Landmark Energy Reform To Reverse O&G Sector's Fortunes

BMI View: We see the recently passed Mexican energy sector reform as the start of a fundamental paradigm shift for the country's hydrocarbon sector. While it does not challenge the national narrative that hydrocarbons belong to the State, working within these constraints the landmark bill takes majors steps to incentivise private sector involvement through the creation of a flexible contract system. Over the long term, we believe this will bolster investment and begin to revive the sector, reversing a nearly decade long decline in oil production.

On December 12th, the Mexican Congress pushed through energy reform, with the Chamber of Deputies (lower house) voting to pass the landmark bill just two days after it cleared the Senate. While the exact magnitude of the reform will be difficult to judge until secondary legislation is enacted in early 2014, we believe this bill is a game changer for the Latin American country's hydrocarbon sector. Indeed, after nearly a decade of plunging oil production, the reform could finally begin to draw the necessary foreign investment to bolster output.

As such, while we stress that it will take a number of years before results are felt in the country's production and reserves data, over the long term this is likely to be highly significant for the Mexican energy sector. The bill now will need to be ratified by a majority of the 32 local legislatures in order to pass. That said, given that the ruling Partido Revolucionario Institucional (PRI) and centre-right opposition Partido Acción Nacional (PAN) (both of which supported the bill) dominate the local level electorates, this is likely to be no major obstacle.

Historic Vote
Mexico - Chamber of Deputies, Vote on Energy Reform, %

BMI View: We see the recently passed Mexican energy sector reform as the start of a fundamental paradigm shift for the country's hydrocarbon sector. While it does not challenge the national narrative that hydrocarbons belong to the State, working within these constraints the landmark bill takes majors steps to incentivise private sector involvement through the creation of a flexible contract system. Over the long term, we believe this will bolster investment and begin to revive the sector, reversing a nearly decade long decline in oil production.

On December 12th, the Mexican Congress pushed through energy reform, with the Chamber of Deputies (lower house) voting to pass the landmark bill just two days after it cleared the Senate. While the exact magnitude of the reform will be difficult to judge until secondary legislation is enacted in early 2014, we believe this bill is a game changer for the Latin American country's hydrocarbon sector. Indeed, after nearly a decade of plunging oil production, the reform could finally begin to draw the necessary foreign investment to bolster output.

As such, while we stress that it will take a number of years before results are felt in the country's production and reserves data, over the long term this is likely to be highly significant for the Mexican energy sector. The bill now will need to be ratified by a majority of the 32 local legislatures in order to pass. That said, given that the ruling Partido Revolucionario Institucional (PRI) and centre-right opposition Partido Acción Nacional (PAN) (both of which supported the bill) dominate the local level electorates, this is likely to be no major obstacle.

Historic Vote
Mexico - Chamber of Deputies, Vote on Energy Reform, %

Struggling O&G Sector

We have long highlighted that energy sector reform is crucial for Mexico. Indeed, since hitting a high of 3.85mn barrels per day (b/d in 2004), the Latin American country's oil output has fallen steadily to just 2.94mn b/d in 2012, and without major changes, the country is looking at net importer status by 2019 according to our forecasts.

Game Changer Reforms Will Reverse Fortunes
Mexico - Liquids Production, Consumption and Trade

One (Not So) Small Step In Congress…

We believe the recently passed energy reform goes a significant way toward addressing this weaknesses inherent in Mexico's oil and gas sector. On the one hand, we acknowledge that the bill does not challenge the dominant national narrative that hydrocarbons belong to the State. Indeed, Article 27 restates that fact in no uncertain terms. That said, within these constraints - which we believe were far too politically-sensitive to successfully challenge - the reform takes major steps to not only permit, but actively woo foreign investment. Namely, it creates a multi-tiered system in which the State is given the power to grant a number of different contracts based on the level of risk involved in developing the resources. These include:

  • Profit Sharing Contracts - Under which foreign companies will receive a percentage of income, likely in cash.

  • Production Sharing Contracts - Under which foreign companies will receive a percentage of the oil itself.

  • Licenses - Under which foreign companies have full rights to the resources after they have been exacted from the ground.

  • Or any mixture of the above models.

Aside from opening the upstream sector, the bill also takes a number of other steps. These include: opening the midstream and downstream sectors to greater investment; the creation of a sovereign wealth fund overseen by the Central Bank to help create distance between the Mexican government's fiscal position and Petróleos Mexicanos (Pemex); and the granting of greater responsibilities (and powers) to various energy regulators. Moreover, in a last minute amendment in Congress, the bill strips the powerful oil-workers union of its five seats on Pemex's board. This move is highly significant not only because it may help to make the national oil company more nimble in its decision making, but also politically given that the PRI has long had ties to the union.

…One Giant Leap For The O&G Sector

These developments have encouraged us to take a more positive stance toward the sector. We stress that the impact will not be immediate. The first auction is unlikely to be held for at least a year and with at least several years needed for E&P firms to develop their new fields, we wouldn't expect to see a significant uptick in output before the middle of our forecast period, at best. That said, we believe this is a hugely significant step, which seems likely to attract considerable investor enthusiasm and transform the struggling sector significantly over the long term, bolstering its competitiveness with regional and global peers ( see table below).

Private Sector Role In Sector (Pre-Reform)
Norway Brazil Colombia Saudi Arabia Mexico
Concessions and partnerships with third parties Yes Yes Yes Yes No
State-owned companies with international upstream operations Yes Yes Yes Yes No
Partnerships In the downstream segment Yes Yes Yes Yes No
Participation of private or foreign companies in refining Yes Yes Yes Yes No
Multiple businesses and price liberalisation in fuels Yes Yes Yes No No
State owned company with international downstream operations Yes Yes No Yes Yes
Source: BMI, Senate of Mexico

While we had long expected energy reform, the extent of the changes - well beyond that proposed in the ruling PRI's original draft bill presented earlier this year - creates significant upside risks to our long cautious production forecasts, such that in the coming weeks we will likely be revising up our medium-to-long term oil output projects. This means that while Mexico's poor regulatory environment has seen it consistently come in at, or near the bottom of our proprietary risk/reward ratings for the last several years, the country could be set to start climbing in the near future.

Trailing The Pack
Latin America - Upstream Risk/Reward Ratings, Out of 100 (2013)

Some Questions Yet Remain

We caution though, that while we are far more optimistic than we were, there are still some issues that have yet to be resolved which are likely to impact the extent to which the recently passed reform transforms the oil and gas landscape in Mexico. Indeed, these issues will not stop us from revising up our forecasts to a certain extent, though suggest a more tempered approach is likely to be necessary for several quarters.

First, the details of how energy sector reform will be implemented remain uncertain. For example, information on local content requirements, how the bidding process will work, and even questions of environmental liability are all only likely to be hammered out in the next four months as the secondary legislation comes together. Even after that, the awarding of the first contracts under the new system will be key, as while the reform allows for a flexible contract system, it remains to be seen the extent to which the government will be adept at judging (and thus granting) sufficiently favourable contract terms to attract foreign interest. While this does not take away from the magnitude of the recent reform, it could have an impact on its implementation.

Second, questions over companies' ability to book reserves remain unanswered at this juncture. As all hydrocarbons below the ground belong to the Mexican state, booking reserves is technically prohibited. However, companies are allowed to show projected income from production sharing deals. It remains to be seen the extent to which companies will view the prohibition on booking reserves as a true deterrent.

Finally, we note that the centre-left PRD, which was strongly opposed to energy liberalisation, is likely to attempt to introduce a public referendum overturning the reform in the 2015 midterm. That said, while energy sector reform is still relatively unpopular by that time, our Country Risk analysts suggest it is unlikely to be repealed. Still, there is some scope for the possibility of a policymaking reversal to see some companies remain jittery.

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This article is tagged to:
Sector: Country Risk, Oil & Gas
Geography: Mexico, Mexico
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