Poised for a Mexican wave

Late last year, Mexico announced sweeping changes that would end 75 years of state control over the energy industry. Then, in August this year, the country’s Congress approved relevant regulations that clear the way for international investors to tap Mexico’s rich reserves of oil and gas.

The doors are now open to deep structural changes which affect the country’s oil and gas sector and the dominant role that state-owned petroleum company Pemex has played since its formation in 1938.

In the near future, Mexico will offer investors shale oil and gas and deep-water business opportunities, some of which may include the Perdido deep-water area discoveries and the marginal fields in Chicontepec, according to legal sources.

Effectively the most ambitious for decades, the energy reforms fundamentally change the way foreign investors can engage with the country’s two industry monopolies, Pemex and the Comisión Federal de Electricidad (CFE).

It becomes more like “dealing with a commercial entity that can actually take decisions… given that (Pemex and the CFE) can directly enter into commercial contracts now,” whereas before there was a procurement process to go through, regardless of “whether you were buying equipment or you are building a $1 billion refinery,” says Jaime Guillen, partner at Mexico Infrastructure Partners, a Mexico City-based infrastructure fund manager.

To some extent, the reforms also make the two state-owned companies competitors to foreign investors.

CFE, the federal electricity commission, will become a “State Productive Entity” that will compete with private generators; while Pemex’ natural gas transport pipelines, as well as its supply contracts, will be transferred to state-owned ISO (Centro Nacional de Control de Gas Natural), according to Stirling Leech, a partner at law firm Clyde & Co in Sao Paulo.

Previously, private firms were only able to work for Pemex under service contracts.

“The relationship definitely changes… and one of the things we are trying to understand is what does this mean? Pemex will be the dominant player in this market, so how does that impact the field of play?” asks Guillen.

Indeed, while the overhaul is expected to encourage necessary development in the stagnant oil and gas sector, fund managers agreed that the full implications for private investors – and when to expect the first foreign investment – remain to be seen.

“It varies by sub-sectors. A lot has to do with how quickly the government will define the details and regulations on how things will be implemented; such as how will the (electricity) wholesale market work and when will blocks be auctioned to the new players on the oil and gas side,” says Guillen.

Infrastructure fund managers say Mexico’s midstream sector is most likely to see immediate capital inflows given that the sector is vastly under-developed.

Existing oil transportation networks in the country comprise just 3,000 miles of pipeline, compared with about 57,000 miles in the US, according to Leech. Equally, there are only 5,500 miles of natural gas pipelines in Mexico.

In response, the CFE is expected to open a bidding process in the near future for the construction of five pipelines in northern Mexico to bring in natural gas from the US to boost electricity generation. The cost of the work is estimated at $2 billion, Leech says.

This is a promising area because private investment in gas transportation was liberalised nearly two decades ago. “Provided that you obtained a permit from the CRE, Mexico’s energy regulatory commission – which is much like the US Federal Energy Regulatory Commission – private investors, including foreign investors – could build gas pipelines,” says Boyd Carano, partner at law firm Vinson & Elkins.

Fermaca, now owned by Switzerland-based private markets specialist Partners Group, has been in the gas transportation business in the country for some time.
One of Mexico’s pioneer overseas investors, Partners Group’s investment focus “is really centered on midstream assets, transportation storage, gas and liquids,” according to Jean Perarnaud, managing director in private infrastructure at Partners Group.

Perarnaud said his firm would be looking at 22 public tenders in gas and liquid pipelines in the next twelve months and expects to see deal flow of $18 billion in pipelines and $70 billion in the power sector during the same time period.

Mexico Infrastructure Partners, on the other hand, is in discussions regarding the funding of several midstream projects that will require investment in 2015, according to Guillen.

The infrastructure manager was established over two years ago in anticipation of the upcoming energy reforms in the country, Guillen points out.

“Prospects for investors are positive compared to the reality prior to the reform. Despite that, how the private sector will be given a more active role has not yet been defined,” according to Leech.

Transmission and distribution remain a public service provided through a new decentralised state entity called Centro Nacional de Control de Energía (CENACE). This entity will be the operator of the national electricity system and wholesale market operator and will be able to enter into contracts with private parties for the construction and operation of the national power grid, resulting in major opportunities for international entities interested in investing in Mexico’s power sector.

Guillen says his firm is looking at investment opportunities in power generation and will be examining distribution as well in the future.“We and the rest of the market are waiting for clarification” on the details of how the wholesale market will work, he says.

“We don’t see investment in electricity and power generation for another 12 to 18 months. The government has to define some rules, and until they define those rules, it is somewhat difficult to go out and develop that,” he adds.

Separately, the law currently provides little guidance for the transport and distribution of crude oil and oil products by pipeline, stating only that permits for these activities will be required and that the Energy Regulatory Commission (CRE) will grant them, according to Leech.

Perarnaud says Partners Group could potentially look at opportunities in the power generation sector in the future, although the current focus is on the midstream space.

Mexico has set a target of 35 percent of energy being generated from renewable sources by 2024. The current level is approximately 20 percent, which means an increase of between 10,000 to 20,000 non-fossil megawatts (MW) will be needed, over and above the figures currently planned, to reach the target by 2024.

The Mexican Oil Fund for Stabilization and Development, which will govern the receipt of all incomes (except taxes) derived from contracts for hydrocarbon exploration and extraction activities belonging to the Mexican state, will be authorised to invest in renewable energies, among others. That indicates that considerable opportunities will arise in the sector, lawyers say.

Again, fund managers say most private investors still want to see further details of the framework so as to understand the mechanism for tariffs and tariff support.

Having been one of the most restrictive markets for private investment, a much more open market now “creates a new paradigm for Mexico that ought to attract a lot of capital,” claims Carano.

For private investors, the key is to find a “right entry point” to buy or sell assets there, Perarnaud adds.

Ultimately, the success of the energy reforms will be determined by the attractiveness of terms yet to be put in place, although the Mexican government is seemingly aware of what needs to be done.

For international investors interested in Mexico’s energy industry, Erik Bethel, a managing director of private equity at Darby Overseas Investment, provides a neat summary. “We are very excited about the opportunities in the Mexican energy sector and hope to be increasingly active in the near term,” he says.