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What Has Mexico Gained with its New Energy Model?

What Has Mexico Gained with its New Energy Model?

Image removed.Written by: Mujeres en Energía*

Last December marked the fourth anniversary of the constitutional reform aimed at modernizing Mexico´s energy sector.  Society has yet to see its benefits. Implementation of the new energy model is in its initial stages. It must be allowed to progress, so that its benefits can come to fruition and be felt by Mexico’s citizens.

Why was the Energy Reform Necessary?

Mexico reached its peak oil production in 2004, at 3.4 million barrels per day (mmbd), dropping to 2.5 mmbd by 2012. Natural gas production underwent a similar evolution, falling from 7,030 million cubic feet per day (mmcfd) in 2009 to 6,384 mmcfd in 2012.

Total hydrocarbon reserves, which represent future production, decreased by 12 percent from 2003 to 2012. In addition, more than half of the country's prospective resources are unconventional or in deep-water.

Increasing production to the required level to meet national demand is a major challenge that entails large investments, cutting-edge technology, and several years to reach commercial production.

Mexican refineries were designed to process light crude oil, yet the country produces mostly heavy oil. Refining heavy oil yields large quantities of fuel oil, which has low market value and is not profitable.

Prior to the energy reforms, retail prices were controlled and involved costly subsidies, generating a significant strain on Pemex. In addition, limited domestic production increased dependence on imported fuels. Pemex, as sole operator, was responsible for meeting national demand at all cost, even to the detriment of its own finances.

Pressure to meet this demand meant that Pemex did not invest what was required in other segments of the sector, including storage infrastructure and transport pipelines. Most gasoline and diesel were transported by truck.  Mexico maintained an average of only three days of inventory, putting security of supply at risk.

The monopoly model also showed deterioration in retail. Natural gas shortage led to critical alerts.  The number of gasoline stations did not increase in step with demand, service was poor, and mechanisms for controlling quality and volume were inefficient, generating opportunities for abusive practices at consumers´ expense. The energy security crisis was real.

In this context, it was urgent to move to a framework that made room for the participation of both State and private companies along the value chain, to the benefit of end-users and consumers. Pemex needed the flexibility to form partnerships that would allow the company to meet national demand while at the same time increase security of supply of oil products, at market prices.

The institutional framework of the energy sector needed to be redesigned and strengthened for markets to be created. Regulatory agencies were required to guarantee the legal certainty required for viable energy projects.

Therefore, the National Commission of Hydrocarbons (CNH), the Energy Regulatory Commission (CRE), and the Agency for Safety, Energy and Environment (ASEA) became the technical backbone of the new regulatory framework. Both Commissions are autonomous and operate independently from the government as well as the industry.

The Reform’s Objectives for Hydrocarbons

The Constitutional amendments to articles 25, 27, and 28, that were approved in 2013, maintained hydrocarbon exploration and extraction activities as strategic for Mexico, and allows the State to assign them to Pemex and/or third parties through contractual agreements which stipulate the terms of their development to ensure their sustainability. Private investors may participate at any stage of the value chain, directly and through alliances with Pemex. Any company that fulfils the requirements established by regulators and other authorities can potentially conduct business, investing and assuming risk, from the wellhead to the burner tip including retail.

Furthermore, the reform made a radical change in the way oil wealth is managed, creating the Mexican Petroleum Fund for Stabilization and Development (FMP). The Fund was created to ensure that royalties are managed wisely to ensure that current and future generations will be able to benefit from the country's fortune. FMP transfers to the country's budget are capped at 4.7 percent of GDP, while additional income is invested in long-term savings funds and specific purpose funds, such as education, innovation, and development. This management change for oil revenue is marked by transparency, seeking to simplify the way the general public can access information on total revenue funds, as well as a breakdown of resources generated from each Pemex assignment and/or oil contract.

Benefits from the Reform

Mexico has already begun to reap the benefits of the new energy model, but the Mexican public has not perceived them yet. Reforms of this breadth take many years to be fully implemented and, in the case of Mexico investment, commitments are in their initial stages. This is one of the reasons why the general public has not yet felt the benefits of the reform, since the model needs to be consolidated in order for the benefits to materialize. Therefore, it is necessary to provide legal certainty and give clear signals of the investment requirements in the sector. The five-year hydrocarbons exploration and extraction plans, as well as the five-year infrastructure plans published by Mexican authorities are especially relevant in this regard.

a) Exploration and Production

Hydrocarbons exploration and extraction is a strategic activity for the State. Pemex received its assigned areas in Round Zero, the first bidding round invoking only Pemex, in which the company chose the areas it wanted to keep under its own management. Pemex may form partnerships for the exploration and development of these blocks or develop them alone. This ability to form partnerships is especially relevant for deep-water, as no company in the world wants to take on this challenge alone. Pemex can also migrate its assignments to new types of agreements and look for partners to participate in subsequent bidding rounds organized by the State.

The Government can now share the risks associated with the oil business by contracting third parties through tenders. The State selects the areas to be offered up for bid and establishes the contracts’ terms and conditions. The bid participants submit their offers in a fully transparent and competitive process.

In this new environment, Mexico has awarded over 100 contracts in only three years. Currently, more than 70 oil companies operate in Mexico, complementing the work of Pemex. They have committed resources to explore and discover new oil and gas reserves and increase production over time. The first barrel of oil from a deep-water development normally happens between 4 and 10 years after having executed a contract. This is one of the reasons why production continues to fall; there was not a portfolio of projects in progress when the reforms were passed. As a result, the impact of the new investments in exploration and production by the new participants will not be evident until the next presidential term.

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The expected investments for these contracts will be over 162 billion dollars over the next 35 years, an amount that Pemex would not have been able to commit to alone. Pemex will continue to be the largest oil operator in the country, due to the assignments it received in Round Zero and the contracts awarded in the tenders. Pemex has competed for and won 14 contracts, both directly and in association with other companies.

In keeping with the experience of most oil-producing countries, participation of several oil operators will create new jobs, develop suppliers of goods and services, and demand new skills of Mexico’s labor force. This will promote a more efficient use of resources.

Mexico has already received investments of 2.5 billion dollars from seismic surveys. The geological information is very valuable, since it allows a better selection and assessment of the areas to be put up for bid. This is a concrete benefit from the energy reform that is evident to industry if not the general public.

b) Natural Gas

The decline in gas production and the increase in demand have resulted in higher imports of natural gas.

Mexico has two sources of imports: a) pipelines from the United States, fortuitously the natural gas market with the most competitive prices globally, and b) liquefied natural gas (LNG) from the Altamira and Manzanillo terminals, which is a more expensive alternative but which provides energy security.

In 2012, there were 7,060 miles of gas pipelines in the national network, limited in both capacity and coverage. It had no redundancy and many bottlenecks; thus, critical alerts -targeted shortages- affected the supply of natural gas for CFE and the industry, with sizable economic repercussions between 2011 and 2014. 

The natural gas market has been open to private investment since 1994, but prices did not reflect scarcity or the real costs of the molecule. This inhibited market competition and limited economic incentives for private investment in infrastructure. The energy reform led to an opening up of natural gas pricing mechanisms, allowing for market prices to be determined by with the international sources of supply.

As a result, new companies will have an incentive to participate in the market, increasing competition in all segments of the natural gas sector. Power generation companies and industrial consumers now have options for services from competing suppliers, and the supply of natural gas will become more reliable as more infrastructure is brought into service. There have not been any new critical alerts since 2014.

The impact on electricity prices and industry competitiveness will be increasingly evident, but it might take more time than anticipated at the beginning of the reform process.  However, there are already some tangible results for the natural gas industry. Investments of almost 12 billion dollars have been announced, to construct over 7,400 miles of new gas pipelines, in some cases connecting areas of the country that had no previous gas supply sources. These projects have direct impact on job creation and a clear contribution to economic development in Mexico.

c) Petroleum products

One of the biggest worries for any society is the availability and price of gasoline and diesel. For Mexico, this is especially complicated given its dependence on imports and a long history of subsidized prices, increasing demand, inefficiencies of Mexican refineries, and insufficient domestic production. Imports are priced at international prices, so the depreciation of the peso therefore directly influences the final price of the fuel. Exchange rate sensitivities make it impossible to subsidize prices without risk of a major negative financial impact on the country’s finances

Mexico has six refineries with a total processing capacity of 1.615 mmbd. Of these, only three have been reconfigured (Minatitlán, Madero, and Cadereyta) and can process 750,000 barrels per day; therefore, investment is still necessary to convert the three remaining refineries (Salamanca, Tula, and Salina Cruz) with an installed capacity of 865,000 barrels per day.

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Gasoline and diesel prices must be set by market conditions without subsidies. Subsidies have a negative effect on the economy and end up benefitting car owners. They also blur the signals on the environmental externalities of its consumption. In simple terms, they are very expensive. In 2012, gasoline subsidies cost $220 billion pesos (1.4% of GDP). Subsidies distort energy consumption of any product or service, leading to waste and overuse.

One of Mexico’s new energy sector’s main objectives is to have markets with accurate price signals for supply and demand. In this specific case, fuel prices are determined by the market, albeit still an imperfect one. This is the only way Pemex will be able to find partners to modernize refineries, without the losses it incurred in the past. As national refineries are modernized and new investment arrives for the country's logistics infrastructure, the cost of supplying gasoline and diesel will be lower and efficiencies will be passed on to the final consumer through lower prices.

Transport and Storage
Saturation and scarcity of transport and storage infrastructure has been one of the biggest obstacles to competitiveness in the liquids segment. It is arguably the biggest obstacle to the development and consolidation of a robust fuels market. Mexico has an average of three days of gasoline reserves, while other OECD countries have an average of 30 days.  Mexico’s logistic network was built under a rationale for moving the refining capacity; its planning did not seek serving demand centers efficiently because price policy was based on a single nationwide price.

With a new sector framework, having capacity and coverage throughout the country at a competitive price is crucial. New pipelines and storage terminals are urgently required and have been made possible under the new regulations.

More than 50 private projects have been announced. The investment is estimated to be over 2.5 billion dollars. These projects respond to SENER’s strategic reserves policy requiring the marketing companies of gasoline, diesel, and jet fuel to keep minimum reserves.

Access to Pemex logistics infrastructure has been limited. Pemex's open seasons for storage and pipeline capacity have either been delayed or have had lackluster results. The primary reasons include: Pemex and the regulator’s learning curve, and Pemex’s reluctance to embrace competition. Companies have only been able to reserve a very small percentage of Pemex's logistics infrastructure to date. Only one company gained access to its infrastructure during the first open season to import gasoline and diesel.

CFE initiated a process to offer its plants spare storage capacity to third parties. Most of its plants have shifted from liquid fuels to natural gas because it is less expensive and has less GHG emissions. 

Open season processes for spare capacity, property of Pemex, CFE, or any other logistics company involve setting tariffs and other terms and conditions for users. 

Before the reform, service station franchises were limited by state and municipal regulations in number and location, including control of a nationwide price. The model actively prevented competition. Consequently, the number of gas stations in Mexico is relatively low compared to other OECD countries.

After decades of just one brand -Pemex-, the new model has allowed more than 30 new brands of service stations to be opened. There are currently 2,500 service stations operating under a different brand than Pemex. This brings about competition in quality of service and perhaps most importantly, total transparency of volumes bought and sold. The market is in its early stages, as the vast majority of new service stations still sell gasoline produced or imported by Pemex.

The full benefits of having other brands and operators will be evident to the general public once there is true competition in the logistics of liquid fuels -new storage, transport, and distribution infrastructure-. This will translate into more efficient costs and potentially lower prices for consumers, in addition to job creation, particularly during the construction phases. With an increasing number of service stations, competition will provide incentives to be more cost-efficient and reflect this in their final prices.

Pending Issues Concerning Consolidation of the New Energy Model

a) Coordination, regulatory   independence and improvements

Many significant infrastructure projects have been announced since the reforms were passed. Their construction will take time and must comply with a series of federal, state, and municipal requirements, which implies long periods of time and complex processes. The three levels of government must review these procedures, simplify and align them. Transparency and clarity of regulatory requirements is critical for the success of these projects.

The success of the energy sector regulators will depend on their ability to act independently, and with technical and financial autonomy. Regulations need to generate incentives for the sector to develop, at the same time avoiding overregulation.
It is important to raise the legal status of ASEA to the same level as CNH and CRE - a more robust constitutional legal status with autonomy from public policy, with its own budget. Currently the agency is dependent upon the Ministry of the Environment (SEMARNAT), which could compromise the agency’s independence.

Energy regulators have been open to listening to industry and use international best practices but there are still many issues to be resolved for the system as a whole. One important example is the implementation of a one-stop-window approach, to submit information requirements for all required permits. The permitting process should take place in parallel and not sequentially as it is currently. Regarding the required reporting, clear and consistent criteria should be developed for the information to be submitted to all regulators, so SENER can reduce discretional behavior, unnecessary paperwork, and bureaucracy.

b) Pemex's new role

The new energy model objective is to strengthen Pemex participating in the market with the same rules of its competitors and partners for the new contracts obtained alone or with partners through the bidding process. The new framework allows Pemex to partner and share the risk as the industry does worldwide which was impossible for Pemex in the prior monopoly framework.

Implementation of the new model unfortunately came at a time when petroleum prices dropped significantly, going from $100 dollars per barrel in June 2014 to less than $30 dollars per barrel in January 2016.  Pemex, as well as all other oil companies, significantly reduced its budget but Pemex had not built a portfolio of projects during the years of high oil prices.  As a result, its performance has been negatively impacted.

The success of the new Mexican energy model requires, among other things, a strong national company that operates efficiently with strong positive financial results. Pemex’s new mandate is to generate value in a competitive market. The company is subject to the same regulations and tax burden as its peers, with independent management and budgeting from the federal government for the new contracts as indicated earlier, but it is not the case for the assignments under Round Zero. This situation has been one of the impediments to improving Pemex’s financial results. It is also necessary to strengthen PEMEX's corporate governance and bolster its resources for investment in projects that are strategic to its financial performance.

The new energy model has allowed Pemex to be the company with the most contracts through tenders, the migration of assignments and farm-outs, putting Pemex in a position to restore its oil reserves. Results will materialize in the medium and long term if the speed at which things have been happening is unchanged.

Strengthening Pemex's corporate governance, as well as the control mechanisms and accountability, is an urgent matter. Pemex’s results will be improved if its management follows financial and commercial objectives, rather than the political objectives of the government.

c) Social Impact and Consultation

The new model establishes sustainability as a critical variable to be considered in developing energy projects. The government must carry out a Social Impact Study ahead of holding a bid round and companies must submit a Social Impact Assessment (SIA) in order to determine possible impacts, both negative and positive. They need to offer mitigation measures and guarantee that the communities receive real benefits. In addition, the rules reiterate the obligation to carry out a Prior Consultation with Indigenous Communities.

The sustainability approach in energy projects entails a learning curve for the stakeholders involved, who will need to assess the social impact of its activities. There is no consultation law in Mexico, SENER developed protocols for each type of project. However, local stakeholders' lack of familiarity with the new legislation, and other authorities' both local and federal unwillingness to assume their responsibilities in terms of the challenge that this implies, have resulted in projects being delayed and over budget. An institutional structure must be created at both a federal and state level, to respond timely to this requirement.

The rules to prepare SIA have just been published by SENER.

d) National Content and development of industry suppliers.

The new framework includes encouragement for the participation of local suppliers of goods and services required by the energy sector. The law establishes that percentages of national minimum content will be determined for specific type of contracts. The goal is to reach a national content average for hydrocarbon exploration and production contracts of 35 percent by 2025.

The Ministry of Economy (SE) is responsible for developing the methodology; it includes six variables: goods, labor, services, training, technology transfer, and infrastructure. The Ministry of Energy establishes requirements for national content in contracts according to the type of project and its stage of development. Operators are required to submit their reports with the applicable documentation.

In addition, the SE has the mandate to develop, implement, and execute a strategy to develop national suppliers. Successful implementation of this strategy would result in a platform to export Mexican goods and services to the energy industry worldwide.

Final Considerations
The new energy model is a paradigm shift for the country.  Implementation has been quick and successful with a long-term vision considering the magnitude of the legal and regulatory changes required. However, it is critical to continue with the current model to ensure its success.

Investment already contractually committed to by companies in exploration and production contracts is one of the many benefits for the next Federal Administration. These investments will positively impact economic growth, jobs, and technological development in Mexico.

Infrastructure projects such as natural gas pipelines, fuels storage and transport pipelines, in areas with no previous access to hydrocarbons, will kick off economic development, increase non-energy-sector industry competitiveness, and create jobs in new areas of the country. Transport, storage and fuel distribution projects are crucial and must be finalized as soon as possible for Mexicans to enjoy the benefits of increased efficiency in logistic operations that will eventually result in lower prices, and quality of service to meet their energy needs.

In summary, contractually agreed investments throughout the entire value-chain will materialize during the next federal administration. These investments imply new good-paying jobs, the development of a national goods and services industry for the energy industry worldwide, as well as an efficient and stronger Pemex. The Mexican energy sector is subject to principles of transparency, sustainability, and respect of communities’ rights.

Implementation of the reforms must continue. Its benefits and obligations are set in contracts and agreements signed between the State and private entities, as well as among private individuals, following the principles defined by the State as a regulator. Honoring contracts is a sign of seriousness and a source of legal certainty that countries worldwide require to thrive and grow.

A change of direction at this time would be the end of legal certainty. The majority of the criticisms to the new framework focus on the drop in national oil and gas production and high fuel consumer prices. This situation is primarily due to the old model, the transition to the new regulatory framework, the collapse in international oil prices, as well as the depreciation of the peso. The new model provides a structural solution that due to time constraints has not been consolidated. It is important not to lose sight of the situation that led to the reforms and the cost to the country and its citizens. Balancing costs and benefits and profitability are the reason why the former system no longer exists anywhere in the world.

Implementation and deepening of the new Mexican energy model is crucial for the energy sector to become a source of competitiveness and economic development. Authorities, society, and industry must keep an open and constructive dialogue to continuously improve processes.

*Mujeres en Energía (Women in Energy) is a group of women with extensive experience in the energy sector in Mexico and in the globalized world and, among others, includes: Alma Porres, Aurora Pierdant, Benigna Leiss, Catalina Delgado, Jimena Marván, Lourdes Melgar, Lucía Bustamante, Maricarmen Medrano, Marisa Hurtado, Meney de la Peza, Monica Bøe, Montserrat Ramiro, Angelica Ruiz, Lorena Patterson, Rosanety Barrios, Silvia Hernández, Tania Rabasa and Vanessa Zárate.

The opinions and statements expressed in this work are exclusively opinions of the authors, and do not necessarily represent the official position of the organization or institution to which they belong.

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