Report

Mexico's Global Gusher

Why a historic energy reform will be felt from Brazil to China.

In Mexico, all eyes are on a historic reform of the energy sector -- reform which opens up the country's oil to real foreign investment for the first time in more than 70 years. But the real impacts of the changes in Mexico could be felt further abroad -- from Venezuela to Brazil and even in Canada and the United States and China.

By finally prying open a resource-rich country to foreign investment, Mexico promises to up the ante for other regional governments who have to compete for scarce capital to develop their own energy projects. But unlocking a potentially important source of supply could also soften historically-high oil prices by the end of the decade.

Analysts already expect that rising output from the United States, combined with increased oil production from Iraq and Iran, could push prices down sooner rather than later. Mexico could speed up that downward slide just by giving the market the expectation of an influx of new investment. And price matters for development, because some tight oil projects in the United States and oil sands development in Canada rely on high oil prices to be viable. In other words, if crude oil slips much below the $100 range it has traded at for a couple of years, some projects in Canada and the United States won't make economic sense.

Another country that will likely be keeping an eye on the Mexican reform is China, which has already invested tens of billions of dollars in Latin American energy resources, but which is especially eager to start tapping expertise in two areas in particular: hydraulic fracturing and deep-water oil production. (That was the rationale for China National Offshore Oil Corporation's acquisition of  Nexen, a Canadian energy company active in both areas.)

Mexico would certainly be eager to tap rising demand for oil in the Asia-Pacific, including China. That's because of the fundamental shift that's taking place in North American energy production as a whole: With U.S. output booming, Canada and Mexico are both looking for new export markets to replace demand from their traditional customer, the United States. An additional reason for Mexico to look abroad to sell either crude or refined products: The probable construction of the controversial Keystone XL pipeline from Canada down to the U.S. Gulf Coast. The pipeline would give U.S. refineries a way to source the same sort of heavy oil they've traditionally bought from Mexico, but at a cheaper price (for now).

The Mexican reform is attracting so much attention because it went further than many analysts (and oil executives) dared to hope when President Enrique Peña Nieto made it a centerpiece of his campaign. Given how sacrosanct nationalized oil is -- it's a tenet of the Mexican Constitution and a central component of the mythology of the revolution -- most observers expected modest, piecemeal changes. They expected that Peña Nieto might secure the necessary support of political parties other than his own by taking a cautious approach to reform rather than a wholesale change in the operating climate for international oil companies.

Wrong. While the Mexican state will still "own" the oil under its land and off its coasts, the reform will enable foreign firms to sign production-sharing agreements that will give them a stake in the development of resources, rather than just a contractor-type relationship.

Granted, the devil's in the details. Certain aspects of the reform are confusing and still controversial, and there won't likely be any new contracts until late next year at the earliest. But the Mexican government expects the reform to boost oil production from about 2.5 million barrels a day today to 3.5 million barrels a day by 2025. Likewise, the reform should allow Mexico to eventually tap abundant resources of shale gas (it shares mighty cross-border gas fields with the United States) and nearly double gas production to 10.4 billion cubic feet a day by 2025.

The reform was a political slog to the end, with one opposition congressman stripping down to his underwear to protest what opponents see as a sell-out of the revolution. But given Mexico's steadily declining oil production, and having completely missed the shale-gas revolution that has transformed the U.S. energy picture, it was a necessary step.

The shockwaves will likely be felt further away than just Mexico, though. Other countries in the region are also under pressure to revive ailing oil industries (Venezuela), tap massive-but-hard-to-reach oil reserves (Brazil), or take advantage of some of the world's most promising shale reserves (Argentina).

Take Venezuela. The country is blessed, on paper, with the world's biggest oil reserves. Yet oil production has dropped almost one-third since 1997, and now sits at just 2.3 million barrels per day. Petróleos de Venezuela, or PdVSA, desperately needs capital and foreign technology to tap the hugely promising Orinoco belt.

And yet that's precisely not what's forthcoming due to the Venezuelan government's heavy-handed approach to energy investment and contracts. While Chinese companies have poured billions of dollars into the company in exchange for access to Venezuelan oil, PdVSA needs more.

Nicolás Maduro, the successor to strongman Hugo Chávez, seems to recognize that. In private, he has reportedly promised more reasonable terms to foreign oil companies. Yet they are skeptical of pouring more money into Venezuela until those promises are codified in law, something that is at least as tricky in Chavista Venezuela as in post-revolutionary Mexico.

"Once Mexico gets this in place, people will use it to prod Venezuela to change, even though that is politically unpalatable," Pedro Burelli, a former PdVSA board member and critic of Venezuela's management of its oil resources, told Foreign Policy.

"These two, Mexico and Venezuela, have essentially been dormant during the oil boom. And that is going to change now," he said.

If Venezuela does soften the way it deals with foreign companies -- by actually honoring contracts it signs with foreign firms, for example, or offering majority stakes in lucrative fields -- it could in time return Venezuela's oil production to where it was. That, in turn, would help fill Caracas' ailing coffers, even if it means abandoning part of Hugo Chavez's revolutionary legacy.

"Energy nationalism has a limit. And that limit is when it starts doing damage to your nation," Burelli said.

Brazilian energy officials will also be keeping an eye on how Mexico's reform plays out. Since it announced potentially huge offshore oil finds almost a decade ago, it has been touted as the producer-to-watch in Latin America. But that was in no small part because Mexico and Venezuela were either off-limits or unappealing to foreign investors.

Make no mistake: Brazil needs to make sure it offers attractive terms to bring the investment it needs to tackle the hugely expensive and complicated development of oil buried thousands of feet under the seabed offshore. Under current plans, state oil company Petrobras has to be the sole operator of all offshore projects, and international firms would have to source many of their supplies inside Brazil.

Indeed, at a much-hyped auction of offshore blocks recently, Brazil was embarrassed by a frostier-than-expected reaction from international oil companies. Only one bid emerged, at the minimum price.

"Brazil will be more responsive. They should look at what Mexico is doing and say, we sort of lost the plot and got sidetracked" in terms of how to attract foreign investment for energy development, said Duncan Wood, director of the Mexico Institute at the Wilson Center. "So this is another reason Brazil could turn back to more liberal policies."

The repercussions of Mexican reform could reach the other end of Latin America, where Argentina's government is working hard to make the country attractive for foreign investment again after an ugly spat with Spanish firm Repsol over the expropriation of Repsol's Argentine assets.

Buenos Aires and Repsol appear ready to compromise on that fight, itself a significant concession for the government of Cristina Fernández de Kirchner. And Chevron has already pounced on Argentina's potentially huge shale reserves despite its own run-ins with Argentina's government in the past.

Of course, the big question in Argentina, as in Venezuela, is whether domestic politics will trump economic wisdom, even for something so vital as developing abundant energy resources.

Ironically, it was Mexico's nationalization of oil in 1938 that kick-started oil investment in other countries around the region, notably Venezuela. With Peña Nieto's ambitious reform, history may be about to repeat itself.

LUIS ACOSTA/AFP/Getty Images

Report

Putin's Gas Gambit Backfires

The turmoil in Ukraine shows that Moscow can't always get its way by being an energy bully.

Under Vladimir Putin, Russia's massive reserves of natural gas have increasingly become a weapon -- one the Kremlin has not hesitated to use to cow neighbors and boost Russian influence. Moscow has used threats of gas cut-offs or outright cuts more than 50 times since the end of the Soviet Union, analysts say.

But judging by the roiling turmoil in the Ukraine, Russia's use of the energy weapon may have backfired, undermining some of its foreign-policy goals and sparking a resurgence of Ukrainian nationalism. 

Moreover, and more important for Russia's aspirations, its ability to wield energy as a geopolitical tool is waning and will likely continue to do so, thanks to a spate of changes that are rocking the energy world: new supplies of gas, especially from the United States, greater seaborne gas trade, and a gradually unifying European gas market.

The ongoing popular protests in the Ukraine, the largest since the Orange Revolution a decade ago, came about after Ukrainian President Viktor Yanukovych pulled an abrupt about-face in late November on forging closer ties with Europe. That sudden reversal came about because of a deluge of Russian economic pressure -- and Russia's control of Ukraine's and Europe's natural-gas supply was a huge part of that pressure.

Russia used both carrots and sticks to make Yanukovych drop his plans to move Ukraine closer to Europe. The sticks included threats to make Ukraine pay in advance for both its own gas and the gas it transships to the rest of Europe, something Kiev simply could not do. The carrots included a hint of cheaper gas prices and some relief for Ukraine's outstanding gas debts to Moscow.

In a limited way, Russia's ploy worked. Ukraine abruptly dropped plans to sign the Association Agreement with the European Union. And Yanukovych, who hasn't been Moscow's favorite since he began flirting with Europe, faces a popular rebellion ahead of elections in 2015.

But more broadly, Russia's heavy-handed tactics backfired. Ukraine hasn't joined the Moscow-led Customs Union -- one of Moscow's main goals -- and there doesn't seem to be any way it can in the near future, given the depth of outrage in the streets of Kiev. Putin said Thursday that Russia hadn't pressured Ukraine, and insisted that country could still join its Customs Union.

In response to the protests, Yanukovych has even suggested he might sign the Association Agreement with Europe after all, European Union foreign policy chief Catherine Ashton said Thursday. That agreement would spur reforms in Ukraine, such as boosting the rule of law and human rights as well as economic reforms, while offering Ukraine greater trade access and cooperation with European Union countries.

Even weakening Yanukovych could be a mixed blessing.

"Since Yanukovych came back to power, he has been anything but a Russian puppet, to the Kremlin's great consternation. They certainly don't have any love for him," said Jeff Mankoff, deputy director of the Russia program at the Center for Strategic and International Studies.

"At the same time, you have to ask yourself what would replace him," Mankoff added. There's the very real possibility of getting new leaders who are "ideologically committed to getting Ukraine out from Russia's thumb."

Of course, Ukraine is still in flux. The European Union has offered plenty of strong words for the government's crackdown on protesters, but little yet in the way of economic support that could offset Russia's threats. Ashton acknowledged Thursday that short-term economic challenges are the biggest problem for Kiev. Failing a sharp financial boost, Moscow could ultimately yank Ukraine more fully into its orbit, essentially by default.

But it won't necessarily be due to Russia's ability to use energy for leverage, as it has in the past. And that, in part, is due to Russia's own behavior.

Big producers of natural gas -- and Russia is about the biggest, behind just the United States -- have a geopolitical advantage over oil producers: Oil moves freely while gas largely travels in pipelines. Those fixed links, with long-term contracts, mean that buyers of natural gas don't have nearly the leverage to shop for other suppliers that oil buyers do. And gas exporters have greater ability to turn the screws.

Russia has used threats of gas cut-offs or outright cuts more than fifty times since the end of the Soviet Union, analysts say. In the last decade, Russia has wielded gas threats to pressure neighbors such as Belarus and Moldova not to forge closer ties with Europe. And it's worked. Belarus, for example, has indeed drifted closer to Moscow, and joined the Russian-led Customs Union.

This fall, Russia leaned on Lithuania, which was leading talks on closer European ties with former Soviet republics. In past years, Russia has also threatened Azerbaijan over its development of alternative pipelines to ship natural gas west.

Countries that are fully reliant on Russian gas often have little choice. When Russia cut off gas supplies to Ukraine in 2006, for example, Ukraine had to buckle to Moscow's demands. It had no alternatives for its own supply, and downstream European customers, such as Germany, were feeling the pain, too.

But all that is changing in a host of small but important ways that nibble away at the power Russia can wield with natural gas. Since energy might stands alongside its nuclear arsenal as Russia's main claims to great power status, anything that weakens its ability to use energy as a weapon is a big deal.

"I think Russia's energy leverage is waning," said Mankoff of CSIS. "One of the challenges they face is, then what?"

Europe is on the cusp of getting new sources of gas supply, and is finally becoming a more unified and less fragmented gas market, reforms that came about in reaction to Russia's heavy-handed dealings with energy. Both make Europe the buyer potentially stronger and Russia the seller potentially weaker. With Europe (including Ukraine) accounting for about three-quarters of Russia's gas exports, that matters. It also explains Russia's urge to find new markets in Asia, where there is a seemingly natural partnership to be had feeding China's appetite for oil and gas.

One surprising threat to Russia's energy arsenal is the big U.S. boom in natural-gas production, unleashed by the hydraulic fracturing revolution. While U.S. exports of natural gas to Europe and Asia are still four or five years away, and questions still remain over how much gas the United States will ultimately export, plenty of lawmakers want the United States to fast-track exports of natural gas to allies in Europe and Asia. European officials have swarmed on Washington in recent months to urge lawmakers to tweak rules so that NATO allies can get access to cheap U.S. gas.

But even before exports begin, the U.S. glut is having an impact overseas. Liquefied natural gas cargoes once destined for the United States went to Western Europe instead. Armed with an alternative source of supply, and at cheaper prices, about a score of European utilities such as Germany's EON and RWE, France's GDF Suez, and Italy's ENI have managed to renegotiate their contracts with Gazprom, the Russian natural gas giant, and get price reductions.

Some European countries, and Ukraine, have started trying to replicate the shale-gas revolution. Chevron and Shell just inked deals in Ukraine to drill for gas. Exxon has tried in Poland. Britain is eager to tap its own resources. While any European shale production is years away, that's another potential source of supply to balance out Russia's dominance.

Another source of supply on the horizon: long-awaited projects such as the Trans-Adriatic Pipeline, which will ship gas from Azerbaijan to the Balkans and Italy. It's not quite Nabucco, the pipedream of a pipeline that Europe toiled on for years, and which would have brought gas into Central Europe, but it does provide another alternative to Russia.

At the same time, and largely as a result of Russia's own behavior over the last decade, Europe has finally tackled its own energy market by liberalizing the gas market, increasing physical interconnections between countries, and building more gas-transport infrastructure. It sounds boring, but binds countries closer together.

Shortfalls in one place -- due to Russian antics or supply problems elsewhere -- can increasingly be addressed by moving gas around the continent. And that becomes even more useful the more additional gas finds its way there, whether from LNG tankers, domestic production, or the Caspian.

"I think there used to be gas dominance (from Russia) but the rapid increase in spot gas pricing, and the rise of shale gas creates absolutely new market conditions," said a Central European diplomat who works on energy issues.

Russia won't lose its energy leverage overnight, of course. All these changes in the gas market will take years to play out; some, such as European shale-gas production, may never fully live up to expectations.

But the seismic shifts rocking the energy world, and especially gas markets, make it increasingly difficult for Russia to use its well-worn playbook to keep scoring geopolitical victories.

ALEXEY DRUZHININ/AFP/Getty Images