MEXICO: An Introduction to Energy & Natural Resources

Mexico | Energy & Natural Resources  

By Goodrich, Riquelme y Asociados  

David Enríquez, Jorge Sandoval and Erika Roldán 

Portraying the Mexican Economy and its relationship with the energy sector

After what could be the end of the COVID pandemic, Mexico's economy is finally growing, at around 2.0% growth, which represents a 5% difference between previous years. In fact, it has been a rather slow come back as compared to OECD countries. The forecast for 2022 is around 3.3% economic growth, just above the growth of the world economy, due to the context of the war in Ukraine, the difficulties on supply chains and the unprecedented global inflation.

Yet, the industrial sector, including the automotive and aerospace industries, have proven to be robust and resilient growing at two digits. Exports are expected to continue to increase; this is thanks to the integration of supply chains strengthened by the updated trade agreement with the United States and Canada, USMCA.

To say the least, not a rosy moment for Mexico’s energy sector

In a nutshell, contrary to environmental world trends embodied on international instruments, such as the Paris Agreement, President López Obrador’s administration is betting on Oil & Gas and putting renewables on hold, heavily affecting investors from dozens of nationalities.

There are currently two main focuses that concentrate on the federal government's major investment: the Olmeca refinery in Dos Bocas and the complete incorporation of the Deer Park refinery. One of the main goals of the current administration is to process Mexican oil, since today the country has a capacity of 714,000 b/d, when the goal is to process 1.5 Mb/d in Mexican refineries this year and 1.9 Mb/d by 2023. Likewise, the Mexican downstream oil and gas market is expected to register a CAGR of less than 1.43% during the 2020–2025 forecast period.

In the upstream arena, although IOCs and independents continue to honour their exploration and development obligations, the speed of investment has decreased and their input to the national O&G production is about 4%. Because of numerous discoveries during the last five years, this figure might change shortly. Additionally, due to unprecedented earnings of the hydrocarbon industry, as a result of the Ukraine invasion, we might see a second wave of M&A activity in the sector in the near future.

In the energy market, the snapshot of the current situation is that 60% of all electricity generation by 2022 will be combined cycle produced from natural gas. In general terms, unfair support has been given to the state-owned companies CFE and PEMEX, damaging the plain field which was created by the 2013 energy reform.

Combined cycle energy based on natural gas is growing since most of CFE's generation plants are based on that technology. By 2022 photovoltaic and wind power is decreasing and only accounts for 12% of all national production, which represents a decrease from previous years, due to public policy conducted by the present federal administration, which has even harmed the independence and operational capabilities of key regulators, such as the CRE.

A main argument for the decrease is that CENACE, controller of the National Electric System, considers it intermittent energy that does not meet the required reliability due to the lack of improvement of the electric grid. Notwithstanding the above, the renewable "intermittent energy" generation capacity represents 20% of the total capacity, superior to various technologies. From 2016 to 2022, the growth of the power transmission grid has been marginal. Meanwhile, 153 renewable generation plants obtained permits to generate electricity, but only two auctions were held for the purchase of energy, despite the fact that it was the world’s cheapest power that a utility company – such as the CFE – could possibly obtain at that time.

Because of the government policy to artificially strengthen the CFE, at the cost of private generators and other players of the industry, there is a crystal clear tendency to reduce the injection of renewable energy into the system, prioritising hydrocarbon-based technologies. The 2022–2036 Electricity Program (PRODESEN) recently published by the Ministry of Energy normalises such tendency, no matter the anger of the private sector, the geopolitical tension and the likelihood of treaty arbitration against Mexico.

It is not surprise that, under such negative environment, foreign companies in the energy sector have decreased their investments to 237 million dollars in Mexico during the first quarter of this year, a 26% drop compared to the same period in 2021, according to data from the Ministry of Economy.

On the positive side, the distributed or on-site generation market is growing and has recently reached its historical record. There are no policies that seek to sanction this activity but to promote it. On the positive side of investment, some important gas distribution projects are also underway in the north of the country, which may become attractive and safe for investments in the sector since natural gas is becoming the primary source of electricity generation. Additionally, LNG exports from the US to Asian markets via Mexico will become a reality by the end of the López Obrador administration, thanks to the long-term vision of foreign investors.

Changes to the law 

Most of the changes in the sector to which reference is made are the result of the policies of the current administration since it entered into office in 2019. The main statutory changes in the energy sector were two, both by virtue of strengthening state-owned companies: the reform to the Hydrocarbons Act and the Electricity Industry Act (LIE).

Both reforms were made in mid-2021 and sought to strengthen the powers of the Ministry of Economy and reduce those of the autonomous control bodies; reduce private investments for “national security arguments”; prioritize the interaction of CFE and PEMEX in the industries; and, in the case of the LIE, change the order of dispatch, pushing renewables to an inexplicable second place.

Furthermore, licences and permits for private investors were reduced, in some cases, to 4.5% of the total amount. In the last quarter of 2021, the CRE increased the number of verifications and sanctions for regulated companies. In addition, in 2021, several guidelines, standards and market rules were issued to increase sanctions and requirements for the industry's activities.

The reform of the LIE was challenged by companies, NGOs and individuals and was even suspended by some general injunctions. Opposition congressmen filed a motion to declare the reform unconstitutional. Faced with this suspension, and the motion of unconstitutionality, the President proposed a constitutional amendment to ensure the desired changes in the law. This initiative was not approved in the chambers. However, the Supreme Court did not reach the majority of 8 out of 11 votes to declare the unconstitutionality of the LIE reform and dismissed the motion. This resulted in the revocation of the general injunctions, and now only some of the companies with ongoing proceedings are protected with respect to the application of the LIE reform.

The entry into force of the LIE reform represents a major milestone for implementing new policies aimed at revoking generation permits or, in fact, their cancellation due to aggressive policies that hinder the economic model and the viability of transactions. In short, these policies tend to reduce the electricity market and make it more dependent on fossil energy from the CFE, contrary to environmental commitments. Naturally, global companies from all sectors are starting to reassess their presence in Mexico due to their own regulatory and corporate obligations to tackle CO2 (and other) emissions.

What’s next? Alternatives to face the aggressive implementation of current policies.

On the one hand, some foreign companies and investors seek relief through local proceedings in domestic courts to try to maintain their business in Mexico. However, given that public policy arguments are at stake, these local proceedings are encountering difficulties to become efficient means of defence, against the rather strict policies.

On the other hand, as previously mentioned some foreign investors seek the possibility of investment claims. The argument for this is that the reform to the LIE was in breach of bilateral and multilateral investment protection treaties. The extent of damages suffered by foreign investors may vary on the outcome of domestic proceedings. However, foreign investors are already entitled to claim damages due to CENACE's application and enforcement of the LIE reform in practice.

Depending on the merits of each case and the amount of damages claimed, a multi-party investment arbitration may be preferable to strengthen the investor's position. Several third-party funders provide financing alternatives for foreign investors to cover the arbitration costs.

Indeed, a dramatic change compared to the 2012–2013 debates that precede the world’s most far-reaching O&G and Energy Reform, as outlined by the IEA. The good news is that Mexico is here to stay, and the energy needs of a country so closely interconnected to the North American markets will make any new federal administration rethink the current energy policies.