The recent constitutional reforms to Mexico’s energy sector have sparked two types of response. The business and finance community has almost universally welcomed the reform as being broader and deeper in nature than it had expected. At the same time most also say that the true impact of the reforms – and the scale of the opportunity for the private sector in oil, gas and power – will depend on upcoming secondary legislation, and to an extent accompanying regulations and operating rules.

So the market awaits the secondary laws that will add greater clarity about how the government will allow state oil company Petróleos Mexicanos (Pemex) and the state power company Comisión Federal de Electricidad (CFE), to interact with the private sector. It will also look for clues as to what new and existing governmental agencies will oversee the industries and how they will interpret their remit.

But excitement is building. Bankers and lawyers report huge interest from overseas clients in the progress of Mexican energy liberalisation. Economists are adding – on average – 150bp to forecasts of annual GDP growth.

Mexican manufacturers already expect the reforms to feed through into their energy costs. For example, concrete manufacturers are already planning to change their kilns to run natural gas or electricity, rather than pet coke, the current cheapest option. The Mexican stock market leapt, and while it was already an outperformer in emerging markets it now has a price/earnings premium of 80% over its peers.

This excitement stems from the amendments to the Mexican constitution [Articles 25, 27 and 28] that allow for the participation of private companies in the energy sector. Some lawyers maintain that private participation was never banned – just the granting of concessions – and that this reform just emphasises the opportunities for the private sector. but this legal nuance is largely lost in the clamour of approval for the reforms.

The impact

What is clear is that private companies will be allowed to participate in upstream, mid-stream and downstream activities through profit sharing, production sharing and licences. Concessions will still not be granted to private sector companies (the issue of oil as a sovereign asset is still highly sensitive in Mexico) but, crucially, the oil and gas E&P (exploration and production) licenses will enable private sector companies to book reserves, thereby leveraging their balance sheet and making huge, capex-intensive projects financially viable.

Midstream and downstream activities have always been open to some extent to private sector involvement through service contracts. But now that private sector players can share in profits and production they will have much greater incentives to get midstream and downstream projects off the ground.

At the same time the reform envisages that Pemex will remain the dominant player in the Mexican energy industry, but no longer a state monopoly. It will retain some privileges and advantages (not least the Ronda Cero, or first right of refusal on projects), but will be expected to become a leaner and more efficient corporate entity. It will also be expected to participate alongside the private sector in joint ventures and conosrtiums for new projects.

There are still significant pockets of caution. “These changes will take a long time to impact on the industry and GDP of Mexico,” says Francisco Ibanez, consultant at PWC in Mexico City. “We need to wait for the secondary laws that should be ready in April, because at the moment all we know is very top level, and we need to wait in order to know exactly how the private sector is going to participate, and how Pemex and CFE want to develop over the next few years.”

Thomas Mueller-Gastell, a partner at law firm Ritch Mueller in Mexico City, agrees: “There is a lot of uncertainty as to how things are going to play out – and uncertainty is not something that investors like. So it will take a little time to see how things will turn out and not only on paper – it will have to be shown how it works in practice.” Mueller even warns that the reforms will slow down projects in Mexico in the short term: “In the interim some projects will be put on hold. Agencies like CFE and Pemex will obviously have to wait before signing new contracts to see what the new regime will be.”

The need

The reform of Pemex is central to the liberalisation process. The need to reform is clear: according to Mexican government statistics crude oil production has dropped by one million barrels per day over the last ten years, while natural gas imports have climbed to 30% of consumption in 2012, compared to 3% in 2003. The US shale gas boom might account for some of that shift, but the picture in downstream consumption is equally dire.

Petrol imports account for 44% of consumption, up from 25% over the same period and petrochemical imports’ share has risen from 41% to 66%. Electricity costs in Mexico are running about 25% higher than in the US and the development of the country’s new, deepwater fields require a level of experience, expertise and capital that Pemex does not posssess on its own.

The greater potential profits in upstream mean that Pemex will focus on this area, according to PWC’s Ibanez: “Right now it’s more profitable to spend money in exploration – you have a cost of about $17 for every barrel extracted and you are selling for about $90 to $100. Downstream is more risky: you have to invest more and the margins are not the same as in exploration.”

Pemex will need to work with other operators, though, and this offers good opportunities for joint ventures and consortiums. “Most of these projects are capital intensive but the risks are very well known by the banks and the development banks,” he adds. “The banks like the Pemex [credit] risk so if you have that [with others] and a good project I think there could be a good project financing structure that the banks could participate in.”

Ibanez also says new sources of capital will be necessary: “We will need the participation of the international banks and the development banks because we are going to need a lot of money. We have very well-known banks in Mexico but there could be a lot of projects. We have also been talking to some of the international [oil and gas] companies and they have their own banks that support them. For example, would we have been in talks with companies from China and they have money they can bring to Mexico – also maybe the Japanese, Korean and European companies.”

Some producers are already staking out territory in downstream. Brazil’s Braskem, which is controlled by Odebrecht, has been investing in the country and Mexichem is already a large player. Midstream will be critical to the development of a modern, cost-effective infrastructure and new pipeline projects are expected to attract private sector expertise to a country that still relies heavily on tankers for distribution. 

Pemex wins freedom to dominate

Private sector companies have been working with Pemex under service contracts for years, though the experience of one player – Spain’s Enagás – provides a practical warning for companies looking to enter the sector. Enagás formed a joint venture with France´s EDF to bid on the Ramones II pipeline project. As the only bidder – and having satisfied all the price and supporting qualifications – it thought the tender had been successful, only for Pemex to scrap the entire procurement process.

“Pemex is not working in an open way right now,” says Enagás’ CFO Justo Garcia, “and, linking that to the energy reform, there needs to be care about the way they are implementing the energy reform,” says Garcia. “We suspect that Pemex will select one or two companies and invite them to bid. It´s not very transparent.”

Garcia contrasts bidding on Pemex with Enagás’ experience with the CFE. “CFE has open tenders and will attract five or six [private] companies to a certain project – and they will get the best price,” he says. “The CFE model works – over the last 30 years the largest corporations in the world have been attracted to this bidding process and in the end the country obtained the lowest possible price. The importance of honouring contracts and having contracts written to international standards is very important in providing private sector companies with an environment regarding law and security where they feel comfortable about where they are investing their money.”

Many also feel that the electricity industry offers a greater short-term opportunity than the oil and gas sector. The reforms should mean that private sector power plants will be able to sell their output more broadly. At present, large industrial users need to take equity in the plants from which they buy power under self-supply contracts.

A rash of new natural gas-fired power plants should increase competition and lower prices to the point where Mexico would become a player in energy-intensive industries such as smelting. But again, there is a caveat: Mexico will require improvement to basic gas and power transmission and distribution infrastructure before such an electricity revolution is feasible.

The smaller print

Vanessa Franyutti, partner at law firm Nader, Hayaux y Goebel, notes that a reform of Pemex four years ago exempted it from the Public Works Act and the Acquisitions Act – allowing the company to ignore the strict procurement rules to which CFE is subject. She says the secondary laws – and a new hydrocarbons commission that will also play a role in the private sector bidding process – will determine if Pemex will remain exempt, though she suspects the exemption will be retained.

However, Estaban Polidura, energy analyst at Deutsche Bank in Mexico City, thinks that Pemex is set on a path of evolution in corporate governance that will require it to adopt international best practices when engaging with the private sector. “Pemex needs to become much more institutional as a company,” he says. “It’s not that Pemex today is far away from what we see in other countries, it’s just that Pemex is used to working in a very specific way. But now they have to work with and compete against very transparent companies – listed companies – then Pemex will evolve to align with those kinds of reporting standards.”

For Polidura, the more interesting and important unknown that the upcoming secondary laws will address is the amount of incentive that will be available to private sector companies under profit and production sharing contracts: “What still needs to be discussed, and I don’t think it is an easy discussion, is how much of that variable proportion will be payable to the private companies,” says Polidura. “In other words, will that variable be capped? The regulator may want to allow variable returns up to a certain IRR [internal rate of return] and that decision is probably the most important unknown as far as the private sector is concerned.”