Reform in Mexico

June 2, 2014
While implementing energy reform of historic importance, the Mexican Congress should learn from a Latin American oil producer further along in the process.

While implementing energy reform of historic importance, the Mexican Congress should learn from a Latin American oil producer further along in the process. Brazil is reported to be considering changes to innovations that have proved too protective of its national oil company. Mexico should avoid the mistake.

Brazil began dismantling the monopoly of its state-owned oil company, Petrobras, in 1997 and has been rewarded for the effort. Brazilian oil production has increased by 1.5 million b/d since then—to 2.7 million b/d. Brazil has become an acknowledged leader in deepwater technology. Much of its offshore discoveries are in technically challenging deep formations below salt.

In 2008, the government suspended licensing while developing terms for participation with Petrobras in presalt exploration and development. It announced the results of its work in 2010 and offered a production-sharing contract for development of giant Lula field, a presalt discovery, when licensing resumed last year. Bidding by large, international oil companies fell well below official expectations for the Lula contract and for concessions not involving presalt targets.

Discouraging investment

The reason for subdued enthusiasm is clear. The presalt contract gave Petrobras automatic operatorship and a minimum interest of 30%. It also created a dominant role in operational decision-making for a new government entity, Pre-Sal Petroleo SA. The terms told international operators that their money and technology were welcome but that their influence was not. The move also told international investors that liberalization had limits in Brazil. Messages like those discourage investment.

Now Petrobras must meet challenging production targets with fewer inputs of capital and know-how from abroad than the government wanted. The company's project queue is daunting. At a May 15 seminar by Mayer Brown in Houston, Alexandre R. Chequer, a partner in the law firm, said, "There is too much oil for one company to develop." He reported officials are considering proposals to let international companies operate presalt projects, saying "I think the government realized it made a big mistake."

Mexico took a bold step last year when it removed barriers to foreign investment in oil and gas development and ended the monopoly of state-owned Pemex. Historic as it was, however, the step didn't fully accomplish reform. Much remains to be done in secondary legislation before Congress. Those laws will specify terms of participation, crucially including legal structures and financial details, for private investors from Mexico and abroad. They also will define the future role of Pemex.

As was the case in Brazil, treatment of the national oil company will say much about Mexican intentions. Will Pemex be more responsible than before for profits and losses but otherwise insulated from competition by a government hoping to continue using it as a national cash register? If so, reform will falter. Pemex under those conditions would remain bureaucratic, cash-poor, and technically deficient. And refusal to overhaul Pemex along with the legal framework would betray a crisis of commitment that would make investors wary. Deprived of capital and technology otherwise available, hydrocarbon resources in Mexico would continue to underperform their rich potential.

Constructive alternative

The constructive alternative for Mexico is to make Pemex a truly competitive enterprise. The government could continue to own a majority of the company. But its financial benefits would be the state share of Pemex profits, supplemented by taxes and royalties no higher or lower than those paid by other operators. Part of Pemex's equity would be held by private investors—Mexican and otherwise—and be freely tradable. The company would receive no guaranteed interest in Mexican projects. And it would be free to invest outside Mexico.

National oil companies of many countries work like that to varying degrees. For Pemex, though, the full suite of changes would be radical. Whether to make them is a test of political courage. Members of Congress should understand that not making them now means revisiting them later to keep reform from failing because the first plunge didn't go deep enough.