A Mexican Development Fund financed by oil revenues Putting the Guanajuato proposal to work

by Dr. Jos Luis Alberro

Director Law and Economics Consulting Group

Paper presented at the Forging North American Energy Security Conference, Monterrey, Mexico April 1-2, 2004

The author Dr. Jos Luis Alberro Director, Law and Economics Consulting Group (LECG) jalberro@lecg.com I want to thank Dr. Jorge Castaeda for the many ideas he contributed to this effort. The opinions expressed in this paper are those of the author, and not those of LECG, its other employees or affiliates.

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A MEXICAN DEVELOPMENT FUND FINANCED BY OIL REVENUES: PUTTING THE GUANAJUATO PROPOSAL TO WORK Dr. Jos Luis Alberro Director, Law and Economics Consulting Group (LECG)

decade after the North American Free Trade Agreement (NAFTA) came into effect, trade and investment amongst its three partners has nearly tripled.i Leveraging this success, three years ago a joint communiqu between Presidents Fox and Bush -the Guanajuato Proposal, talked about going farther by developing, after consultations with Canada, a North American approach to the important issue of energy resources.ii NAFTAs energy chapter chapter 6- set two goals: to strengthen trade through sustained and gradual liberalization and to have viable and internationally competitive energy sectors. The first goal has been reached but, in the Mexican case, the second has not because government owned monopolies still dominate the electricity and hydrocarbons sectors and energy prices are above those that would prevail in a competitive environment. The first article of that chapter provided a measure of the resistance to change in the sector as it established that the parties confirmed their full respect for their Constitutions, because it was a political imperative in Mexico. Over the coming decade, the demand for oil in the United States is expected to increase by 3 million barrels a day while its production decreases by 600,000. Canada is expected to increase its exports by about that same amount thus leaving an unmet demand of close to 3 million barrels a day.iii Thus, North America will have to increase its dependence on energy imports. This creates a market opportunity for Mexico, particularly because, as ambassador Rozental has stated, it has a grade of oil difficult to compete with, neither light nor heavy, reliable crude. In fact, Mexican crude oil exports to the U.S. have increased by two thirds since NAFTA contributing to North American energy security. The Guanajuato Proposal also talked about striving to consolidate a North American economic community whose benefits reach the lesser-developed areas of the region and extend to the most vulnerable social groups in our countries. At last years conference, Pastor, Morley and Robinson presented a paper, which, among other things, analyzed the European Union experience with convergence and concluded the task of closing the gap between richer and poorer countries in a free trade area is a formidable one, but the E U has demonstrated that it can be done, provided that its members made a serious commitment and appropriate significant funds expressly for that purpose.iv They estimated it would take 17 billion dollars of foreign aid annually to push the Mexican economy to grow at a rate required to start closing the gap. Using three different approaches, Shiau et al. (2002) conclude that with existing capital stock and productivity, Mexico cannot sustain a 7% growth rate and that capacity has to increase significantly through a high rate of investment to attain such a growth path.v The OECD is equally pessimistic; its medium-term reference scenario which assumes no new major structural reforms has GDP growth hovering between 4 and 4.5 per cent; for GDP growth to reach a rate of 7 per cent per year, a number of bottlenecks have to be removed by investing in human an physical capital.vi It is unlikely that Canada and the United States would fund a 17 billion dollars a year program, particularly given Mexicos oil reserves. But it might be possible to design a two-step strategy that creates an energy investment fund that leverages Mexicos reliable crude and uses the revenues from increases in production to carry out the investment in human and physical capital needed to start bridging the

NAFI EGAP Comexi: Forging North American Energy Security

development gap. Jorge Castaeda, Mexicos ex foreign relations secretary and the architect of the Guanajuato Proposal has put forward such an idea. For the plan to be successful it needs to recognize three imperatives: First and foremost it has to be consistent with the Mexican political compact and its Constitution. Making it contingent upon changes in the current legal framework will guarantee its failure; Secondly, it has to include an independent control system so as to guarantee that funds are dispensed in a manner that is transparent and exempt from conflicts of interest;vii and, finally, It has to be effective. This paper explores financial mechanisms to increase oil production in Mexico without modifying the Constitution. This restriction is acknowledged, not because it is considered to be adequate for the challenges Mexico faces in the XXI century but because conservative politicians representing rent seeking constituents still yield enough political power to block any other agenda. Cautious optimism is justified because, once before during the Tequila Crisis, the international financial community assisted Mexicos pressing financial needs by providing credit lines backed by oil revenues, thereby bounding the destructive effects of a liquidity crisis. Such support 50 billions dollars- was available, however, because the Mexican government convinced the international community it would make prudent use of those resources and because it accepted that its disbursement could be closely supervised. This optimism can further be buttressed by the fact that private investment in the energy sector has been mounting even though the liberalization of electricity generation and of the natural gas sectors that occurred between 1993 and 1996 was timid: 13 gas pipelines crisscross the U.S.-Mexico border with a total capacity of 2.5 Billion cubic feet a day (Bcfd);viii New power plants have been built in Baja California to supply electricity to Southern California; Private companies own more than 1,000 Km of pipelines [an amount expected to grow 60% by 2005] and 50 million horse power of compression capacity [expected to grow more than fivefold by 2005]; Local distribution companies have invested a billion dollars to serve 2.4 million homes in twenty cities; Five newly devised multiple service contracts [Contratos de Servicios Mltiples, CSM] worth 4.4 billion dollars have been granted to four consortia to explore and develop dry gas fields in the Burgos basin in northern Mexico. Total new production is expected to reach 440 million cubic feet a day (mmcfd);ix and PIDIREGAS, a financial instrument used to attract private capital while respecting the Mexican Constitution, has become the main source of financing of capital expenditures and totaled 24 billion dollars in 2002.x

NAFI EGAP Comexi: Forging North American Energy Security

One step at a time, with political tension and at a pace that does not match the impatience of many, the Mexican energy sector is increasingly relying on private companies and private funds. It is unlikely that the financing needs of the Castaeda proposal can be met by relying only on private sources but they should constitute a significant component. RESOURCE BASE AND PRODUCTION Even though PEMEX has had a poor reserve replacement record (reserves decreased 20% between 1990 and 2003), Mexico still has the largest conventional proved crude oil reserves in North America.xi The decrease in reserves reflects the fact that little investment in exploration and development occurred during the period 1990-2001: it amounted to only $615 million dollars a year between 1990 and 1995; and decreased to $475 between 1996 and 2001 with the result that only 25% of production was being replaced when the industry standard is 105-120%. Mexicos total oil reserves
48,000 46,000 44,000 42,000
mmb

40,000 38,000 36,000 34,000 32,000 30,000 1990 1992 1994 1996 1998 2000 2002

Note: The methodology used to quantify reserves changed in 1999 so the data are not strictly comparable

NAFI EGAP Comexi: Forging North American Energy Security

Spending in exploration has increased to almost 2 billion dollars for each of the last two years and as a result the number of exploratory wells has increased 40%, development wells 90% and 38 new fields have been discovered.xii PEMEX is now replacing 75% of the reserves it uses. That level of investment will be maintained for the rest of the decade until new reserves represent 100% of production.xiii In 2003, oil production reached 3.4 million barrels a day and gas production 4.4 Bcfd so existing (proven plus probable) reserves are sufficient to maintain current oil production during 22 years and current natural gas production during 28 years, levels way beyond those of Norway, Canada, or the United States that maintain about 10 years worth of reserves. In 2003, Mexico exported 1.8 million barrels a day of crude oil and imported 750 million cubic feet a day (mmcfd) of natural gas. Castaedas proposal entails doubling oil exports by 2010 and becoming a marginal exporter of natural gas, thereby strengthening North American energy security. It would also provide the government with 10 billion dollars of additional revenues that could be invested in human and physical capital to qualitatively change the countrys growth path. This level of production would mean that current reserves would sustain 14 and 13 years of production respectively, still above international standards. Analyses carried out by PEMEX indicate that these goals are attainable if appropriate financing can be obtained and preliminary estimates place the financial needs at 15 billion dollars per year for the rest of the decade: 12 billion to sustain current production levels and make them grow to the mentioned targets, and 3 billion for interest payments and amortization. A NORTH AMERICAN ENERGY FUND TO FINANCE A MEXICAN DEVELOPMENT FUND Mexico possesses a rich hydrocarbon resource base, and is thus wealthy if not liquid. A two-step strategy that first converts Mexicos reserves into financial resources and then uses them to fund the investments required to put Mexico on a higher growth path, may be acceptable to the NAFTA partners since, as Pastor, Morley and Robinson observed the United States, Mexico, and Canada are not prepared at this time to contemplate a North American Investment Fund.xiv Two funds should be created: the North American Energy Fund (NAEF) whose net revenues will finance the Mexican Development Fund (MDF).

NAFI EGAP Comexi: Forging North American Energy Security

The two NAEF decision-making processes securing funds and disbursing them for investment projects- should be transparent and supervised by Mexican and North American stakeholders alike to insure that PEMEX carries out its investments with the highest standards, that all operations are subjected to benchmarking and that risks are minimized. The NAEF could have offices outside Mexico to increase accountability to the international community and facilitate the relationship with financial institutions.xv Mexico will have to lead the financing effort by example and show its willingness to make sacrifices by having Congress increase its appropriations for PEMEXs investment in exploration and production to the year 2000 level, 50% above its current level of 2 billion dollars. Additional funds could be raised through the Bolsa Mexicana de Valores. Indeed PEMEX recently placed 1.4 billion dollars of three and a half to six and a half year debt certificates in the Mexican stock market to refinance PIDIREGAS. The rates were no higher than those in international markets in some cases lower, and it should be noted that it received offers for 3.7 billion dollars. If private sector financed PIDIREGAS and CSM continue to flow at the rate of 7 to 8 billion dollars a year that leaves 3 to 5 billion dollars a year to be financed from other sources. The NAEF will have to raise those funds from many sources including governments (of the NAFTA signatories as well as other countriesxvi), multilateral financial institutions and the private sector. There is no magic bullet and the advantages and disadvantages of each mechanism will have to be analyzed. The task is ambitious but well within the capabilities of PEMEXs and of Mexicos Secretary of the Treasury if the international financial community subscribes to the appropriateness of increasing oil and natural gas production and if Mexico pledges total transparency and accountability. None but PEMEX can carry out this project in the current political context but a different corporate culture has to be put into place given its traditionally opaque workings. A political consensus has to be forged in Mexico on the importance of this project and on the fact that transparency and supervision in the disbursement of funds are indispensable.

NAFI EGAP Comexi: Forging North American Energy Security

Close to 80 percent of flowing oil, and possibly a higher percentage of reserves, can be produced at a cost of under US$5/barrel Pretax rates of return for investments in new oil projects vary from a low of 26 percent in the Norte region, to highs in excess of 70 percent in the marine area.xvii Extraction costs are expected to increase over the next decade but preliminary analyses carried out by P E M E X indicate that the IRR should be expected to remain significantly above the 15% threshold usually required to justify such investments. Profitability is more than adequate to attract private financing. Even in that case, however, raising 15 billion dollars a year by only relying on private sources may not be possible without introducing risk contracts or concessions, which require constitutional changes. Waiting for the stark realities of a non-performing economy to force political change and constitutional amendments may take too long. The brunt of the funds to be raised by the NAEF will have to come from private sources and may have to be guaranteed by the revenues that will flow from domestic sales of natural gas and increased exports of oil, in particular to the United States. There seems to be five different options: 1. Leasing techniques could be used to finance large ticket items like rigs, oil platforms, etc... A special trust could be set in the United States that would hold lease agreements for that equipment, obtain financing and acquire equipment whose property rights would not be PEMEXs. 2. A significant proportion of the inputs needed for this project will be imported so the indirect beneficiaries will be firms in Canada and the United States. The US and Canadian governments could create a special facility at their Import/Export banks for loans, insurance or guarantees thereby supporting this effort while promoting their business community. The terms of these instruments could be tailored so that the willing government(s) could bear part of the risk associated to the specific investment projects. A special task force within the banks should be created to deal with this project in a manner that is more streamline than normal. 3. Institutional investors in the United States and Canada or pension funds could be interested in holding debt backed by oil revenues.xviii 4. Even though development banks (IDB, World Bank) have traditionally been unwilling to commit to this sector except as part of a liberalization process, Jamal Saghir, Director Energy and Water at the World Bank recently presented an Evolving Model for Infrastructure and Energy Service Delivery that combines bank group instruments (IBRD/IDA loans, credits and guarantees, IFC loans and investments, and M I G A guarantees) and specified that these instruments would be available for projects anywhere along the spectrum between private and public investments offering hope.xix 5. Finally, the US government can establish a long-term purchase program for the Strategic Reserve and advanced sales of new oil production could be used for a few years. This endeavor will require a significant increase in PEMEXs debt and financial markets could react negatively unless there is a clear understanding of the nature of the project and of its profitability. A multi-part strategy will be needed: lenders will have to be convinced of the appropriateness of the plan and of P E M E Xs creditworthiness; a campaign will also be needed to convince credit rating agencies that they should not downgrade PEMEXs credit risk and this campaign will have to be extended to key institutional investors in both Mexico and North America. The Mexican oil sector is de facto dollar denominated since its products are traded in dollar denominated markets so there is little exchange rate risk: indeed credit agencies (ie Standard&Poors or Moody) grant PEMEX ratings that are not significantly different depending on the currency of the instrument. On the other

NAFI EGAP Comexi: Forging North American Energy Security

hand, a number of PEMEX contracts acknowledge the authority of US courts typically New York, thereby decreasing contractual/judicial risk. The significant risk is in design and execution and that is the area in which the biggest effort will have to be made. It is important to create a backlog of energy projects and have them audited/certified by experts. International agencies (Inter American Development Bank, and the World Bank) have important contributions to make given their wide and deep experience in these matters. The main obstacle to this endeavor is not the existence of constitutional restrictions but the lack of a social compact about the Mexican energy sector. This absence of a coherent long-term hydrocarbon strategy has weakened PEMEX and contrary to the goals set in NAFTAs energy chapter, it has undermined the competitiveness of the energy, petrochemical and industrial sectors. The central issues should be how to insure that PEMEXs and CFEs reach high levels of productivity and how to set energy prices equivalent to those that would prevail in a competitive environment. Unfortunately, these real issues have been pushed to the side and replaced by ideological confrontations about privatization. In this environment, the challenge is to design and implement a prudent strategy that will permit todays wealth to be leveraged to solve todays problems. THE SOCIAL INVESTMENT FUND The impact of ten billion dollars of additional government revenue on the economy will depend on whether it becomes an excuse to not carry out the needed structural reformsxx, and it is used to increase subsidies and tolerate low productivity levels or whether it becomes the vehicle to increase total factor productivity. The accepted wisdom is unequivocal in underlining that potential growth is constrained by low levels of human and physical capital, widespread poverty and institutions that are inadequate for the XXIst century. Prudence and accountability compromises should include: Macroeconomic stability; Decreasing the cost of special fiscal privileges (that amount to close to 30 billion dollars a year); Increased governmental non-oil revenues; Labor reform to foster flexibility and decrease the disincentives to formal employment; Reform of the justice system to streamline it, make it transparent and predictable; Deregulation to facilitate investment; Investment in human and physical capital; and Measures to alleviate poverty. While ten billion dollars a year will not solve all these problems at once, they can go a long way; they can finance doubling expenditures in science and technology, increasing by a half spending in justice and law enforcement AND increasing investment in health and education 25%. There is little doubt that such a strategy would significantly increase total factor productivity and long run growth perspectives. In all likelihood it would trigger self-reinforcing virtuous mechanisms that would benefit Mexicos North American partners.

NAFI EGAP Comexi: Forging North American Energy Security

CONCLUSION A decade after NAFTA came into effect it has reached its trade and investment goals with flying colors but the world is not static and it has to be reinvigorated. The Guanajuato Proposal, talked about going farther by consolidating the North American economic community so that the benefits would reach the lesser-developed areas of the region and extend to the most vulnerable social groups and by developing a North American approach to the important issue of energy resources. The two-step strategy put forward in this proposal meets these two objectives by calling all three partners to the task. The burden will be heavier on Mexico but so it should because so will its benefits. Mexico will have to dare to carry out the profound reforms needed to access a different set of opportunities. The additional resources will ease the transition and open the possibility of triggering self-reinforcing virtuous circles. Mexicos partners have an opportunity to invest in a project that is risky but it is the only one that offers a reasonable long-term solution to some of the endemic problems that plague their relationship. To mitigate these risks they have to demand prudence, transparence and accountability. They can do it by relying on existing private and public sector institutions as long as enough creativity is mobilized. This is a worthwhile challenge for all three. Lets hope that the governments rise to the task

Pastor, Robert A., Samuel Morley and Sherman Robinson Closing the Development Gap: A Proposal for a North American Investment Fund, March 2003. ii http://www.presidencia.gob.mx/?P=2&Orden=Leer&Tipo=Pe&Art=548 iii http://www.eia.doe.gov/emeu/northamerica/engindex.htm. iv Pastor, Robert A., Samuel Morley and Sherman Robinson (2003). vv Shiau, A., J. Kilpatrick, M. Matthews (2002), Seven per cent growth for Mexico? A quantitative assessment of Mexicos investment requirement, Journal of Policy Modeling, June 2002. vi OECD Economic Surveys, Mexico, November 2003. vii Pastor, Robert A. and Christine Frechette Quand le libre-change ne suffit pas. De lintrt a crer un Fonds dinvestissement nord-amricain, March 2003. viii Just in Reynosa, the throughput has more than doubled. ix Among the participating companies, Repsol from Spain, Petrobras from Brasil, Teikoku from Japan, Tecpetrol from Argentina, Lewis from Texas and two Mexican companies. x http://www.pemex.com/index.cfm/action/content/sectionID/11/catID/66/subcatID/143/index.cf m?action=content&sectionID=11&catID=66&subcatID=143, and Banco de Mexico, Informe Anual 2002. xi http://www.eia.doe.gov/emeu/northamerica/engindex.htm; and http://www.energia.gob.mx/wb/distribuidor.jsp?seccion=1495 xii Pemex Exploracin y Produccin, Anuario 2003. xiii Pemex Exploracin y Produccin, Plan de Negocios, 2002 p.26 xiv Pastor, Robert A., Samuel Morley and Sherman Robinson (2003). xv In the era of the Sarbanes-Oxley Act, accountability is a condition sine qua non. xvi The Japan Bank for International Cooperation recently granted PEMEX a 500 million dollars unattached line of credit. xvii Energy Policies and the Mexican Economy, ESMAP, World Bank, January 2004. xviii Ie the Carlyle Group, Soros Management Fund, Warren Buffets Berkshire Hathaway, etc xix International Comparisons of Efficiency in the Energy Sector, October 2003 xx Fiscal, labor and energy prices equal to those that would prevail in a competitive environment

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