The long game

For three quarters of a century, two monopolies towered over the Mexican energy sector and crowded out opportunities for investors.

Mexico’s oil industry was dominated by Petroleos Mexicanos (Pemex). By 2013, the lack of investment by Pemex and dearth of opportunities for foreign investors had contributed to a decade-long fall in oil production while federal subsidies cut a hole in the Mexican budget. A similar trend had taken hold in the power sector, as the monopoly of the state-run Comisión Federal de Electricidad had led to inefficiency and rising costs.

On 21 December 2013, the Mexican government amended its constitution to overhaul its energy sector. Though contentious in Mexico, leading to fistfights in Congress and causing one lawmaker to strip to his underwear in protest, the reforms were praised as necessary by observers and earned cheers from investors and financial markets.

The reform turned Pemex from a parastatal organisation to a state productive company, which now competes with new entrants into the industry. CFE will also operate as a state company, competing with the private sector to generate and sell electricity to the national grid. The reform came alongside the government’s 2014-2018 National Infrastructure Plan (see box), which called for approximately $300 billion in energy investment.

In the upstream sector, Mexico looks on track to reverse the falling production seen in recent years. After the first auction of offshore oil leases – the shallow water blocks in July of 2015 – was a disaster, subsequent auctions have shown dramatic improvement. The first deep-water oil auction in December beat expectations, with contracts going to companies including Chevron and Exxon Mobil and eight of the 10 blocks awarded.

“I see this as a big success,” explains Francisco Mendez, a partner at law firm Mayer Brown. “We’re seeing that the whole industry is very interested in Mexico.”

Despite having some of the world’s largest shale gas reserves, Mexico has increasingly relied on natural gas imports from the US, with domestic production dropping off as the country takes advantage of low prices in southern US states. This has created investment opportunities in the midstream sector, with a boom in pipeline construction across the US-Mexican border. Pipeline capacity from the US is expected to double to 100 billion cubic metres between 2016 and 2019.

“The number of projects that connect Mexico today with the US gas market is high and increasing. In addition, Mexico has a distinct need to develop its midstream infrastructure both for storage and distribution of natural gas within the country,” said Juan Alberto Leautaud, the head of BlackRock’s Mexico Infrastructure Investment Group, which has invested in projects including the Los Ramones gas pipelines.

Javier Chavarria, senior VP at Partners Group, says Mexico’s energy sector is moving towards gas-based power generation. “The idea is, long term, to replace the oil-based power plants,” says Chavarria, who leads Latin America direct investment for the Swiss-based firm.

Partners Group has been active in the midstream space, purchasing a majority stake in the Mexican pipeline operator Fermaca in February 2014 for an enterprise value of $750 million. Fermaca is building a nearly 2,000km pipeline network, running from the Permian Basin in Texas to Guadalajara, as well as several compression stations along the route.

The other sector that stands to benefit from Mexico’s move away from oil is renewables, which is poised to grow rapidly in the next decade. The government has vowed, ambitiously, to generate 35 percent of its electricity from renewable sources by 2024, up from 14 percent when the reforms were announced.

“We are well on our way to meeting that target,” predicts Leautaud. “I think what we’ve seen is a huge commitment on the part of the administration towards renewable energy.”
With little room for growth in hydropower capacity, the onus will fall on wind and solar. Auctions held in 2016 were a good start, as 34 projects totalling $6.6 billion in investment were awarded to companies including Italy’s Enel Green Power, Spain’s Acciona Energy and France’s Engie.

In the last renewables auction, prices came in at an average of $33.47 per MWh, which officials called highly competitive at an international level. While the low prices showcase developers’ eagerness to enter the market, investors are likely to wonder whether there is an opportunity for significant returns.

Reforms to the electricity sector have also created competition and investment opportunities. Prior to the reform, the CFE maintained a vertical monopoly from energy generation to supplying the end user. Now, the CFE serves as just another market participant in the generation and transmission of power.

“The opportunities have multiplied,” says Pedro Javier Reséndez Bocanegra, of Greenberg Traurig law firm’s Mexico City office. “Now, everybody is able to produce electricity on their rooftops and sell it to the grid. Everybody is allowed to build power plants for safe consumption or to sell it to the grid. We now have an open market.”

While the energy sector’s development in the past five years has been formidable, investors have had to cope with the normal difficulties expected from such dramatic changes, and then some. Just as reforms began kicking in, oil prices dropped 70 percent to their lowest point in decades.

Recently, rising gas prices in Mexico after the government cut subsidies have been blamed on the reforms, leading to protests and causing Peña Nieto’s popularity to plummet.

This comes on top of the challenges inherent in such reforms. George Osorio, managing partner at Conduit Capital Partners, has seen similar reforms take place elsewhere in Latin America and says there are generally “growing pains” as the legal system adjusts to them and banks get comfortable providing long-term financing.

“While it’s great for Mexico, it’s great for the region and it’s great for the sector,” Osorio says of the reforms, “you’re going to have a time lapse where people are going to see how the system operates for a couple of years before they really make a full commitment.”

When Peña Nieto embarked on the path to the reforms in December 2012, Barack Obama had just been elected to a second term as US president. Donald Trump was still the host of The Apprentice, and the US-Mexico relationship and the globalised economy on which it rested were seemingly invulnerable.

With Mexico a major importer of US gas and refined fuel, the oil and gas industry may be one of the least impacted were Trump to move towards leaving NAFTA or imposing tariffs. Trump’s energy-friendly policies – in his first week in office, he revived two pipelines put on hold by the Obama administration – could even bring new opportunities, some investors say.

But that does not mean Trump’s election has not fazed them. For one thing, it has led to a significant drop in the value of the peso, which fell to an all-time low after Trump’s win (though it has since rebounded). And if Mexican manufacturers saw access to the US market curtailed, their energy needs could conceivably decrease.

“Trump’s election did not help,” Osorio says.

But new presidents come every four to eight years, while energy investors are weighing the prospects of returns over decades. So while the election may be a speed bump for Mexico’s energy sector, its overall success depends more on domestic factors. In sum, Trump’s impact is one of several risks priced in for investors.

With so much in flux, many investors remain on the sidelines until there is more clarity. But to others, that is what makes the current opportunities unique.

“I would invest now, because based on what I’ve seen in other markets in similar stages, the uncertainty is an opportunity to get better returns,” says Osorio. “But for most investors and banks, there is going to be some time needed before they gain more comfort”. ?