E&D opportunities may loom in Mexico's natural gas industry

Mexico faces decreased natural gas production at a time when industrial demand in northern Mexico is skyrocketing. Will the country move towards some sort of privatization of its vast gas fields near the Texas border?

This question is being bandied about the country as President Fox seeks to find a way to supply the burgeoning demand by industry.

Legal framework

To understand the situation, one must step back 63 years when then President Cardenas expropriated large oil operators in Mexico and created Petroleos Mexicanos (Pemex) to operate the state oil and gas monopoly.

As expressed in the Mexican constitution, it means that the nation owns all subsurface minerals. Regarding subsurface hydrocarbons, only the nation may exploit them without regard for concessions or contracts. Furthermore, the public sector is exclusively in charge of the "strategic area" of petroleum.

Nonetheless Pemex used smaller and independent private contractors. Up to 1958, it even offered a percentage of production in these exploration contracts as part of their service compensation. But then a law ended the practice: the rule being that contractors may be paid only in money. Subsequent Mexican legislation and the North American Free Trade Agreement liberalized some energy activities, mostly in downstream business.

Current climate

Today investments in Mexican hydrocarbon industries are still controlled by the state monopoly itself as a form of protection against the large, international oil interests. Only Pemex may exploit gas.

This is against the backdrop of the current situation, in which:

1. Pemex gas production slipped 6.4% in May 2001 compared with the same month last year. It actually fell 4.48 bcfd and almost 1% from April 2001.
2. Gas imports, which annually provided 15% of Mexico's gas, more than doubled to 244.7 MMcfd in May, compared with 105 MMcfd in April.

Energy Minister Ernesto Martens declared this past July that by 2006, Mexico must boost its gas production from the current 4.7 bcfd to 12 bcfd. In fact, the sector needs $50 billion in investment over the next decade to keep up with industrial growth.

In 1999, Mexico only drilled 20-30 wells. By 2010 it will need to drill 500-700 wells/year to keep up with demand. For example, the electricity sector, largely gas-powered, needs to double capacity by 2008, requiring significant amounts of gas.

Yet the country is rich in gas reserves, some 30 tcf. Most of these massive gas reserves are located near the northern Mexican border where exploitation would be readily accessible and economical to international firms.

Unfortunately, the energy provisions of the Mexican constitution and NAFTA have ambiguities. They are "deliberate blurovers" made to protect the country. In light of current economic realities, President Fox's administration is attempting to review some of Mexico's nationalist petroleum policy and resolve the historical controversies in light of the nation's current needs.

The opportunity for independent oil and gas producers is to develop a strategy to deal with anticipated changes in Mexican law. In fact, there are meaningful signs that the Mexican government is willing to allow some foreign independent companies to participate in developing vast gas reserves in northern Mexico, the region that represents the largest source of dry gas.

Hopeful signs

Several promising signs have emerged in the past several months.

Rafael Munoz Leos, head of Pemex, in a presentation to the American Chamber of Commerce in Mexico on Mar. 16, 2001, noted, "We want to inviteellipsecompanies to collaborate in the exploration and development of gas fields." This was a very significant statement.

And at a May 24 lunch with business and community leaders of the northern state of Coahuila, President Fox promised to "open up" nonassociated gas to private investment. "We're trying to remove some bottlenecks, open some areas of energy to private investment, such asellipsegas, nonassociated with oil."

In gas reform, Fox added, "we could expect [substantial] investment ellipse apart from the guarantee and security of relying on that energy to help the economy grow." He further stated, "We have two initiatives that head in that direction." Prior to this, he had never mentioned any initiative on gas in public.

In analyzing whether Mexico would benefit from opening up gas exploration, Energy Secretary Martens emphasized that even Cuba found it in its national interest to open "oil exploration and development to the private sector."

These comments suggest that Pemex will show some flexibility in allowing foreign drilling companies to collaborate in the development of Mexico's dry gas reserves in the next few months. In fact, President Fox during a June trip to Japan tried to woo Japanese interest in energy deals. In addition to his prior overtures to American and Canadian investors, he commented, "We are pushing Congress to open private investment in natural gas, a key element ellipse for the economy, and this is an area for investment opportunity."

Political factors

It is anticipated that because Fox's party is in the minority in both legislative bodies, the two-thirds legislative process to amend the constriction is not a realistic alternative. If action becomes required, most observers believe that at most the current government will propose legislative action after requiring a majority vote.

This kind of nonconstitutional amendment approach to foreign investment will reflect a continuation of the Mexican government's success in opening certain sectors of the gas industry, such as the transportation, distribution, and storage aspects, without implementing the formal constitutional amendment procedures.

A similar maneuver could lead to a presence in the Burgos basin, across the border from Texas, where unlike other major supply basins in Mexico, gas production is not associated with petroleum. There is a possibility that the Mexican government and people might decide to make a distinction between associated and nonassociated gas.

Implementation options

Although the Fox administration has given little detail on how it plans to bypass the constitutional ban regarding foreign involvement in the exploration and development of hydrocarbons in Mexico, it is clear that certain alternatives are under active consideration.

At the very least, service contracts-under which all foreign companies currently operating in Mexico must work-might be enhanced so that payment is linked to performance. This would give companies the opportunity to make money if work is completed ahead of deadlines or if other checkpoints are met or exceeded, and not require legislative action.

It has been rumored that Pemex might try to launch a "Multiple Services Agreement" in the Burgos basin. This is reported to be a 20 year program for the production of 12 blocks of dry gas wells. These blocks may be put out for bid as early as second quarter 2002. In doing so, this would be the first incentive-based contract developed by Pemex.