Reform the reform?
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Strongly backed by President Peña Nieto, Mexico's program of energy reform, which has opened the industry to foreigners, has been affected by the crash in crude oil prices and currently seems destined to "freeze" until the 2018 presidential elections

Mexico’s energy reform stands out as one of the most important institutional rearrangements made in the country in the last seven decades. The participation of several international oil companies and national oil companies from all over the world in the first four bidding processes and the deep-water offshore joint-venture with PEMEX attest that there is appetite for international investors to develop untapped oil & gas potential in one of the most vibrant regions in the industry in the last decade. However, timing has not been an ally for Mexico’s energy reform. Political lobbying for the reform started and became stronger when oil prices where above 100 USD per barrel. A few months after the bill was approved by Congress and enacted by President Pena Nieto, prices dropped around 50%, only to decrease even further throughout 2014. International market conditions have thus certainly slowed down potential interest in Mexico’s oil & gas resources, which in turn have favored the narrative of current political opposition, especially left-wing. In mid 2018 Mexico will celebrate presidential elections and so far, all polls favor left-wing long-term leader Andrés Manuel López Obrador, a politician who has repeatedly stated that President Pena Nieto’s energy reform is a mistake and should be reversed. The question then becomes: could the Mexican energy reform be reversed? In short, the answer is no. However, the energy reform can undoubtedly be paralyzed by three factors: the prospective political environment due to Mexico’s 2018 presidential election, especially if López Obrador wins the election; the inefficacy of laying out the foundations of an institutional framework to eliminate incentives for expropriation under certain political and economic conditions; and the inefficiency or lack of public polices devoted to “eradicate ghosts from the past.” This article shall explore all possibilities.

A strong political arrangement made energy reform possible: The Pact for Mexico. This agreement was signed in late 2012 by Mexico's top three political forces and President Peña Nieto in order to set in motion coordinated actions to increase democracy in Mexico

The political starting point

Despite opposition from Mexico’s left wing parties, led by PRD, Mexico’s energy reform was approved by Congress in mid-December 2013 and enacted by President Peña Nieto on the 20th. This was considered Peña Nieto’s greatest achievement in his then young administration insofar as other four Presidents before him (i.e. Salinas, Zedillo, Fox, and Calderón) unsuccessfully tried to modify the institutional arrangement of Mexico’s energy sector. Some of those former Presidents did introduce changes in legislation that started to open certain activities of the energy sector to private investment. Yet, none of them could modify the Constitution to allow for private investment across the whole value chain, particularly in oil & gas. A strong political arrangement made Peña Nieto’s energy reform (and some others) possible: The Pact for Mexico. This agreement was signed in late 2012 by Mexico’s top three political forces and President Peña Nieto in order to set in motion coordinated actions to increase democracy in Mexico. The Pact for Mexico was based on five major principles: a) A society of freedom and rights; b) Economic growth, employment and competitiveness; c) Security and justice; d) Transparency, accountability and measures against corruption; and e) Democratic governance. President Peña Nieto presented his energy reform bill in August 2013, and its strongest case was the urgency to transform Mexico’s energy sector in order to make it standard with respect to international best practices. In other words, to allow for private investment across the oil & gas and power sectors. Mexico’s energy sector remained under the control of two monopolies headed by PEMEX and the Federal Electricity Commission (CFE) for over seventy years. Coupled with poor decision-making and short-sighted energy policy, incentives were not aligned for PEMEX (and CFE) to be efficient. Therefore, Mexico’s oil & gas industry started to falter and given that the country’s fiscal stability had always depended on oil production, economic and fiscal pressure for the federal government was not sustainable. Hence, Mexico’s energy reform was advocated under the argument of creating a positive environment for (private) investment, energy markets establishment, incentives creation for the efficient operation of PEMEX, robust and smart regulation, and ultimately, increase the country’s competitiveness by taking advantage of compelling (unconventional) prospective resources. Unfortunately for Peña Nieto’s administration, one year after the enactment of the energy reform, oil prices dropped to a minimum below 20 USD per barrel (i.e. 80% less to the price when the energy reform was conceived). This aspect, coupled with adventurous promises made by several public servants from the government that have not materialized up to date related to lower prices for gasoline, electricity tariffs and gas, gave fuel once again to deterrents of the energy reform.

Future prospects

Most polls in Mexico show a clear preference with considerable margin in favor of López Obrador to win 2018’s presidential election. Given that he has frequently expressed his rejection towards the energy reform, there is a mild concern that the process could be reversed by his potential administration. Allegedly, López Obrador would not revert Mexico’s energy reform through authoritarianism, i.e. he has expressed he would not nationalize the oil and gas and power industries or confiscate physical infrastructure and assets. Rather, he would intend to revert the reform through a national referendum. López Obrador strategy to win the presidential elections of 2018 revolts around one topic: eradicating corruption and create better conditions for the poorest sectors of the population. His flagship is clearly to revert the energy reform. While the amount of investments generated by Round 1 (first bidding processes of oil & gas fields in Mexico’s history) are considerable—up to 34 billion dollars, tangible results are not perceived by the population and will not happen in the short run. This is precisely the reason why López Obrador will play such card, because he knows there is not yet substantial evidence to make a case against his claim at least in the mind of the average voter. Should López Obrador win 2018’s presidential election, he can somehow “freeze” the advancement of the energy reform. A plausible way to do so is through the National Infrastructure Plan and the five-year plans for the strategic bidding and assignment of oil & gas fields and the development of the natural gas network, plans proposed by the National Hydrocarbons Commission and the Natural Gas Independent System Operator (CENAGAS) but presented by the Ministry of Energy. López Obrador can somehow slow down the implementation of the energy reform simply by validating plans that do not provide adequate incentives for private firms to invest. Another form of “freezing” the implementation of the energy reform is through providing subsidies to energy (e.g. gasolines, electricity bills, and gas) as he has claimed. This would not provide the right signals (i.e. market prices) for investment. Now, regardless of who wins Mexico’s 2018 presidential elections, there are public policy issues to be addressed by Mexico’s government which might also “freeze” Mexico’s energy reform depending on the efficacy it will display in doing so.

When incentives may create disparities

Another possibility that might jeopardize the smooth operation of Mexico’s energy reform is the persistent investment-expropriation cycle that has been observed historically in Latin America. In a very comprehensive article, highly respected scholar Francisco Monaldi, analyzes expropriation cycles in Latin America and reaches the following conclusion. There are high incentives to governments in countries with strong nationalism to generate reforms to allow for private investment in the oil & gas sector when production, reserves and investment fall, prices are low, and there are vast untapped resources with high-costs of production (e.g. non-conventional or deep water). This traditionally leads to the creation of energy markets with attractive conditions for private firms (e.g. IOCs) and promotes a transition in slow and inefficient NOCs to a more flexible configuration. This new cycle of investment can lead to new reserves discoveries, higher production and the consolidation of an industry. If such is the case, the prevailing fiscal regime is regressive, the country energy status is that of a net exporter and prices of oil are high, nationalism drastically becomes salient and incentives for expropriation become starker. In the case of Mexico, incentives to avoid the so called investment-expropriation cycle are related to the establishment of a fiscal regime less dependent on oil & gas. While it is true this has already been attained with respect to income generated by production, Mexico’s budget is still highly dependent on income generated by hydrocarbons, particularly on fuel taxes. Another element relevant to the elimination of incentives to be locked into the investment-expropriation cycle is establishing a genuine institutional framework to foster and secure economic competition among market agents. As already explained, there is substantial evidence that Mexico’s experience since the 1980s in opening markets to private investment while it can be regarded as successful in attracting foreign investment flows, the same claim does not hold in terms of securing economic competition among market participants. The stronger the economic competition a sector has, the more difficult—and politically more costly—would be for the government to engage into the cycle.

The weak public policy obstacle

Mexico has a vast experience in creating industrial policy through legislation. Certainly, the latter has become more sophisticated at the technical level. However, the level of implementation of reforms in any sector has not matched that of legislative instruments. There are four areas of public policy in which poor implementation performance might strengthen (albeit not necessarily validate) López Obrador’s case, or create incentives to trigger and investment-expropriation cycle, or simply freeze the development of oil & gas projects with increasing costs for firms and the State.

 

- Poor fossil fuel subsidies restructuring communication. This is related to the (responsible) process of removal of subsidies to gasolines that started in January 2017 in order to establish a competitive market. While the measure is by all means sensible, the timing and communication campaign that the government followed with such removal has not quite resembled the international experience of successful removal in other countries. Furthermore, the transition period to a full-blown market that will end in December 2017, has been characterized by convenient manipulation of the Ministry of Finance in order to sustain a good flow of revenue from gasolines while possible and not allowing for the price to drop when international conditions allow it.

 

- Transparency. Cases of corruption in Mexico, as in any other part of the world, are not infrequent. However, it cannot be denied that great efforts have been made to promote transparency and that Mexico’s intention to become a member of the International Energy Agency is linked to its adherence to the Extractive Industries Transparency Initiative. 

 

- Economic Competition. Mexico’s experience in opening markets to competition is not uniformly overwhelming. Take the banking sector for example. At almost thirty years of ending the State control over the banking system, five banks control around three quarters of clients and the cost of credit for individual customers ranks among the worst in the world. In the energy sector, the Federal Commission of Competition (then COFECO) brought PEMEX to court for the anticompetitive practice of tied selling. PEMEX’s fine 32 million dollars. Mexico’s Supreme Court Justice waived PEMEX from paying the fine claiming the accusation was done at the time when PEMEX was constitutionally a monopoly, thus acting in accordance to law. New regulators of the energy sector have a great deal of work to promote and foster competition amongst market participants in the next years. 

 

- Land use and social conflicts. Of all public policy challenges, this stands out as the greatest, especially for the development of inland oil & gas fields in indigenous communities. These conflicts have represented a major headache for developers of wind farm projects in Oaxaca for years before the energy reform, and have still not found a suitable solution. Several contracts from Round 1 are facing the same type of obstacles in inland projects and blocks to be offered for bidding in Round 2 this year will be subject to indigenous communities’ consultation, a highly complicated process that has not actually started yet. In Coahuila, a hub for shale gas projects development, more than half of the territory suffers from the same problem: paperwork is not validated by the public registry of property. This issue has already shown signs of concern among participants of Round 2, insofar as the number of interested private firms have decreased considerably with respect to Round 1.  

 

The wait for the new tenant of the National Palace

It is highly unlikely that Mexico’s energy reform can be reverted regardless of Mexico’s 2018 presidential election outcome. Irrespective of the identity of the winner, none will have the benefit of majority in Congress. Other legal instruments created to submit to popular consultation relevant aspects within the public realm are excluded from topics related to State income. Hence, López Obrador’s narrative of using a referendum to revert the energy reform might prove more profitable to win votes, rather than actually attaining such goal. Yet, the energy reform will face several challenges that might “freeze” it and probably reduce its potential. First, if López Obrador wins, he will surely find a legal way to create obstacles for energy markets development in favor of his own political agenda. But also, slack implementation of public policies and the inherent perverse fiscal incentives faced by the State will ultimately become obstacles of any future administration.