Energy Supply and Energy Security: a Mexican Perspective edit
Oil prices have almost doubled in the past two years. After having breached the 75 dollar a barrel threshold for brief periods the market seems ready to test a price of 80 dollars for WTI, while global demand continues to grow. Future prices on the NYMEX are currently above 70 dollars until December of 2012. Yesterday the far dated quotes reached a new record. Refining margins have remained high and the average retail price of gasoline in the US should be higher this summer than last year. Prices are reflecting multiple constraints and imbalances along all of the supply chain. Capacity increases will be limited for at least the next three years, both in the upstream and in the downstream. More important, the oil service sector as well as construction and engineering companies are not able to meet their costumers' requirements. The resulting cost inflation is contributing to a shift of oil industry supply curves. Manpower and managerial experience in the oil industry have become significant limiting factors that cannot be easily relaxed. The strength and expected length of the current industry cycle have surprised most analysts.
-->We are now witnessing a pendular swing in the balance of power between producing and consuming countries, governments and oil companies. The entry of large scale emerging actors to world oil markets is intensifying competition as they attempt to lock up energy supplies. Changes in the direction of the oil and gas trade will also have significant geopolitical repercussions. Government-take in many regions is increasing, and the terms and conditions of access to resources are tightening. The response by companies and by international institutions has been inadequate and at times insensitive, if not arrogant. The Deputy Director of the IEA warned producers that «If you don't get the balance right between the companies interest and the country's interest, the country will ultimately loose». It would be wiser and more constructive to explore new partnership patterns that can cope with the negative consequences for all of the predictable cycle of power relationships that Raymond Vernon termed the obsolescing contract.
In this context it is not surprising that security of supply concerns have intensified as we have moved from a buyers' to a sellers' market. In the US, the growing oil and gas import dependence, and the prospects that these imports will increasingly originate in the Persian Gulf, are a source of increasing anxiety and a focus of foreign policy. The vulnerability of oil and gas supply chains has been heightened by rigid constraints that have left the world with insufficient excess capacity. Under these circumstances, supply interruptions in any single area can have a significant impact on global balances and on prices. Political events in producing countries, as well as the force of nature, can easily disrupt oil markets. It is clear that geopolitical risk is a function of the magnitude of excess capacity and of its geographical location in the supply chain.
Traditionally the US has shown a marked preference for hemispheric supplies. Today, half of its crude imports come from this region. If this share is to be maintained, exports from Canada and Venezuela must increase, given the expected growth rate of imports. Mexican production has probably peaked and it will not be easy for Brazil to sustain self-sufficiency. The maturity of Argentine oil provinces offers little hope and the potential for incremental exports from the Andean region is limited. On the other hand, natural gas exports from Canada will probably decline gradually, while LNG imports from Trinidad will continue to grow, although not their market share. Special mention must be made of heavy and extra-heavy sour crude imports. Mexico, Venezuela and Canada are the almost exclusive sources of these types of crude which are processed in high-conversion refineries specifically built for them. The eventual reduction of Mexican heavy crude exports will be partially offset by incremental Canadian exports that must flow all the way to the US Gulf Coast. Although Venezuelan exports have almost fully recovered, growing political risk should affect Gulf of Mexico market dynamics.
The resurgence and assertiveness of resource nationalism is taking different forms in all of the major producing countries. A fundamental change in short- and mid-term market conditions has renewed its latent potential. Extraordinary recent industry returns and embarrassing oil company liquidity have justified, and made feasible, important increases in royalties and taxes. The longing to regain control of their natural resources has led governments to increase their equity stake in upstream projects and, in some cases, to re-nationalize the oil industry. The hand of resource owners is being strengthened by the realization of the enormous production challenges posed by maturing assets. A significant increase in supply costs of relevant marginal producers gives economic support to producers' claims and actions. Producing countries should behave prudently and exercise self-restraint in order to manage effectively this change of circumstances and to sustain achievable gains. Greed and the lack of political responsibility can easily turn against their long-term interests. Oil companies and consuming countries must recognize the vulnerability of their dominance under these changing conditions, show flexibility and offer constructive options. I must admit, however, my own pessimism with respect to the behavior of the parties involved in striking a new bargain. The news flow is not encouraging.
Oil nationalism was born in Mexico and is deeply embedded in Latin America, where it has flourished in differing forms. Recent events in Venezuela and Bolivia are conditioned by this historical tradition. Mexico has been unable to give it the contemporary content that would allow this country to design and implement much needed reforms in its energy sector. Past certainties have become dysfunctional commonplaces. A number of oil and gas producing countries in the region are pursuing conflicting energy policies at this juncture. One example is their aspiration to promote investment and, at the same time, control domestic prices. In some countries this has resulted in the reduction of output. Social tensions in producing areas, where extreme poverty prevails, have deepened and become more intense. The presence of large scale modern industry in poor, ecologically fragile, rural areas poses complex challenges to local communities as well as to national and international oil companies. The failure of the State to arbitrate the ensuing conflict has given oil companies responsibilities which they are ill-equipped to handle. In some places the resulting disputes turn into a struggle over the rights of indigenous populations in order to gain further legitimacy.
These oil industry issues have been evolving in the context of the recent ascendancy of populist governments in Latin America. There are many different populisms that have their roots in the plebiscitary regimes of the 1930's and 1940's. They are an authoritarian and anti-imperialist reaction to the frustrated expectations associated to the liberal economic reforms of the 90's and their linkage to US foreign policy as expressed by the Washington Consensus. US unilateralism and military intervention in the Middle East are seen as a major threat by left of center governments. However, under the Bush Administration, Latin America has benefited from the American neglect that its involvement in other regions has implied.
Let me now center my comments on Mexican oil and gas reserves and production, and on security of supply issues that are specific to this country. The crude oil expansion cycle that began in 1995 has come to a close. Since 2004 production is on a declining path. In the coming years a substantial effort will have to be deployed in order to moderate decline rates. In the short- and mid-terms production levels will basically depend on the behavior of two super-giant fields: Cantarell and Ku-Zaap-Maloob in the Bay of Campeche. The first of these fields has peaked and the production ramp-up of the second will only partially compensate the decline of Cantarell. The effort required to sustain heavy crude oil output should not be underestimated. It is very likely that heavy crude oil production will fall gradually in the next three years. Incremental light crude production from the coast of Tabasco and from other onshore fields in the Southeast will also contribute to check aggregate decline rates. In this same time frame, the domestic supply of natural gas will continue to increase due to additional production of non-associated gas from Veracruz and from the Burgos Basin. However, given the maturity of the gas reserve base it will not be possible to sustain the current recovery unless new large fields are discovered very soon. In Mexico, as in other world class provinces, the era of easy, low cost, low risk oil and gas seems to be coming to an end.
Proved reserves from the great discovery cycle of the seventies and early eighties in our Southeast Basins are depleting rapidly. The hydrocarbon reserve to production ratio has fallen to 10 years and the reserve replacement ratio of the last 3 years is merely 25 percent. More important, the proved and probable reserve endowment is very mature: close to two thirds of ultimate recovery has already been produced.
Mexico's exploration and development strategy must aggressively pursue three basic objectives that could contribute to maintain production in the longer term. First, Pemex must return to its traditional production areas and rejuvenate some of the mature assets that it holds. As in other parts of the world, brownfield developments offer interesting opportunities. Closing technological and best practice gaps can make a significant contribution to reserve and production growth by rising ultimate recovery factors. Second, the Chicontepec Basin in Central Veracruz must be developed as it holds more than a third of the proved, probable and possible oil reserves of the country and almost one half of total gas reserves.
Development and production in this area will be characterized by high development and lifting costs, low recovery factors and slow production growth due to low well productivity and high initial decline rates. Chicontepec projects are intensive in the use of capital, technology, engineering and mid-level management. They will also have to address complex environmental and social issues. The third objective relates to the intensification of exploration activities in offshore areas, including deep water targets in the Gulf of Mexico. We must quickly develop a better understanding of the potential of undiscovered resources in the Gulf and prepare for a major effort in this region. Contrary to the Pemex diagnosis, I believe that the binding constraints that we face are not technological but of a managerial nature. Needless to say, this overall strategy will require ample financial resources, wide ranging institutional change and disciplined risk management.
Gross annual crude oil exports reached their historical record in 2004, while net liquid hydrocarbon exports peaked the year before. Mexico has become a substantial net importer of oil products and natural gas. This is the result of chronic under-investment in the refining system and the maturity of proved natural gas reserves. Last year the country imported 38 percent of the gasoline sold in the domestic market, as well as close to a fourth of the internal consumption of LPG. In 2004 natural gas imports accounted for a third of domestic sales.
Paradoxically, although Mexico is a major crude oil exporter, security of supply concerns have now entered public policy debates. Short-term attention centers on oil product and natural gas import dependence and relates both to supply reliability and high prices. Preoccupation has increased due to a greater awareness of the fact that the US is a growing net importer of the fuels that it exports to Mexico and to the expanding North American structural natural gas deficit. Supply constraints and higher prices are forcing Pemex to acquire these fuels from more distant sources. With respect to natural gas this country will have to substitute pipeline imports with LNG that originates in West Africa, Russia, Australia and Peru. This particularly rigid logistical chain in emerging global markets poses serious challenges for which we are badly prepared.
Long-term security of supply has come to the forefront in Mexico as the reserve to production ratio has converged to 10 years. The adequacy of proven reserves to sustain current production levels and, more important, to guarantee expected future domestic requirements is an issue that arises while crude oil exports account for more than half of total production. Recently the Mexican Congress assumed the power to set and authorize oil export levels. Instead of determining specific volumes it would be preferable that legislators develop criteria and decision rules for this purpose. Regulating the inter-temporal distribution of production from a changing reserve endowment is not an easy task. Equally difficult is to protect the setting of volumetric production and export targets from short-term political expediency and from political passions. Subjecting exports to a reserve adequacy test, that would guarantee future Mexican requirements for a reasonable period, can stimulate exploration activities. If this strong incentive does not increase oil reserves, export levels would have to be adjusted. For Mexico, as for its main trading partners, energy security has become a matter of national strategy.