With Mexico’s crude oil production at a 38-year low, following a 15-year decline, and the most important elections in decades taking place this summer, the country’s oil and gas industry finds itself at a crossroads. The 2013 Energy Reform transformed the industry’s outlook, but whether the over US$161 billion investment committed by the winners of the first 9 licensing rounds will reverse Mexico’s declining production is a key question that remains to be answered. At the same time, PEMEX still produces 97 percent of the country’s oil and is destined to remain the dominant operator. Mexico’s next president will be instrumental in shaping the future of the Mexican oil and gas industry and operating environment of PEMEX, private operators, and the entire supply chain. Looking at the past year, however, the industry’s momentum is best summed up by one word: discovery. Outgoing President Enrique Peña Nieto’s 2013 bet to liberalize the energy industry finally paid dividends in the oil and gas sector when Talos Energy, Sierra Oil & Gas and Premier Oil announced their historic discovery in the Zama-1 shallowwater well, estimated at over 1.4 billion boe. PEMEX also flexed its onshore muscle in 2017 with its biggest discovery in 15 years, at the Ixachi-1 well in the state of Veracruz. These milestones were made possible by the successful implementation of the licensing rounds, which the Ministry of Energy and CNH tweaked and adjusted from round to round, with ASEA formulating the regulations that will ensure industrial safety and environmental protection matters. Since the Energy Reform’s launch in 2013, the E&P operator landscape has been transformed from a PEMEX monopoly to a competitive market with 73 winners representing 24 countries that have collectively been awarded 107 blocks.
Aldo Flores, Deputy Minister of Hydrocarbons at the Ministry of Energy, highlights the positive impact of the Energy Reform. “In total, we have over 170 new players across the oil and gas value chain. They are all interacting, competing and developing their business models to foster a modern and competitive industry in the country.” His perspective is supported by Bernardo Cardona, Partner and Energy and Resources Industry Leader at Deloitte Consulting Mexico, who says that “the role of CNH, the Ministry of Energy and ASEA has been extremely important in achieving this, as they have conducted transparent and clear bidding processes and provided regulatory and legal frameworks that offered sufficient certainty to the market and made it attractive for companies to venture into Mexico.”
Nine rounds have come and gone, and the results have been internationally praised for their success, competitiveness and potential to increase Mexico’s reserves and production rates. In particular, Minister of Energy Pedro Joaquín Coldwell highlights the achievements of Mexico’s Energy Reform in the upstream sector. “The hydrocarbons licensing system has allowed us to reach 67 percent in contract allocation with 107 awarded contracts from 161 offers, and with no complaints from participating companies. Moreover, we have had an average 74 percent government take. The expected economic spillover from these contracts amounts to US$161 billion and around 900,000 direct and indirect jobs in the country’s oil regions. New entrants into the market have created a highly diversified hydrocarbons industrial system with 73 operators from 24 countries, ranging from the world’s most renowned IOCs to 34 new Mexican companies founded after the reform’s approval.”
Two more rounds – 3.2 and 3.3 – have been announced and Round 3.3 will be the first to include areas with unconventional resources. “We waited a longer time to tender unconventional blocks because the proper regulation had to be in place and we needed to communicate to society the real situation and processes involved with these types of resources exploration and production,” says Franco.
The business opportunity present in unconventional resources is also seen by PEMEX, and while it is not yet known whether the company will place bids in Round 3.3, Ulises Hernández, Director of Prospective Resources, Reserves and E&P Associations at PEMEX, indicates that is likely. “PEMEX has been participating, in partnership or independently, for assets that complement our portfolio and that can contribute to meet future reserve restitution and production goals. In terms of unconventional fields, we are very interested in highly-experienced players in this arena.”
According to a CNH drilling report, from January-April 2018, the pieces of drilling-related equipment in operation climbed to 37, representing an increase of 54.1 percent over the same period in 2017. Of this equipment, 24 pieces were engaged in development activities and 13 in exploration. Regarding location, 17 were onshore and 20 offshore and the number of onshore pieces of drilling equipment between January and April 2018 was 3.4 times than in the same period in 2017.
During that time, 62 wells were drilled, representing more than double the number of wells drilled during the first four months of 2017, when only 24 wells were drilled. Of these 62 wells, 53 were drilled onshore and more specifically, 36 were located in the Tampico-Misantla basin. In terms of specific activity, PEMEX has been moving forward. “During 2017, we focused strongly on shallowwater exploration,” says José Antonio Escalera, Director of Exploration at PEMEX E&P. “We made some significant discoveries in these regions and are already working to drill some delimitation wells. One of the latest wells we are drilling in shallow waters is Yaxché, where we are testing pre-salt production.” Regarding onshore activities, we discovered the Valeriana field in Tabasco, where we are also drilling a delimitation well. This was a significant discovery worth approximately 200 million boe.”
Private advances were highlighted by the Zama-1 well discovery of 1.4-2 billion boe. “The key to success at Zama was to do our homework ahead of time,” says Timothy Duncan, President and CEO of Talos Energy, the company appointed as operator in the consortium conformed by Talos Energy, Sierra Oil & Gas and Premier Oil. “At this moment, the oil discovered at Zama is classified as a contingent resource instead of a reserve. Once a final investment decision has been completed and the development plan has been approved by the government, these resources will migrate into reserves.”
During the first five months of 2018, Mexico produced an average of 1.864 million b/d of crude oil and 4.801 bcf/d of natural gas, which represents a drop of 3.4 percent and 6.2 percent from 2017 and a decrease of 12.1 percent and 17.6 percent from 2016, respectively.
Mexico’s 1P reserves totaled 7.037 billion boe in 2017, according to PEMEX’s financial statement posted to the US Securities and Exchange Commission (SEC) at the end of April. The reserve replacement ratio came in at 17.5 percent, an improvement on the rate of 4.0 percent in 2016. But total 1P reserves dropped 11 percent to 6.427 billion barrels from the previous year. In its SEC filing, the NOC cited a decrease in production from its Cantarell, Crudo Ligero Marino, El Golpe-Puerto Ceiba, Bellota-Chinchorro, Complejo Antonio J. Bermúdez, Cactus Sitio Grande, Ixtal-Manik, Chuc, Costero Terrestre and Tsimín-Xux fields.
PEMEX’s farmout program, started in 2016 with BHP Billiton selected as the NOC’s first farmout partner for the Trion field, is also a strong bet to boost production. “Farmouts can certainly help the country make a direct change in this area. Of course, the blocks auctioned in the licensing rounds, especially in deepwater, have great projections but that is for the long-term. In the near-term, the most essential event for Mexico is the PEMEX farmouts,” says Palma Méndez, Country Manager at Wood Mackenzie.
New discoveries such as those at Ixachi and Zama will also underpin the countries production and reserves, but improved data collection and analysis will be key, according to Finance Minister Pedro Joaquín Coldwell. “With 2D and 3D seismic data multiplying threefold, we are improving our understanding of the resources that lay underground,” he says, pointing to the tangible results already emerging with the discoveries by Eni and the Talos-Sierra-Premier consortium.
PEMEX has dominated the oil and gas industry in Mexico, celebrating its 80th anniversary this year, and its hold on the sector remains in place after the nine concluded licensing rounds. The NOC emerged the biggest winner from the rounds, taking 14 highly competitive blocks – three of them individually. Says Joaquín Coldwell: “The Energy Reform has provided PEMEX with the necessary tools to build associations and to venture into technologically-challenging or financially-robust projects along with partnering companies. The reform has provided PEMEX with the possibility to compete for E&P contracts in CNH’s licensing rounds and the NOC has obtained 11 contracts in partnership with seven IOCs so far, with a projected investment that totals US$17.5 billion. Additionally, PEMEX has been awarded three independent contracts that prove its capacity to win blocks on its own.”
The company won 83 percent of the country’s 2P oil reserves distributed mostly in shallow waters and onshore and also took five deepwater blocks, either individually or with partners. But several factors have converged and hampered its ability to meet its exploration commitments. These include a shortfall in the NOC’s committed exploration budget, focalization of investment on the most onerous wells, leaving some blocks unattended, and delay of the regulating guidelines, according to CNH Commissioner Alma America Porres. The Ministry of Energy gave PEMEX a two-year extension to come up with an exploration plan to meet its commitments, which Porres says implied a shift in PEMEX’s strategy to achieve at least one discovery per assignation. “This goal seems difficult to reach; however, during 2017 PEMEX had a 50 percent exploration success rate. Given this success, we are confident that the NOC’s goals will be meet. For the 2018/19 term, PEMEX will conduct exploration activities at 130 wells and we are confident that PEMEX´s production will increase.” To this end, more farmouts will be vital going forward, says Rubén Cruz, Leading Partner in Energy and Natural Resources at KPMG in Mexico. “Farmouts represent the perfect means to develop the fields awarded to PEMEX during Round Zero. They are a shortcut for the NOC to sustain a production volume of 2 million b/d and look to have a stable development as new discoveries will imply better planning to revert the trend of shortening production outcomes.” In its SEC filing, PEMEX pointed out that it was sticking to its five-year business plan to 2021, that included strategies to improve cash flow and reduce debt while targeting continued cost-cutting and administrative discipline. It also said it was evaluating an updated 2018 plan. As a change in presidential administration looms at the end of the year, the NOC also outlined its objectives for the rest of 2018. These include maintaining production levels and developing farmouts and associations, accelerating the migration of integrated E&P contracts and FPWC to exploration and extraction contracts. PEMEX will also evaluate prospects for further Open Seasons for parts of its pipeline and storage systems, after holding the first one in 2017.
The company also mentioned the risk factors that could hit its balance sheet, including crude oil and natural gas price volatility, its high debt load, its potential exposure to cyberattacks and transportation risks and increased competition in the energy sector. The NOC also cited the political developments in Mexico. “Political events in Mexico may significantly affect Mexican economic policy and, consequently, our operations,” it said. “We cannot provide any assurances that political developments in Mexico will not have an adverse effect on the Mexican economy or oil and gas industry and, in turn, our business, results of operations and financial condition, including our ability to repay our debt.” PEMEX's total financial debt as of March 2018 totaled US$106.3 billion, down 4.3 percent compared to the same period in 2017. It also reported a net loss of MX$113.3 billion in 1Q18, but that represented a 29 percent improvement over 1Q17. For the 2017 year, PEMEX spent US$10.81 billion, of which 84 percent was allocated to E&P activities, 10 percent to refining and petrochemicals and 6 percent to other expenses. It reported a full-year net loss of MX$333 billion in 2017 compared to a MX$191 billion loss the previous year.
With an open market and newly arriving companies looking to exploit the Energy Reform, the country’s pipelines and storage infrastructure have come under scrutiny, particularly for natural gas. Imports must be moved from Point A to Point B and Mexico is currently undertaking “the largest expansion our pipeline network has ever seen,” says Flores. In fact, the country’s pipeline network has added 7,372km of pipelines during the Peña Nieto administration, according to the latest update to the Five-Year Plan.
More is on the way. TransCanada, in a joint venture with IEnova and Infraestructura Marina del Golfo, was chosen in 2016 to build, own and operate the 800km South TexasTuxpan pipeline for natural gas. The project will interconnect with CENEGAS’ pipeline network in Altimira. During 2017, Mexico imported around 4.223 bcfp/d, mostly from the US, while its national consumption totaled 8.017 bcfp/d.
While building for today’s needs, the country must also keep in mind the future, when natural gas supply is expected to outpace demand. “Now, challenges are related to the drop in local production that leads to more natural gas imports as we are reaching our limit for imports capacity,” says David Madero, Director General of CENAGAS. “On the positive side, there are many pipelines being built right now and they are close to starting commercial operations. Once this happens, we will enter an era of larger transportation capacity than demand, which will be good for gas security but financially challenging for transportation companies.”
Even before the gas is put into the pipelines it needs to be stored and this has become an increasingly important issue – and opportunity – in the industry. “Mexico has limited fuel security, sufficient for only three days of consumption with the existing facilities,” says Guillermo García, President Commissioner of CRE. “In contrast, that storage ranges from 40-70 days in other countries. There are significant efforts on the public policy side to establish a mandatory storage target so more companies will participate in this market.” In terms of natural gas storage, Madero mentions the mandates received by the Ministry of Energy “to build 45 bcf of strategic storage capacity by 2026 to face potential setbacks for gas in Mexico. The ministry has already set a target to tender the construction of 10 billion cf of storage capacity by the end of this year, which is challenging.” This commitment can be seen in the 33 storage and distribution projects sent to CRE for approval, out of which 24 are already approved and started construction.
REFINING AND PETROCHEMICALS Mexico has six refineries strategically positioned in the cities of Cadereyta, Madero, Tula, Salamanca, Minatitlan and Salina Cruz to cover the country’s demand for refined products with an installed capacity of just over 1.6 million b/d. With an average national consumption in 2017 of 1.58 million b/d, out of which 70 percent is imported from US refineries, the problem of the country’s refining industry is not so much capacity but refining efficiency. In 2015, production efficiency of refined products only reached 61 percent, and the percentage of unscheduled shutdowns reached almost 13 percent.
Although operational excellence represents an opportunity for improvement, downtimes are also related to supply chain inefficiencies, as 74 percent of the unscheduled shutdowns were related to the supply of services.
In its 2017-21 business plan, PEMEX stated its commitment to revamping its refineries through alliances focused on auxiliary activities and operation and maintenance, areas in which private companies see a bright future. Stefan Lepecki, CEO of Braskem IDESA, emphasizes the importance of value chains, and the opportunity Mexico has to be a highly competitive country. “Production and commercial chains start with securing feedstock and the potential of Mexico is incredible in that regard, as it has the feedstock reserves and the necessary markets, the two fundamental pillars for this business.”
In 2017, Mexicans were able to see the Energy Reform’s results first-hand as fuel prices were liberalized, and market competition was reflected at the pumps. At the same time, the country saw brands other than PEMEX sprouting up at gas stations nationwide. Competition and competitive prices became the name of the game. “We had a landmark year in 2017 thanks to the implementation of further changes in the industry,” says CRE’s García. “The government liberalized fuel prices in general and regions were given the opportunity to set their own prices gradually, and within a year, price liberalization became a reality nationwide. Unified prices used to be the norm in the country and now they are differentiated by region and set by the players involved, injecting competitiveness into the market.”
Among the first names to make a mark on the retail end of the market was BP Downstream, which opened 200 stations in 13 states in 2017, with plans to have 500 opened by the end of 2018 and another 1,500 stations expected in the next five years. “We consider Mexico key to our global strategy since it is about the sixth-largest fuel market in the world,” says Álvaro Granada, General Manager Mexico of BP Downstream. To date, Mexico has 11,992 service stations, out of which 2,908 (24 percent) belong to 45 new retail brands. From these new brands, OXXO GAS has the lead with 464 service stations.
Despite the successes, challenges remain, particularly when it comes to regulations. “From a regulatory perspective, we still need a fair playing field for all companies wishing to participate in the market,” says Alberto de la Fuente, Director Source: CNH General of Shell Mexico says. “The country also needs to develop and attract more investment in infrastructure because we currently depend on PEMEX’s infrastructure. We need more storage terminals, pipelines and routes for the product to move around the country. We believe that Mexico has approximately three days’ worth of storage, which is insignificant, particularly when trying to manage different operators and more competition.”
Mexico has a strong local supply chain that has supplied PEMEX across its entire life. Between January and March 2018 PEMEX spent over MX$20.9 billion in procurement contracts, out of which 21 service companies accounted for MX18 billion, 86.31 percent of the total amount of PEMEX expenses. This local supply chain will have to compete against consolidated international service companies with the highest performance and quality standards and best practices to comply with the strict requirements of IOCs and operators from all over the world.
Regarding the Mexican oil and gas industry in general, service companies are committed to providing costefficient products and services at prices where operators can develop E&P activities without concern regarding low oil prices. To mention a good example, service companies worldwide are structuring their final prices to operators keeping in mind a US$45-55/b price. This price structure allows both operators and service companies to incentivize investment, particularly in exploration activities and maintains a strong and organic flow throughout the entire life cycle of the E&P contracts.
Nevertheless, according to KPGM’s Cruz, “Mexico has gone through a learning curve quickly and successfully. Interest in the country’s fields was present from the beginning but the lack of experience in handling day-to-day operations required different implementations.” Local content requirements are also part of the equation. “As investments flow and they grow larger, meeting local content percentages will be harder to achieve. There is a need to bind Tier 1 and Tier 2 service suppliers to local requirements since they only apply to operators at the moment and industry players need to work under coordinated rules to make sure there is a commitment to deliver.”
The continuity of the Energy Reform is instrumental for the development of the industry as PEMEX would not be able to substitute the investment commitments made by the winners of the awarded blocks in the licensing rounds, as well as their technological capabilities and execution capacity. This is particularly true at this juncture, with a new presidential administration ready to take the country’s political and economic reins, which could deeply impact the overall energy industry. This concern is shared by José Uriegas, CEO of Grupo IDESA, a company with a presence across the value chain of the Mexican oil and gas industry and that has developed partnerships with both national and international companies. “The future of the oil and gas industry in Mexico is bright but we have to be careful about how to balance short and long-term benefits we want to achieve. The reality is that it will take at least five to 10 years for the projects brought by the licensing rounds to reach maturity, which shows how important it is to secure the integrity of the investments in the long term.”
According to KPMG’s Cruz, avoiding over-regulation and ensuring close interaction between all the regulatory institutions – CNH, CRE and ASEA – is crucial to ensure processes are streamlined. “Ideally, we should move to create a single database where each agency, along with the Mexican Petroleum Fund, inserts all the information collected from new companies and makes it available to the other regulatory bodies to avoid duplicating processes.” One of the country's major milestone was its integration into the International Energy Agency
Private industry has also praised the achievements of the Ministry of Energy, CNH, CRE and ASEA in terms of providing a stable basis to do business in Mexico. “Both national and international investors have pointed out that in Mexico we have created a robust and clear legal framework,” says Eduardo Núñez, Managing Partner at Núñez Rodríguez Abogados. “The fact that the constitutional reform was ratified by the Congress through a political consensus is also an important political achievement.” But it is still too early in the process to declare victory, says Pablo Guzmán, Management Consulting Leader PwC Mexico, adding that, although the oil and gas industry in Mexico has a long history, the open market is extremely recent. “There is 110 years of history behind the Texas the oil and gas industry, while in Mexico the Energy Reform is only 3 years old. It is an excellent reform from a legal perspective but some things need to be optimized. Now we have to work on the details, to start polishing the legal framework.”