Michelle Michot Foss
University of Houston/Michot
Foss Ltd.
Houston
If we look ahead 10 20 years, what do we see for natural gas in Mexico?
Will U.S. natural gas continue to play a role? Or will Mexico maintain the resumption of its role as a net exporter? Will foreign companies participate in the value chain from resource development to end use? Or will the pace of reform in Mexico's energy sector stagnate?
OPTIMISTIC SCENARIO
An optimistic scenario for natural gas in Mexico might go something like the following:
Mexico makes a commitment to natural gas for environmental reasons, and a strong economic rebound boosts demand even more. Initially, Mexico's state petroleum company Petroleos Mexicanos is not able to meet all of the new demand for gas with domestic supply. To make up the shortfall, Pemex relies on imports of natural gas from the U.S. and, via backhauling, Canada. Demand growth for natural gas is such that every proposed crossborder pipeline is constructed so that capacity increases from the current 960 MMcfd to nearly 2.3 bcfd. Crossborder lines are almost always full, so Mexico is taking almost 1 tcf/year of gas imports in addition to its own increased domestic gas production.
Meanwhile, in order to maximize crude oil export revenue, Pemex directs all of its investment dollars toward expanding production in Mexico's rich Reforms Campeche basins. Importantly, U.S. and other foreign companies are participating as partners with Pemex in these upstream investments as a consequence of the North American Free Trade Agreement (Nafta) and the strengthened resolve to continue economic and energy reforms in Mexico. The result of this infusion of cash and technology is that Mexico is able to bring its oil production up to 4 5 million b/d.
Because most of Mexico's gas production is associated with crude oil, and most of Mexico's oil production is from Reforms Campeche, eventually natural gas produced in Mexico is plentiful. Ultimately, Pemex and its partners expand production of nonassociated natural gas as well, particularly in northern Mexico. With an abundant natural gas resource base and the efficiency gains in its upstream businesses, Pemex begins sustained exports of natural gas to the U.S. In this future scenario, U.S. and other foreign companies are building and operating natural gas processing, transmission, and distribution facilities with Mexican partners to meet growing demand for gas in Mexico as well as expanding markets for Mexican gas in the U.S.
A beautiful future? Certainly. The key questions are: How real is this outlook? How long will it take? Events in Mexico during the next year to 18 months will provide some clues about future outcomes. World crude oil prices will also be an influence. Even with a new North American trade regime, the investment risk is substantial for U.S. and other foreign companies who have targeted or made a commitment to Mexico as a potential area of interest.
For now, I will offer some observations that may shed some light on the complexities of natural gas in Mexico and what it might take to achieve the most successful outcome.
SUPPLY/DEMAND FACTORS
The natural gas market in Mexico is characterized by an array of conflicting factors for demand and supply. A thumbnail sketch from a more detailed study, is provided here.
Demand for natural gas in Mexico is influenced by overall economic growth. Natural gas consumption in Mexico is linked to gross domestic product (GDP), as might be expected. Natural gas consumption is also affected by the real price of natural gas, but with a lag effect. The effect of fuel oil prices is more complex, because while switching capacity exists, costs of switching are high.
Of the approximately 1.4 tcf of natural gas consumed in Mexico in 1992, most was used by petrochemicals and non petrochemical industry applications, or in field operations and production.
Most of the gas imported by Mexico has been used to satisfy incremental demand in the northern states, particularly Nuevo Leon, with its concentration of industry around Monterrey.
The domestic supply of gas in Mexico has been constrained by the slow pace of upstream investment, a consequence of the economic dislocation suffered by Mexico during the late 1970s and early 1980s. Excessive fiscal deficits strangled critical investments. Mexico's economic problems worsened when world oil prices collapsed in the 1980s.
More than 80% of the gas produced in Mexico is associated gas, and more than 70% of Mexico's crude production is from Campeche Sound. With only one main transmission line to carry gas from south to north, the problem in Mexico has been how to satisfy natural gas customers in the northern states, particularly large industrial users who want better service and prices. Favorable U.S. prices and supply and ample and expanding cross border transmission capacity, led to the gas import strategy used by Pemex since 1985.
Beginning in 1989, demand for natural gas in Mexico outstripped supply, triggering a noticeable increase in gas imports by Mexico. After climbing to more than 110 bcf in 1992, natural gas imports by Mexico are expected to total 40 50 bcf in 1993. Based on Pemex data through June 1993, gas imports were averaging about 120 MMcfd, compared with about 250 MMcfd on average for 1992 (Fig. 1). Since June, gas imports by Mexico have frequently been below the 100 MMcfd mark. Mexico averages about 3.6 bcfd of production (Fig. 2). Gas production in Mexico has increased in recent months in conjunction with expanded crude oil output.
MEXICAN ECONOMY THE CULPRIT
Many in the U.S. gas industry were dismayed when gas imports by Mexico began to decline in 1993.
Many will also be dismayed in 1994 as imports remain weak, or as Mexico continues to move gas into the U. S.
The major reason for this reversal is weakness in Mexico's gas demand. For at least the past year, Mexico has been in a recession, a concept that is generally unacknowledged in that country. GDP growth for the first 9 months of 1993 was only 0.5%. Hardest hit has been Mexico's manufacturing, textile, and agricultural sectors. The service sector continued to expand. Consumer purchases have been slack, discouraged by interest rates in excess of 20% and higher taxes. The cause of the current malaise has been adjustment to much needed economic reforms and the fiscal and monetary policies designed to cool an overheated economy. Also, the extensive privatization program since 1988 in Mexico's non energy industries exacerbated the economic downturn.
While the privatization program has been well received outside of Mexico, it has entailed costs within Mexico. In some instances, job losses and plant closings were necessary to Streamline operations and enhance competitiveness. For the most part, it appears that the adjustment process simply required more and is taking longer than anticipated. In addition, while privatization is often viewed as the best remedy for inefficiency in state dominated economies, it also eliminates a traditional source of capital for reinvestment: the government. Without a ready replacement, production expansion has come up short.
Gas requirements in Mexico's biggest gas consumption sector, petrochemicals (Fig. 3), were depressed by the decline in domestic demand as a result of the soft economy and weak world chemicals markets. More sensitive has been the effect of new transfer pricing strategies at Pemex for internal and external transactions. The upward pressure on feedstock costs as a result reduced profitability, and therefore output, of many chemical operations.
The upshot of Mexico's weak economy is excess capacity in its energy sector. In October, Pemex had excess gas supplies of about 100 MMcfd. Pemex officials then stated that this gas would have been exported to the U.S. but for technical problems. However, by December, Mexican gas had begun flowing into the U.S. Pemex officials had estimated that Mexican gas would be flowing into the U.S. during first half 1994. As of late December, Pemex was exporting all of the 100 MMcfd of excess gas it had in October. Pemex sees opportunities in U.S. markets, now and in the longer term. As astute U.S. industry experts have noted, companies interested in building long term relationships will view Pemex as a customer and as a gas buyer and seller.
FUEL OIL THE KEY
How long the situation will last depends on the pace of recovery from this recession and how the Mexican economy performs the next 2 years.
As the forecast horizon lengthens, storage capacity and production of nonassociated gas become more important. Over a period of 1 or 2 decades, however, it is the timing of investment in gas fired electric power generation facilities that will be crucial to the demand side and to foreign interests. It is here that Mexico's "fuel oil problem" shows up so acutely.
Resid is the dominant fuel for electric power generation. Fuel oil use in electricity production has been a target of environmental concern, especially in the heavily industrialized population centers. More than 50% of generation capacity is fuel oil fired, based on 1991 data from the Secretaria de Energia, Minas, e Industria Paraestatal (Semip), compared with 13% for natural gas. Clearly, the incursion of natural gas into power generation would afford a large potential for expanding natural gas use. The difficulty lies in the loss of a major domestic market for Mexico's high sulfur fuel oil, which has limited value, if any, outside of Mexico.
Mexico produces large quantities of high sulfur Maya crude but has limited downstream capacity to produce lighter products that are needed. The dilemma is how best to remedy the problem. One solution is to expand coking and desulfurization capacity in Mexico but at an extremely high cost. In addition, the sulfur content of petroleum coke would still be about 12%. At least one of the proposed refinery expansions, at Salina Cruz, seems to have been approved for a 65,000 b/d coker.
Another is to install scrubbers at electric power plants, also at an exorbitant cost and with negative implications for gas. The difference between these two solutions lies principally with the burden of payment and who should bear the responsibility, Pemex or Mexico's Commission Federal de Electricidad (CFE). Thus, not only is the problem an economic one, but a political one as well, involving Mexico's largest parastate organizations. A third solution is a joint venture on downstream projects, such as the Pemex/Shell Oil project at the Deer Park refinery in Texas. Maya crude is used as feedstock and lighter products are exported back to Mexico. With time, more collaborations such as this one may emerge and may offer Pemex a way to leverage the cost of cracking the bottom of the barrel.
A critical point to make here is that export crude prices for Mexico are linked to the differential between high and low sulfur fuel oil. Therefore, exports of high sulfur fuel oil to the U.S. affect crude prices in a big way.
Until Mexico finds an adequate solution, the pressure to consume heavy fuel oil domestically will remain because it cannot be used to enhance export revenues. The fuel oil problem will effectively cap natural gas market share, even with the addition of gas fired independent power and cogeneration projects. Finally, these dynamics actually may work to encourage Mexican exports of natural gas. This is because, in contrast to Mexico's fuel oil, Mexican natural gas does have export value. Setting aside environmental concerns, a case could be built for using the lower value product at home, while sending any excess gas supply into the U.S. market.
OTHER LONG TERM FACTORS
There are, of course, many other considerations in assessing longer term natural gas demand and supply in Mexico, and consequently North American natural gas trade.
One that has received an enormous amount of speculation and discussion is Mexico's ability to stimulate domestic gas production. Does Pemex have adequate technology, capital, and managerial skills to accomplish its goals? The general assumption is that it does not, and that foreign capital and know how are needed. The usual conclusion has been that these constraints will stymie domestic natural gas production and thus make imports from the U.S. more attractive. This argument is fine as long as U.S. gas prices are low (Pemex uses U.S. gas prices to set its own). Higher gas prices, low world crude prices, and the fact that environmental benefits of gas seem to be valued more highly in the U.S. may provide Pemex a rationale to develop gas for export.
As to whether Mexico needs foreign technology and know how, this is true but in specific ways and for particular problems. A technology transfer process is taking place now and has been for some time. Pemex is gaining upstream knowledge from multinational companies interested in some day breaking into the exploration and production business: from service companies interested in obtaining contracts; from equipment suppliers with niche markets; from gas transmission companies, producers, marketers, and brokers who have been selling and are now buying gas and providing transportation; and from investment bankers. The knowledge flow is manifested in the sophistication Pemex has shown in taking advantage of North American gas market conditions. The payback is in business relationships.
Does Pemex need investment capital, and does it need a comprehensive upstream program for gas? Yes, and sort of. Mexico eventually needs to test and develop its nonassociated gas resource base, but, like other North American producers, the price needs to be right. While some investment capital should be directed to the upstream, Mexico could also gain from stemming gas losses. Pemex alone consumes about a quarter of production as a result of field loss and stimulation, transmission loss, flaring - which has been reduced dramatically over the years and the like. Pemex could invest in improvements in its own system and free up quite a bit of additional gas for other uses and would have an incentive to do so if the cost is less. With a focus by Pemex on its own system, opportunities for foreign companies are there, but they are more difficult to ascertain and are more specialized.
CONCLUSIONS
This leads me to the following conclusions about the prospects for natural gas in Mexico:
- If one looks only at the prospects for natural gas imports, then a reasonable conclusion is that Mexico could continue to import some gas so long as prices are favorable and so long as the largest component of demand, petrochemicals, remains at least stable. This latter condition is uncertain. As petrochemicals operations are rationalized and privatization of some facilities proceeds, gas feedstock requirements could stay flat or even drop until the petrochemical sector recovers. The expectation at Pemex is that, at some point, a permanent counterclockwise flow of gas will develop with Mexican gas reentering the U.S. through northeastern Mexico. Mexico will continue to take imported gas for use in its northwestern markets indefinitely, as netbacks. There is always the possibility, of course, that Pemex will devise a way to move its own gas to Pacific Coast markets in Mexico, perhaps through the U.S.
If the question is not simply whether Mexico would continue to import gas, but whether import volumes will increase and whether the natural gas market in Mexico will expand, my conclusions are different:
- Conversion from heavy fuel oil to natural gas in Mexico's electric power and non petrochemical industries would have the greatest impact on gas import volumes. Outside of petrochemicals, Mexico's current usage of gas is quite limited. Consequently, the problem Pemex faces in finding markets for the displaced high sulfur resid poses the greatest constraint to increasing the levels of natural gas imports by Mexico. This is not to say that opportunities will not arise elsewhere in the gas stream, for example in distribution or vehicular transportation, but they will represent a smaller share of the market.
- Apart from the constraint posed by fuel oil use, for the time being there appears to be a rational quantity of natural gas imports to meet incremental demand. Cross border transmission capacity almost doubled in 1992, from 559 MMcfd to 959 MMcfd (Fig. 4), but imports by Mexico peaked at only, 300 350 MMcf/d. Indeed, new cross border capacity served more to introduce competition to transportation rather than to increase imports of gas. While some analysts would fill this capacity with gas exports to Mexico, it is important to remember that gas will flow either way depending upon comparative advantage. Pemex officials speak of "border arbitrage" - movement of gas back and forth across the border as Pemex takes advantage of price and volume differentials.
- The reentry of Mexican gas to the U.S. was spurred by high gas prices relative to crude prices. A severe winter in the U.S. and a big burst of the gas bubble would preserve the northward flow and probably raise some concerns about U.S. gas exports.
PROSPECTS
The overall prospects for gas in Mexico are good, but getting to that most optimistic scenario will be a bumpy ride. Opportunities for foreign participants will exist but must be pursued with careful strategies and patience. Optimistic outcomes are possible but not necessarily what people in the U.S. want or expect.
The operating and policy environments for energy in Mexico are changing. Views in Mexico vary widely as to the extent Nafta win stimulate industrial production, exports, and job gains, and how long it will take to feel the effect. The bet among leading experts in the U.S. and Mexico has been that implementing Nafta would help preserve economic and energy reforms achieved thus far and encourage further reform. Presidential succession politics and post election cabinet selection and public opinion win be important in determining whether money gets left on the table. Implementation of Nafta is no guarantee for energy, but it certainly will help. It is safe to say that the best opportunities for gas exports to Mexico lie with major planned projects, and the best prospects for these projects lie in how Nafta implementation and presidential succession unfold.
Internal and external conflict surrounding energy in Mexico has been extremely high. In spite of the conflict, for the most part enthusiasm seems high at Pemex, CFE, and elsewhere in Mexico's energy sector. Energy is critical to Mexico's economic development and holds a unique position. Mexico is at the cusp of an historic transition, and many energy experts in Mexico feel they are taking their country in creative and innovative directions.
Debate about which direction to take is lively, even while the traditional barriers to expression exist. Curiosity about the U.S. market is strong, and the conviction that competition is necessary and desirable is gaining ground. However, Mexico will do it her way or not at all.
REFERENCE
- Foss, Michelle Michot, Francisco Garcia Hernandez, and William A. Johnson, "The Economics of Natural Gas in Mexico Revisited," The Energy Journal special edition on North American Energy Markets After Free Trade, 14(3): 17 50. Published by the International Association for Energy Economics, Cleveland, Ohio. Also available as a working paper from the University of Houston's Center for Public Policy, Pub. No. 93 11.
Copyright 1994 Oil & Gas Journal. All Rights Reserved.
