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Special Report: Mexico Energy Sector - Opportunities, Challenges and Risks

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Background

Mexico’s energy sector has opened up to foreign direct investment in an attempt to reinvigorate an industry that has suffered several years of continual declines in output. Oil majors like Italian giant Eni S.p.A. recently signed a production sharing accord with the Mexican government for exploration and production (E&P) activity in the Bay of Campeche. Eni was granted the right to the Amoca, Mizton and Tecoalli fields, which could yield up to 800 million barrels of oil and 480 billion cubic feet of natural gas, according to Mexico’s National Hydrocarbons Commission (CNH).

Eni’s upstream activities are likely going to be followed by deeper penetration across the oil and gas value chain, and potential foreign investors are taking notice with keen interest. Mexico auctioned another round of blocks on 15 December, with around 79 companies qualified to bid. Most of the firms were Mexican upstarts—another result of Mexico’s liberalisation efforts in the energy sector.

During the 30 September offshore auction, only 20 companies took part. The next set of blocks are situated in Nuevo Leon, Tamaulipas, Veracruz, Chiapas, and Tabasco, states with numerous and nuanced political risks that companies will have to negotiate through.

Political Risk and New Market Entry

Mexico’s oil and gas industry has been dominated by state entity Petroleos Mexicanos (Pemex) for over 75 years, but declining production has impacted incoming revenue for the government. According to the US Energy Information Administration in 2014, overall production declined by around 25% over the past decade.

Additionally, there has been a steady growth in consumption and demand compelling the government to import natural gas and other refined petroleum products from the US. Despite this, Mexico is still affected by shortages that are stymieing economic growth.

Government interference, high tax burdens, low workforce productivity, lack of investment and innovation in technology and infrastructure as well as widespread corruption and theft have placed a stranglehold on growth and expansion, especially into deep-water extraction and hydraulic fracturing. These are some of the political risks that investing companies will have to consider, particularly for those looking at Mexico as a new market entry. Political risk analysis will also enable investing companies to appreciate the interactions, connectivity and context of risk.

Constraints and Challenges in Mexico’s Energy Sector

Mexico can be a complex and challenging environment for companies to operate in, but not impossible. From a traditional security perspective, organised crime, gang violence and corruption have made major headline news. In April 2014, gang members rolled up to the Hotel Asya in a makeshift tank and riddled the building with bullets. At the time, there were several employees of a UK-based oil and gas services company staying at the Asya, but none of them were hurt. The British company had been working the Burgos Basin, which straddles some of the more violent states in north Mexico.

Pipeline security has also been deeply affected the sect. According to a Pemex spokesman, there were 1,620 illegal taps on pipelines in 2012, significantly rising to 4,218 in 2014, and as of July there were 2,813 taps. Pemex also reported that pilfering more than quadrupled from 2009 to 2013, partially contributing to an 11-year decline in crude production. Many of these illegal taps have taken place in the 25 onshore blocks that will be auctioned off in December. Pemex reported a loss of USD1 billion from fuel theft, prompting them to announced in February that it would halt distribution of “ready-to-use” diesel and gasoline through land pipelines.

Environmentally, communities have been directly impacted. In April, pipeline sabotage caused an oil spill that polluted several rivers in Tabasco state, leaving around 100,000 people without potable water. Activist groups and segments of the general public have remained concerned over the liberalisation of the energy sector and its potential detrimental impacts on the environment. Sabotage and environmental damage poses very substantial risks to business continuity and reputation, among others.

Shortages have caused stress on the retail side. Petrol stations and the supply chain are vulnerable to business continuity disruption due to shortages. Over the summer, several states, including Chihuahua, Coahuila, Jalisco, Nuevo Leon, Aguascalientes, and Zacatecas, were hit with fuel shortages. The remedy was to increase imports from abroad.

Very often theft is aided by the corrosive influence of corruption. Organised crime entities may bribe or recruit individuals with the relevant skills and expertise to aid in thefts. Bribes and/or blackmail are the tools to get an employee to facilitate an awarding of contracts to vendors that may not have the right capabilities or to pay off someone to ignore an alarm triggered by a drop in pipeline pressure during an illegal tapping.

Mexico’s Federal Audit Office (SFP) found that more than 100 Pemex contracts worth around USD11.7 billion, which were awarded between 2003 and 2012, had irregularities and tainted with fraud allegations. The SFP imposed an estimated USD427 million in fines against 14 Pemex executives for contract irregularities.

Monitoring Political Risks and Enabling Opportunities

Understanding the broader political risk picture is fundamentally critical to understanding the array of risks to operations, assets and personnel. A seemingly isolated incident such as illegal pipeline tapping may generate a far-reaching outcome on its own. But when that single incident is viewed in the context of other interactions, such as the activities of single-issue activists group protesting the damaging effects of oil theft or the corruption that may aid in pilfering, then it becomes significantly clearer that more potentially impactful outcomes to a business can materialise.

Affected communities may begin to target the foreign oil company and any supporting firms for failing to prevent the incident. Single-issue activist groups may launch campaigns that could disrupt operations and affect reputation. Organised crime groups may target oil employees for kidnapping and ransom. Indigenous companies, local officials and the national government may try to distance themselves by shifting culpability on the foreign oil company or they may impose tighter regulatory measures in response to public pressures. Awarding of future projects, contract frustration or increasing security risks to personnel are also plausible outcomes. The overarching message points to a necessity to understand the operational environment from social, economic and political perspectives in order to navigate through the myriad of risks and manage them to tolerable levels.

Political risk analysis marries the “top-down” and “bottom-up” approaches to identifying and analysing risk variables. Its underlying purpose is to forecast relevant political risk developments in a clear manner and evaluate the effects of such developments on the company’s goals and operations. It breaks down complex dynamics and interactions to better understand and comprehend, adapt to, manage and control identified political risk factors, and for an industry that is highly politicised, such as oil and gas, carrying out political risk analysis may be a critical tool to facilitate, protect and ensure longevity of investment.