How Mexico's Oil Industry May Benefit US Investors

The political agenda of incoming Mexican president Enrique Pena Nieto has profound implications for Latin America’s second largest economy, including new labor laws, fiscal restructuring to broaden the tax base, and a take-no-prisoners stance against the drug cartels.

Incoming Mexican president, Enrique Pena Nieto.
Yuri Cortez | AFP | Getty Images
Incoming Mexican president, Enrique Pena Nieto.

But no industry, arguably, stands to be potentially transformed the way the energy sector does.

Pena Nieto, who takes office Dec. 1, vowed during his campaign to push for further private sector participation in the state-owned oil and gas monopoly, Petroleos Mexicanos, or Pemex.

Pemex, a major source of revenue for the Mexican government, was partially deregulated in 2008, allowing private and foreign companies to bid on projects for the exploration and production of natural gas and oil refining.

It still limits their ability to share risk, however, or share in the potential upside of any oil finds. (More:Mexico...Surprising Land of Opportunity)

Pena Nieto’s reform initiative would open Pemex to further private sector investment — and potentially even list the company as a publicly traded stock down the road, a la Brazil’s semi-public energy company Petrobras , which was deregulated in 1997 and began selling shares in 2010.

“If he succeeds, it would have huge beneficial effects for Mexico's economy,” says Shannon O’Neil, senior fellow for Latin America studies at the Council on Foreign Relations. “The most obvious is an increase in foreign direct investment in the energy sector itself. But the benefits would spread to infrastructure more broadly, to services, and would lower the energy costs for companies in general — improving competitiveness.”

Oil contributes to roughly one-third of Mexico’s total federal budget.

Pena Nieto has publicly stated that energy deregulation is necessary to provide Pemex the capital needed for deepwater oil exploration and technology upgrades.

Indeed, crude oil production at Pemex, the world’s fourth-largest oil producer, has been falling for the last eight years despite abundant reserves.

And economic growth has caused energy demand to outpace the country’s ability to generate supply.

“The reform that happened a few years ago under [current Mexican president Felipe] Calderon opened up space forservice companies, but a more fundamental reform is necessary to bring in the major [energy companies] for exploration, production, and potentially distribution,” says O’Neil.

Thus far, only oilfield-services companies are getting a piece of the pie. (More:Crime Explodes — but an Economy Booms)

In May, engineering firm McDermott International in Houston was awarded a Pemex contract to construct an offshore drilling platform for oil exploration and production.

And Houston, TX-based Schlumberger won a contract in June to develop oil fields in Northern Mexico with U.K.-based Petrofac.

Chevron in San Ramon, Calif., Baker Hughes of Houston, TX and Halliburton of Houston, are also reportedly making bids for rights to develop offshore oilfields in the Gulf of Mexico.

The opportunity for growth, as deregulation takes shape, is not lost on New York investment firm Morgan Stanley Private Equity, which announced in January it was working with former Pemex CEO Jesus Reyes Heroles to identify drilling and oil services companies that are ripe for investment.

It plans to invest between $35 million and $110 million in each of Mexico’s most promising energy companies.

More private capital on its way?

In its “Mexico Equity Strategy” report in June, Morgan Stanley Research Latin America says it would “not be surprised” to see several rapid initiatives that would welcome private capital into the gas exploration, pipeline construction and downstream areas going forward, namely the opening of shale and conventional gas exploration, further deregulation of the selling and distribution of petrochemicals, and development of pipelines and energy distribution.

Omar Torres | AFP | Getty Images

“These reforms will likely produce both significant business development and investment, major changes to many industries and some inflation,” the report points out.

Future Unclear

But energy market reform is hardly a foregone conclusion.

Pena-Nieto’s political party, the Partido Revolucionario Institucional, or PRI, did not win a Congressional majority in the recent election, which will make it tough to sell his agenda.

Harder still, the Mexican constitution guarantees Pemex a monopoly position in the country’s oil industry, and it requires a two-thirds majority vote to change the constitution.

Investors who are seeking growth opportunities in Mexico, however, and are willing to roll the dice, might consider a small allocation to Mexican stocks that are poised to benefit from deregulation, according to the Morgan Stanley report. (More:Latin America's Export Engine and Stock Juggernaut)

The firm is currently overweight on petrochemical company Alpek and conglomerate ALFA in its Mexico Model Portfolio, along with banks Banorte and Bolsa Mexicana .

“We continue to like financials, especially Banorte, a bank that will benefit from higher economic growth,” the report notes. “We also like the stock exchange Bolsa, which could benefit from reform even without a full privatization of Pemex.”

All in all, the report suggests, “structural reform is good news for long-term investors in Mexico,” as lower energy costs and new opportunities give industrials, like manufacturing and petrochemical companies, a leg up.