The Oil and Gas Sector
The Power Industry
The oil and gas and power sectors have grabbed investors' attention during the last few years in light of the partial opening to private investment taking place in these areas.
Mexico's oil and gas sector, both upstream and downstream, has been closed to private participation for more than six decades, since March 18 1938 when President Cárdenas expropriated the petroleum industry after difficult and fruitless negotiations with the oil companies. The previous regime was quite different: Mexico's Mining Law of 1884 established private ownership of oil and gas reserves. By the 1930s oil and gas exploration and production were controlled by major foreign companies. The Mexican Constitution of 1917 reversed such schemes, seeking to reduce the influence of foreign investors in Mexico's wealth, specifically reserving the ownership of hydrocarbons to the nation.(1) The US and English companies immediately sought protection from their governments to preserve their ownership with respect to their petroleum activities in Mexico, and as a result obtained protection with respect to their vested rights over their assets and oil. Such protection ended in 1938. Then, the federal government assumed control over the whole petroleum industry and instituted a public instrument, Petróleos Mexicanos (Pemex), to conduct and control all oil and gas related activities. All government agencies involved in the petroleum industry were dissolved and their functions assumed by Pemex. This entity then gained broad control over exploration, exploitation, refining, transportation, distribution and sale of oil, gas and by-products.
The extent of the constitutional mandate that all petroleum-related activities are conducted by the state has often been discussed. Article 27 of the constitution only provides for the ownership and exploitation of hydrocarbons, and establishes a limitation for private enterprises prohibiting exploration and production through contracts and concessions. However, downstream activities comprising transportation, distribution, storage and sales are not part of the constitutional mandate. Such monopoly enlargement was a result of the enactment of the Regulatory Law of Constitutional Article 27 in the Field of Petroleum(2) in 1958 (the so-called Petroleum Law). The Petroleum Law broadened the spectrum of the oil and gas monopoly by entrusting the petroleum industry to Pemex. It defined the 'petroleum industry' as including (i) exploration and exploitation, refining, transportation, distribution, storage and first-hand(3) sales of oil, gas and by-products of oil obtained through the refining process, and (ii) production, transportation, distribution, storage and first-hand sales of by-products that can be used as basic industrial materials, as well as those considered basic petrochemicals.
In 1992 Congress enacted a structural reform of Pemex, creating four subsidiaries and dividing the tasks of the petroleum industry into the following:
- Pemex-Exploración y Producción, entrusted with exploration, the exploitation of oil and gas, and the transportation, storage and marketing of oil;
- Pemex-Gas y Petroquímica Básica (PGPB), entrusted with natural gas transportation, distribution, storage and marketing, as well as with all activities relating to basic petrochemicals, although some of these activities were later opened to private participation;
- Pemex-Refinación, entrusted with refining activities and production of petroleum derivatives; and
- Pemex-Petroquímica, which handles - now through subsidiary companies - the secondary petrochemical complexes owned by Pemex.(4)
The Pemex holding entity and its board of directors take the general policy and management decisions. This year, after the appointment of Vicente Fox to the presidency and the appointment of a business-oriented chief executive office,r Raúl Munoz, Pemex was reorganized, concentrating management and coordination powers in the Pemex holding entity. New offices were created, one handling the strategic gas programmes and another one in charge of large projects launched by Pemex through bids. However, each subsidiary remains autonomous.
Mexico has incorporated specific reservations to the free trade agreements it has negotiated with many countries, including the North American Free Trade Agreement (NAFTA) and the Agreement on Economic Cooperation with the European Union, expressly exempting its state energy monopoly from competition or private participation.(5) However, private entities, both national and foreign, have gained some ground in participating in this area under various structures.
Under the current framework Pemex is barred from granting concessions or contracts for exploration and/or production of oil and/or gas under internationally used schemes such as risk contracts and production sharing agreements. However, Pemex resorts extensively to outsourcing for technology, equipment and financing for exploration and production activities through service contracts. Although service contracts are the only scheme where private entities participate in the sector, both exploration and production are typically undertaken through such agreements.(6)
Mexico's Constitution and the government procurement codes(7) require that all service contracts and services provided to Pemex (and any other public entity) be awarded through a public bid. As a result of NAFTA, Mexico opened its public bid process to international bidders. With a few exceptions, Pemex is not allowed to restrict the participation of foreign service companies.(8)
In addition to prohibiting risk contracts, production sharing agreements and other contracts and concessions, the Petroleum Law went even further by prohibiting Pemex from making payments in kind (ie, paying with oil or gas) for its service contracts.(9) Many sectors consider that this restriction should be eliminated, giving service companies a greater incentive to participate in the sector. The cost of the services would then be lower for Pemex. It is argued that such elimination would be very beneficial for Pemex, which will be able to pay with its most available currency - its produced oil or gas, rather than having to meet significant financing costs to obtain hard currency and pay its service providers.
Refining is another sector where Mexico may see a change in the mid-term. Mexico's refining capacity is very limited, and Pemex currently imports a large percentage of the gasoline and other derivatives sold in the Mexican market. The successful venture it has had in a refinery located in Texas may set a precedent to favour the establishment of similar structures in Mexico.(10)
Midstream and downstream
Downstream activities have seen an opening in one of the branches of the industry: natural gas. While transportation and storage of petroleum remain within the state monopoly, natural gas transportation, distribution, storage and marketing were opened to private undertakers, with no limitation on foreign participation. This is why Congress excluded such activities from the definition of the petroleum industry. In the same year, the president issued the Natural Gas Regulations. One of its main purposes is to regulate the participation of the government, through PGPB, in the transportation, distribution, storage and marketing of natural gas, and to foster, implement and regulate the participation of private companies in the same activities. As a result of the new framework PGPB became a transporter of gas subject to the same market rules as new private transporters coming into the market. Also in 1995 the Law of the Energy Regulatory Commission vested upon such federal agency (CRE) broad powers to regulate the natural gas industry, including the authority to issue administrative general provisions known as directives.(11)
Pursuant to the Natural Gas Regulations natural gas services became subject to a federal permit granted by the CRE. Permits operate as 30-year renewable quasi-concessions, and impose on the service providers a series of regulatory obligations, including the granting of open access, safety restrictions and the regulation of rates.
As with the oil and gas industry the Mexican electric power sector was not always closed to private investment. Foreign private investment in the electricity industry was actively present in Mexico until 1960, when the electricity industry was nationalized through the amendment of Article 27 of the Mexican Constitution, and the subsequent acquisition of the privately held companies that had undertaken the power generation, transmission and distribution activities in Mexico. Under the amended Article 27 generation, transformation, distribution and marketing for public utility purposes are reserved for the Mexican state, and no concessions to private parties shall be granted in this area.(12)
This vertically integrated state monopoly is currently entrusted to two governmental entities: Comisión Federal de Electricidad (CFE) and Luz y Fuerza del Centro. Of these CFE has undertaken a substantial share of the Mexican electric power industry, whereas Luz y Fuerza del Centro serves only certain areas of the central region of the country.(13)
In 1992 a partial opening of the Mexican electricity industry was introduced by Congress through an amendment to the Electric Power Public Utility Law (the Electricity Law), allowing private investment - with no foreign investment restrictions - in certain power generation modalities that were expressly excluded from being considered part of the electric power public utility service exclusively reserved for the Mexican state. These are:
- independent power production;
- small-scale production; and
- generation for export purposes.
Likewise, the amendment to the Electricity Law allowed private parties to import power.
The generation of power in each case is subject to a permit granted by the CRE.(14) Independent power production entails the generation of electric power with the exclusive purpose of selling the associated power output to CFE, whereas self-consumption entails the generation of power with the exclusive purpose of satisfying the electricity needs of the permit holder or a determined group of offtakers, which shall collectively own the relevant generation facilities or create a self-consumption company to hold the relevant permit (so-called 'consumption clubs'). A cogeneration permit allows the generation of power along with steam or other secondary thermal energy, or the generation of power using the thermal energy or fuels produced as a result of other industrial processes. Small-scale production permits are granted for power generation projects with a capacity between 0.5 megawatts (MW) and 30MW, when the associated power output is exclusively sold to CFE, or projects with a generation capacity of up to 1MW when, under the self-consumption scheme, the associated power output is supplied to rural areas lacking electricity public utility services. Export permits allow the generation of power for export purposes, while import permits allow the permit holder to import power to satisfy its own needs only, without the possibility of selling such power to third parties.
As a result of the bidding processes launched by CFE during the last five years the most important private power generation scheme in terms of the generation capacity being installed is independent power production.(15) The independent power producers (IPPs) are responsible for building, owning, operating and maintaining the corresponding power plant. In exchange they are awarded a 25-year power purchase agreement for the supply of power to CFE.(16)
Some of the IPPs have oversized their power plants, surpassing CFE's power generation requirements. The excess capacity of an IPP may be used to satisfy the requirements of a consumption club of offtakers that become partners of the IPP company, or used for export purposes. These projects involve operating a power plant under a dual-permit structure, which is permitted under the applicable legal provisions.(17)
One of the key issues affecting IPPs is the lack of infrastructure to supply natural gas to the power plants being developed, as well as the inconsistency between the terms of the natural gas supply services offered by PGPB and the fuel supply terms required to make these projects suitable for project finance structures.(18) The lack of infrastructure (which is worsened by PGPB's budgetary constraints to expand the national pipeline system), is being handled through private gas marketing and transportation companies who have undertaken the development of complementary gas transportation systems and/or the expansion of PGPB's available gas transportation capacity through compression facilities. However, negotiations between the IPPs and PGPB to improve the terms of PGPB's gas supply services are still taking place, in many instances with the intervention of the Mexican energy authorities (ie, the Ministry of Energy and the CRE).
Cogeneration projects and self-consumption power plants are also being developed, but the installed capacity under these schemes is still small. On the other hand, only few import and export permits have been granted. One of the reasons why power import projects have not been very attractive are the restrictions imposed by the Electricity Law and its regulations for import permit holders to share transmission facilities, and the requirement of having one permit per company, without the possibility of creating consumption clubs.(19)
The power generation and power import permits granted by the CRE give the permit holders the option to either (i) build, own and operate the transmission facilities required to deliver the associated power output to the authorized offtakers, or (ii) request transmission services from CFE for this purpose. Most permit holders requiring transmission as part of their projects have resorted to CFE's transmission services.(20) CFE's transmission services, along with back-up power supply services also available from CFE, are regulated by the CRE through the approval of the formats of agreements to be entered by the parties. However, the Ministry of Finance and Public Credit also influences the regulation of some of such services, mainly with respect to the considerations payable to CFE by the permit holders.
CFE, on the other hand, has been required to expand its transmission grids in order to cope with the increasing electricity demand of Mexico's expanding industry. Accordingly, CFE has successfully called a substantial number of bidding process for the construction of power transmission lines and substations. In these cases, the construction of the relevant facilities is completely financed by the contractor, which is paid only when the facilities are finally delivered to CFE.(21)
Mexico's electricity demand is expected to increase at a rate of at least 6% each year. Coping with such demand will require additional generating capacity of over 21,000MW within the next eight years, coupled with an expansion of the National Electric Grid over approximately 20,000 miles, and 70,000 megavolt amperes in substations for the 2000-2008 period. This entails capital investments of more than $51 billion.
No public budget is capable of meeting these requirements. So despite the success of the IPP scheme it is still necessary to promote other investment structures to further enhance the participation of private capital in the Mexican electricity industry. It will eventually become necessary to amend the applicable legal provisions (including the inevitable amendment of the Mexican Constitution), to create a market that is attractive for national and foreign private investors.
A fruitless effort was made at the end of President Zedillo's administration, when in February 2000 the government presented to Congress a bill amending Articles 27 and 28 of the Mexican Constitution, and an aggressive programme to open and restructure the Mexican electricity industry (the Electricity Bill). However, the Electricity Bill was submitted at a time when all political forces in Mexico were readying themselves for the presidential elections in 2000. Although the Electricity Bill was discussed in the media for a few weeks, the political scenario at the time was too complex to entertain discussions at Congress and the bill was shelved.
New but more discrete endeavours have been undertaken by Vicente Fox's administration to cope with the electricity demand in Mexico. Just recently, as part of an 'emergency' package of economic measures to promote growth, an amendment to the regulations of the Electricity Law was published, aimed at promoting the expansion of Mexico's installed generation capacity through privately held projects. The amendment allows CFE to enter into power purchase agreements (without the need to award contracts through a bidding process), comprising the payment for both capacity and associated power output with self-use permit holders and cogeneration permit holders, in order to purchase such permittees' power surpluses. Under this scheme CFE may purchase up to 50% of installed capacity from self-supply permittees, and 100% of the installed capacity from cogeneration permittees. The amendment to the regulations of the Electricity Law has not yet been implemented because Congress has filed a 'constitutional dispute' with the Mexican Supreme Court of Justice, alleging that the amended regulations surpass the statute being regulated (ie, the Electricity Law). This issue is still pending a decision from the Supreme Court of Justice.
If supported by the Supreme Court of Justice the amendment to the regulations of the Electricity Law will be useful only as a temporary mitigation measure, but it is not a solution for Mexico's electricity requirements. The power crisis in California has increased attention on this issue, as the United States continues to put pressure on the Mexican government to liberalize further the energy industry. However, the topic is not expected to be deeply discussed by lawmakers until the overhaul of Mexico's taxation laws has been agreed and approved. Although different alternatives to modify the applicable legal framework continue to be evaluated an effective and clean proposal by the executive branch to enhance private participation in the electricity sector will require a constitutional amendment giving private investors the necessary comfort to develop capital-intensive projects in Mexico.
For further information on this topic please contact Jorge Jiménez, Amanda Valdez or Rogelio López-Velarde at Lopez Velarde, Heftye, Abogados by telephone (+52 55 50 81 1424) or by fax (+52 55 50 81 1425) or by e-mail ([email protected], [email protected] or [email protected]).
(1) Article 27 of the Mexican Constitution.
(2) See: Alejandro López Velarde, Some Considerations on the Foreign Investment Possibilities in the Mexican Oil and Gas Industry, 1997 WL 771481 (West), p2.
(3) 'First-hand sales' are defined as the first transaction where the hydrocarbons change hands after being extracted and refined. Once the petroleum or gas is sold once, further sales can be conducted freely.
(4) Article 3 of the Organic Law of Petróleos Mexicanos and Subsidiary Entities, DO July 16 1992.
(5) See: Chapter 6 and Annex 602.3 of the North American Free Trade Agreement.
(6) Pemex-Exploración y Producción has recently awarded a large contract for integrated drilling and completing services for dry gas wells in the Burgos Basin. This contract - the largest in Pemex history - is part of a programme to increase gas production and meet the demand arising from the exponential appearance of gas-fired power plants and the conversion of several industries from high sulphur fossil fuels to natural gas.
(7) Mexico has two government procurement statutes, the Law of Public Works and Related Services and the Law of Acquisitions, Leases and Services for the Public Sector. See Mexico's Federal Register, January 4 2000.
(8) Mexico incorporated a set-aside clause for an amount of contracts to be reserved for Mexican nationals by Pemex and the public power entity, Comisión Federal de Electricidad. This set-aside right, however, has a phase-out calendar ending in 2004.
(9) Article 6 of the Petroleum Law establishes that Pemex shall only pay in cash, and may not grant rights over the production.
(10) Pemex-Refinación has a refinery with Shell in Deer Park, Texas, through a joint venture. It currently sells its product both in Mexico and in the US markets.
(11) The Energy Regulatory Commission is an autonomous administrative agency of the Ministry of Energy, and regulates the players of both natural gas and electricity industries, including private entities, Pemex-Gas y Petroquímica Básica and CFE.
(12) See: Daniel Resendiz, 'El Sector Eléctrico Mexicano', Fondo de Cultura Económica, 1994, p17.
(13) Through CFE and Luz y Fuerza del Centro the Mexican state has installed electric power generation capacity of approximately 36,000MW, of which more than 95% corresponds to CFE.
(14) Article 36 of the Electricity Law.
(15) Fourteen independent power producer projects have been awarded by CFE to the following companies: Iberdrola, Unión Fenosa, EDF, Transalta, Mitsubishi and Intergen.
(16) The award of these power purchase agreements and the corresponding bidding processes are regulated not by the government procurement statutes, but by the Electricity Law. However, the rules that apply to the bidding process are very similar to those rules embodied under the government procurement statutes.
(17) Article 81 of the regulations of the Electricity Law.
(18) The terms and conditions under which PGPB is allowed to offer gas supply are regulated by the Natural Gas Regulations, the Directive on Prices and Rates for Natural Gas Regulated Activities and, more specifically, the Directive on Natural Gas First-Hand Sales and the General Terms for Natural Gas First-Hand Sales, approved by the CRE and published on August 23 2000.
(19) The holder of a power import permit is required to either (i) build, own and operate the transmission facilities used to import power, or (ii) interconnect to the National Electric Grid owned and operated by CFE. However, power importers are not allowed to share any transmission facilities or create consumption clubs, which prevents them from obtaining the benefits of economies of scale.
(20) The CFE has only acted as common carrier for private power generation companies using CFE's transmission services for a few years. Last year, for example, a subsidiary of Enron Corp obtained a cogeneration permit for a 245MW power plant in Monterrey, NL, which will be serving a consumption club of more than 30 offtakers located all over Mexico using CFE's wheeling services.
(21) Unlike IPP projects, the award by CFE of contracts for the construction of power transmission lines and substations is indeed governed by the Law of Public Works and Related Services.
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