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Mexico oils the dealmaking machinery

by Claire Poole  |  Published September 30, 2013 at 9:38 AM

MexicoGears-LG.jpgOn Sept. 2, Mexico's movie-star handsome new president, the 47-year-old Enrique Peña Nieto, gave his first State of the Union speech since taking office in December. In it he talked about all the reforms his administration was embarking on to modernize Mexico's economy, from education to energy to taxes, implying that his critics should either get on the bus or get out of the way. "In the coming months we will be writing the future of Mexico," he said. "We have 120 days so that 2013 can be remembered as the year Mexico dared to take off."

Probably the most ambitious of the reforms -- which could have the biggest impact financially -- concerns energy. Mexico's proven oil and gas reserves -- which amount to an estimated 10.3 billion barrels -- belong to the Mexican people, as was written in Mexico's constitution almost 100 years ago. But Mexico's oil production -- around 2.5 million barrels per day -- has stagnated for years, remaining below levels of just 10 years ago while continuing to feed about a third of the government's revenues.

The country doesn't have the capital and expertise to plumb some of its most promising areas, including the deep waters in its portion of the Gulf of Mexico and shale oil and natural gas in northern Mexico's Burgos Basin, which many consider to be an extension of South Texas' Eagle Ford Shale (and where only three unconventional wells were drilled last year). By some estimates, Mexico has the fourth-largest shale reserves in the world.

Peña Nieto's constitutional reform -- which requires two-thirds approval by the Mexican Congress -- would allow private and foreign companies to share in the profits of any oil and gas reserves they discover, which many said they believe could evolve into production-sharing contracts. The energy reform also would allow direct foreign investment in refining, distribution, pipelines and petrochemicals, freeing up more capital for state-owned Petróleos Mexicanos, or Pemex, to focus investment on growing oil production and reserves. The country's goal: to add 1 million to 2.5 million barrels of oil to its daily production totals, or reach 3 million barrels by 2018 and 3.4 million barrels by 2025.

Most observers think the passage of the reforms will come in December, followed by secondary legislation in June that would also need two-thirds approval, and then bidding could begin. So by late 2014 or early 2015, Mexico could have its first contract under the new scheme.

If energy reform passes -- and is palatable to national oil companies and majors around the world, including reasonable local content requirements and a way to work, or not work, with the unions -- then the move could lead to deals in Mexico's burgeoning energy sector.

WHEN PEÑA NIETO announced the energy reforms in August, he called them "transformational." But some analysts who follow the industry thought they were a bit oversold. Simmons & Co. International, for one, wrote in a report that the changes stopped short of allowing outright ownership of reserves via concessions and that profit sharing arrangements in Bolivia, Ecuador, Iran, Iraq and Malaysia haven't been "sterling examples of great success" for the majors. It also noted that profit sharing proposals historically have precluded international oil companies and majors from booking reserves.


However, if Mexico lifts restrictions on companies registering the value of contracts with the U.S. Securities and Exchange Commission (which would come as part of the secondary legislation), then they could be converted into volume and recognized on balance sheets, which might bring foreign companies in, Simmons said.

"In a cash flow constrained world where capital allocation is becoming increasingly important, is this latest proposal likely to result in a step-change increase in capital investment on the part of the majors?" Simmons asked. "Time will tell."

Rafael Alexandri Rionda, a former director of the Mexican Geological Survey who does consulting work, said at a Thompson & Knight LLP forum in Houston that executives at companies like Exxon Mobil Corp. have told him they won't go to Mexico if they can't book reserves -- or at least monetize the contracts somehow on their financials. "It's a major factor for the sector," he said.

George Baker, a longtime follower of Mexico's energy sector who has a consulting company in Houston, said that the reforms look to him to be "más de lo mismo" -- more of the same. "Even if the reforms are upgraded to risk-service contracts, they may or may not be attractive," he said at a BNAmericas conference in Houston this month.

In the new Brookings Institution book "The End of Nostalgia: Mexico Confronts the Challenges of Global Competition," Duncan Wood, director of the Mexico Institute at the Woodrow Wilson International Center for Scholars in Washington, wrote that if the reform initiative isn't successful, Mexico could lose as much as half a million barrels of oil production over the next six years, including from its most productive oil field, the Ku-Maloob-Zaap in the Bay of Campeche, which has been compensating for the dying Cantarell oilfield but is itself expected to enter into decline by 2015.

"Opening of the sector, either partial or complete, is needed to bring the technology, expertise and financing needed to boost hydrocarbon production and to transform hydrocarbon resources into products that the Mexican economy needs," he wrote.

At a Mayer Brown LLP conference this month, Wood said that while the reform may not be enough to generate the activity people are expecting, "It's a step in the right direction."

While the oil in the ground still belongs to Mexicans, all kinds of companies working in the energy complex -- from oil services providers to contract drillers to transportation, processing and storage providers -- could become valuable targets or joint venture partners if the reforms go through. Those working in the industry said Mexican companies that provide services to Pemex will probably become operators, and foreign companies wanting to win some of Mexico's new energy contracts should consider joint venturing with them to gain a local presence -- with an eye toward eventually making acquisitions.

"Foreign companies are evaluating the opportunity and the market," Manuel Cervantes, an attorney at MCM Abogados in Mexico City who advises clients on contracts with Pemex, said in an interview. "They're trying to understand the scope and make connections. We get calls on a daily basis. There's a lot of interest."

Nicolas Borda, an attorney at Greenberg Traurig LLP in Mexico City who worked on energy privatizations in Bolivia, Peru and Mexico (the secondary petrochemical plants of Pemex-Petroquímica in 1997), was also seeing a lot of interest from foreign players. "Now is the time for foreign companies to start looking at their options and understanding the Mexican business culture, legal framework and the Mexican and foreign players," he said. "I see a lot of opportunities for M&A, especially in foreign companies joint venturing with Mexican companies."

SO WHO ARE THE MAJOR Mexican players already on the ground? Billionaire Carlos Slim Helú, who bought telecommunication company Telmex when it was privatized, already has a piece of Mexico's oil industry through Grupo Carso units Cicsa, Servicios Integrales GSM and Swecomex, which are performing drilling and completion services for Pemex, manufacturing parts and operating a shipyard near the Gulf of Mexico. In May, Cicsa won a $415 million contract from Pemex for the rig Independencia 1, the first offshore rig built in Mexico.


Slim knows the U.S. players: He held an interest in Bronco Drilling Inc., which has done drilling for Pemex, before Chesapeake Energy Corp. bought it in 2011 for $315 million -- a 40% return for his family investment company. He also owned shares in oil and gas driller Allis-Chalmers Energy Inc., which was sold to Norway's Seadrill Ltd. in 2010 for $890 million.

Another important service provider is Offshore Drilling Holding, a unit of Ramiro Garza's Grupo R, which has worked with Pemex for 25 years. It owns three ultra-deepwater rigs and last month raised $1 billion in a debt offering. "It's a favorite company of Pemex right now," said one industry lawyer.

Then there's Grupo Alfa, led by Armando Garza Sada, whose unit Newpek LLC has a joint venture in South Texas' Eagle Ford Shale with Pioneer Natural Resources Co. and India's Reliance Industries Ltd.

Others include construction services provider Grupo ICA, which is building the Etileno XXI petrochemical complex for Mexichem SAB de CV and Brazilian partner Braskem SA with Fluor Corp.; Grupo Viavaz, which was awarded integrated services work on an important block in the Poza Rica Altamira Basin in the north; Grupo Mexico unit Perforadora Mexico, whose parent is known for its mining operations but which offers drilling services on land and offshore; Constructora y Perforadora Latina, led by Adolfo del Valle which has provided offshore platforms for Pemex; Oceanografia, a Pemex marine contractor that has raised money in the public debt markets and is looking to do more; and IEnova, a unit of Sempra Energy's Sempra International LLC -- led by former Communications and Transportation Secretary Carlos Ruiz Sacristan -- that is building natural gas pipelines for Pemex.

Still others include Integradora de Servicios Petroleros Oro Negro, led by José Antonio Cañedo White and Gonzalo Gil White, which has provided drilling platforms for Pemex in the Gulf of Mexico and is backed with $250 million by Mexican private equity firm Axis Capital Management, Ares Management of the U.S. and Temasek of Singapore; Mexichem, led by Antonio del Valle, which recently signed a joint venture with Pemex to produce vinyl chloride monomer at its Pajaritos petrochemical complex in the state of Veracruz -- it bought the vinyl dispersion, blending and suspension resin assets of PolyOne Corp. this past March for $250 million; Arendal led by Adrian García Pons, which has built some of Mexico's natural gas pipelines; and Grupo Tradeco, led by Federico Martínez Urmenta, which has worked on infrastructure projects across Latin America, including ones for Pemex.

"Since 2008, there has been a lot of private industry expanding into oil services and completions," MCM's Cervantes said. "They've been preparing for the next step."

According to Bank of America Merrill Lynch, Mexico spent about $8 billion on drilling and completion services last year, which should jump another $2.5 billion in the next two years if the reforms go through. Merrill analysts think U.S. companies that will benefit most from the new opportunities in Mexico include oil service and equipment providers and offshore drilling specialists.

Among them: Noble Corp., which is thought of as the most active offshore drilling contractor in Mexico with 11 jackup rigs operating in the Bay of Campeche; Ensco International Inc., another offshore driller that has four jackup rigs working in Mexico's shallow waters for Pemex through 2015; and Weatherford International Inc., which does a lot of drilling in Mexico -- so much that it blamed weakness south of the border for a 6% decline in second-quarter revenues in Latin America compared with last year.

Pico Petroleum Services of Egypt also has been involved in Mexico's oil sector, offering integrated turnkey drilling and workover services beginning in 2009. It was the winner of a fee-per-barrel contract allowed a few years ago, along with Halliburton Co., Schlumberger Ltd. and Baker Hughes Inc.

TO GET A FEEL FOR THE SIZE of the potential offshore market, Seadrill, which has drilled some of Mexico's deepest wells, estimates that in the past 10 years only 552 wells were drilled off Mexico's shores. That's compared with 4,653 wells that were plumbed in the U.S. part of the Gulf of Mexico. "With similar geology, this highlights the enormous potential for the Mexican portion of the Gulf and we believe the first leg of the growth story will occur in the shallow water," Seadrill said recently. "Seadrill sees Mexico as a strategically important market going forward."


Analysts said the offshore drilling rig market is already tight and expected to be that way for years, and any movement by Mexico to add equipment would significantly cut supply, which would allow companies to raise rates -- and thus make them more valuable.

Developing Mexico's oil and gas potential could not only bring valuable resources to the country's growing economy, it also could bring jobs to the country's 112 million people, half of whom live in poverty. "How can we move to the future if we don't change?" Alexandri said. "Pemex needs a new way of doing things."

The state-owned oil company, which has been criticized for being bloated, slow moving and corrupt, is already making moves with the reforms.

Last December, Peña Nieto appointed Emilio Lozoya Austin as head of Pemex. The son of a former Mexican energy minister, Lozoya previously worked in structured finance and distressed assets at the Inter-American Investment Corp. and later co-founded a $1 billion investment fund. He's already replaced a third of the company's management and instituted tighter controls on costs. He's getting the company ready for what he estimates will be a $10 billion annual boost to oil investments in Mexico, which he's calling "the new Middle East."

Last month, Lozoya announced plans to create a new company to focus on exploring for and producing shale gas and deepwater oil in the U.S., giving it the experience it needs to do the same at home. Executives hope it will be up and running by year's end and are already looking at several projects, including possibly buying a refinery, one source said. It's the first time the company -- the fifth-largest crude producer in the world -- has expanded beyond its borders other than a refining joint venture it has with Royal Dutch Shell plc in Texas.

"Ecopetrol [Colombia's state-owned oil company] has interests in 100 blocks in the U.S. part of the Gulf of Mexico," Borda noted at the BNAmericas conference. "Pemex has zero."

MEXICO HAS TRIED to reform its energy sector before. In 2000, Mexican President Vicente Fox -- from the National Action Party, or PAN -- promised to change laws to open the energy industry to private investment. He tried first with the petrochemical sector, launching Proyecto Fénix, his plan to revive a world-scale petrochemical complex with $2 billion in private investment. But when the company's partners, Canada's Nova Chemicals Corp. and Mexico's Grupo Indepro and Grupo Idesa, wanted to buy natural gas from Pemex at prices lower than the spot market, the government refused and the plan fell apart.


President Felipe Calderón, another panista, who took over after Fox in 2006, tried to revive the oil industry by changing laws to allow foreign investment, but those reforms fell by the wayside when he couldn't get opposition parties to agree. In 2008, Congress did approve laws giving cash incentives to companies helping Pemex pump out more oil. But the move failed to bring in a lot of foreign investors and the first incentive contracts -- to players such as Schlumberger and Petrofac Ltd. in mature fields near Veracruz -- proved disappointing, according to Beatriz Maney, a managing director of OFS Capital Group, which advises companies on investments in Latin America. "They found some of the wells hadn't been properly drilled or weren't even producing," she said at the BNAmericas conference.

Pemex's last auction, in July for contracts to help turn around the Chicontepec Basin, didn't attract any bids from multinational oil producers because it was offering too low a fee per barrel. Shell and BP plc bought the project specifications only to review them and to be able to ask Pemex questions about them, people in the industry said.

While Halliburton won the contract to operate the Humapa block and Grupo Diavaz -- led by Luis Vásquez Senties -- won the Miquetla block, the Pitepec and Amatitlan blocks drew no bids.

Will the new energy reforms get passed? Most observers think they will -- that Mexico must change lest it become a net importer of oil and natural gas, which is projected by the end of the decade. It already is a net importer of gas. "No doubt it will go through," Alexandri said. "It's fundamental."

But it won't come without a fight, as memories in Mexico run deep. When former Mexican President Lázaro Cárdenas nationalized the oil industry and expropriated foreign oil company equipment in 1938, people responded with hours-long celebrations in the streets of Mexico City. "Cárdenas was hailed by workers, peasants and students as the architect of Mexico's economic independence, while even wealthy women were seen donating jewelry to the National Solidarity Fund that would be used to compensate the expropriated companies," New York Times correspondent Alan Riding wrote in his best-selling book, "Distant Neighbors: A Portrait of the Mexicans."

Schoolchildren in Mexico were taught that "el petróleo es nuestro" -- the oil is ours. "Oil had graduated from resource to symbol," Riding wrote. After that, the country's oil industry turned inward and no longer strived to be one of the world's great exporters. Pemex focused on pumping oil for the country's consumption, its income was limited by low domestic prices and its development program was directed by "cautious engineers who were guided by a conservationist ethic based on the conviction that resources should be husbanded for future generations," energy consultant Daniel Yergin wrote in his book, the Pulitzer Prize-winning "The Prize: The Epic Quest for Oil, Money & Power."

But with two parties supporting the changes -- the ruling Institutional Revolutionary Party, or PRI, and the PAN -- and Andrés Manuel López Obrador of the left-leaning Democratic Revolution Party, or PRD, not having the influence he once did (a rally he held in early September opposing the changes failed to attract his usual hundreds of thousands of supporters), ratifying the reforms appears certain.

Dallas Parker, an attorney at Mayer Brown LLP in Houston, said at the conference held by his firm that the people he's spoken with at Pemex are excited about the reforms. "They would take the shackles off and allow them to become a world-class oil company," he said.

A few things might still need to happen for that to take place, including shrinking Pemex's 150,000 employee count and cutting the debt it took on to continue to feed the government's coffers, which at last count amounted to $56 billion and growing. It also has an estimated $100 billion in off-book unfunded pension liabilities.

Calderón, Peña Nieto's predecessor, supports the changes. At a packed luncheon hosted by the World Economic Forum of Houston recently, where he shared a table with sponsors Exxon Mobil and Baker Botts LLP, he told the audience that Pemex badly needed participation of the market and private investment to take full advantage of its resources. "We'll become irrelevant if we don't act," he said. "I hope we don't lose this opportunity."

Tags: Armando Garza Sada | Carlos Slim Helú | Democratic Revolution Party | Emilio Lozoya Austin | Enrique Peña Nieto | Felipe Calderón | Grupo Alfa | Institutional Revolutionary Party | Luis Vásquez Senties | National Action Party | natural gas | Offshore Drilling Holding | oil | PAN | Pemex | PRD | PRI | Ramiro Garza | Seadrill | SEC | Vicente

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Claire Poole

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