INDUSTRY SKEPTICAL ABOUT MEXICAN GAS REFORMS

The international gas industry is looking skeptically at Mexico's most recent steps toward boosting competition and private investment in its domestic gas industry.

Investors on one hand are interested in competing for shares of a gas market with 80 million potential customers. On the other hand, they say many serious issues still must be resolved for gas to play a meaningful role in the Mexican economy.

INDUSTRY CONCERNS

Mexico's constitution still bars private companies from taking equity interests in oil and gas production. Some challenge the idea that a country can successfully introduce competition in energy markets while retaining full control of upstream activities.

Many other criticisms leveled at Mexico's emerging legal framework for gas reflect wariness of actions by state company Petroleos Mexicanos (Pemex) in the new regime. Observers chiefly wonder whether Pemex will willingly give up its near monopoly as Mexico's biggest gas producer, transporter, and distributor. Concern also persists over whether Pemex-even if it welcomes new gas sector players-will refrain from unfair competition on domestic markets.

Some potential investors are uncertain about whether enough Mexicans now using high sulfur fuel oil and liquefied petroleum gas (LPG) produced and sold by Pemex will have adequate incentives to switch to natural gas. Others question whether Pemex has the will or the means to develop a gas supply adequate to meet projected demand.

Even with those concerns allayed, questions remain about how private companies will be able to finance construction of gas and power facilities in a currency subject to sudden and extreme devaluation.

Underlying all of those concerns are uncertainties about Mexico's legal system.

Mexico's Gas Pipepine System Chart (96623 bytes)

MEXICO'S ENERGY REFORMS

Mexico in the past 2 years has enacted a series of laws intended to provide the basis for further reforms in the gas and power sectors.

In late 1993, the congress approved the Greenfield Power Act, part of which created Mexico's federal Energy Regulatory Commission (CRE) as a technical analysis and consulting agency within the Energy Ministry. It followed that action in 1994 with passage of air quality legislation setting clean air goals beginning in 1998.

Earlier this year, federal legislators amended Article 27 of Mexico's constitution to allow the private sector to construct, own, and operate grassroots gas transportation pipelines, storage sites, and distribution facilities. Gas facility operators are obligated to provide services to all shippers on an open access basis. In addition, the Energy Ministry put in place internal regulations intended to spur gas and power reforms.

The main objectives of the reform measures are to lay the groundwork for a more efficient gas industry in Mexico by promoting competition in areas where possible, while regulating natural and legal monopolies.

To complement the reforms, Mexican legislators earlier this fall passed into law two parallel proposals, approving the Energy Regulatory Act (ERA) Oct. 31 and the Natural Gas Act (NGA) Nov. 8.

NGA is intended to complement gas industry reforms already in place by laying out the regulatory provisions needed for Pemex and private companies to take part in the reformed gas industry.

ERA expands CRE's authority in an effort to strengthen the institutional framework built to implement the legal changes mandated in the gas sector.

CRE now is an autonomous technical, operational, and budgetary agency within the Energy Ministry responsible for implementing gas industry regulations.

NGA HIGHLIGHTS

NGA includes provisions intended to promote development of the gas industry while protecting gas customers and limiting market power of individual players.

The regulation anticipates five general participant groups in the reformed gas industry, all of which may engage in gas marketing.

Pemex will be responsible for initial gas sales and operation of its transmission network. Transporters will build, own, and operate new gas transportation pipelines; storage companies will develop and operate storage facilities; distributors will supply end users; and marketers will buy and sell gas and may broker transportation, storage, and distribution services.

Only Mexican corporations or trusts may own real property and rights along the country's borders and coasts. Mexico's foreign investment law does not limit private ownership or opera- tion of gas system. But it does limit to 49% the level of foreign participation in pipeline construction.

Providers of transportation, storage, or distribution services must allow open access to their systems as long as they have capacity available and/or a feasible interconnect.

Pemex within 6 months is to submit to CRE a detailed plan for gradually opening its gas transportation system to all shippers. The program is to achieve full open access on Pemex's system within 2 years.

Transportation, storage, and distribution providers in Mexico's reformed gas industry must offer unbundled services and specify the cost of each service to users. They may not subsidize one service with revenue from another.

Any gas consumer in a geographic region may sign contracts with other parties for gas supplies, and distributors must allow open access to their systems. End users may bypass distribution infrastructure and connect directly to transportation systems by obtaining self-use transportation permits. A user holding such a permit may not market gas or provide third party transportation or distribution services.

Transportation customers will be able to yield their capacity rights in secondary markets.

CRE'S NEW ROLES

CRE under ERA is responsible for applying and interpreting Mexico's gas regulations.

Service providers in Mexico's reformed gas industry will calculate tariff rates through a maximum rate mechanism with CRE approved methods. However, parties will be free to negotiate tariffs different from those defined by regulation.

CRE may grant transportation and storage permits for initial terms of 30 years, with 15 year renewal options. Transportation and storage permits do not confer exclusivity.

In contrast, CRE will grant the first distribution permit in a geographic region through a competitive bidding procedure. A regional distribution permit will carry an exclusive 12 year ini- tial term, after which CRE may grant other nonexclusive distribution permits.

The same entity may hold transportation, storage, and distribution permits. However, the holder of a transportation permit in a specific region may not hold a distribution permit in the same area without a CRE exception based on efficiency of ser- vice. In regulating monopolies, CRE may approve or determine maximum prices in first hand sales, maximum rates for transportation, storage, and distribution services, and terms and conditions of service. Pemex will continue to own and operate its transmission pipelines but will take part in gas activities as would any other permit holder subject to CRE regulation and authority.

In addition to approving maximum transportation, storage, and distribution tariff rates, CRE is empowered to set prices for first time gas sales, as well as terms and conditions of service.

Maximum prices in initial gas sales are to be based on CRE methods that take into account conditions in international markets, where the sales occur, and consumers' supply alternatives.

The regulation setting initial sale maximum prices will remain in effect in a given market until Mexico's Federal Competition Commission decides competition effectively exists in the market area.

Pemex in arranging initial sales must quote prices to prospective buyers at a given processing plant and at a delivery point determined by the buyer.

Prices distributors charge end users for gas service are to be the sum of gas acquisition costs plus the applicable transportation, storage, and distribution fees. Parties may agree upon a different price, as long as it is not lower than the cost of providing service.

MISGIVINGS ABOUT GAS

Despite the extensive details Mexico released about its plan to restructure the domestic gas industry, the legal framework came under intense criticism at a Houston meeting last month sponsored by Baker & Associates (B&A), Oakland, Calif., and Gaschool, a Houston gas seminar and conference organizer,

B&A principal George Baker at the meeting listed Mexico's string of gas reforms, noting that a lot of ground had been covered in the previous 18 months.

"Still," Baker said, "trying to step back and take a larger picture, you might say there are still some serious things to do."

But despite assurances that Pemex will cooperate in Mexico's gas industry restructuring, Baker said significant physical and financial constraints remain.

Perhaps the most serious concern raised by Mexico's gas industry reform is how to ensure Pemex will not dump fuel oil or LPG on domestic gas markets.

Baker pointed out that Pemex refines about 400,000 b/d of high sulfur fuel oil, most of which it sells into domestic power and industrial markets, displacing about 2.4 bcfd of gas.

As Mexico's largest producer, transporter, and consumer of oil, gas, and refined products, it is in a position to discount supplies or services related to any of its downstream products. Nothing in the new laws prevents Pemex from exercising that competitive advantage. Questions also remain about whether Pemex will be willing to spin off plum industrial accounts to independent local gas distributors.

"My own view is that Pemex should get out of gas distribution," Baker said. "Gas distribution has to be turned over to the private sector, because as long as Pemex is in gas distribution, it always will be able to come in and market suc- cessfully against a would-be competitor."

Yet, even if it turned over all its industrial gas accounts to private companies, Pemex still could underprice gas supplies with LPG or fuel oil.

Mexico's Natural Gas Shortfall in 2000 chart (36646 bytes)

GAS SUPPLY SHORTFALL

Another big problem is a looming gas shortage that could develop by the end of the decade.

While Mexico aims to sell excess associated gas to power plants or industrial customers, that gas is being kept off the market by cheap fuel oil. Since 85% of gas produced in Mexico is associated gas, without significantly changing investment priorities Pemex can't substantially increase gas production without also boosting oil output-assuming it could significantly increase oil production soon, which is not the case because of the state company's capital and technical constraints. Without new export markets for its oil, the increased oil production would be processed into still more volumes of fuel oil and LPG for which it would have to find buyers.

If Pemex doesn't divert more resources to developing domestic gas supplies soon, Baker estimated Mexico risks a supply shortfall by 2000 of as much as 2 bcfd.

"Pemex fundamentally is a black oil company dedicated to producing oil in the Gulf of Campeche," he said. "So the question persists: Is Pemex going to devote the resources needed to develop an adequate supply of domestic gas?"

In addition, many officials expect new gas facilities in Mexico to be built with project financing. But as devaluations of the Mexican peso in the past year indicate, a project generating revenue paid in a currency subject to possibly major devaluations might not show enough profit to repay debt.

As a result, Baker said, lenders willing to finance construction of gas facilities in Mexico likely will want borrow- ers to have a way of tying tariff rates to a more stable currency.

"This hasn't been figured out for either gas or electricity," he said.

Energy consultant Thomas D. Clarke, Oakton, Va., said Mexico's gas industry reform can be successful only if investors believe CRE is proving itself through the regulations it proposes and through the restraint it exercises. To entice the type of conservative foreign investors it needs to finance gas infrastructure expansions, Mexico must offer every assurance possible of a fair chance to earn a reasonable return.

"Mexico has started out with a good set of rules," Clarke said. "They're far from complete.

"We have to stay on top of the transition. We have to help them make the right rules and create the tools necessary to grow the market and convince consumers to switch over to gas."