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Outlook for the Energy Sector in Mexico [1994]

George Baker
The recent appointment of two officials from Mexico's federal Finance
Ministry to lead the country's two state-owned energy monopolies is an
unmistakable sign that the Government is worried about the financial health
of the energy sector.
A quick survey Mexico's energy landscape shows several areas for concern:
one is the lack of private investment in electric power generation, a
second area is the lack of regulations for natural gas transmission and
distribution, a third area is the issue of natural gas supply itself.
One of the accomplishments of the Energy Ministry under outgoing Lic.
Emilio Lozoya was the development of a visionary ten-year plan for
supplying Mexico's growing electric power needs.  The idea was to invite
private capital, Mexican and foreign, to invest in electric power
facilities.  Toward the end of increasing installed capacity in the next
ten years to something in the area of 50 GW, from a current level of
roughly 28 GW, the Lozoya team  visualized major investments by independent
power producers (IPPs).  One white paper anticipated that perhaps as much
as 80% of future electric power capacity could come from privately built
and financed electric power stations.  Toward this end the federal law
governing electricity was modified in late December 1992 to allow for
private investment, and a new set of regulations for electricity were
issued on May 31, 1993.
At this point, to judge from results to date, the vision died:  In July of
that year the International Finance Corporation (IFC) of the World Bank
withdrew its backing of a proposed electric plant known as -Carbon II in the
border state of Coahuila.  In reaching this decision, the IFC was
responding to a controversy over the perceived environmental threat posed
by the plant, which would burn high-ash coal.  As neither the project
sponsors nor the Mexican Government were willing to fund the $300 million
for emission scrubbers, the project also was dropped by the normal
commercial lenders who, otherwise, would have provided stand-alone project
financing.  This unexpected turn in the outlook for financing sent the
project sponsors scurrying to the bond market, but the idea did not
prosper, and by October the American sponsors announced their total
withdrawal from the project.
A second project that appears headed toward a similar fate is a proposed
natural gas-fired electric plant near Merida, on the Yucatan peninsula.
Initially, thirty companies were interested enough to pay $10,000 for the
construction bid package.  Some of these companies have submitted bids,
which are to be opened and evaluated in January.
Yet, unless there is a major shake-up in policy, such bids, even if
awarded, will likely not receive funding for construction.  Why?
The proposed electric plant is some 600 kilometers from the nearest source
of natural gas. Since early 1993 there have been discussions followed by
debate and then acrimony between Pemex and the Federal Power Utility (CFE)
over who would finance and build the gas pipeline to supply the plant,
known as Merida III.
Even if the pipeline were to be built, prospective lenders and developers
have two other awkward questions about managing risk.  One question
concerns the mechanisms to be used to adjust future prices and tariffs of
natural gas, gas pipeline transmission and electricity.   In the United
States and Canada questions of price are answered by the marketplace of
multiple gas suppliers and transmission options.  Tariffs are set by state
public utility commissions and federal agencies.
In Mexico the Government maintains a monopoly on natural gas supply and
transmission, and there are no federal or state public utility commissions
to serve as forums in which rates and tariffs are negotiated.  Since 1992,
the Government has accepted a controversial policy, one proposed by Pemex
market strategists, of indexing domestic hydrocarbon fuel prices to a
basket of U.S. market prices, to which are added transportation costs.  In
a recent break with policy, however, Pemex has announced a 20% increase in
petroleum prices for Monterrey industrial plants, which account for most of
the industrial natural gas demand in the entire country.  Such arbitrary
pricing should open opportunities for U.S. and Canadian gas exporters,
whose prices respond to market forces, not to decrees by government
agencies.  While end-user gas contracts are in theory allowed by NAFTA,
such contracts have yet to be tested commercially or in court.
Which raises the second question:  Can investors trust the Mexican court
system, where ambiguity and unpredictability undermine expectations of
equity by Mexican and international companies?  Here there are two matters:
the Mexican courts have never decided issues Pemex liability to either the
CFE or IPPs for costs associated with problems of fuel supply; but, even if
such cases had been decided, Mexican judges, operating under
a civil-code legal system, have no obligation to decide on the merits of
similar cases in the same manner.
The third area of concern in energy policy is natural gas supply itself.
Analysts foresee a supply deficit of natural gas that cannot be met by
increased oil production in the Bay of Campeche. To meet this challenge,
Mexico has only two real options:  import gas from Texas, New Mexico or
Canada or develop major new supplies of dry gas.  Imports represent the
easiest solution to visualize and fund, but the long-term cost may be much
higher than that of increasing domestic production.  For this, the most
promising areas for increased dry gas production are the Sabinas and Burgos
basins near the northeastern border with Texas.  The petroleum geology of
these fields, however, is complex, and requires expensive 3-D seismic
Pemex, which is essentially a southeastern oil producer, is under pressure
to maintain oil production to keep foreign exchange from export revenues
steady.  Pemex has little interest, therefore, in undertaking gas pipeline
projects in the Yucatan, Sonora, Baja California or anywhere else that are
unconnected with oil production, refining or the distribution of refined
petroleum products.  Spending capital budgets on risky natural gas plays in
the northeast does not tap into Pemex's core interests or abilities.
Prospective investments in private electric power generation, therefore,
are in doubt not only because of a lack of a regulatory framework that can
support the requirements of project financing but also because they lack of
peace of mind about Pemex's commitment to the production, supply,
transmission and fair pricing of natural gas.  Such doubts, in turn,
reflect a situation long-observed by prospective lenders and investors,
namely, that managers in Pemex and the CFE, as well as officials in the
Energy, Commerce and Finance Ministries, generally lack information about
the economics, financing requirements, and operational and environmental
efficiencies of market-oriented energy policies.
All of this points back to the recent appointment of two capable career
public officials to head the major two energy agencies in Mexico, Carlos
Ruis Sacristan in Pemex and Rogelio Gasca Neri in the CFE.  Their challenge
of crafting an integrated approach to electric power generation and natural
gas supply will be made more difficult by the long-established pattern of
Mexican agency managers, ministry officials and regulators acting
independently of each other in relation to issues of energy policy.
Financing will be a central dilemma:  Pemex wants to apply marginal
investment dollars to oil production first, refining second. Natural gas
supply and distribution have never had a high priority in Pemex.  The CFE
wants to keep its monopoly on electric power distribution, and often gives
the impression of being impatient toward the folded arms and what-if
questions of prospective lenders and developers.
For six years, the Salinas Administration, which just ended, staked out the
energy sector with signs that read "No Trespassing."   Prospective
investors and lenders were struck by how Salinas's economic modernization
programs systematically overlooked the opportunities for energy-sector
gains in production, efficiency, environmental protection and tax revenue
that the option of private investment in the oil, gas and electric power
offered.  For all the talk of reform and modernization, six years passed
without a single major private investment in any area of the petroleum or
electric power industries.
Business as usual in energy policy in Mexico can only be expected to spur
lenders and investors to look elsewhere around the world.  Massive
investment opportunities in Asia and elsewhere in Latin America beckon.
The costs to Mexico and the U.S.-Mexico border region of not crafting a
workable energy policy will be high, and will be measured in missed
opportunities for economic development, employment and environmental
protection.  So the new Government is right to be worried, and it will take
courage and an informed vision to make the immediate future turn out better
than the recent past.
George Baker directs Mexico Energy Intelligence,
a subscription service based in Oakland, California.
Tel (510) 208-5600; Fax 208-3139;
1611 Telegraph Ave., Ste 620, Oakland CA 94612
Tel (510) 486-1247
Fax (510) 208-3139