80 by 2018, regardless of the outcome of energy reforms. We now expect upside to this.

Meanwhile, we expect floater demand growth to kick in prominently, especially toward the back half of this decade. While local contractors already have a significant market share, fleet expansion of this scale should nevertheless impact the overall rig market and also benefit established drillers.

Activity is less clear for the upstream winners. We believe the integrated oils will likely be heavily involved, and given the diverse asset offering, they could build a business across various assets, particularly deepwater, heavy oil (both Exxon and Chevron) and potentially mature fields.

If deepwater terms compete with the Gulf of Mexico (GoM) (50% gross take), we expect deepwater interest will be robust and might include Chevron, Exxon, ConocoPhillips, Anadarko Petroleum, Marathon Oil, Cobalt International Energy, Murphy Oil and Noble Energy. We also believe Chevron is well-positioned to become a JV partner with Pemex in deepwater finds Trion and Exploratus, given Chevron’s interest in Perdido Field and declining production in Great White Field.

Round 1 standalone opportunities

Round 1 standalone opportunities will include 39 deepwater exploration blocks, 70 unconventional exploration blocks, and 60 developed fields across 28,500 square kilometers. Pemex is permitted and intends to participate in bids for some of these assets.

Among the offshore exploration blocks, 11 (three subsalt) are in the Perdido area where there has been significant exploration success on both sides of the border that will likely attract significant interest. There are 17 frontier blocks offered in Cordilleras Mexicanas and Aguas Profundas Sur areas.

Finally, there will be 70 onshore blocks that encompass largely unconventional opportunities with eight blocks in the Maverick Basin (Eagle Ford oil extension). The other 62 unconventional blocks are in the Tampico Misantla Basin. Here, as in other global unconventional opportunities, we expect slower development given lack of infrastructure and installed services base. Further, the size of the current U.S. opportunity and capital demands against a lower global capex allocation will also temper interest and pace of development. Longer-term, we see significant potential.

Lastly, there will also be 60 development fields on offer with heavy oil and EOR applications. We see the potential for local or Latin American interest that would be heavily reliant on North American service companies.

Round 1 JV opportunities

The JV opportunities with Pemex include 2.6 Bboe of 3P reserves and 81,000 bbl/d of production across various assets including deepwater discoveries (both oil and gas), extra-heavy oil fields (shallow water and onshore) and large mature fields (EOR potential). Deepwater JV oil discoveries include the Trion and Exploratus discoveries, which are on trend with the Shell-operated Great White Field on the U.S. GoM side (one of three fields producing on the Perdido hub in the U.S.).

These discoveries hold some 500 MMboe of 3P resource (Pemex estimates). We believe Shell and Chevron, within the Perdido platform, are logical partners given leverage to existing U.S. GoM infrastructure. While Pemex will have flexibility in qualifying potential partners, it is unclear if it could “qualify” partners so narrowly to only include companies with interest in existing infrastructure.

Pemex is also offering a JV for a deepwater gas discovery (Kunah, 430 MMboe), yet interest levels are less clear unless fiscal terms account for lower relative economics and or natural gas prices. Given the political objective for increased natural gas production (and concomitantly lower electricity prices), we see this as potential.

JVs will also be offered in extra-heavy oil, shallow-water fields. These include 723 MMboe of 2P reserves and hold upside, given average recovery factors of only 11%.

Finally, Pemex will offer JV terms for mature fields where water and gas injections could increase recovery factors and drive a near-term production response. While term-contract structures for various opportunities differ, we see potential for enhanced oil services contracts here, similar to Ecuador’s Shushufindi Field.

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Most of Pemex's roughly 250 assets are producing nominal volumes and are in need of workover/stimulation.

Base-case spending growth is estimated at about 66% from 2014-202, but there is an upside case for 150% capex growth on higher upstream private investment.

Mexico accounts for about 10% of global jackup demand and the region is expected to see the largest growth through the end of the decade.

Open questions

Mexico’s energy reform is historic and a significant undertaking, with widespread potential energy industry and economic impact. The country is converting a monopoly of an entire sector into an increasingly open investment forum with newly created oversight and regulators while offing significant resource across various asset classes via a series of wide-reaching (likely virtual) data-rooms with multiyear potential/ambition. We expect execution delays on the offering, given its size and the newness of the system and regulators, yet the significance of the Mexican resource prize should ultimately triumph.

Key open questions include general fiscal terms and standards (whether API or otherwise), which will be important as global major spending is declining (peak capex views, outside the U.S.) while investment opportunities are contemporaneously expanding. A key indicator or outcome on comparability of term standards and risk assessment will be whether companies categorize Mexico as within “North America” or “Latin America, ” the latter having a significantly higher capital allocation. Given Pemex’s falling production and the political importance of successful reform, we expect competitive terms.

In the JV rounds, it is unclear how much flexibility Pemex will have in qualifying potential partners. General pre-qualification cri- teria include financial ability, execution abilities, demonstrated know-how and safety record.

Lastly, we believe the rolling auctions are pragmatic, as they will allow companies to assess and pace the process. This structure should result in better price discovery and lessen the prisoner's dilemma element of a big bang offering, which can result in poor economics and, hence, poor ultimate execution (i.e., Iraq).

Upstream investment

We see Rystad estimates of 66% upstream capex growth from 2014 to 2020 as a floor on potential investment, and highlight an upside scenario of over 150% spending growth. Using Rystad Energy spending forecasts, we see the potential for substantial upstream spending growth, driven both by increased spending by Pemex to optimize mature fields (about 40% spending growth in 2020 vs. estimates for 2014) and increased private investment (about $5 billion higher private spending in 2020 vs. 2014). However, we note that private investment could grow to nearly $30 billion per year by 2020.

We believe the Mexican opportunity within discovered fields is akin to many bitten apples. Given the Mexican resource abundance with a single and monopolist explorer, many fields were not fully optimized prior to Pemex moving to another discovery and bigger “apple.” Over the years, the result was many bitten apples and, while “mature” fields are labeled as “EOR opportunities,” they have largely been abandoned and are under-invested rather than over depleted. We believe there is significant upside opportunity for enhanced production. For instance, only 300,000 bbl/d, or 10% of Mexican production, comes from 200 fields.

Mexico’s mature onshore fields have largely been left to decline over the past three decades as incremental barrels were largely produced offshore, particularly from Cantarell Field. We now believe that onshore assets will see the earliest licensing and thus believe integrated service companies will be the first to benefit. Meanwhile, we believe that GoM permitting will be more of a 2016 event, with Seadrill, Diamond Offshore, Ensco and Paragon Offshore Plc most likely to benefit in the longer term.

J. Evan Calio is the analyst for the integrated oil, E&P and refining industries and Ole Slorer is the analyst for global oil services, drilling and equipment, at Morgan Stanley.

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