Via Knowledge@Wharton, a look at Mexico’s energy sector:

For more than a decade, Mexicans have watched with dismay as other energy-rich countries in the region, such as Colombia and Brazil, have dramatically increased their oil production levels while Mexico’s levels have stagnated. The country’s oil production peaked at 3.38 million barrels in 2004 but has since declined to a projected level of 2.538 million barrels in 2013, according to the U.S. Department of Energy. That’s almost exactly the same level as what the country was producing in 1990.

In contrast, Colombia’s production has more than doubled — from 440,000 barrels in 1990 to 990,000 barrels in 2013 — and Brazil’s production has more than tripled from 631,000 barrels (1990) to 2.107 million barrels (2013). All of this comes at a time when Mexico’s population has continued to grow — from 81 million in 1990 to 112 million in 2013, further sparking demand for energy on the part of the country’s growing middle class.

What has gone wrong? Critics usually blame Petroleos Mexicanos (Pemex), the Mexican government’s oil and gas monopoly. The second-largest Latin American enterprise in terms of revenues after Brazil’s Petrobras (as of 2009), Pemex was granted a constitutional monopoly after it was nationalized by the Mexican government in 1938.

A holdover from the bygone era of strident Mexican nationalism, Pemex has revenues of $128.6 billion (as of 2012), some 138,000 employees (2011) and total assets of $26.1 billion (2012), but it continues to lose money. The company’s declining financial health is critical because Pemex pays out more than 60% of its revenues in royalties and taxes to the government, providing some 30% of the government’s total tax revenues, according to data from the Organisation for Economic Co-operation and Development (OECD). Pemex currently pays about four times as much in taxes as what it invests, according to Emerging Markets Political Risk Analysis (EMPRA), a Mexico City-based consultancy.

“Mexico has one of the world’s most closed oil and gas sectors,” says Duncan Wood, director of the Mexico Institute at the Woodrow Wilson Center, a Washington, D.C., think tank. “Although the private sector provides services for Pemex, [private firms] are not allowed to actually go into oil or sell the oil, or book the reserves and sell the oil on the central market. So what you have is a situation where all the responsibility falls on Pemex.”

“What’s special about the Mexican oil system is not just what is written in the constitution, but how Mexicans feel about it.” –Duncan Wood

Seventy-five years after Pemex was nationalized, things are about to change. In August, recently inaugurated President Enrique Peña Nieto announced the outlines of an energy reform that would, among other things, amend Mexico’s constitution, allowing for the first profit-sharing agreements between Pemex and the private sector. In addition, the government’s dependency on Pemex’s revenues would be reduced, allowing Pemex to reinvest these funds to enhance its productivity and profitability.

A Special Relationship 

In unveiling the reforms, the new president insisted that the proposal respected, word-by-word, the principles outlined in 1938 by the late Mexican President Lázaro Cárdenas when he nationalized the oil company. Peña Nieto said that Pemex would still belong to Mexico and that private companies would be able to exploit sites under agreements, but that the firms would own neither them nor the extractions. 

“What’s special about the Mexican oil system is not just what is written in the constitution, but how Mexicans feel about it,” adds Wood. “They have a very, very close emotional connection to it. The belief is that it is really tied to national sovereignty. Mexicans believe that the nationalization of 1938 was a defining moment in Mexican history, whereby they pushed out foreign oil companies — and [ would] use the oil for the national good.”

For their part, Mexico’s left-leaning PRD (Party of the Democratic Revolution) opposes any constitutional changes that would allow for private sector participation via contracts or concessions, while the conservative National Action Party (PAN), which ruled Mexico between 2000 and 2012 under presidents Vicente Fox and Felipe Calderon, advocates modifying the constitution in order to allow for increased private sector participation through royalty-paying concessions. Peña Nieto, from the ruling PRI party, has proposed giving companies a share of the profits that result from their deals with Pemex, rather than ownership of the production generated by such ventures. The three political parties agree that Pemex must be given fiscal autonomy so that it can productively reinvest its revenues.

Jose Valera, partner at Mayer Brown law firm in Houston, notes that if Congress passes Pena Nieto’s constitutional proposal, hydrocarbons will continue to belong to the state, and the government will grant no concessions in the strict sense of the term in which resource ownership would change hands. Pemex would be allowed, however, to enter “profit sharing” contracts with private and foreign oil firms. Moreover, the government’s claim on Pemex’s energy revenues would be restricted so that Pemex could become profitable.

“The Mexican government wants to maintain control of the commercialization of the oil for political reasons. [It wants] to prove to the Mexican public that [it] is not losing control of the oil.” –Duncan Wood

“For Mexicans, the change will mean that the state will still own the oil, but that the Mexican government will give the right to private firms to exploit the oil and then receive a share of the profits that are generated,” Wood notes. In contrast, many other countries have a joint venture or production-sharing approach, in which private firms can go into business with the national oil company and are allowed to keep a share of the oil that they produce. In the profit sharing model, oil produced by the foreign firm is given to the government, which sells it.

The production-sharing model will give foreign oil firms a key financial advantage, according to Kirk Sherr, managing director of Oil Finance Specialists Capital (OFSCap), a boutique energy and investment merchant bank, because “it typically allows companies to ‘book their reserves.’” Thus, if a foreign company gets a 40% stake in a block of land that has reserves of 100 million barrels, that company can “book” 40 million barrels of reserves on its balance sheet. “That is a primary way for oil and gas companies in the U.S. and Canada to increase the value of their company,” says Sherr. “These reserves are  leverageable assets.”

The value of a profit-sharing agreement “could [turn out to] be nothing, because there could be no profits” from that operation, once taxes and expenses are deducted from the revenues generated, Sherr adds. On the other hand, a profit-sharing agreement could wind up being attractive. “The devil is in the details” of any contract, he notes.

“This is an important issue for the valuation of the oil companies,” adds Barbara Kotschwar, research associate at the Peterson Institute for International Economics, a Washington, D.C., think tank. “People are more willing to invest in a company that has higher proven reserves.”

Investors’ Lukewarm Reaction 

Unfortunately, notes Wood, “it doesn’t look as if [production-sharing] is going to happen in Mexico” because “the Mexican government wants to maintain control of the commercialization of the oil for political reasons. [It wants] to prove to the Mexican public that [it] is not losing control of the oil…. Firms are very wary about this [prohibition on production-sharing]. They are saying, ‘We would be willing to go in under a profit sharing model if all of the other conditions are right — one of which is if we are allowed to book reserves. But if we’re not allowed to book reserves, we’re not going in there. That directly impacts upon our creditworthiness.’”

For those reasons, Sherr is cautious about viewing the reform plan as a victory for the government. “They are on the right track to keep companies interested, but it is very early in the game to know whether they will attract the [right] kind of investor” or how much investment they will be able to bring in.

After resisting reforms for so many years, why is Mexico changing now? Sherr points out that the political consensus in favor of reform has strengthened as the performance of Pemex has continued to suffer in recent years. During the administrations of PAN presidents Vicente Fox (2000-2006) and Jorge Calderon (2006-2012), there was hope that somehow Pemex would get its house in order, Sherr says. “But with new leadership [the PRI government of Pena Nieto], there is acknowledgement that neither party [PAN nor PRI] can fix Pemex” on its own. In the United States, “a lot of oil and gas technologies have developed during the past 10 years,” including fracking, horizontal drilling and advanced techniques for drilling offshore. But there is growing recognition that “a significant” gap has developed between Pemex’s capabilities in these sectors, and those of the U.S. and other major oil producers.

A second factor, notes Sherr, is that with the growth of Mexico’s middle class, there is “rising demand for gasoline and diesel, a lot of which is imported.” Frustrations with Pemex’s performance have increased along with a growing awareness in Mexico of the “tremendous performance of the U.S. oil sector” just north of Mexico, in the Eagle Ford Shale, which stretches across the border with Texas.

“Mexican demand is very likely to keep growing very rapidly, despite the fact that all sorts of efficient technologies are being developed.” –Arthur van Benthem

On the Texas side of the border, Eagle Ford Shale oil production has grown from just 352 barrels a day in 2008 to 362,936 barrels a day in 2012. Overall oil production in Texas has doubled — an increase of more than one million barrels a day — over the past four years, to a current pace of nearly 2.2 million barrels, according to the U.S. Energy Information Administration. Daily oil production in North Dakota has also skyrocketed in recent years. The robust development of the Mexican side of the Eagle Ford Shale alone would double Mexican oil production, according to Sherr.

Given the deterioration in its production volumes, does Mexico have any other alternative to pursuing these kinds of reform options? According to Kotschwar, “there is a real threat that if [the government doesn’t undertake] this [reform], [it] will have to take less popular reforms, such as raising taxes” on income, as well as value-added taxes, in order to compensate for Pemex’s inability to generate more revenues for the federal government.

Longer-term Prospects 

Longer-term, there is reason to believe that Mexico’s demand for energy will continue to surge, despite the advances of the latest generation of energy-saving devices, according to Wharton business economics and public policy professor Arthur van Benthem. This is another reason why Mexico needs to enact a major reform of its energy sector. As Van Benthem notes, “Mexican demand is very likely to keep growing very rapidly, despite the fact that all sorts of efficient technologies are being developed.”

Van Benthem recently completed a research paper titled, “Has Energy Leapfrogging Occurred on a Large Scale?,” in which he compares growth in per capita energy use of consumers in today’s emerging economies — such as China, India and South Korea — with the growth in per capita energy use of consumers in the United States, Germany and other industrialized countries when they were in earlier stages of industrialization. A major finding of that study: The average Indian consumes more energy-related products today than the average American did in the 1920s, when the per capita income of the U.S. was near the same level as that of India in 2013. Such a conclusion seems counter-intuitive, says Van Benthem, because today’s Indians benefit from access to cheaper, more efficient automobiles — such as the Maruti Suzuki and Tata Nano — as well as light bulbs, refrigerators and other electrical devices engineered to consume less energy.

Using the income elasticity of energy demand for both current less-developed countries (LDCs) and industrialized countries in the past, Van Benthem found in his research that “despite dramatic improvements in energy deficiency, economic growth in LDCs is not less energy-intensive than past growth in industrialized countries. Energy savings from access to more efficient technologies have been offset by other trends, such as a shift towards more energy-intensive consumption bundles and industrial outsourcing.”

This conclusion, Van Benthem notes, “has important implications for influential projections of future energy consumption” — which typically assume substantial leapfrogging to more efficient technologies — for Mexico and other emerging economies. Demand will continue to grow, observers say, and Mexico will either make the reforms required to meet that demand internally, or the country will be obliged, despite its huge energy reserves, to become a net importer of oil and gas.