Haynes and Boone, LLP
  August 16, 2004 - Texas

Mexico's Gas Markets
  by Tim Powers

I. Introduction President Vicente Fox has devoted significant political efforts to reform the energy sector. He is well aware of the current needs for investment, particularly in power generation and non-associated gas exploration and production. He is also aware that the government will not have the necessary funds to match the anticipated growth of energy demand. However, under the current political scenario in Mexico, his intentions to develop the energy sector have faced strong resistance from opposing political parties. II. State of Mexican Energy Sector Mexico has abundant natural resources. It has the 12th largest proven oil reserves in the world and the 7th largest natural gas reserves in the hemisphere. However, despite this rich supply of hydrocarbons, Mexico is facing a possible energy crisis in the near future unless important actions are taken. The energy sector in Mexico is owned by the state and it plays a very important role within the national economy. It provides 37% of the federal income. The federal government spends 56% of its yearly budget on energy-related investments. It is foreseen, however, that the energy sector will need a total of US$139 billion dollars of investment over the next seven years to match the growing demand; US$59 billion in electricity, US$40 billion in oil exploration and production, US$21 billion in natural gas, and US$19 billion in refining. Mexico’s energy demand is expected to grow at 5% per year in the next seven years. The natural gas demand will grow at an annual rate of about 9%, from 4.0 BCFD in 2001 to 9.0 BCFD in 2010, with an expected deficit between national production and demand of close to 2 BCFD by the year 2010. Regional development and demand for natural gas are closely correlated. The main drivers of gas demand are power generation, industrial consumption, use of cleaner fuels, and development of local distribution companies. The power generation sector is becoming the largest user of natural gas. The electricity demand in Mexico will grow at a 5% rate annually. Over the next 10 years, 27,400 Mw of new generating capacity must be added to meet the growing demand, most of which will come from combined cycle plants consuming natural gas. The federal government has not been able to reinvest the necessary funds to increase gas production, since most of the revenues are assigned to other social and economic development activities. The lack of funding for exploration and production of natural gas by the federal government has left the country with insufficient production to satisfy its growing consumption. III. Natural Gas Legal Framework The Mexican Constitution reserves to the state the exploration and production of all hydrocarbons located in Mexico. The oil and gas industry was nationalized in 1938. Since then, the industry has become a matter of national pride, the symbol of the wealth and patrimony of the Mexican people. It is considered a strategic activity by the Mexican Constitution, which means that it is strictly reserved to the state. No private participation is allowed, with few exceptions. The Nation has the exclusive right to: • Explore, exploit, refine, and process crude oil and natural gas, • Produce basic petrochemicals and liquid petroleum gas (LPG), • Carry out first-hand sales of those energy products. The Mexican government carries out all activities related to the oil and gas industry through the state-owned Petróleos Mexicanos (Pemex) and its four vertically integrated subsidiaries: Pemex Exploración y Producción, Pemex-Refinación, Pemex Gas y Petroquímica Básica, and Pemex Petroquímica.8 Private participation in the oil and gas industry is very limited. Basically, private parties may participate in this sector only in the capacity of contractors through construction, procurement, or service contracts with Pemex or any of its subsidiaries. Pemex may enter into contracts with private parties, but, by force of law, all contracts must be paid in cash, and may not be paid through a participation or percentage in the production or results of the operations.9 In 1995, amendments to the “Ley Reglamentaria del Artículo 27 Consititucional en el Ramo del Petróleo” were issued by Federal Congress to allow private participation in natural gas downstream activities. Private parties may own and operate natural gas transmission, storage and distribution systems. Since exploration and production of natural gas are still reserved to the state, the only source of gas in Mexico is either Pemex-Gas y Petroquímica Básica or imports. Transmission, storage, and distribution activities by private parties require a permit granted by the Mexican Energy Regulatory Commission (Comisión Reguladora de Energía) (CRE), upon fulfilling all technical standards. IV. Investment Needs and Opportunities A. Pemex Multiple Services Contracts (MSCs) In December 2001, Pemex announced the beginning of a process to increase the production of non-associated natural gas to accelerate domestic gas development and production. However, since exploration and production of oil and gas is reserved to the state and no participation or ownership of the reserves may be offered to the contractors, Pemex has come up with a new strategy to hire specialized companies to perform a wide variety of services under a single contract, the MSCs. Basic Elements of the MSCs Under the MSCs, a contractor, or a group of them, will be responsible for performing multiple services under a long-term single contract (including drilling and completing wells, installing gathering pipelines, conducting field operations, etc.). The MSCs are government contracts subject to the provisions of the Public Works Law and to budgetary constrains imposed to Pemex by the Federal Congress. The purpose of the contract is to grant the contractor a determined work area where it will be responsible for performing development, infrastructure and maintenance works related to the production of non-associated natural gas in the Burgos basin. By law, the contract term must be fixed, initially for 20 years, but such term may be reduced depending on the production of the work area. The contract is divided in three phases; (1) Development Phase (up to 8 years), (2) Reactivation phase (5 years), and (3) Maximum Recovery Phase (7 years). The contractor has a minimum work obligation during the first 3 years of the Development Phase, and then continues performing work until there are no more drillable locations within the work area. Although the contractor is responsible for the day to day operations, Pemex retains control and supervision of the works at all times, and may conduct similar operations in the work area. Pemex also has the right to terminate, rescind or temporarily suspend the contract for cause or for convenience, in which case Pemex shall have to compensate the contractor for works performed and certain non-recoverable expenses. The contractor will not have any ownership of the reserves or the production and will not participate in the value of the production or the benefits from exploitation. The contractor will be responsible for obtaining the financing for the total capital investment and the operating expenditures, and will be paid a service fee based on a unit price per service provided, subject to a monthly payment cap predicated on the contract area’s delivery capacity and the price of gas. Awarded MSCs Pemex has awarded five MSCs already and the works are under way. Most of the awarded companies have been international oil and gas companies and a couple of consortiums formed by Mexican and international, mid-sized oil and gas companies. However, it is important to point out that Pemex did not receive as many offers as it had envisioned. Some of the bids were canceled because no bidders appeared. The lack of interest has been ascribed to a combination of poor profit margins, difficult contract terms, questionable expectations as to reserves, lack of upside, inability to book reserves, and constant political threats of litigation over the constitutionality of the MSCs. Political Debate Pemex has taken the position that the MSCs are not concessions, production sharing contracts, or risk agreements. Rather, they are purely service contracts because they do not grant exclusive exploration and production rights or ownership of hydrocarbons. These statements should be viewed against the back-drop of the constitutional limitation under which Pemex operates, and are intended more to assuage political criticism than to describe the undertakings and risks of the contractor. Recently, on April 20, Congressmen finally decided to take action on the issue of the Constitutionality of the MSCs. Opposing political parties asked the General Assembly of the Mexican House of Representatives to vote on whether the House would decide to file a constitutional challenge before the Mexican Supreme Court against the MSCs. The General Assembly of the Mexican House of Representatives ratified the resolution taken by the Commission for Constitutional Matters, and its members voted 299 in favor of the MSCs, 113 against, and 10 of them decided not to vote.10 Notwithstanding this favorable vote, there are new threats to litigate from various unions. After this Congressional resolution, Pemex has confirmed that it will continue with the MSC program in the near future, but it is doubtful that through this program it will produce enough gas to meet the growing demand. B. LNG Projects Technical Aspects Due to the shortages in national production of natural gas, several multinational energy companies are looking to develop liquefied natural gas (LNG) storage and re-gasification facilities in Mexico. LNG is a multiple-step product. Natural gas is produced and then liquefied (in foreign countries) by cooling it to freezing temperatures (about -256°F). The LNG is shipped in tankers to LNG gasification facilities (terminals) in North America. Recently, there has been a sudden surge in LNG activity in the United States and Mexico driven by a change in the economics of LNG. The price of natural gas has risen dramatically – today’s price is in excess of $6.00/MMBtu – and is expected to remain at historically high levels into the future. Demand for natural gas has risen and is expected to continue to climb, while domestic and conventional imports are nearly flat. The cost of LNG has declined throughout the value chain – liquefaction, shipping and regasification – to approximately $2.50-$3.50/MMBtu. The Projects This growth in demand will allow the development of three LNG receiving terminals in Mexico; one (or maybe two depending on the demand growth) in Rosarito, Baja California, a second in the port of Lázaro Cárdenas in the South Pacific, and a third one in Altamira, in the Gulf of Mexico. The Rosarito project is designed to serve both the US and Mexican markets. Most of the gas will be transported to the Californian market. The Lázaro Cardenas project will serve the gas needs of the central part of the country and it will be developed by the Spanish oil and gas company, Repsol. The Altamira project has been awarded to Shell through a bid procedure carried out by the “Comisión Federal de Electricidad” (CFE), the state-owned electricity company, which entered into a long term gas purchase agreement with Shell. Opposition to LNG Receiving Terminals The proposed LNG terminals have been criticized by opposition political parties, and environmental and social activists. Some experts in the US contend that LNG facilities are easy targets for terrorist attacks and other causes for disaster, such as leaks, problems in ancillary equipment, etc. Nevertheless, LNG has an excellent safety record, but opponents cite: • An explosion in Cleveland in an LNG storage tank in the 1940s that killed 130 people • An explosion at an Algeria liquefaction facility in January 2004 that killed 27 people LNG also has the usual panoply of conventional environmental considerations associated with extremely large energy facilities. In Mexico, Marathon had already obtained a gas storage permit from the CRE to build an LNG storage and regasification facility, but due to strong opposition from the local community in Rosarito, the local government denied the land-use rights to build the facility. ChevronTexaco is also trying to develop a similar project 20 miles off the coast of Baja California, at an offshore site near the Coronado Islands. Congressmen have criticized this project under the argument that foreign multinational companies will end up having control of Mexican sovereign waters. Basic Elements of LNG Regulations LNG storage and re-gasification facilities may be 100% privately owned and require, among other local and federal permits and concessions, a gas storage permit from the CRE, which regulates the operation and technical standards of the facility. Open access and non-discriminatory provisions for available capacity are included in the permit title. Rates are regulated and approved by the CRE. Other federal and local permits and authorizations are (i) an environmental permit from the Secretaría de Medio Ambiente y Recursos Naturales (“SEMARNAT”), (ii) authorization from the Secretaría de Comunicaciones y Transportes (“SCT), and (iii) land-use permit(s) from the local authorities. Technical standards are still under development, but the CRE has strongly emphasized that it will require full containment tanks to avoid accidents and spills. V. Conclusion Since the nationalization of the oil industry in 1938, the Mexican people have developed a strong sense of pride and sovereignty around the state’s ownership of the energy industry. Now that times have changed, and it has been demonstrated that the government needs funds to develop the industry, it is unfortunate that this sense of pride is being used as a political tool to prevent a modernization of the industry which includes participation by much-needed private investment, not only through services contracts, but by means of an integral energy reform. The challenge President Vicente Fox is facing in the Mexican energy sector is key to his success as the first PAN president in Mexican history. If the energy sector is not developed at the same pace as the growth of energy demand, the damage to the Mexican economy could be serious. It is clear that the Fox Administration is aware of the situation and is trying to take the necessary measures to avoid an energy crisis, but the question of his political ability to implement those measures is yet to be answered. Nevertheless, under the current limited legal regime, the Federal Administration is trying to foster private participation to increase domestic gas production through the MSCs, and natural gas imports through LNG storage facilities.