George Baker
Baker & Associates
Oakland
Baker is managing principal of Baker & Associates, a management consulting firm that specializes in Latin American oil and gas industries.
Adapted from a paper given at an Aug. 18, 1994, conference sponsored by the Institute of Economic Research, National University of Mexico, Mexico City.
Compared with the experiences of the U.S. and Canada, Mexico has vet to make any meaningful evaluation of the potential costs and benefits of the deregulation of natural gas markets.
Mexico has all three elements of the gas industry--reserves, pipelines, and customer pricing--under control of government agencies. Since 1992 there has been a tug of war among several agencies and ministries of the Mexican government regarding regulations for natural gas distribution.
The administration of President Carlos Salinas de Gortari had hoped to see the regulations published during his term of office, but lack of agreement between the operating agencies Petroleos Mexicanos and the Federal Power Utility (CFE) and the principal ministries of commerce, treasury, and energy derailed hopes that final regulations could be issued before 1995.
The general perception in the U.S. and Canada is that Mexican policy planners in the operating agencies have taken preservation of the regulatory status quo as their principal negotiating objective. The perception is that the approach in the ministries to deregulating natural gas markets has been too weak and too narrow.
START FROM SCRATCH
The new administration of Ernesto Zedillo may be wise to scrap previously prepared planning documents on natural gas regulation and start over.
The place to start would be an examination of the experience of other countries, especially Mexico's partners in the North American Free Trade Agreement (Nafta). Mexico's objectives in such a review would be to seek a middle ground between overregulation and underregulation. The middle ground for natural gas regulation would:
- Maximize development of the gas sector, providing clean energy for industrial, commercial, and residential users.
- Encourage development of the private electric power sector, such that the fuel supply issue for independent power producers (IPPS) will be one that inspires confidence in developers and project finance lenders.
- Promote the use of natural gas as an alternative, environmentally sensitive fuel for vehicle fleets in major metropolitan areas.
- Enhance availability of funds from private lenders on a stand alone, nonrecourse basis for the development of gas infrastructure, mainly pipelines and storage facilities.
- Encourage the optimum development of new dry gas fields, especially the small and medium sized fields that are generally overlooked by large, integrated oil companies.
- Establish market based incentive mechanisms that would reward producers and consumers for gains in efficiency in the production and utilization of natural gas.
- Establish regulatory bodies that would inspire the trust of investors, lenders, operators, and consumers, while optimizing tax revenues for the government.
- Promote industrial and regional development by making natural gas available on attractive terms to prospective industrial investors as well as to areas that currently lack this resource-Baja California, for example.
The unique challenge of the Zedillo government will be to develop a new vision of natural gas regulation that takes as its starting point not the traditional, vested interests of Pemex and CFE but the long term interests of the national economy, regional development, and the environment.
BACKGROUND
The natural gas industries of Canada and the U.S. differ from that of Mexico in these ways:
- Natural gas produced in Canada and the U.S. is mainly dry, nonassociated gas, whereas in Mexico historically most gas production has been associated gas.
- About 70-75% of natural gas production in Canada and the U.S. is provided by small and medium independent producers. In Mexico, there is only one large integrated oil company, whose E&P interests are mainly focused on the Offshore Campeche region.
- Canada and the U.S. have developed regulatory institutions and legal frameworks that engender a sense of security and predictability among producers, pipeline companies, electric utility developers and operators, consumers and, above all, lenders, Mexico has virtually no regulatory framework for natural gas at all.
LACK OF REGULATORY FRAMEWORK
In Mexico the lack of a regulatory framework is poignantly visible in the area of local gas distribution companies (LDCs).
Of the dozen LDCs in Mexico, about a third are in bankruptcy or near bankruptcy. Why? For their own reasons, each of them valid in isolation, Pemex and the Commerce Ministry dictate their respective prices and rates at levels that make the business of gas distribution more of a state subsidy than a real business. Since 1991 the government has indicated that it wants to privatize these LDCS, but prospective buyers have been turned away by the lack of transparent costs and liabilities and the absence of a regulatory framework. In spring 1994, one of the bankrupt LDCs was sold to an international buyer, but the sale was an insider deal between Pemex and the buyer, not the outcome of competitive public bidding.
In Mexico the lack of a regulatory framework is also seen in the new IPP arena, an area the Salinas government had hoped would be attractive to developers and lenders. The only test case of viability of the new electric power regulations of May 31, 1993, was the aborted investment of Mission Energy in the ill starred, coal fired Carbon II project.
Further, Canada and the U.S. have common law traditions, ones in which the concept of law is dynamic as well as institutionalized. The simple idea is that, all other things being equal, a ruling of a court or regulatory agency in one case should apply to subsequent cases as well.
For gas producers, pipeline companies, electric utilities, and lenders, the rule of legal precedent means that they have a precise understanding of how courts and regulatory bodies are likely to rule under a wide variety of conditions. Such an understanding helps all parties quantify business risks and opportunities. In Mexico, the institution of common law does not exist. The civil law that prevails is some version of the Napoleonic Code, and case law has much less importance than it does in U.S. or Canadian courts.
CHALLENGE DOWNSTREAM
In Mexico, overregulation has eliminated competition from almost all segments of the gas industry, downstream and upstream.
The place where government policymakers should start their review of the regulatory environment for natural gas is in the area of gas transmission. The market clearly needs an incentive mechanism to stimulate investments in gas transmission. Unfortunately, there is no simple, magical way to guarantee such investments. Not even a change in policy that would allow private gas pipelines would be sufficient. What the gas market wants is the security of knowing that, if the pipelines are built, the cash flow--a function of equitable rate structures--will come. Absent a credible framework in which rate structures are decided, not even the option to build private pipelines would stir investor or lender interest.
Investors in pipelines want to know that they will have some protection from competitors--through the concept of service area--while at the same time knowing they will be free to compete among themselves to expand their businesses. For their businesses to grow, such investors need to know that new gas accounts will not be preempted by Pemex.
Investors in gas pipelines in Mexico will want to know two things: Will they be owners or lease-operators of the pipelines? And will the regulatory environment be sufficiently transparent and fair so as to assure them and their lenders that adequate tariff rates will be in force for the life of the project?
REGULATORY CHALLENGE UPSTREAM
Mexico is facing an emerging gas supply crisis, one that cannot be ameliorated by increasing associated gas production in the Bay of Campeche.
In May 1994 Pemex Gas said that by 2005 Mexico would need about 2 bcfd of delivered gas to cover increased needs of the electric, industrial, and residential sectors.
With a 70% efficiency rate and a GOR of 800:1, Pemex would have to increase oil production in Campeche to 3.6 million b/d by 2005 to be able to provide burner tip supplies of 2 bcfd. Such a projected increase, equivalent to 1.4 times current levels, is an impossible requirement for a 10 year horizon without private investment.
Pemex currently obtains 85% of its gas supplies from associated gas. Very little attention has been given to increasing dry gas volumes, and Pemex is already cash poor for its oil production programs.
Such circumstances suggest that Pemex and the government might be receptive to a policy framework that would have the following effects:
- Significantly increase gas supplies.
- Not entail ownership of a resource base by private concerns.
- Increase Pemex revenue while decreasing its investment needs.
- Not entail additional Pemex or sovereign debt.
- Enhance technology transfer upstream.
- Provide economic multipliers measured in employment, regional development, and environmental gains.
- Increase government tax revenues.
In dry gas fields in northern Mexico, Pemex and the Mexican government should consider a policy innovation that would authorize private contractors to undertake E&P services and be compensated on an incentive basis keyed to the profitability of gas production.
The key to acceptance of such an innovation in the regulations is the approval of an incentive based method of compensation. Such a method would reimburse developer costs and permit the contractor to charge a management fee as a percentage of Pemex's profits before special contractor fees and taxes.
REGULATORY INSTITUTIONS
In Mexico, there is only one agency that has effective regulatory authority over the development of natural gas markets in Mexico: Pemex.
Pemex has determined that each dollar of its capital budget is better spent in the Gulf of Campeche in oil and associated gas production than in the development of dry gas fields in the North.
Pemex also decides where pipeline investments are made. For the past 2 decades, Pemex has all but ignored repeated requests of the state government of Baja California for gas pipeline connections to U.S. and Canadian gas suppliers.
And Pemex can restrict utilization of its gas transmission lines and set its own prices for gas transmission without review by another regulatory body. Further, Pemex can deny requests by prospective gas customers for connections to existing pipelines and can undersell the gas market by offering LPG and fuel oil at rates that, on a BTU basis--regardless of environmental issues--make these fuels more attractive to consumers than natural gas.
A second tier regulatory authority that also affects natural gas markets in Mexico is CFE. Its role in natural gas markets in coming years is expected to grow as an increasing number of IPPs require natural gas supplies.
CFE in early 1994 completed a rushed gas supply contract with Pemex in order to prepare the bid package for the Merida III power project. CFE expects developers to take this supply contract on its face value, even though there has never been a single instance in which the Mexican courts have ruled, for or against CFE, in an action alleging the breach of a gas supply contract with Pemex. For a developer or lender seeking possible recourse for damages, CFE's gas supply contract with Pemex is largely an unknown commodity.
SOLUTIONS
Pemex needs increased capital for gas supply, transmission infrastructure, and investment.
Funds for investments in gas supply can be obtained from U.S. and Canadian oil and gas companies provided that they are hired by Pemex as contractors to be compensated under an incentive and efficiency based mechanism.
Pemex needs to understand that the objection it has traditionally raised over private participation in profits from oil and gas production no longer holds water. So reservoir management and production services that the contractor provides should be regarded as part of Pemex's costs, not a sharing of Pemex's profits.
Investments in gas transmission can be obtained by opening gas pipelines either to private ownership or to private operation by build-lease-transfer developers. However, a simple decree authorizing private pipelines or the lease operation of Pemex or bank-trust held pipelines will not unlock investment flows. The more subtle and difficult job of creating credible regulatory institutions in Mexico is still ahead.
RECOMMENDATIONS
The Zedillo government should proceed by recognizing that its predecessor succeeded and yet in some instances also failed in the task of developing a long range energy policy.
It succeeded in:
- Freeing Pemex of much of the excess staff and costs associated with the oil union's centralized control of Pemex's labor force. As a result, Pemex's overall labor force shrank to about 113,000 from a previous level of more than 200,000, and costs of supporting the union's hierarchy shrank correspondingly.
- Devising a law and regulations that authorize investments in private electric power generation.
- Holding the traditional hard line about foreign investments in oil and gas activities in the face of intense pressure from the Canadian and U.S. governments during Nafta negotiations.
- Radically reorganizing Pemex into four operating units and in 1993 rewriting the book on how Pemex is to report its financial information to the outside world.
The value of these accomplishments must be measured in terms of their contribution to the efficiency of Pemex and CFE operations, capital budgets, and profits. The general view in Canada and the U.S. is that these accomplishments were a good beginning but fell far short of the desired mark.
One oil company representative in Mexico observed, for example, that Mexico produces roughly as much oil and gas as does the North Sea, where, in a given year there may be investments of as much as $10 billion.
"In Mexico Pemex spends $1-2 billion on investments in oil and gas production, a tenth to a fifth of what is needed," he said. "The Mexican government is never going to increase Pemex's capital budget by a factor of five or ten. So, without the required investments, the environment, exports, regional development, and employment stagnate."
The new government must find the courage to look at the conundrum of financing gas production and pipeline infrastructure squarely in the eyes.
CONCLUSION
The new government should avoid at all costs yet another homegrown solution to the challenge of creating a viable regulatory framework for the development of Mexico's natural gas market.
The new government must also find a way to assert real authority over Pemex and CFE. Policymakers should realize that current policies are likely to lead only to a shortfall in domestic gas supply, underinvestment in gas transmission, and more embarrassments and delays in the financing of private electric power generation.
The new government must look again at the experience of Canada and the U.S.. Officials of the new government must meet with gas producers and pipeline companies from those countries to discuss how they would visualize their role in increasing gas production and gas transmission infrastructure.
Such meetings, analysis, and discussion will not be the work of the first 100 days. Nevertheless, by the time the new government leaves office in 2000, there should be, either completed or under construction, at least 5 million kw of privately funded electric power capacity and in development dry gas fields that would contribute an additional 500 MMcfd of domestic supplies.
For such results to be booked, the challenge of a credible, fundable regulatory framework must be taken up at once.
