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Russ: Welcome back to The BusinessMakers Show, brought to you by Comcast Business, built for business. Our topic today is Mexico and the significant changes taking place right now and my guest is Carlos Sole, the head of the Latin American practice here at Baker Botts; Carlos, welcome to The BusinessMakers Show.
Carlos: Russ, thank you very much, it's a pleasure to be here with you.
Russ: All right Carlos, so let's set the stage; take us back to the beginning, what's the unusual nature of the Mexican oil and gas industry that's lead us to this point?
Carlos: So since the 1930s Mexico's oil and gas sector has been exclusively reserved for the Mexican government acting through Pemex. It nationalized its oil industry in the 1930s and the oil and gas in Mexico has been viewed as a sacred right belonging exclusively to Mexico and its people. But starting this century Mexico has been investing more in its ENP activity, yet it's been producing less; it's been having to import more to meet its energy demands. And finally after a couple of different presidents from the opposition party had attempted to reform the energy sector, to open it up to foreign investment, the PRI and President Enrique Pena Nieto have come in and recognized that a fundamental change needed to be made. And so they have made amendments to their constitution that will now allow foreign multinational energy companies, foreign domestic ENP players to come in and invest, take production to the oil and gas that they develop, uh, explore directly, take title and ownership and - and the types of issues that you see elsewhere in the world. So you have a very unique circumstance in the global oil and gas industry where you have a very large market, it's a market that's right next door and it's one that's been relatively untapped.
Russ: So it's a huge change.
Carlos: It's a huge change, it's a huge opportunity. The prize, so to speak, is the deep water Gulf of Mexico opportunities that exist and likewise the shale gas opportunities that exist in Northern Mexico along the Texas boarder. And the transformative change is Mexico's recognition that they need foreign capital, they need foreign expertise to be able to develop these resources.
Russ: So it seems like there ought to be some concern about safety, I mean, you know, the deep water stuff as what happened a few years ago, are - are there people that are concerned since we share the Gulf of Mexico with Mexico…
Carlos: So they are and that was safety is an issue that's addressed within the legis-the transitional legislation. Now obviously the details need to be implemented but with the Mexican policy makers envision is the creation of a new entity that will regulate safety and environmental matters in the oil and gas space. And what they've done is they looked at the U.S. example where you had the conflict of interest with certain agencies, the Bureau of Land Management that was responsible for the granting of licenses as well as safety oversight with Mexican policy makers, have taken from that experience is that those entities need to be separate and distinct. Obviously the effectiveness of these regulatory bodies will depend on the people within the positions, but from an intellectual perspective, they've set up a structure that tries to take a little bit of the lessons learned from the U.S. experience and improve upon it with what they're setting up in Mexico.
Russ: Okay, so if you roll back in the era when it was working, uh, that Pemex was nationalized, I understand that oil and gas was a huge contributor to the income of the country.
Carlos: It is. About some have pegged the estimates as high as 40% of the government's operating budget came from Pemex.
Russ: Okay, so this decline now in production is really, you know, kind of choking off everything throughout the country.
Carlos: It's choking off everything and it's a recognition that to stimulate their economy, to regain the competitive advantage that they had with international manufacturing they need to lower their energy costs and the macro economic view is this will be an event that can add 1 to 2% for their GDP and it's something that will have the same type of effect that NAFTA had for them in the 90s.
Russ: Okay. Now, from what I understand too from just watching from here across the border it's kind of been a - political hot potato for a decade, has it not?
Carlos: It's very much been a political hot potato. At the start of the century you had the PRI - the revolutionary institutional party that had governed Mexico since the 1920s. They - Mexico finally became a true Democracy when an opposition party won the Presidency, Vicente Fox. And there was hope that with Vicente Fox you were going to see transformative change that included reforms in the energy sector and that didn't happen. And then 2006 a candidate from the… again - the National Action Party, Vicente Fox's party - he also was elected president Felipe Calderon. And again, he attempted to introduce these types of reforms, unsuccessfully; those failed.
He, in fact he was in Houston earlier in September at a luncheon address and his comments were the effect of these energy reforms are the same ones I tried to introduce 6 years ago and the PRI at that time said no, this is never going to happen and well, they finally did. This past summer the reforms - when the reforms were initially announced, the initial proposals by the PRI were ones that disappointed the international markets but as their political dialog and debate evolved through the fall, what emerged in December were very open market facing reforms that lead to some amendments to the constitution, that lead to some transitional articles that lay out a broad framework that will have a modern legal system that will be one that will be attractive to multinational energy companies, domestic ENP companies and, uh, it's an exciting opportunity.
Russ: So, before this round came around and you said it wasn't looked at in favor by the international companies; it was obviously an arrangement that they probably weren't going to invest in, right?
Carlos: No, that's exactly right. The initial proposal in the summer by the PRI was one that was limited to profit sharing contracts, but what the new regime that has emerged and what is going to be allowed is licenses will be allowed, production sharing contracts, a whole range of contractual arrangements that, when you look at the global gas - oil and gas industry, there'll be structures that are similar to what one sees in other places in South America like Colombia, like Peru, like Brazil, like what one sees in West Africa as well too.
Russ: Okay, but I suppose there's still a segment of the voting population in Mexico that didn't like this and is suspicious about what's happening.
Carlos: There is but I think the view was if that opposition was going to manifest itself, it would have and it didn't. The revolution - the PRD, the Revolutionary Democratic Party tried to engage in street protests did some political theatrics like putting barricades to the House of Deputies to prevent people from coming in. One politician gave a very impassioned speech where late in the wee hours he talked about how this legislation would mitt - would strip Mexico of its wealth and then he proceeded to strip off his clothes. But it failed and the legislation passed through so I think, while it was something that valuable and sacred to the Mexican people, they at the same time too there was an inherent skepticism or cynicism that Pemex had grown a little too big. Pemex had grown, perhaps, the cynicism about its corruption as well too, so a recognition that Pemex needed to be changed to, uh, be internationally competitive. So one aspect to be cognizant of is from the Mexican political perspective they have to make sure that they get this right, that is proves to be a success. Because if it's not, if you start seeing power prices going up, if gasoline prices start going up, if the reform doesn't start bringing the benefits and the jobs that have been promised, then the risk does exist that there'll be a political backlash and that there'll be a counter reform. And in terms of a time table, Mexico has mid term elections in 2015, so they very much need to have this new legal landscape set out before then so it doesn't become a political football.
Russ: Sounds important.
Russ: Okay, well I, you know, I understanding that Pemex is a nationalized company but it still had lots of employees, had executives, has leadership; how are they coming out in this thing? Did they ever express their opinion on one…
Carlos: So Pemex is very engaged, very involved and there are going to be some very interesting changes that will have to have to occur to Pemex.
Russ: And they will play a role…
Carlos: They will play a role. They - once - in this new system they will have to compete for opportunities, either alone or in joint ventures.
Russ: That probably bummed them out.
Carlos: It's one that as new entrants will come in to the market there will be new opportunities for Pemex employees. Naturally international oil and gas companies will recognize that we need some anyl-we need folks who have been on the ground, who understand the landscape so that will create opportunities.
Russ: But Pemex will continue as an entity, as a company?
Carlos: It will and there will be interesting changes to the Mexican laws for instance that Pemex executives, their compensation structures will have to be realigned so that their executives don't all get raided and decide to go join the multination energy companies.
Russ: Okay, okay. Now you mentioned one of the areas of opportunity is deep water in the gulf which probably makes since because they didn't have the technology to go do that and it takes technology.
Carlos: Technology and capital.
Russ: Okay, but what about shale, is there shale opportunities still out in Mexico?
Carlos: Shale, there's shale opportunities as well too all along the border between Texas and Mexico; all along there that geology is in the Burgos and Sabines basins is presumed to be very similar to what you have on the Eagle Ford side. And again, you need the technology, the expertise and you need the capital as well too. And what's also we've talked mostly about that upstream space, but the energy reforms touch all facets of their energy sector. There's the midstream markets and the downstream markets are complete privatizations and Mexico needs pipeline infrastructure.
And likewise too, in the electric power sector, it's the intent is to create a wholesale market that's regulated by an independent system operator. And so that should create opportunities for investment in electric generation. So the whole energy lands - of you - 5 to 10 years from now if you looked at the Mexican energy landscape when it's all said and done, it's going to be very different from what exists today.
Russ: Okay. Sitting where you sit today do you observe international companies that are perhaps in the lead in some of these partnering opportunities and investment opportunities?
Carlos: Everyone's interested. Coincidentally this morning I had a conversation with a significant multinational energy company that's in many other places in the world but they're not yet in Mexico and the conversation went along the lines of what do we need to do and how do we get started. We know that we are 12 to 16 months out from getting into the deal making phase so to speak, but we need to figure out what type of entities we set up, we need to figure out what the labor and employment laws are like, we need to make sure that we've got efficient operations from a tax perspective so yes, I think you have a landscape and like I said, the energy markets down there were ones that from the upstream perspective - upstream ENP players weren't interested in the opportunities in Mexico so they are all naturally figuring out what they need to do next, catching up on their homework so to speak and laying the ground work so that when the opportunities do arise, they'll have everything set up so that they can go into an implementation and execution mode of developing the assets.
Russ: Okay. Has there been any discussion about, uh, what impact this might have on the social culture, the cartel, the crime that's been going on for quite some time in Mexico?
Carlos: So I don't - obviously from the Mexican policy makers' perspective the hope is as you create economic opportunity, that will help stabilize your society. From a foreign investor perspective you get that that's a potential security concern, particularly in the shale gas plays on the border with Texas where there's been much attention about the violence. But the international oil and gas industry is one that sometimes when you're drilling for oil and gas you're doing it in places that aren't the safest; places. But as I said a large view from the Mexican perspective is trying to create economic opportunity for its people and its country and as it rises the level of economic activity that should create opportunity and that should thus lessen crime.
One another element of the reform is to create a sovereign oil fund similar to what has been done in Norway with the idea being that the wealth that is created from the oil and gas exploration activity that gets paid back to the government through taxes, through royalties, through bonus payments, that money will go into this oil fund and then this oil fund will be administered and delivered for the benefit of the country. Interestingly the Mexican legislation contemplates that the Central Bank of Mexico will administer that oil fund with obviously the hope and intention that by removing it one step from the politicians down there, those monies will be put to their best use and not necessarily the most politically expedient ones.
Russ: Great. Well obviously from something that's this big of a change and this complex, there still could be some hurdles along the way.
Carlos: There are many hurdles to go. There are new regulatory bodies that have to be developed, there are 20 to 25 new laws that have to be spelled out in detail, there have to be bid processes for the awarding of oil and gas opportunities in exploration blocks. So if you were to look at the landscape down there, 2013 was the year in which they made their amendments, the year in which they set the details - laid out the big picture of what they want to do, but 2014 is very much about the details and what those accompanying details are, and then perhaps the latter part of 2014 and 2015 will - will be the implementation.
Russ: Okay, but it seems like some of those might even be big enough to derail the positive momentum.
Carlos: I think it, they're big and that potential exists certainly, but I think it's very much one where President Enrique Pena Nieto of Mexico has recognized that this is his presidency, this is his legacy, and so he placed his political capital at risk in 2013 to, uh, to get the constitutional changes done, so I think that will continue. But I your observation is a good one in that now there are more stakeholders involved with the process, there are new regulatory bodies, there's the institutional bureaucracy's within Pemex, within CFE, the electricity monopoly down there. And so as a consequence there will be more voices in the debate and so certainly, the potential exists for that occurring. But I think fundamentally there's too much at stake, expectations have been elevated too greatly in the international community, in the international financial markets so I'm bullish on Mexico and I it certainly I think many foreign investors are as well too.
Russ: Carlos, I really appreciate you sharing your perspective with us.
Carlos: Thank you.
Russ: That wraps up my discussion with Carlos Sole, head of Latin American practice here at Baker Botts. And that wraps up this episode of The BusinessMakers Show, heard on the radio and seen online at TheBusinessMakers.com.