George BakerRecent decisions in Mexico by regulators have potential investors in that country's gas infrastructure concerned.
Baker & Associates
Houston
The scenario that is emerging as the most likely is not what they were expecting 2 years ago when, on Nov. 8, 1995, President Ernesto Zedillo and Energy Minister Ignacio Pichardo unveiled an innovative policy framework.
Early in his administration, former President Carlos Salinas de Gortari gave a clear direction to Mexico's energy policy. His successor, Zedillo, has followed the same course.
Mexico decided to find ways to invite the participation of private capital in the downstream energy sector as well as in other areas. While the Salinas government started-and stopped-with electric power, the Zedillo administration's list started with petrochemicals and included natural gas transportation, distribution, and storage.
Although populist agitation of the oil union derailed the petrochemical privatization initiative, there has been real progress in the natural gas sector. By early November 1995, a full-fledged program had begun for privatization of gas transportation and distribution.
Gas privatization program
The gas privatization program had several key features:- Gas transportation prices were to be related to those at the Houston Ship Channel.
- Gas distribution prices, in contrast, were to be decided by competitive bidding (at least for new distribution areas).
- Winners of gas franchises would enjoy 5-10 years of exclusivity for customers whose aggregate loads were less than 2 MMcfd.
- Pemex Gas Marketing (PGM) would withdraw from gas distribution in regions where local distribution company (LDC) franchises were to be awarded.
- By regulatory design, Pemex and private gas transmission companies would compete fairly for existing and new gas loads.
- Bidding for local gas distribution franchises would be done transparently and consistently, always with an eye to lowering energy costs to consumers.
To implement this principle, a new regulatory agency, the Comisión Reguladora de Energ!a (CRE), was chartered. Key to the success of CRE would be its ability to create an atmosphere of trust and goodwill among bidders for gas transportation permits and distribution franchises, which CRE initially visualized as separate wholesaler and retailer businesses.
Investor outlook
A string of financial setbacks and controversial policy rulings in Mexico has darkened the short-to-medium-term outlook for natural gas markets and related investments.Mexican gas markets now seem to be headed toward that semi-frozen state that has characterized attempts by the government since mid-1995 to attract private investment for building infrastructure in the energy and petrochemical sectors.
Investors say that, to be motivated, they need a reasonable expectation that there will be wide-scale switching from fuel oil to natural gas. They also need to be able to expect to compete for present and future industrial loads. Potential investors also want regulatory decisions that affect them to be made with consistency, fairness, and open hearings.
For its part, Mexican industry needs to expect that real competition between several potential suppliers will reduce energy costs. A half-dozen developments over the past 12 months have put in doubt many of these expectations and remain of concern to investors.
Gas demand
The severe financial and risk-taking features of Pemex's plan to build a coker at its Monterrey refinery led to the withdrawal of all but two bidding groups-Mitsui/Mitsubishi/ Itochu with Bufete Industrial; and Sunkyong, Siemens, and Tribasa.On Nov. 17, the award was given to the Tribasa-led group, whose bid offer was substantially lower than Mitsubishi's.
It is not clear whether financing is in place for this $1.5 billion project. It is doubtful that construction could begin before 1999 or that the start-up date would be sooner than 2001.
The delay in building the coker means the refinery's 50,000 b/d of heavy, high-sulfur (3-4%) fuel oil will continue to displace about 300 MMcfd of natural gas in the region.
It is unlikely that regional gas demand will grow either from environmentally driven fuel switching or from increased industrial output.
Environmental compliance
Pemex has asked Profepa (the Mexican equivalent of the U.S. Environmental Protection Agency, on the enforcement side) for a temporary waiver from compliance with air quality standards (known as NOM 85 and NOM 86) scheduled to take effect Jan. 1, 1998.If Pemex receives this waiver, all of Mexican industry can ask for the same treatment.
The predictable result will be continued deterioration of air quality in Monterrey and other air sheds (including several on the U.S.-Mexico border).
Regulatory environment
Since August 1996, there has been an unsettling change in CRE's communications philosophy and operating "style."During its early period-1995 and first half 1996-when CRE was crafting its rules and guidelines, it held a series of open meetings with prospective investors, regulators, industry consultants, and lawyers. Since August 1996, however, when CRE made its first award of a natural gas franchise, the open discussion philosophy and environment has faded.
The following anecdotes will illustrate this change.
In 1996, the bidding for the gas LDC in Mexicali was awarded to the lowest bidder, a group led by Pacific Enterprises (PE), parent of Southern California Gas Co. PE's bid was lower by a factor of three than that of the next highest bidder (Tenneco Inc.) and lower by a factor of 10 than that of the third bidder, Repsol SA.
From these wide price disparities, it could be inferred either that the proposals represented significantly different ideas about what was being bid or that the bidders' accounting philosophies were wildly divergent. Nevertheless, CRE accepted the radical differences in the proposals without comment and issued the award to the lowest bidder.
A year later, on Sept. 11, 1997, CRE made the opposite ruling in the award of another LDC franchise. In this case, the so-called Río Pánuco franchise in Tampico was awarded to a NorAm-led group whose bid was three times higher than the two other competitors-a group led by Gaz de France (GDF) and a group led by Royal Dutch/Shell Group.
During the evaluation process, CRE disqualified three bids: those of GdF and Shell in the cost evaluation stage and that of Enserch Corp. in the previously held technical evaluation stage. CRE decided that the proposed accounting procedures were inappropriate and that market assumptions were not adequately justified. On well-reasoned grounds (explained on CRE's website: www.cre.gob.mx), the agency disqualified two bidders, thus leaving the third as winner by default.
Bad feelings issued from the investors' beliefs that CRE had crossed a line between regulatory oversight and regulatory interference (OGJ, Sept. 9, 1996, p. 27). In this case, CRE had questioned the soundness of the corporate strategies and accounting practices of two major international companies.
At a Sept. 17, 1997, dinner reception of the Natural Gas Council in Mexico City, Mexico's Energy Minister said that anyone who did not agree with the ruling could take the matter to the proper authority for reconsideration. A week later, GdF submitted its request to CRE for a formal review of its bid, and on Oct. 3, Shell did the same.
Inherent in the initial results of the Pánuco bid is the issue of economic reality. Local industry and state economic development officials need to ask themselves how badly, and in what time-frame, they want to see long-term benefits from real competition in gas. For reasons good or bad, local industry in the Tampico region stands to pay rates three times higher for gas distribution than would have been the case with either of the other two bidders.
To judge only from the Mexicali and Río Pánuco awards, CRE can be expected to award gas LDC franchises either to the lowest bidder or to the highest bidder. A CRE rule prohibiting contact with the bidders past the bid submission date would promote an atmosphere of transparency and equal treatment. At the same time, however, the level of clarity and transparency in the regulations should be such that the bids of two companies such as GDF and Shell should never be disqualified because of misunderstandings or disagreements about rules.
Investors believe that CRE must accept some of the responsibility for such misunderstandings, which have the primary effect of disheartening bidders but also create doubt for Tamaulipas industrial consumers as to whether Tampico received the best deal possible under the circumstances.
There is also the matter of the controversial ruling by CRE in the case of the gas franchise in the Toluca region of central Mexico. By CRE guidelines, a gas distributor may not also be a gas transporter, except in unusual cases where competition is unlikely. Yet, before making the distribution award to Repsol, CRE ruled that the winner of the LDC franchise could also be an owner of the Palmillas-Toluca gas transmission line.
Because CRE gave no explanation of why market conditions called for such a ruling, prospective investors in the pipeline remain puzzled.
Lack of competition
Investors understood that the intention of CRE early in 1997 was to divest the Pemex lines and incorporate the assets into distribution.Unexpectedly, on Aug. 25, 1997, CRE ruled that Pemex Gas would be allowed to keep the existing customers on its Monterrey pipelines.
The reversal in CRE policy was made in response to the outcry from Monterrey heavy industry. Such businesses believed they would be subject to price increases if Pemex's lines were made a part of the pending tender for Comisión Federal de Electricidad's (CFE) largely residential distribution system.
They reasoned that the probable winner of the CFE tender would be Cía. Mexicana de Gas (CMG)/Enserch, which already had been permitted by CRE to provide industrial and residential service in Monterrey. With a monopoly by a single gas distributor, prices could only rise--as has happened in Chihuahua and Altamira after an LDC award was made. For this reason, it was preferable that Pemex keep the pipeline, to establish bypass privileges for industry, even before the CFE system was bid.
There are several immediate effects of this ruling:
- First, if a distinction can be made between Pemex Gas Pipelines and PGM, the result is that PGM retains its retail accounts in Monterrey.
- A second effect is that the overall value of the CFE system for investors (the tender for which was announced Oct. 2, 1997) will be perceived as much lower than it would have been otherwise, as the system would lack upside potential without the Pemex accounts.
- The biggest impact, however, is that nearly 40% of the Monterrey gas distribution load is now reserved for a state agency (see table, p. 29).
CRE said its ruling "reflects consumers' concerns." Monterrey industrialists told CRE, the Energy Ministry, and President Zedillo that they wanted no middlemen between them and Pemex. They went so far as to threaten authorities with lawsuits if they continued in their earlier course.
In facing this potential crisis, which could have derailed the pending privatization of the CFE gas distribution system in Monterrey, CRE did not, however, call for a hearing of existing and interested investors in gas distribution and transportation in order to gauge their reactions and concerns.
CRE's resolution obeyed political expediency but did not adequately assess the broader implications of such a ruling for competitive gas service to the region. Where, before, Monterrey industry could look forward to tariff competition between gas transportation systems, now, with its approved status as PGM customers, Monterrey industries forgo, for the time being, knowing what benefits real competition might have brought.
While, earlier this year, CRE voiced publicly its intention to reduce the number of Pemex-operated gas lines into Monterrey to one from four, the Aug. 25 ruling leaves Pemex Gas with all four of its existing transportation and distribution lines, but now they are all considered transportation lines.
Investors are asking two questions: What happened to CRE's commitment to downsize the presence of Pemex in gas distribution in Monterrey, as was envisioned in the original CRE guidelines in a geographical zone designated as a gas distribution franchise? And will this approach be applied nationally, leaving PGM with all of its existing industrial accounts?
Blurring of definitions
The Aug. 25, 1997, ruling on the Monterrey system blurs the line between gas transportation and distribution.CRE's ruling gives customers that have built their own laterals three options: they may either permit them as bypass lines (what CRE calls "self-supply" lines), they may transfer ownership to Pemex Gas Pipelines or any other gas transporter (there are no other transporters in the region at present), or they may transfer ownership to a local distributor.
In making this ruling, CRE has given a blanket classification of "transportation" to all 57 of the Pemex accounts, regardless of whether they meet the 2 MMcfd minimal volume requirement for direct connects.
The implication of the CRE's ruling is that PGM will be able to solicit new business in the Monterrey distribution franchise by shifting volumes currently in distribution to transportation. Local distributors will be "competing" with a state agency that does not have a distribution permit, but which nevertheless will be able to expand its business through offering or soliciting bypass lines.
Under this scenario, distributors will be at a disadvantage, as their higher-volume customers gradually migrate from distribution to transportation.
Another blurring of definitions is between gathering and transportation.
CRE's charter specifies that it has jurisdiction over "transportation and storage of natural gas that is not related to exploration or production." Not specified, however, is a standard that would differentiate between gas that is related to exploration or production and gas that is not.
That a line is within the operations of Pemex E&P in the Burgos basin does not, by itself, constitute sufficient evidence of the industrial purpose of that line. Consider the case of the 24-in., high-pressure line that Pemex E&P is building in two segments between Mier, near the U.S. border, to the Monterrey trunk line about 50 miles away.
Pemex Gas told a Houston audience on Oct. 7 that this line was an E&P line. In the U.S., the industrial purpose of a line of this size, length, and pressure ordinarily would be transportation. If the line is classified as "E&P" but has the effect of providing non-CRE-regulated gas transportation to Pemex Gas and bringing its gas 50 miles closer to market, then market distortions are created by cross-subsidies between Pemex E&P and PGM.
"Exclusivity" is another slippery term. A CRE ruling regarding the Monterrey system on Sept. 25, 1997, puts the meaning of "exclusivity" in doubt.
CMG and Enserch were awarded a 30-year distribution permit and "a 5-year exclusivity right for the construction of a distribution system and the delivery of natural gas within the region." CRE says that it also plans to award a separate distribution permit in the same region to the winner of the scheduled tender for CFE's gas distribution system.
In the Monterrey gas market, in which Pemex, CMG, and CFE all have retail accounts, an important question emerges: What is CRE's intended meaning of "exclusive?" Has CRE introduced a new concept of "dual exclusivity?"
Anti-competitive tariff
In the 1993 North American Free Trade Agreement negotiations, Mexico agreed to a schedule for natural gas import duties under which duties declined annually over a 10-year period. The schedule continues to be a policy trouble spot, both in Mexico and the U.S.The import duty was 10% and is scheduled to decline 1%/year. It is currently 6%-an amount sufficient to eliminate the incentive for Mexican industry to use alternative (U.S.) sources of gas and make importation impractical.
The effect of the import duty has been to delay any progress from the open access program announced by the Mexican Energy Ministry 2 years ago. International investors view the tariff on natural gas as a disguised tariff on natural gas transportation. Many perceive that such a tariff serves principally to maintain the status quo in Mexican gas markets.
The import duty has been treated by the Mexican government as a matter of trade policy, not energy policy. For this reason, chief gas regulator H?ctor Olea and others have encouraged U.S. companies to lobby the Office of the U.S. Trade Representative (USTR) to "horse trade" import duties-gas in exchange for tomatoes, for example.
An element that makes this policy gridlock hard to untangle is Pemex's opposition to eliminating the tariff. Since May 1997, Pemex has carried out unprecedented lobbying efforts to assure Mexican industrialists that a sole-sourced gas market would be fair and competitive and that there is no present need for them to seek gas supplies elsewhere.
Pemex head Adrián Lajous has argued that the tariff was negotiated in good faith and that there is no good reason to change it. Further, significant displacements of Mexican gas caused by imports could conceivably shut in Pemex oil production, which, in turn, would have significant negative effects on federal tax revenues.
Critics of Lajous's point of view argue that Pemex is stalling on the tariff issue until its own dry gas production program in the Burgos basin (OGJ, Nov. 10, 1997, p. 89) increases output enough to displace potential U.S. or Canadian gas supplies to Mexican end-users.
Pemex's reluctance to have alternative supplies of natural gas in Mexico is further grounded in the serious oversupply of high-sulfur (4%) fuel oil from Pemex's mostly landlocked refineries. Current production is 400,000 b/d. Pemex needs Mexican industry as an outlet for its fuel oil, which otherwise has little or no commercial value in world markets.
The Mexican Natural Gas Association (AMGN) recently called for the accelerated reduction or complete elimination of gas tariffs--as have virtually all international gas companies interested in Mexico. And, because Energy Ministry officials see it as a matter of trade policy rather than energy policy, they say it is outside their authority.
CRE has urged international investors to persuade the U.S. to drop a U.S. tariff (on tomatoes, for example) in exchange for Mexico's dropping of the gas tariff.
On the U.S. side, the USTR, which has a rule against tariff negotiations across industries, has seen fit only to include natural gas on a list of several hundred products nominated for accelerated tariff reduction. On Oct. 23, 1997, the USTR published in the Federal Register its request for comments on several hundred products, including natural gas.
Comments may be sent by e-mail to [email protected]. The deadline for comments is Dec. 12, 1997.
On the Mexican side, comments must be sent by individuals or companies by Dec. 19, addressed to the Commerce Ministry (Secofi).
Not until January at the earliest will the three Nafta parties decide whether the original tariff-reduction schedule will be accelerated.
Tasks ahead
In the Monterrey industrial market-by far Mexico's largest-decision-making on behalf of gas supply competition has been set aside in recent CRE rulings.The CRE ruling of Aug. 25 was made under pressure from Monterrey industrial firms; nevertheless, if the price of that decision is that real competition in gas markets is damaged, the ruling cannot stand. It needs to be reviewed by the Federal Competition Commission or a higher authority. Otherwise, there is no downward pressure on gas transportation tariffs from the effect of real competition.
A second matter, also affecting Monterrey gas markets, concerns the E&P pipeline that Pemex is building in the Burgos basin. Because the line is under the control of Pemex E&P, however, CRE has no authority.
In the past, Pemex has said that it planned to leave new transportation pipeline construction to the private sector (suggesting a bidding process). In this case, however, a non-tendered line is being built for the purpose of transportation under the label of Pemex E&P.
This example illustrates the need for further definition on this point by CRE. In order to avoid future ambiguities of this kind, it would seem either that CRE should have regulatory cognizance of all gas pipeline construction in Mexico, or that the transfer point between Pemex E&P and Pemex Gas should be in the field or at the wellhead.
The request for a formal review by GdF of the Tampico bidding results will give CRE a chance to do some introspection. CRE was certainly right to uphold the principle that most costs and revenues are regulated and must be accounted for when calculating average tariff yields. Distribution revenues cannot be disguised as other service fees--and vice versa.
It is unfortunate that, in the three hearings held by CRE at which bidders could ask questions about bidding issues, the points on which the bids of GdF and Shell were disqualified were not discussed.
Finally, CRE needs to reevaluate the mechanism by which industrial customers can bypass distributors. At present, customers in Monterrey count on their pure political clout in Mexico City to get the rulings they want. In other geographical areas, customers are free to form paper "associations" to buy gas, therefore technically qualifying for bypass rights.
The distributor needs the ability, supported by regulatory authority, to defend his market against the bypass strategies of PGM and industrial consumers.
CRE has done a great deal to promote investment in gas distribution, but no investor can build (or buy) distribution infrastructure only for the sake of residential customers.
Here, then, is the challenge for CRE: Pemex Gas Marketing wants to keep Mexico's industrial load, but private investors cannot support only residential customers. Industrial consumers cannot receive the long-term benefits of competition unless regulators do everything in their reach to bring about competitive gas sourcing, transportation, and storage systems. Clearer rules--plus the "bidding pitfall" guidelines that CRE is in the process of preparing--will help avoid misunderstandings in the future.
Meanwhile, companies in Nafta-member countries should strongly urge their trade offices to negotiate for the accelerated reduction or elimination of Mexico's duty on natural gas.
Mexican gas markets now seem to be headed toward that semi-frozen state that has characterized attempts by the government since mid-1995 to attract private investment for building infrastructure in the energy and petrochemical sectors.
Industrial consumers cannot receive the long-term benefits of competition unless regulators do everything in their reach to bring about competitive gas sourcing, transportation, and storage systems.
Companies in Nafta-member countries should strongly urge their trade offices to negotiate for the accelerated reduction or elimination of Mexico's duty on natural gas.
The Author
George Baker
Copyright 1997 Oil & Gas Journal. All Rights Reserved.
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