OUTLOOK FOR ENERGY SECTOR IN MEXICO

George Baker


A quick survey of the energy landscape in Mexico shows several areas for
concern:  one of these deals with electric power generation, with
regulations for natural gas transmission and distribution, a third with
natural gas supply itself.

One of the accomplishments of the Energy Ministry under outgoing Secretary
Lic. Emilio Lozoya, now replaced by former PRI president Ignacio Pichardo,
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 50,000 GW, from a current level of roughly 28,000 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 changed in late December 1992 and a new set of regulations
for electricity were issued on May 31, 1993.

At which point, to judge from observed results, the vision died:  In July
of that year the International Finance Corporation (IFC) of the World Bank
pulled its support of a proposed electric plant known as Carb=F3n II in the
border state of Coahuila.  In taking 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 the
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 to
try the bond market, but the idea did not prosper, and by October the
Americans announced their total withdrawal from the project.

A second project that appears headed toward the same crossroads is a
proposed natural gas-fired plant near M=E9rida, on the Yucatan peninsula.
Initially, thirty companies paid $10,000 for the bid package, and some of
these companies have submitted bids, which initially were scheduled to be
opened and evaluated in January.  Delays and a new cycle of negotiations,
however, will extend this process into an indefinite future.  As one
prospective developer puts it, "Mexico is speaking the language of private
electric power, but there's little evidence from either the CFE or Pemex of
a genuine commitment."

Yet, unless there is a major shake-up in policy, such bids, even if
awarded, will likely not receive outside 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, debate and
acrimony between Pemex and the Federal Power Utility (CFE) over who would
pay for and built the gas pipeline to supply the plant, known as M=E9rida
III.

Having built the pipeline by whatever financing device, prospective lenders
and developers have two other questions:  One, what are 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.  Questions of tariff are answered 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, plus transportation.  In a recent break with
policy, however, Pemex has announced a 20% increase in petroleum prices for
Monterrey industrialists, who 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:  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 upon issues of the liability of Pemex to either
the CFE or IPPs for costs associated with problems of fuel supply; but,
even if such cases had been decided, Mexican judges,  for operating under a
civil-code legal system, have no obligation to decide on the merits of
similar cases in the same manner.

A third question of uncertainty 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
increasing domestic production.  For this, the most promising area 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 evaluations.

Pemex, which is essentially a southeastern oil producer, is under pressure
to keep oil production up in order, in turn, 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 and the
distribution of refined petroleum products.  Spending capital budgets one
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 because of the lack of
peace of mind about Pemex's commitment to the production, supply,
transmission and fair pricing of natural gas.  Such doubts, in turn, in
part 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 which points back to the recent appointment of two capable career
public officials to lead the major two energy agencies in Mexico, Rogelio
Gasca Neri, a nuclear specialist, in the CFE and, Adri=E1n Lajous, a ten-ye=
ar
Pemex veteran, as head of Pemex.  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 what-if questions of
prospective lenders and developers.

The Salinas Administration, which just ended, kept private investment out
of the energy sector.  Prospective investors and lenders were struck by how
its economic modernization programs systematically overlooked the
opportunities for 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.

Coupled with the recent devaluations of the peso, business as usual in
energy policy in Mexico can only be expected to spur lenders and investors
to look elsewhere.   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 foregone increases in economic development, employment and environmental
protection.  The current challenge facing Dr. Zedillo's government is not
the creation of spending-plan X or spending-reduction plan Y, but the
development of a regulatory framework and legal setting that will attract
direct investments financed on the basis of non-recourse, project
financing.

George Baker directs Mexico Energy Intelligence,
a subscription service based in Houston, Texas.

Tel: 713-627-9390 Fax: 713-627-9391