The liberalisation of Mexico’s oil and gas sector under the administration of President Peña Nieto has created significant commercial opportunities for foreign investors. Mexico is thought to have vast untapped hydrocarbons potential, but above-ground risks, namely security, corruption and regulatory uncertainty, will continue to create challenges for potential investors.
Lawmakers in Mexico approved landmark reforms in 2014 that for the first time opened the oil and gas sector to private investment, ending a decades-long constitutional monopoly held by national oil company Pemex. Mexico’s oil production averaged 2.8 mn barrels per day (bpd) in 2014, a 27 percent decline from its peak a decade earlier, demonstrating the need for private capital and technology. For Mexico, which relies on the proceeds from the oil sector for around 30 percent of total government revenues, the reforms and subsequent investment could add up to 1.5 percent of GDP on average between 2016 and 2030 according to UK-based bank Barclays.
Encouragingly for investors, Mexico has responded to industry concerns following the first unsuccessful bidding round in July. Only two shallow water blocks out of the 14 offered in the country’s first round were awarded amid low investor interest due to concerns over poor fiscal and legal terms, exacerbated by questions over geological factors and the weak price of oil. Prior to a second bidding round in September, the National Hydrocarbons Commission (CNH) oil regulator introduced a series of reforms, which included increasing the flexibility of minimum work requirements and lowering the corporate security guarantee required for contracts to USD 2 bn from USD 6 bn previously. These changes greatly improved participation in the second tender, in which three of the five shallow water blocks on offer were awarded. The success of the September round was further demonstrated by the fact that previously absent major intentional oil companies, including Statoil, Russia’s Lukoil and China National Offshore Oil Corporation (CNOOC), submitted bids. Reforms, including allowing pre-qualified companies to undertake multiple bids using the same capital arrangements, have been introduced to shore up interest in a tender for 25 mature onshore fields in Chiapas, Nuevo León, Tabasco, Tamaulipas and Veracruz that is expected to close on 15 December. On the back of the regulatory changes, even greater interest is now anticipated in deep water blocks scheduled to be auctioned in early 2016.
Regulatory Uncertainty and Corruption
Notwithstanding the popular changes observed over recent months, authorities have yet to reveal the contract model for the 2016 round, making it difficult to fully assess the terms investors will bid under. Contracts unveiled in earlier rounds have included local content requirements of up to 35 percent in the development phase, and there remains a lack of clarity over the definitions and metrics that will be used to measure compliance with these obligations. Energy reforms have expanded the power of existing agencies, such as CNH, and created new bodies, such as the National Safety, Energy and Environmental Agency. Judicial and regulatory authorities lack experience in oversight of a competitive energy sector, a factor further complicated by the implementation of a still evolving regulatory regime. There is also continued uncertainty over an auction round planned to focus on shale and unconventional plays that was suspended in August 2015 following disappointing results in the initial bidding round.
High levels of corruption in Mexico are another a key area of concern for investors. Mexico was ranked 103 out of 175 states in Transparency International’s 2014 Corruption Perceptions Index, and has consistently ranked poorly in the survey despite government anti-corruption efforts. There have been reported instances of corruption in the oil and gas sector previously and Pemex has failed to seriously investigate evidence of corruption. In 2014, US-based Citigroup’s Mexican affiliate, Banamex, accused a Pemex supplier, Oceonagrafía, of falsifying USD 400 mn worth of invoices. Mexico’s Federal Audit Office identified more than 100 Pemex contracts, worth some USD 11.7 bn, signed between 2003 and 2012 that had serious problems, including evidence of fraud. Federal auditors recommended that Pemex take action on contract irregularities in 274 cases from 2008 to 2012, but the company has done so in only three instances, according to a Reuters report from early 2015.
The security of companies’ assets and personnel also presents serious considerations to investors in the oil and gas sector. Levels of kidnap are high and kidnappings of Pemex workers in Veracruz throughout 2014 demonstrate a precedent for attacks on energy workers. In April 2014, gunmen in a makeshift tank attacked a hotel housing oil workers employed by Swiss multinational Weatherford in Ciudad Mier, a town in Mexico’s gas-rich Burgos Basin area. Though the workers were not the intended target, the incident is nonetheless indicative of the exposure of staff to wider environment of violent crime inside the country. A 2013 survey by the American Chamber of Commerce of Mexico found that on average, foreign investors allocated around 4 percent of operating costs to security, while other reports have suggested that security-related costs average around 3-5 percent of revenues for oil companies operating onshore in Mexico.
Civil unrest also presents a threat of disruption to onshore operations. In May 2014, activists motivated by environmental concerns and opposition to energy reforms used vehicles to block access to 128 active Pemex wells in Miquetla, in Veracruz state. Past violent protests over energy reform in Veracruz, and demonstrations that have blocked access to Pemex facilities in Tamaulipas, suggest a heightened threat of unrest against the oil and gas sector in blocks that are due to be awarded in these states as part of the December onshore bidding round. Future development of the country’s shale gas sector will also likely face opposition from Mexico’s communal land owners, the ejidos.
Investors in Mexico’s offshore oil and gas sector may be less exposed to the poor security environment onshore, but high levels of violence in coastal states do present logistical and operational considerations. Pemex’s current offshore hubs include the ports of Tampico in Tamaulipas and Dos Boacs in Tabasco, states that experience high levels of violence and recorded the first and third most kidnappings respectively according to an interior ministry report from early 2015. The movement of personnel and equipment onshore, including between ports and offshore facilities, could be affected by poor security. Organised criminal groups reportedly have developed deep ties with port authorities, creating possible opportunities for sabotage, extortion or theft of equipment. Narco-traffickers have deployed vessels laden with drugs from the port of Tampico, a major hub for exports of petrochemicals, and the Knights Templar group was linked to a vast smuggling network of both iron ore and drugs from the Michoacán port of Lazaro Cardenas in 2014.
The operations of drug trafficking organisations and other criminal networks have evolved to directly target Mexico’s oil and gas industry. Since 2007, crude theft from pipelines has increased each year, and over the past decade, roughly 100 Pemex employees have been implicated in the illegal siphoning of oil and fuel products. In 2014, some 3,600 illegal fuel taps on pipelines were identified, a 66 percent increase from the 2,167 identified a year earlier, costing Pemex an estimated USD 792 mn in lost revenues.
Despite ongoing efforts to strengthen the capabilities of security forces, violence in Mexico is likely to persist at high levels. Organised criminal groups will retain significant networks of influence that present a potential threat to planned foreign investment in the oil and gas sector. Ineffective governance and weak institutional capacity, alongside endemic corruption among the security forces and public officials, strengthen impunity for criminals and serve to reinforce high levels of crime. Although regulatory reforms since the first bidding round have strengthened investor interest, a failure to address security issues and political risks will remain a key consideration for companies, potentially dampening the extent of investor appetite in the 2016 bidding rounds.