MEXICO'S ENERGY POLICIES STAND AT CROSSROADS

George Baker
Baker & Associates
Oakland, Calif.

Baker is principal of management consultants Baker & Associates and publisher of Mexico Energy Intelligence, an industry newsletter.

Decisions will be taken within the next 6 months that will determine the shape, direction, and activity of Mexico's energy and petrochemical industries for the rest of the decade. Here are the decisions:

Prospective petrochemical investors will decide if the current balance of opportunity and risk justifies serious bidding on Petroleos Mexicanos' petrochemical plants and complexes. They are to be sold in the coming year.
Natural gas transportation and distribution companies will decide if new natural gas regulations scheduled for release by Nov. 11 will provide enough protection against Pemex's overwhelming presence in Mexico's industrial fuels market to justify an investment in pipelines or local distribution.
Developers of independent power projects (IPPs) will ask themselves whether the same natural gas regulations, coupled with Pemex's new interest in entering into long term gas supply contracts, will counterbalance the inherent investment risk of Mexico's uncertain electrical power market.
Lenders, investors, and developers will decide on acceptable discount rates applicable to future earnings associated with prospective investments or acquisitions. These discount rates, in turn, will affect the bidding as well as the availability of off balance sheet financing.

BACKGROUND

The purpose of privatizing certain Pemex petrochemical plants is to allow Pemex to concentrate its resources on its energy business units.

It does not reflect a decision to privatize the whole of Pemex, of which petrochemical privatization would be the first step. Instead, the energy business units are to be strengthened through strategic alliances.

By early 1991 several important decisions had been reached in Pemex regarding its mission and medium term business strategy.

With McKinsey & Co. consultants as advisers, Pemex's decision was to concentrate investments, staff, and other corporate resources on its energy business units: exploration and production, refining, natural gas, and distribution.

Pemex's nonenergy business units--lubricants and asphalt, for example--deemed noncore by McKinsey were to be downgraded in their ability to draw on corporate financial and staffing resources.

The first problem for Pemex was that neither its core nor its noncore business units were set up as businesses. At the time, they were but large departments of an integrated, state owned oil company.

But it was only after negative publicity as a result of a tragic explosion of a sewer line in downtown Guadalajara in April 1992, which apparently resulted from a Pemex gasoline pipeline leak, that Pemex made its strategic thinking public.

In July 1992, Mexico's congress reestablished Pemex as an organization made up of a corporate staff and four operating units: E&P, refining, gas and gas products (originally gas and basic petrochemicals, although this unit handles only natural gas and natural gas liquids), and petrochemicals.

POSTREORGANIZATION

The new organizational chart (27896 bytes) for Pemex did not point to management's strategy to concentrate future resources on its energy business units.

Since 1992, Pemex has aggressively sought partners for some of its nonenergy business units. For example, partners from the private sector were found to take majority positions in the areas of air transportation, lubricants, and bunker fuel.

In addition, Pemex sought strategic partners in selected areas of its energy businesses, mainly the joint venture with Shell U.S.A., to refurbish and upgrade its refinery at Deer Park, Tex.

With Shell as a partner, Pemex was able to obtain off balance sheet financing for the first time in its history--and possibly the first time for any Mexican company.

Terms of the financing were favorable. Shell gained a long term source of crude supply from Mexico, and Pemex gained badly needed coker capacity for its heavy Maya grade crude.

With Pemex established in operating units and with the arrival of the new government of Ernesto Zedillo, it became possible to launch a program to spin off Pemex's petrochemical units.

Mar. 18, 1995, was the kickoff date. With President Zedillo and his principal cabinet ministers present at Expropriation Day ceremonies, Pemex Chief Executive Officer Adrian Lajous set forth a frame of reference that justified the prompt sale of Pemex's petrochemical plants.

PETROCHEMICAL INVESTMENTS

Lajous' plan called for the privatization of 61 Pemex petrochemical plants located mainly in 10 petrochemical complexes.

The idea would be for Pemex to take a minority position in each plant for several years, at least until labor conditions and contractual terms had been stabilized to the satisfaction of the new investors, the government, and the union.

The privatization initiative was immediately questioned, however, by the head of the oil union, Carlos Deschamps. He stridently argued that the moment had come not to privatize Pemex's petrochemical plants but to rededicate the resources of the state and the experience and commitment of Pemex's work force toward upgrading the technology, operating efficiencies, and profits of the plants.

In succeeding months the union's opposition to the privatization measure would not subside but would grow to include full page ads in the Mexico City press as well as rallies in a number of the towns that make up Mexico's petrochemical corridor in Veracruz and Tabasco states. This increasing union opposition should be of concern to prospective investors.

Doubtless, in the event privatization of the plants takes place, the current union leadership would angle for a perpetuation of its exclusive negotiating role with the new plant owners.

Other issues for prospective investors in Mexican petrochemical plants include concerns about feedstock supply and pricing and environmental liabilities.

NEW GAS RULES

With Pemex senior management intensely involved in planning for privatization of petrochemical plants and in dealing with prospective electric power investors that wanted long term gas supply contracts, the government unexpectedly changed the rules in the areas of natural gas transportation and distribution.

Last Apr. 21, with Lajous in Houston, Energy Minister Ignacio Pichardo called a press conference to disclose that the government had decided on a new policy that would allow private ownership and operation of grassroots natural gas pipelines and storage and distribution systems.

In July, the Energy Regulatory Commission, an agency that reports to the Energy Ministry and one set up in 1993 to advise the ministry on electrical power tariffs, held hearings with representatives from companies from six countries to learn their views on the appropriate regulation of natural gas transportation and distribution. Pemex also presented its views at these hearings.

Meanwhile, in the area of private power generation, despite nearly 3 years of having the principle of private investment in electric power in force in Mexican legislation, there have been no projects successfully negotiated.

The much touted Carbon II project in Coahuila failed to obtain financing, and the principal U.S. developer withdrew in October 1993. The long delayed IPP at Salamayuca in Chihuahua-- nicknamed "Salamanunca," literally "Salama never" by persons close to the project--is still awaiting closure and financing.

NATURAL GAS SERVICE

There is no natural gas service at all in West and Northwest Mexico.

If all goes well, this situation will change in the next 2 years.

Since about 1980, Baja California Norte state has asked Mexico City for natural gas service for its principal cities, Mexicali and Tijuana. City and state planners, along with industrial park developers, have said that, until now, numerous international companies have chosen Ciudad Juarez over Mexicali because the former has natural gas service.

With natural gas as fuel, an expansion of power capacity in Rosarito could take place free from the environmentally risky operation of unloading imported fuel oil and diesel from barges.

For 10 years the answer in Mexico City to this request was silence. Since 1990, Pemex and state electric power utility CFE have been carrying out feasibility studies of Baja California's potential as a market for natural gas.

With election of Zedillo, whose hometown is Mexicali, Baja California is taking on new importance.

The Greenfield Natural Gas Pipeline Act of 1995 may be the answer to getting natural gas to Baja California. By the terms of the new act, such prospective private investors as SoCalGas and San Diego Gas & Electric will be able to build and operate natural gas pipelines in the state. Moreover, natural gas may be imported and exported freely.

OPPORTUNITY FOR TEXAS?

The problem of financing gas imports needed for Baja California might be solved by a policy innovation that would bring in producers with experience in South Texas to explore for and develop gas that would be exported to the U.S. and swapped for gas supplies to Baja California.

In this indirect way, Baja California gas demand could be satisfied with Mexican production.

In a swapping strategy, the equivalent number of jobs and backward and forward linkages stay in Mexico. Otherwise, given a gas demand of about 250 MMcfd at $1.50/Mcf, the Mexican treasury would face an import bill of about $400,000/day for Baja California alone.

The investment needed for this program could be carried out by foreign companies in association with Mexican partners in the private sector. There are dozens of independent producers of all sizes that might be qualified from a technical and financial standpoint.

Compensation to any combination of large and small contractors could be handled by the concept of a sliding management fee for reservoir development.

Regarding the policy area of E&P, many U.S. and Canadian analysts believe the linchpin of energy policy in Mexico lies upstream. In their view, Pemex is unnecessarily restricting its ability to provide industrial fuels to satisfy not only end users but investor middlemen and their bankers in pipelines, distribution, and power generation.

There are policy implications for Mexico of gas production in Texas, where more than 50% of gas production comes from independent companies, most of which are producing from fields that would be regarded as noneconomic by Pemex or any other major oil company.

The production pattern in South Texas can be expected to repeat itself in Northeast Mexico.

The inference that follows is that Pemex probably is leaving more than 1 bcfd of gas in the ground that could be produced by operators with lower overheads. Another 500 MMcfd or more could be produced in abandoned or rapidly declining fields by companies that have developed specialized techniques to revive reservoirs.

Such new production from private contractors would complement Pemex's production and provide a basement rock that would support the emergence of competitive energy markets in Mexico.