AMLO’s Energy Sovereignty: A Pipeline Dream? [GGP]
In just under nine months since assuming the presidency, Andrés Manuel López Obrador has shaken up Mexico’s energy industry even more than anticipated. His prioritization of state-owned firms Petróleos Mexicanos (Pemex) and the Comisión Federal de Electricidad (CFE) and distrust of the private sector have proven to be even more deep-seated than many expected, and many analysts are doubtful that the measures he is taking will produce the outcomes he envisions—Pemex’s return to greatness and cheap and abundant energy made in Mexico.
The cancellation of bid rounds for new oil and gas acreage indicates that, in the hydrocarbons sector, AMLO is placing all his eggs in one basket—one that is becoming dangerously frayed. A heavy tax burden, constant politicization, and inefficiencies have loaded Pemex with more debt than any oil company in the world and dragged its output to half of its 2004 peak, or 1.7 million barrels per day. AMLO hopes to boost this by more than 50% by 2024, and the government has sought to soothe investors, citing the steps it has taken to ensure the firm’s solvency. However, the construction of the Dos Bocas refinery in Tabasco state (and doubts about its cost, its timeline, and the purpose it serves) and the cancellation of farmout tenders for partnerships with Pemex have generated skepticism. And its 2019-2023 business plan, released on July 16, which aims to balance the company’s budget by 2021 met a frosty reception, including a drop in the peso. Fitch has already relegated Pemex bonds to junk status. If S&P or Moody’s follows suit, it could knock the Pemex listing off investment-grade indexes and trigger mass forced selling.
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AMLO’s disdain for energy liberalization has not spared the power sector. Mexico’s fourth long-term electricity auction, scheduled for December 2018, was scrapped with no rescheduling in sight, as were tenders for two important transmission lines, even though the first three power auctions had proven effective in attracting private investment in generation at competitive prices. CFE recently startled investors by seeking renegotiation of several natural gas pipeline contracts signed with private companies under the previous administration, as well as recovery of almost $1 billion in payments.
To see through the dust kicked up by the AMLO administration and discern where Mexico’s energy sector is headed, I posed some questions to the Energy Program’s non-resident senior fellow, Héctor Castro Vizcarra, the former representative of the Mexican energy ministry in Washington, DC.
Nate Graham: What are the key points of the new Pemex business plan, and why hasn’t it assuaged the concerns of investors?
Héctor Castro Vizcarra: The plan argues that despite Pemex’s low operation costs and profitable production, the company continues to register negative financial balances due to the fiscal regime that places it among the most highly-taxed companies in the oil industry. In 2018, Pemex’s earnings before interest, tax, depreciation, and amortization (EBITDA) were equivalent to 33% of total revenues—a higher margin than those of Eni (22%), Chevron (22%), ExxonMobil (14%), Shell (13%), and BP (11%). The company generated 2 trillion pesos of income, with which it achieved a primary balance (before tax and interest payments) of 993 billion pesos. However, 933 billion pesos in direct and indirect taxes, in addition to interest payments of 122 billion pesos, dragged its total balance for the year down to -62 billion pesos (roughly -$3.3 billion).
To alleviate the heavy tax burden, the government plans to reduce a profit-sharing tax that Pemex pays to the Treasury from 65% currently to 58% in 2020 and 54% in 2021. This tax break will provide Pemex with around $2.4 billion more to invest next year and $4.4 billion in 2021.
The plan to “rescue the oil industry,” as described by the president, will also seek to double exploration activity by focusing on shallow water and mature fields. The logic behind moving away from deepwater exploration, according to the CEO, is that “from 2011 to 2018, 45% of investment went to deepwater, and we have not seen a single barrel.” Mexico’s oil regulator, CNH, expects a maximum of 318,000 barrels per day (b/d) from the 20 fields Pemex considers “priority.”
The plan’s tax reductions and increased public investment provide unquestionable support from the government, but the question remains of whether Mexico will be able to stop the decline of oil production under a scheme with limited private investment. Betting on shallow water fields over deepwater is a shortsighted strategy as the majority of Mexico’s potential lies in deepwater oil fields. And the government’s plan to shift to exploration and production (E&P) service agreements, in which Pemex keeps ownership and control of the operation, will be unattractive to major oil companies that can bring needed capital and expertise.
Likewise, other agreements in the new environment will also fail to attract as much investment as the schemes developed under the previous government that allowed private companies more ownership and control of projects. These include agreements that allow private companies to invest in expanding infrastructure capacity while Pemex maintains ownership and joint ventures to develop projects using private investment while Pemex acts as the decision maker and coordinates the operation.
In brief, Pemex’s 2019-2023 business plan lacks a feasible long-term vision.
Nate Graham: What are the principal challenges facing Mexico’s downstream and natural gas sectors?
Héctor Castro Vizcarra: Mexico’s natural gas sector is going through a difficult stretch that is exacerbated by the current administration’s policies. Despite annual demand growth of 2.4% in the Mexican domestic market, production of natural gas has declined more sharply than that of oil. Mexican gas production peaked in 2009 at 6.5 million cubic feet per day (MMcfd), but output has since fallen to 3.9 MMcfd in 2018.
In addition to the burdensome fiscal regime and payment of rights regime for hydrocarbon extraction, production costs have more than doubled since 2010. In 2018, 35% of the total production cost was comprised of taxes on E&P activities and payment of rights, and the sum of these payments in 2018 was equivalent to that of all production costs a decade ago.
The problem of declining gas production is particularly acute in the southeastern part of the country, which is mostly supplied by domestically-produced gas. In this region there is a supply shortfall, mainly as a result of Pemex’s own consumption (for E&P and refining activities). It is also a highly industrial zone and the Yucatán Peninsula consumes significant quantities of electricity.
On top of all this, pipeline capacity that is insufficient for the heavy flow of natural gas from the US has led to the saturation of imports by land, necessitating the importation of liquefied natural gas (LNG) at a significantly higher cost.
On the refined products side, there has been a significant decline in crude processing at Mexico’s six refineries. Refinery inputs of 1.2 million b/d of crude in 2013 dropped to 629,000 b/d by 2018—the lowest level in Pemex’s recent history. Low production of refined products combined with burgeoning domestic demand has intensified the dependency on imported gasoline and diesel, particularly from the US. In 2018, imports represented 74% of gasoline consumption and 70% of diesel.
Deficiencies in Mexico’s natural gas and downstream sectors factored into the recent resignation of the finance minister, Carlos Urzúa. In a public letter he argued that by demanding new contract terms and filing an international arbitration complaint against natural gas transportation firms, CFE is “literally playing with fire and with the well-being of millions of Mexicans who live in the Yucatán Peninsula, where they are already suffering severe blackouts because there is no gas.” As to the possibility of Pemex being revived within three years, he said “this will only be possible if we avoid projects like the [Dos Bocas] refinery and we focus in an intensive way on the exploration and production of crude.”
President López Obrador’s overwhelming prioritization of state investment over private in order to diminish import dependence and enhance energy security creates a lack of legal certainty and sends a troubling message to investors.
Nate Graham: What are the administration’s priorities and plans for increasing power generation, transmission capacity, and energy security in Mexico?
Héctor Castro Vizcarra: Carlos Urzúa’s resignation letter reveals the tension at play between different groups in President López Obrador’s cabinet: pragmatism versus ideology. He writes: “This administration has made public policy decisions without enough support. I am convinced that all economic policy must be carried out based on evidence, keeping in mind the diverse effects these decisions can have, and that they must be free of all extremism. However, during my time I did not find this was the case.”
The “ideology” group in the cabinet, under the banner of “energy sovereignty,” has gained control over the power sector and operates with a radically different perspective than the architects of the energy reform, which was rooted in a commitment to open markets, accountability, and aggressive goals on clean energy. These commitments were supported by policies and mechanisms such as the long-term power auctions and centered on concrete strategies to achieve the reform’s mandates, including partnership with private industry.
By contrast, the current energy minister and head of CFE have been vocal for years about favoring strengthening state companies, generating energy without private companies, and maintaining a closed market.
The energy plan of the new administration is laid out in the National Electric System Development Program (PRODESEN 2019-2033). The document establishes ambitious plans to expand power generation capacity, mainly from hydrocarbon resources, including combined-cycle and efficient cogeneration plants, but also from geothermal energy.
The plan proposes the installation of 18.88 gigawatts by CFE alone between 2019 and 2025, an amount equivalent to 27% of Mexico’s current capacity, although the finance ministry is also considering involving the private sector in national electrification, incorporating financing plans that were used even before the energy reform.
The energy ministry, SENER, also proposes 18 projects to expand the national transmission network and distribution networks. Priority will be given to three projects intended to 1) meet the growth of demand in Cancún and Riviera Maya, 2) compensate the reactive power of the Bajío region, and 3) increase the transmission capacity from the northeast to the country’s central region.
The federal government laments that the gains of private companies facilitated by the energy reform have led to the loss of market and economic resources by CFE. Indeed, last year, CFE Basic Services, one of six subsidiaries produced by the 2016 breakup of the state utility by the electricity regulator, CRE, suffered losses of 119.6 billion pesos (about $6.3 billion) due to the rules of market operation. And in 2019, for the sixth consecutive year, CFE closed the first quarter in the red.
The López Obrador administration has sought to come to CFE’s aid. One of the ways in which the 2013 energy reform opened the Mexican market to private competition was through the “Terms of Strict Legal Separation,” which in 2016 broke up CFE vertically into subsidiaries for each activity, and horizontally by creating six generation subsidiaries. In March, SENER published an amendment to these terms which would allow the generation subsidiaries to coordinate by sharing information, employees, and other functions. However, Mexico’s antitrust commission, COFECE, deemed that such a decision could jeopardize competition by allowing one or a few generation companies to consolidate market power. This attempted move is indicative of the current administration’s efforts to reverse the reform’s opening of the electricity market at the perceived expense of state companies.
Héctor Castro Vizcarra, non-resident senior fellow for the Energy, Climate Change & Extractive Industries Program at the Inter-American Dialogue. Nate Graham is Program Assistant, Energy, Climate Change & Extractive Industries at the Inter-American Dialogue.
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