Will Mexico Deliver on Downstream Energy Reform Under AMLO?

Authors: Sam Davis and Guillermo Suarez

Mexico’s refining system has been on a steady decline for the past decade as poor maintenance and reliability have hampered refineries and reduced domestic production of fuels. The country’s logistics network faces serious bottlenecks as the existing infrastructure, built by Pemex over seven decades ago, is geographically limited; however, the energy reform policy passed in 2014 was supposed to reverse courses and address Mexico’s refining system and much needed investments in midstream infrastructure to meet demand for product imports. Instead, refineries in Mexico are worse off today than they were five years ago and midstream projects still face challenges with permit approvals. In this week’s blog, we examine the state of downstream in Mexico and assess whether the new Administration of President Andres Manuel Lopez Obrador (AMLO) will deliver on the country’s downstream energy reform.

Will a new refinery get built?

Refineries in Mexico (on average) were operating at almost 70% utilization five years ago when the reform was passed. Since then, crude runs have steadily declined with average utilization rates reaching 35% last year (Figure 1). The poor refining performance has been largely due to lack of execution, budget and capabilities, along with overall mismanagement of capital and resources needed to address these issues. AMLO has promised to tackle these challenges by allocating 25 billion pesos ($1.3 billion) to improve its refinery maintenance and reliability programs. Additionally, the Administration has also announced plans for the construction of a new 340,000 b/d grassroots refinery at Dos Bocas in the Gulf Coast state of Tabasco and the hometown of AMLO.

This refinery, with an announced estimated cost of $8 billion is already facing a great deal of skepticism. Facility siting concerns from geological risks to existing port infrastructure along with independent cost estimates of the refinery approaching $15 billion are some of the reasons for concern. The refinery economics are also being challenged especially in a scenario whereby project financing comes exclusively from public resource-funding. Two weeks ago, the rating agency, Fitch, downgraded Pemex’s ratings from BBB+ to BBB- citing high leverage, large capital investment requirements, and exposure to political interference risk. This will pose significant funding challenges for the project but could be mitigated by a public-private investment partnership with majority share and control being given to outside investors. AMLO has indicated that the new refinery will be completed in 3 years and expects to launch bids next month. The bid process is expected to be managed by Pemex and bids will be restricted, with companies participating by invitation only in the government’s attempt to weed out companies with a history of corrupt practices.

For now, it appears AMLO is moving forward with refinery construction plans following reports of land clearing activities already beginning. It remains to be seen whether a refinery actually gets built, as previous attempts at new refinery construction have failed in the past. The three-year timeline is overly ambitious given detailed engineering requirements, construction delays and a lack of execution capabilities by Pemex.

Infrastructure Developments

Unlike refining, a number of developments have occurred in building out much needed infrastructure to transport refined products and natural gas to demand centers. U.S. refiners have gained access to the market through construction of storage terminals or in some cases partnering with Pemex to utilize their logistics systems for fuel distribution. These terminals are expected to be in operation beginning in 2019 and into 2020 and will add to the approximately 74 product import terminals that exist today in Mexico. While terminal projects have been under construction, companies have been leasing capacity in some terminals to supply their retail fuel stations. The terminals will also help address the need for additional storage capacity to meet rising product demand. Today, Mexico’s gasoline stock levels are only able to meet three days of cover, compared to an average of 25 days in the U.S.

Pipelines have also been built to bring natural gas from the U.S. into Mexico, along with underground storage tanks and terminals under construction. In most cases, local private companies in Mexico are partnering with U.S.-based companies on these infrastructure projects. Natural gas demand has been increasing especially in the power sector with imported gas reaching 5 bcf/d in 2018, up from the 2 bcf/d of gas imported in 2014. However, more logistics are needed to move natural gas farther south of the country to alleviate bottlenecks in Central Mexico. Concerns remain on what will happen to existing contracts to import gas from the U.S. as the AMLO Administration has indicated a desire to review all service contracts in an effort to “rid the system of any corruption.” Companies are on edge waiting to see if the government will enact new structures for the bidding and awarding of contracts. Many of these contracts are set to expire mid-2019 so, will they be renewed? Right-of-way is also a challenge in developing natural gas pipelines in Mexico which is expected to introduce significant delays in approving new pipeline construction projects to access the interior and southern parts of Mexico.

Where does Mexico go from here?

Mexico remains an attractive market for both energy and economic reform. Opportunities for private investments to help develop its resources are still available, but some key risks remain on pursing these.

  • The political and regulatory agenda needs to be set with clarity on policies for how the industry will continue to develop. The midstream sector is the fastest growing and represents the greatest opportunity currently. Will pipelines have open seasons? Will they be subject to regulation similar to the FERC in the U.S.?
  • Government agencies need to be autonomous and free from political interference. Regulators also need independence in order to set public policy. They must also be empowered to enforce rules to address abuse, increase transparency, and have the conviction to execute their mandates.
  • Commodity prices in Mexico do not reflect prices in the U.S. with the added logistics cost for transportation. Pricing should reflect dislocations from lack of infrastructure to drive incentives for private company investments in logistics.
  • The priority for refined products is the construction of terminals. This continues to face major delays as the review and approval process is generally inefficient and fraught with political red tape.
  • Staffing is also an issue as the AMLO mandated salary cuts across the government have led to recent departures of experienced employees and badly needed resources to execute on reviewing and approving contracts and permits. Vacancies in some key energy agency roles are becoming an issue due to the log jam of permits waiting for approval.

TM&C will continue monitoring these developments in Mexico as part of a new offering to be launched in the coming months aimed at assessing the evolving downstream reform under AMLO (See our January 8, 2019 blog).  We will be releasing our 2019 Crude and Refined Products Outlook (CRPO) later this month. This report provides a comprehensive and detailed forecast of supply, demand, and prices for crude and products on a regional and global basis through 2035.  Market, policy, demographic and technology developments are all considered in our analysis and forecasts. The CRPO also includes a forecast of refinery projects and their market impacts.  This analysis is done in more detail in our Worldwide Refinery Construction Outlook (WRCO). This report includes a comprehensive tabulation of all refining projects being developed globally and handicaps their likelihood of being completed.  It also forecasts their impacts on supply and demand for both crude and refined products.  As in the CRPO, all the important factors which drive refining investment are considered in this Outlook. For more details about either of these publications or other TM&C services, please visit our website or give us a call.