Firing up the growth engine

Mexico has long enjoyed considerable reserves of oil and natural gas, but in recent years its oil production has declined and the country has experienced oil shortages and rising electricity prices. It is not unreasonable to ask why, despite having the necessary raw materials, Mexico has been unable to exploit its relative riches to become a major energy and industrial power.

For many years, Mexico lacked the political will to open up the country’s energy sector to foreign investors. This could have brought expertise, technology and money to a broad range of industries, but it would also have meant fundamental change to Mexico’s constitution.

This dated back some time, in fact to 1938, when Mexican president Lazaro Cardenas nationalised the hydrocarbons sector. Since then, any discussion around foreign investment has been politically sensitive.

When Mexico did decide to open its energy border, it brought to an end decades of vertically-integrated state monopolies and tepid private participation in hydrocarbons. The reforms are not just targeting a revitalised set of energy sectors, but also aimed at accelerating the growth of the entire Mexican economy.

The most far-reaching of the changes driven by the reforms will be overseas involvement in the natural resources and power generation sectors. That said, the state will continue to be the owner of all subsurface hydrocarbons and the exploration and extraction of oil and other hydrocarbons remains the exclusive preserve of the Mexican government.

SWEEPING CHANGES

But, importantly, private participation in such activities is now permitted. Amid these sweeping changes, Petroleos Mexicanos (PEMEX) will become a “productive state enterprise” alongside other similar entities to be established.

While PEMEX is pivotal in the new paradigm – the company is likely to receive the mandate for exploration and extraction of hydrocarbons – the reforms are aimed at ending the company’s monopoly while making it a more capable, self-sustaining and competitive entity. Although converted to a state-owned company, it can raise debt on the capital markets, but cannot sell shares or equity instruments.

Interestingly, both PEMEX and private market entrants in the midstream and downstream oil sector are expected to build export capacity to the Pacific markets. There is recognition that there is little room for exports to the US market given the surfeit of light tight oil. Conversely, Mexico may start to import light crudes from the US as its own refining capability grows.

Three laws will be the cornerstone of the reform of oil and gas: the Hydrocarbons Law; the Hydrocarbons Revenue Law; and the PEMEX Law. All are key in increasing the production of oil and natural gas, and bringing down electricity prices by replacing high-cost fuels with new supplies of natural gas.

The Hydrocarbons Law regulates all activities related to the industry in Mexican territory. The Revenue Law supplements the Hydrocarbons Law and deals with royalties, taxes and fees. The law has different formulas for setting payments based on the nature of each contract.

But what can we expect to see emerging in the coming years? The reforms will strengthen competitiveness in the generation of power while expanding transmission networks, improving distribution and, ultimately, providing better value for the consumer. In addition to PEMEX’s new role, Comision Federal de Electricidad (CFE) will also become a productive state business.

OPPORTUNITIES TO PARTICIPATE

For the private sector, there will also be opportunities to participate in electricity projects, ranging from investments in generation, to transmission and distribution. The energy sector in Mexico has great potential. For example, the Ministry of Energy estimates the annual demand for electricity will grow at an average rate of more than 4 percent per annum right up until 2028. This will involve the installation of around 25 gigawatts (GW) of new generating capacity from 2013 to 2020.

Mexico also intends to generate 35 percent of its total energy produced from clean sources by 2024. As Mexico moves its base load generating capacity towards natural gas, it will in turn drive a significant upgrade of the country’s natural gas distribution system.

The private sector may also venture into retail activity as well as power generation. At present, Mexican retail energy rates are almost 50 percent higher than those in the US, so it’s easy to see how cost-efficient companies could flourish in this environment. Companies specialising in transmission and distribution may also establish partnerships with CFE to upgrade and expand the grid.

Private companies can also benefit from a more liberal oil and gas sector. After peaking in 2004, oil production in Mexico began falling at an alarming rate with the ongoing depletion of the Cantarell Oil Field, which was central to Mexican oil production. From 2004 to 2014, oil output fell by one million barrels a day.

Original expectations for oil production were set at a Compound Annual Growth Rate (CAGR) of 1.5 percent from 2014 to 2025, but the reforms are predicted to increase this by between 12 percent and 14 percent, boosting the CAGR to almost 3 percent. So we can expect oil field auctions that will be opened up to private participation.

BUILDING THE PIPELINE

Among the projects that will emerge will be the ambitious plan to expand the gas pipeline network to 6,000 kilometres over the next four years, some 50 percent larger than the current set-up. Petrochemical activities, including refining, will also be subject to private investment.

When the reforms were first announced, a number of companies were lining up to invest in Mexican energy. The country is the third-largest oil producer in the Americas and has the sixth-largest source of recoverable shale gas. But at present, more than 50 million people live in poverty. The potential to improve people’s lives was always clear, but technology and capital were badly needed and PEMEX, for example, did not have the resources to capitalise on this.

Moreover, PEMEX was widely considered a bloated entity weighed down by pension liabilities and declining production levels. The model was outdated and, to quote President Nieto, “worn out”. The potential of Mexico as an energy producer offers more than just improved services, it can also propel the country into any future plans for an integrated North American market that includes the US and Canada.

So where does the financial services industry come into this? With so much private sector interest and the prospect of investors snapping up contracts in the auctions, increased activity in the project finance sector can be expected.

Industry specialisation will be in demand, along with emerging market expertise. We can expect to see activity among export credit agencies, as well as significant activity among the private equity/sponsor community, especially from the US.

GLOBAL PERSPECTIVE

Interest will not come just from Mexico’s neighbours, however. Europe and Asia – notably China – may also eye opportunities in a more liberalised market. Local companies are also in need of a broad range of products and services and, with non-Mexican investment coming into the country, banks with a truly global perspective will have a clear advantage.

The broad energy reforms in Mexico will not only provide the country with fresh impetus and economic growth, but will also bring vigour to the local capital markets and broaden the investor base in Mexico. It can be a good news story, but will have to be carefully managed to ensure the country derives long-term benefits that transform it into a growth engine for the region.

Will Marder is a New York-based global product manager for project finance at Deutsche Bank Global Transaction Banking