The Fuse

NAFTA and the Implications for North American Oil and Gas

by Nick Cunningham | September 10, 2018

On August 27, the U.S. and Mexico announced that they had reached a preliminary deal on the renegotiations of the North American Free Trade Agreement (NAFTA), and negotiations are underway to include Canada. While the talks focused on high-profile sticking points such as the trade of agricultural goods and automobiles, the agreement could have significant implications for the energy sector.

Growing energy trade

From the perspective of international oil and gas companies, the continuity of free trade access and unencumbered cross-border flows has been paramount, more important than any specifics. That is because the flows of oil and gas between the three countries party to NAFTA have increased dramatically since the original agreement was ratified in 1994, and the trade of oil and gas has particularly accelerated in the past decade.

U.S. natural gas exports to Mexico have been rising quickly over the past few years, averaging 4.4 billion cubic feet per day (Bcf/d) in the first five months of 2018, more than double the levels seen as recently as 2014. According to Genscape, U.S. gas exports to Mexico actually jumped over 5 Bcf/d in July for the first time ever. New pipelines from the Eagle Ford shale in South Texas into Mexico have boosted shipments, as have interconnections within Mexico itself, allowing gas from Texas to reach further into Mexico’s western and southern regions.

Meanwhile, Mexico’s declining production of crude oil and refined gasoline has led to a greater reliance on imports from the United States. An estimated 60 percent of the gasoline Mexico consumes now comes from the United States, up from less than 30 percent earlier this decade.

The energy trade between the U.S. and Canada has also ballooned in recent years. U.S. oil imports from Canada have surged to over 3.3 million barrels per day (Mbd), up from less than 2 Mbd in 2010. The oil flows have grown so much that midstream capacity is essentially tapped out, resulting in steep discounts for Canadian oil and a scramble to build new cross-border pipelines.

Mexico adds uncertainty

The outlook for passage of the new NAFTA deal is uncertain, and the change of administrations in Mexico adds another layer of complexity. The current administration of President Enrique Pena Nieto is heading up Mexico’s trade team, but President-elect Andres Manuel Lopez Obrador (AMLO) has a negotiator participating in the talks. The Pena Nieto administration has hoped to accelerate the trade negotiations for much of this year so that the Mexican Congress would have time to pass the deal before AMLO takes power in December. Time is running out on that plan, and AMLO’s unexpectedly strong victory, which delivered his party, Morena, majorities in both houses of Mexico’s Congress, gives him more leverage in the current negotiations since any deal may have to be approved by him and a legislature friendly to him.

In the lead up to the August 27 announcement of a preliminary deal, AMLO’s team pushed back against the inclusion of the energy sector in the new NAFTA deal. For years, AMLO opposed the 2013-2014 energy reforms in Mexico, which opened up the country’s oil and gas sector to private sector investment for the first time in more than seven decades. AMLO has moderated his stance more recently. Nevertheless, he does not want an international treaty to inhibit his authority to regulate the energy sector to his liking. Reports have suggested he wants to suspend new oil and gas auctions, infuse more power and money into state-owned Pemex and perhaps tighten local content rules, although more recently he has tried to reassure the oil industry that auctions will continue.

AMLO’s trade negotiator, Jesus Seade, said that the main thrust of Mexico’s energy reforms would be preserved, adding that the incoming president would not violate the terms of contracts already awarded to international oil and gas companies.

The text of the new NAFTA deal has not been released, so the specifics remain to be seen. But AMLO voiced support for the latest breakthrough in talks after claiming that some revisions were made to the energy chapter. “We put the emphasis on defending national sovereignty on the energy issue and it was achieved,” Lopez Obrador told reporters. “We are satisfied because our sovereignty was saved. Mexico reserves the right to reform its constitution, its energy laws, and it was established that Mexico’s oil and natural resources belong to our nation,” he said. AMLO’s trade negotiator, Jesus Seade, said that the main thrust of Mexico’s energy reforms would be preserved, adding that the incoming president would not violate the terms of contracts already awarded to international oil and gas companies.

As a result, the access that international companies will have in Mexico will remain, at least for companies that already won the rights to exploration from past auctions. That does not mean that there will not be new hurdles, such as stiffer local content rules, which would require foreign companies to source or employ a certain amount of equipment and personnel from within Mexico.

ISDS

One controversial provision in NAFTA and other trade agreements has been the investor-state dispute settlement (ISDS) system, which offers protections to investors, allowing them to sue foreign governments if their investments are negatively impacted by national, state or local policies. Companies argue the system offers certainty, leading to more investment, while critics argue it subverts national sovereignty to outside companies.

Mexico’s team was worried about its sovereignty, while the Trump administration sees reduced protections on foreign investment as a means to keep U.S. companies from moving investments abroad.

The renegotiated bilateral agreement between the U.S. and Mexico reportedly waters down the ISDS system by forcing companies to go through domestic court systems rather than an opaque tribunal, while only offering compensation if assets are directly expropriated. In other words, international companies could lose some power under the new trade agreement. The Mexican and U.S. negotiators agreed to these revisions, for different reasons. Mexico’s team was worried about its sovereignty, while the Trump administration sees reduced protections on foreign investment as a means to keep U.S. companies from moving investments abroad. However, with all of that said, the new deal reportedly includes a carve out for the oil and gas contracts awarded in Mexico, grandfathering them in under the old system, a win for the oil and gas industry.

Political hurdles remain

When announcing the breakthrough on August 27, the Trump administration signaled its willingness to play hardball with Canada, suggesting it would forge ahead with a bilateral deal with Mexico if Canada balked at the new agreement. But that seems unlikely. Some experts question the legality of a bilateral trade agreement with the old NAFTA deal still in place, while members of Congress have suggested it would be politically difficult to ratify a bilateral deal. The path forward without Canada is hard to envision, meaning the result will most likely be a trilateral agreement or a breakdown in talks. At the time of this writing, talks were ongoing, with a deadline looming at the end of September.

Even though there is enormous pressure on all three sides to reach an agreement, and many analysts assume a successful outcome, ratification is another matter. Some in the U.S. business community are not happy with the proposed deal, arguing it could put new burdens on the auto industry without much of a corresponding benefit in terms of job creation, ultimately making the politics of the trade deal in Washington tricky, to say the least.

On top of that, the timing is not fortuitous. The U.S. has upcoming midterm elections, which could reshuffle the makeup of Congress, while in Mexico, incoming President Andres Manuel Lopez Obrador, and his soon-to-be majorities in Congress, are not nearly as enthusiastic about the trade deal compared to the current administration, although for now they have signaled support. As a result of these political clocks, time is of the essence.

Energy is a very strong common thread tying the North American continent more tightly together.

The deal will not pass or fail based on the energy sector, as those issues appear to have been hammered out. At this point, energy is a very strong common thread tying the North American continent more tightly together. All three countries in NAFTA do not want to see new barriers erected that could impede the growing trade in oil and gas. There is a great deal of momentum to successfully conclude a new trade deal, although sticking points – largely unrelated to energy – remain.

Even if NAFTA fell apart without a successor, it would be unlikely that new tariffs would be imposed on oil and gas flows. However, trade fights this year offer a cautionary tale. Few expected the threat of steel and aluminum tariffs to emerge between trading partners as close as the U.S., Mexico and Canada. Moreover, the U.S.-China trade war could yet result in tariffs on oil and gas, another example of the damage that could result if negotiations go south. For now though, all sides are keen to reach an agreement.

 

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