Alejandro Vanags
Principal
Strategy& Energy, Chemicals & Utilities Practice, Houston Office
Guillermo Pineda
Audit Partner
PwC, Leader of the Mexican Energy Business
Juan Trebino
Vice President of Strategy&, Managing Director
The Houston Office and Energy Practice Leader for Spanish-Speaking Americas
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Insight

Implications from Energy Reforms in Other Countries

Mon, 09/01/2014 - 15:44

As Mexico embarks on a journey captained by the Energy Reform, one of its main considerations must be to learn from previous experiences in other countries to build upon these lessons, maximize the impact of the Energy Reform and avoid common pitfalls. Mexico is in an advantageous position as it has ample growth platforms, particularly in untapped deepwater and unconventionals, a strategic geographic position with access to Atlantic and Pacific markets, proximity to the US, know-how and suppliers, a large market with a relatively low cost of natural gas, and an underinvested hard asset base where marginal contributions will have a significant impact.

Strategy& (formerly Booz & Company, and now part of the PwC network) conducted a comparative analysis of energy reforms in countries with analogue conditions focusing mostly in the upstream segment. The company identified 11 countries which experienced energy reform, and prioritized six countries (Norway, Colombia, Brazil, Venezuela, Nigeria, and Malaysia) that had comparable conditions to Mexico in terms of oil and gas contribution to GDP, production levels, reserve growth, and ability to attract foreign investment. The lessons derived from these experiences can be synthesized into five key levers: fiscal model for upstream activities, structure and role of government agencies, role of the national oil company, local content requirements, and the pace of evolution of the energy reform. These are four types of fiscal models for upstream activities, which have differing implications for investment and risk:

Countries have structured their fiscal model to attract investments and maximize resource monetization while reducing government capital at risk. Some countries have chosen to implement a variety of fiscal models for different types of reservoirs and risks. A few good experiences in implementing these models are as follows. In Nigeria, regulators implemented a dual model that allowed PSAs to accelerate the exploration of deepwater reservoirs by partnering with IOCs, and formulating joint venture agreements for onshore and shallow water reservoirs given limited risk of exposure for the government. In Colombia, the regulators deverticalized the fiscal model of technical evaluation, exploration, development, and production. Designed royalties on a sliding scale based on technical complexity allowed IOCs to own 100% of the oil ventures, implementing a new fiscal model while honoring the legacy contracts with IOCs. In Malaysia, regulators implemented an innovative PSA model that was reviewed and restructured through the reform process to attract operators and investment. It removed the signing bonus in the early stages of the reform process, increased the cost recovery ceiling from 20% to 50%, and implemented a low royalty rate of 10%, thus attracting higher levels of foreign investment. Restructuring the PSA over time enabled Malaysia to attract operators and investments. Some pitfalls to avoid also include Nigeria, where the initial model focused only on joint ventures which had significant financial pressure on the government to match the IOCs’ investment. In Malaysia, extensive profit payments  decreased government revenue potential. In Colombia, the market was slow to react to concessions as a first come basis, and growth occurred after bidding rounds increased transparency in 2007. In Venezuela, constant changes in the fiscal regime, sometimes abruptly, have significantly reduced the attractiveness of opportunities for FDI. In Mexico, the markets have been pleasantly surprised by the level of flexibility that the current reform proposal signals. The government should carefully craft the state’s end vision for the industry by stating its objective functions (e.g. maximizing production growth, increasing tax revenues, attracting investment, generating employment, and minimizing government capital being at risk) and using the fiscal regimes as a means to deliver on this vision, while considering the cost of handling a complex multi-regime fiscal model.

STRUCTURE AND ROLE OF GOVERNMENT AGENCIES

Many countries shifted from comingled responsibilities between executive and regulatory functions to clear role separation between the regulator and the law-making body to drive effectiveness and transparency. 

Brazil provided some good experiences as the MME and CNPE have clear control and drive over all policy- related matters, while the ANP acts as the oil and gas regulator, holding public feedback on bidding rounds to ensure continuous improvement and coordinating with other agencies, such as CENPES, BNDES and IBAMA. It also provides some lessons about what to avoid as the government forced informal price control over Petrobras, limiting competition in midstream activities.

In Mexico, significant work will be required to develop the new capabilities required by SENER and CNH to generate and administer the new market rules. This is a  critical element in the implementation roadmap for the Energy Reform and the authorities should reserve enough investment and efforts to support the development of these entities as the roles, responsibilities, processes, tools, and organization are defined and the interfaces with the different market participants are put in place.

ROLE OF THE NATIONAL OIL COMPANY

In many countries, the NOC became an independent operator in the market with limited or no involvement in policy or regulatory activities. Some positive experiences include the example of Norway, where Statoil gained scale and capabilities in a favorably controlled environment and became a global competitor. With the build-up of its capabilities, the State’s Direct Financial Interest (SDFI) was formulated in 1985 to allow direct government investment of funds and equity via Petoro and Gassco. Today the fund has investments in 158 production licenses and 15 joint ventures in pipelines and onshore processing facilities creating a predictable source of cash flow for the government. In Brazil, the law gave Petrobras additional leverage by increasing public ownership and implementing increasingly transparent corporate governance. It also gave Petrobras a higher degree of freedom to hire personnel and expedite procurement to increase investments in R&D capabilities, while executives were provided with enhanced freedom and increased accountability for results. On the other hand, some pitfalls to avoid include the experience of Nigeria, where the NOC still has regulatory and administrative functions as the roles were not completely separated but as a result, reform effects have been attenuated. In Brazil, “informal” pricing controls were reestablished by the government soon after price liberalization and Petrobras acted to avoid competition in refining, transportation, and marketing.

The journey to become more competitive has proven to be both long and challenging for many NOCs. Lawmakers in Mexico should consider aligning the benefits of opening the market with the pace of transformation of PEMEX. As the Energy Reform is implemented, lawmakers should consider providing the national champion with more flexibility and tools, such as farming contracts in or out, raising capital in private markets, easing of hiring and firing of employees, and using variable compensation to level the playing field with other competitors.

LOCAL CONTENT REQUIREMENTS

Many countries have included robust local content rules in their reforms to boost domestic economic activity and knowledge transfer. This immediately generates demand for in-country talent and services. However, it is equally crucial to match the development of local supply capabilities to support the demand. Good experiences include the strong local content requirements that were institutionalized in Norway via local content policies, bids heavily weighted towards local content programs, heavy investments in R&D, and the Goods and Service Office to monitor and enforce local content requirements. In Brazil, local content requirements forced a structured local content development program. However, some of these efforts point to some lessons learned, such as the unrealistic local content requirements in Brazil that led to heavy penalty pay outs. Increased demand in already overheated segments such as labor or engineering are leading to high cost and quality issues. In Nigeria, although the government created demand for local content through laws, the local industry was not ready to offer the requisite services.

Generating local supply is particularly difficult in specialized types of assets like those in deepwater and unconventional segments. As local content rules are designed, lawmakers should consider the merits of including gradual increases in local content rules to allow the market to build up supply for oil and gas talent and services. Mexican lawmakers should also consider that implementing high local content requirements without increasing local supply can create human capital flight from PEMEX as it is the only source of experienced talent in the local market.

PACE OF EVOLUTION OF THE ENERGY REFORM

Reforms in many of the countries examined were a journey that took place over several years, refined with feedback from many stakeholders, rather than a single event. Lawmakers had to make adjustments according to geological and macro-economic conditions.