Despite the sharp oil price decline, we must not forget that the opening of the Mexican hydrocarbons industry makes Mexico one of the most attractive markets for the sector.

Arturo GARCÍA BELLO Partner and Energy and Natural Resources Leader DELOITTE

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October 19, 2017

Arturo García Bello, partner and energy and natural resources leader at Deloitte in Mexico, talks to TOGY about how companies decide to invest in the domestic oil and gas industry, which sectors have the best outlook for growth and some of the risks that pose challenges for investors in Mexican energy projects. Deloitte is the largest professional services firm in Mexico.

In Mexico, from its 22 offices, the company advises 83 of the top 100 companies, according to local CNN affiliate Expansión’s 2016 list of 500 most important businesses in the country. Deloitte provides auditing services for 71% of the public companies listed on the Mexican Stock Exchange, including 67% of the country’s listed energy companies, 33% of oil and gas companies 81% of mining entities and all of the water and marine transport businesses.

• On opportunity in Mexico: “Despite the sharp oil price decline, we must not forget that the opening of the Mexican hydrocarbons industry makes Mexico one of the most attractive markets for the sector. The energy reform represents a window of opportunity to generate investment in the country, increase GDP, improve the competitiveness of industries with high energy consumption and generate employment through national content.”

• On legal security: “The energy reform has established a robust legal basis in all areas and a first-level transparency scheme. This has been evident in the hydrocarbons bid rounds. However, corruption remains a latent problem and the judicial system has many areas of opportunity. A particular case is the one related to rights of way for pipelines and access to power plants, which has been one of the main problems for the development of these projects.”

Most TOGY interviews are published exclusively on our business intelligence platform TOGYiN, but you can find the full interview with Arturo García Bello below.

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How do foreign companies assess the attractiveness of the Mexican hydrocarbons industry?
Despite the sharp oil price decline, we must not forget that the opening of the Mexican hydrocarbons industry makes Mexico one of the most attractive markets for the sector. The energy reform represents a window of opportunity to generate investment in the country, increase GDP, improve the competitiveness of industries with high energy consumption and generate employment through national content.
Mexico today represents a big opportunity for all the global companies, with a focus on repositioning its reserves, because even if a financial balance says a lot, the reserves say more. Even though the state continues to be the owner of the reserves in the subsoil, the economic benefit of those reserves is a valuable asset for these companies.
There is another factor that has to do with the midstream and downstream hydrocarbons market. The reform has opened the possibility to participate in the transportation, distribution, storage and marketing of liquid hydrocarbons. This is a huge opportunity for private companies to invest in a sector that has important growth potential and a non-attended market. Petrol and diesel marketing has been controlled by the Pemex franchise for decades and consumers are looking for better services in all aspects. This is certainly an attractive market to foreign and local private companies.
In this context, the regulation provides a framework of stability for capital attraction that we see today with the growth and start-up of the gas pipeline network, further opening of the electricity and gas sectors, and the opening of the fuels market.
These are some of the reasons why many oil and gas companies, both foreign and local, have decided to invest in Mexico’s oil and gas sector.

Which domestic sectors are witnessing the strongest growth?
The sectors in which we see more growth are natural gas infrastructure and renewable energy. Natural gas is the main fuel source for power generation and manufacturing. Prices in the USA are at their lowest levels and domestic production has declined substantially. Natural gas demand is estimated to grow around 20% by 2030. These factors have driven the need to invest heavily in this sector. There are plans to invest more than USD 16 billion in the sector.
With regards to renewable energy, power demand is also increasing and the goals to diversify our generation matrix have driven investment in new wind and photovoltaic farms. The long-term power market auctions have provided the framework for new market participants to enter this sector. Investments regarding projects for the first two auctions amounts to approximately USD 6.6 billion.
Regarding upstream, investments in projects related to contracts awarded in all the rounds are estimated at about USD 57 billion during the contract lifespans. After a contract has been awarded through the tenders, companies will begin operations within 18-24 months. You can measure this timeline as a trigger for activity. Promised investments are very high, but the ones that have been made in upstream still haven’t reached the scale we were expecting. Those investments are still very low and these are related mainly to strategic services.

What key areas are likely to experience more growth in the near future?
The midstream and downstream sectors for petrol and diesel are and will continue to be very dynamic, as imports of these fuels are increasing and because of the lack of existing infrastructure capacity in the country. Many Mexican companies have decided to form groups and Deloitte has provided strategic advice regarding site location for storage terminals, transportation methods, what to offer to their clients and whether it is more convenient to import fuels themselves or instead work with trading companies. We have observed substantial growth in this area.
Another very important item, which perhaps is not seen in the agenda, is that there are pollution issues that will need to be addressed in the near future, particularly those related to unconventional onshore development. In the case of shale oil and gas, there is an intensive use of water; therefore, when these activities begin, development of water treatment plants will also boom in Mexico.

How has the global oil price downturn impacted the hydrocarbons industry?
The fall in oil and gas prices has certainly led to a decline in the development of the upstream sector. Under these circumstances, many of the companies throughout the value chain have been significantly hit with a reduction in their revenues. They have cancelled or renegotiated contracts at lower rates and have reduced staff numbers.
Given this situation, some of the companies in the sector had to go out of business or sell their assets; however, other companies have come to the forefront by implementing cost-reduction strategies, redesigning their internal processes and developing new products. The breaking points of some of the producers have dropped substantially, especially those that have shale activities in the USA, which has generated a global supply.
Coupled with lower GDP growth in countries such as China, India, the USA and Russia, it is estimated that prices will continue at levels of USD 40-50 in the next few years. The expectation of investors in these types of projects are focused on the long term, so increases in prices and cost reductions for better technology are considered in their projections.

 

Has access to financing changed in light of low oil prices?
As we all know, these projects are capital intensive and high risk, factors which have to be balanced in a low-price environment. Banks and investors are looking to reduce these risks in principle by supporting experienced contractors in the sector and increasing spreads on applicable rates.
The supply of bank financing in this situation of low prices has decreased and there has been a greater participation of specialised investment funds in the sector; of course, with expected returns higher than those of debt.

What challenges related to legal security exist for oil and gas companies in Mexico?
In any country, this is a relevant factor to encourage investment, both domestic and external. The energy reform has established a robust legal basis in all areas and a first-level transparency scheme. This has been evident in the hydrocarbons bid rounds. However, corruption remains a latent problem and the judicial system has many areas of opportunity. A particular case is the one related to rights of way for pipelines and access to power plants, which has been one of the main problems for the development of these projects.
The first issue regarding rights of way is the negotiation with a large number of landowners who are each seeking different objectives. The second issue is that some of these land owners are not or don’t want to register with Mexico’s SAT [Tax Administration Service]. Payments that the project owner makes for the rights of way and/or future rental fees, which can be substantial, are non-deductible if they are not registered. As a result, this makes the project more expensive. Fortunately, the tax authority is working on a regulation to solve this issue.

What was Mexico’s environmental regulation modelled after and why?
The regulatory framework of ASEA [National Agency for Safety, Energy and Environment] is based on clear objectives, taking into account international and local references regarding regulation, best practices and specific standards. To structure these new guidelines, the agency looked at experiences from several countries, including Australia, Brazil, Norway, Colombia, the United Kingdom, the USA and the Canadian province of Alberta.
To design a robust regulatory system for a complex sector such as oil and gas, it was compulsory to review prior experiences to evaluate histories of success and failure. It was important to consider firstly public security and environmental integrity, to assure a reliable legal and procedural framework and consider a reasonable cost for the government and investors.

Do you think ASEA has the tendency to overregulate?
The environment takes precedence. There was a need to cover some priority issues and protect the environment and safety. The rules we had were lax or non-existent. As part of all new regulation issuance processes, there is a socialisation process whereby all stakeholders are able to participate by submitting their opinions, making the process as transparent as possible. There will certainly always be complaints. Nevertheless, this is a high-risk activity and it needs to have a robust regulation.
At Deloitte, we think that laws should be clearly written, which will benefit both parties – those who regulate and those who have to comply – regarding rights and obligations.

How are the public and private sectors co-ordinating to attract investment?
The institutional framework has undoubtedly been a key factor in attracting foreign direct investment. A fundamental issue we have seen is the transparency of the bidding processes for both hydrocarbons and in the long-term auctions for electricity. Also, it is important to note that the prudence in the country’s fiscal and monetary policies has allowed the generation of stable macroeconomic performance, strengthening the confidence of investors. According to information from the Secretariat of Energy, to date, the energy reform has attracted approximately USD 78.4 billion in potential investments.
Of course, with the new regulatory framework in Mexico, private investment will be the key driver for the growth of the industry. In this respect, some investors consider that the definition of some regulatory issues is still not completely clear, and the international situation of the sector will determine the level of investment in the coming years. Private-public collaboration for infrastructure projects will continue to be necessary.

Are any other innovative investment instruments being rolled out in the energy industry?
In general, we have seen that the capital raised for energy infrastructure projects in Mexico has been executed through CKDs [capital development certificates] and CERPIs [stock certificates for investment projects]. The CKD has been the vehicle generally used to channel infrastructure investments.
With regards to the Fibra E infrastructure and investment trusts, operations have not been seen yet, since the structure establishes certain requirements that have made it difficult for Pemex, Cenagas [National Centre for National Gas Control] and the CFE [Federal Electricity Commission] to use.
A new investment vehicle, the Special Purpose Acquisition Company, or SPAC, was used by Vista Oil & Gas, a company backed by Riverstone. Vista launched an initial public offering in the Mexican Stock Exchange, raising USD 650 million. Vista’s objective is to invest in the oil and gas sector in LatAm. These types of operations could be repeated in the market with new players.

What energy topics will be key in the NAFTA renegotiations?
Although NAFTA, in its sixth chapter on energy and basic petrochemicals, reserved the main activities of the sector for the Mexican state, with the constitutional changes that resulted from the energy reform, private investments for both national and foreigners in the sector are now allowed and have already become effective, leaving the reservations aside. Certainly, the renegotiation of NAFTA must take into account this new reality, regarding the liberalisation of investment and trade in the sector.
It is important to consider that the energy integration of the region can generate great benefits for the three participants. At present, Mexico relies heavily on imports of natural gas, petrol, diesel and petrochemicals, mainly from the USA, so it is necessary to prevent Mexico from establishing trading conditions that affect these transactions.
On the other hand, with the energy reform, Mexico has liberalised its energy markets, allowing US and Canadian investors to participate in the entire chain, both in hydrocarbons and electricity. This fact should serve as a counterweight in the negotiations that are being carried out.
Taking geography into account, Mexico’s hydrocarbons strategy is crucial for the renegotiation of NAFTA.

What are Deloitte’s goals for 2018 and what is the company’s medium-term strategy?
The opportunities and challenges posed by the new open market in Mexico, together with a fall in oil prices, induces corporations to seek strategic cost reductions and adjust for future growth. Therefore, it is key to be prepared and answer at the appropriate speed.
Deloitte is part of this moment, offering experience, innovation and knowledge that help our clients meet the most complex challenges in the oil and gas sector. We support the development and execution of initiatives that allow them to achieve their strategic objectives to offer value to their stakeholders.
In the short and medium term, we will concentrate on services related to digital transformation, operational excellence, business growth and optimisation, among others, with a transversal focus on our core and specialised services: audit, tax and legal, and financial and risk advisory and consulting.

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