Magazine | March 24, 2014, Issue

Oil Flowing Freely

Mexico’s energy reforms are good for Mexicans, Americans, and the world

Mexico City — ‘Although the neoliberal dogma was already forgotten in other countries, including those that imposed it decades ago,” writes Jesús Ortega, editor of a prominent Mexican left-wing magazine, “in our country the current leaders continue using it.” The observation is worth pondering, because it is so wrong-headed — and so true.

The countries that “imposed” the neoliberal free-market “dogma” — an obvious allusion to the United States — do indeed seem to be forgetting it. The statist policies of the Obama administration belie what little free-market rhetoric remains in its pronouncements. In Mexico, strangely enough, rather the opposite has been true. Since the terrible Revolution of 1910, Mexican governments have stopped far short of their populist left-wing rhetoric.

The key campaign slogan of the current government in its push for energy reforms is a case in point: “No to privatization! Yes to reform!” In fact, the country’s energy sector is being privatized — in spades — and the consequences could go far beyond making Mexico a strategically powerful oil producer. In just a decade, North America could eclipse the Middle East as the world’s leading energy-producing region. Under the aegis of NAFTA, this in turn could lead to a new North American century — and to a historic global victory for the neoliberal model. Indeed, if Mexico does it right, it could become a compelling model even for the United States, where a suffocating and unpredictable regulatory regime spells big trouble ahead.

Mexico’s decision to lay its energy industry wide open to foreign investment represents a dramatic leap forward in its political culture, and it’s particularly surprising given the country’s problematic history with the United States. The turbulence and misery of 19th-century Mexico were greatly worsened by the loss of Texas and the ensuing loss of half the country’s territory in the Mexican–American War of 1846. In 50 years, 50 different governments ruled, ending finally in the dictatorship of Porfirio Díaz, whose famous lament was “Poor Mexico, so far from God, and so close to the United States.”

America’s heavy-handed interventions during the Revolution of 1910, which left one of every ten Mexicans dead, carved deep and lasting scars in Mexico’s psyche. The United States invaded twice during the seven years of the Revolution, deposed a president who was subsequently murdered, and generally left the perception that Americans were stealing the country’s natural resources. By the time President Lázaro Cárdenas came to power in 1934, Mexico had become the world’s second-largest oil producer, after the United States — owing largely to the fact that Americans had invested heavily in Mexico’s oil sector and owned most of its oil wells.

Lázaro Cárdenas remains among the most revered leaders in Mexican history. A former teacher with a genius for the common touch, Cárdenas not only redistributed land to poor peasants on a massive scale but also traveled widely through the countryside, visiting remote villages on horseback and even on foot, usually with no security detail and often with just one or two friends and a handful of aides at his side.

This beloved figure has greatly complicated the effort to reform Mexico’s oil sector, because, by a tragic coincidence, he also happens to be the one who in 1938 shocked governments around the world by expropriating all foreign oil assets, forming the world’s first national oil company and to this day one of its largest — namely, Pemex. According to Juan Pardinas of the Mexican Institute for Competitiveness, the 1938 nationalization was one of Mexico’s “greatest moments of national dignity.”

In this epic arc of revolution, humiliation, and redemption, oil played a major role, with the United States more often than not cast in the part of chief villain. Hence the gravity with which one Pemex official said to me, lowering his voice and slowing his cadence, “Oil is the most delicate subject in Mexico.”

From the reign of Lázaro Cárdenas until the very last year of the 20th century, Mexico was ruled by the Institutional Revolutionary Party. The PRI, as it is known, brought political stability and economic progress only at the expense of democratic participation. Predictably, the benefits didn’t reach the masses. Despite the party’s populist and often socialist rhetoric, economic policy consistently favored companies. Inflation padded corporate profits, and real income fell persistently.

The PRI had organized poor peasants, labor unions, and the petite bourgeoisie, in order, so it was believed, to represent their interests. In reality, the PRI was controlled by a political elite that had not just captured the government but even taken control of the very constituents it was supposed to represent. To this day, for example, the heads of major labor unions are appointed by the government. 

By the 1970s, this political arrangement was losing popular support, and as the country’s economic fundamentals worsened, the PRI embraced the same state-heavy policies that had become depressingly familiar among post-colonial states. Government control of formerly private companies expanded dramatically, from 80 enterprises in 1970 to 1,155 by 1982. The PRI was finally embracing policies that matched its left-wing rhetoric. Disaster was not far behind. 

#page#Mexico’s discovery of one of the largest oil fields in world history — Cantarell, in the southern Gulf of Mexico off the coast of Campeche — didn’t help matters much in the short run. The field came on line in 1979. Because the windfall went to the government rather than to the private economy, not only did the government embark on a huge spending spree, it also started borrowing like there was no tomorrow. The national debt quadrupled in just a few years.

Then, in 1981, disaster struck. With no warning, the Saudis decided to ditch the oil embargos of the 1970s and ignore OPEC quotas. In a matter of months, they more than doubled their oil production. World oil prices plummeted, leading to a glut of ultra-cheap oil that would last for decades. Within months, the Mexican government found itself in one of the worst crises since the Revolution. The economy ground to a halt. 

And yet, while much of Latin America doubled down on left-wing policies, Mexico boldly turned the other way. The Reagan–Thatcher revolution of free trade, low taxation, and low regulation went international with the G7’s Bonn Declaration of 1985, and few countries embraced those principles as wholeheartedly as Mexico. Beginning in the late 1980s with the Harvard-educated Carlos Salinas de Gortari, the PRI slashed the budget, reined in both inflation and debt, dramatically lowered trade barriers, adopted NAFTA — and voluntarily ended its 70-year monopoly of political power in Mexico.

In 2000, Vicente Fox, of the overtly pro-business opposition National Action Party (PAN), was elected president. Fox seemed bent on pushing the free-market model further still. But soon, production at the Cantarell oil field peaked and began to plummet, along with declines in oil and gas production throughout Mexico. Pemex had systematically gone after the easiest oil in one field after another, neglecting to invest in potential resources, as the private market would have done. Despite a quadrupling in Pemex’s budget once the decline started, oil production slid from 3.4 million barrels per day in 2004 to less than 2.5 million today; it was recently projected to bottom out at 1.4 million by 2025.

This was a real disaster, and but for the grace of God — a simultaneous tripling of oil prices starting in 2004 owing to increased demand from China and years of underinvestment in capacity by national oil companies — it could have been even worse. The national government depends on Pemex for a third of its revenue. If low oil prices had lasted just five more years, the national budget would have taken a hit of 20 percent or more. With plummeting export earnings, the shock to Mexico’s current account and reserves would have devastated the country’s economy, destroying a huge fraction of GDP, which among other things might have turned the United States’ illegal-immigration wave into a tsunami.

It didn’t take long for Mexico’s political elites to realize that they had been saved from catastrophe by what amounted to divine intervention in the world oil market — and that they had also missed a huge opportunity. As a result of America’s fracking revolution, which arose purely in the private sector and took the Obama administration and everyone else completely by surprise, America’s long-dwindling oil production has soared from 5 million barrels per day to 8 million in only a few years, with similar increases in Canada — and with little end in sight. The United States is projected to become the world’s largest oil producer in the next four years. Nor has the oil boom been confined to North America. Brazil and Colombia have each doubled their oil production in recent years — by opening their energy sectors to competition and private investment.

As for its newfound abundance of natural gas, the United States hardly knows what to do with it. Electricity here now costs a third of what it does in Europe and an even smaller fraction of what it costs in Mexico, even though Mexico has some of the world’s largest natural-gas reserves. As predicted by no less reliable a source than George Soros, abundant natural gas has added more than a million manufacturing jobs in the United States in recent years and has made American manufacturing increasingly competitive not only with Europe but also with China.

“How did oil production go down when investment went up?” asks the PRI’s Enrique Ochoa, until recently undersecretary of energy for hydrocarbons and now head of the national electricity company. He answers his own question simply: In the United States, thousands of companies are engaged in oil and gas extraction, while in Mexico one company has a monopoly of the entire supply chain, from oil wells to gas stations. “Pemex can’t do this all by itself,” he says. 

When the PRI came back to power in 2013 under President Enrique Peña Nieto, Mexicans across the political spectrum had reached consensus about the need for sweeping reforms, and not just in the energy sector. In 16 months, 16 major reforms were enacted, in telecommunications, election laws, the budget, education, corruption laws — and energy.

Because much of Mexico’s antiquated energy policy was enshrined in the constitution, reform would need to start with broad constitutional amendments, which were adopted in December 2013. Pulling on one cigarette after another in his office, Juan Gabriel Valencia, a senior adviser to the Mexican senate’s energy committee, explains that the reforms have two objectives: “to open the energy sector to competition and to provide legal certainty to international investors.”

#page#Javier Treviño, chairman of the energy committee in the lower house of Mexico’s congress, also stresses the importance of a predictable regulatory framework. “Business decisions are based on rule of law, clear rules, and legal certainty, which should be provided by the government,” he tells me. 

The Left now vehemently opposes the energy reforms, but the political debate in Mexico seems to be leaving it behind like a relic of the past. As Enrique Ochoa puts it: “The Left still has not recognized the problems demonstrated by the technical diagnosis of what has gone wrong in the Mexican energy sector, or the opportunities for Mexicans that reform could bring.” Technical diagnosis! I couldn’t help wishing that phrase were more common in the United States, where policy issues that should be discussed in technical terms are often politicized to the point of inanity. 

The professional detachment with which Mexico’s leaders seem to have approached the emotional issue of oil is a hopeful sign. At an early stage in the reform effort, Mexican officials traveled the world, visiting Norway, Azerbaijan, Colombia, Brazil, and other countries. “Many national energy models have been studied,” Valencia says, “in order to learn from best practices and not make the same mistakes.”

Reform proponents worked hard to put the most contentious issues to bed at the outset, and they’ve largely succeeded. The reform package amends three articles of the Mexican constitution and contains a complex set of “transitional” constitutional provisions. Pemex will remain the national oil company, but it will now have to be a “productive enterprise.” It is given a kind of right of first refusal with respect to current and future production “blocks,” but it must demonstrate to the government that it can operate them profitably if it wants to keep them. Once Pemex has done that, which it has just a few months to do, the process will begin of putting every other current and potential production block in Mexico up for competitive bids from national and international companies; and with respect to those, Pemex will have to compete on the same terms as any other company.

Similarly, the electricity sector will be opened up to competing power generation, the natural-gas pipelines will be privatized, and the petrochemicals and refinery sectors will be open to competition. As one Mexican essayist writes: “We are going from alpha to omega. Everything will be different.”

The constitutional reforms provide for four kinds of contracts, covering most of the investment types that are common in the global energy market. These contracts were a major point of contention. The Left had taken the position that it would be okay to permit standard service contracts as well as profit-sharing arrangements in which the company receives royalties but the government takes the risks and the profit. However, the Left adamantly opposes production-sharing contracts, in which the government receives royalties but companies take the risk and the profit. It is even more stridently opposed to concessions of oil under the ground, on the cardinal principle that the nation’s oil wealth must never be ceded to foreigners.

Alas for the Left, nobody seems to be listening to its protests anymore, and the question of production-sharing contracts has been largely decided. In lip service to the rhetoric of sovereignty, the constitutional amendments proclaim that oil under the ground will remain the property of the Mexican nation. But the transitional provisions make it clear that foreign investors can expect to be able to book oil reserves as assets on their balance sheets — and when it comes to who really “owns” the oil underground, that’s what really matters from an investor’s point of view. This issue could turn acrimonious in the months ahead, but the secondary legislation needs to pass Mexico’s congress only by a simple majority, and the Left simply doesn’t have the votes to stop it.

The reforms will also create a national sovereign oil fund like those in Norway and other countries. U.S. experts have noted that the fund will be among the most transparent on earth, and that distributions from the fund will be capped; but the Mexican government, unlike Norway’s, will still depend on the national oil fund for its revenue up to 4.7 percent of GDP, about what the government gets from Pemex now. Thus, the specter of the “resource curse” — visible in countries such as Venezuela, where government plunders the nation’s natural resources to create a dependency society — still looms over Mexico’s energy reforms.

“The name of the game now,” says Treviño, “is execution and implementation.” The constitutional reform contemplates more than two dozen laws on a variety of subjects ranging from hydrocarbons to the national oil fund to environmental regulation and transparency measures. The December constitutional amendments mandate that this secondary legislation be enacted in the current session of the Mexican congress, which adjourns at the end of April. On the specific provisions of these bills rests the success or failure of the energy reforms. But, in the words of former U.S. ambassador Tony Garza, a wily Texan now at the law firm White and Case in Mexico City: “They’ve taken the guys who quite literally live at the intersection of policy and politics and put them in charge of the process. You can’t beat that.”

The biggest worry from a policy point of view, according to David Goldwyn, who was a senior energy adviser to former secretary of state Hillary Clinton, is the specific form the contracts will take and whether the government will keep the business terms competitive enough to secure substantial private investment. The issue here is complex, because different parts of the bidding and contracting process fall (in principle) under any one of five different regulators. Which set of regulators will decide the key business terms will depend on the type of contract. The potential for overlap and confusion, and for regulatory turf battles to gum up the process, is considerable. If Mexican legislators don’t get it right the first time, investors might stay away, especially given the increasingly attractive opportunities elsewhere.

#page#Another potential problem — to which Mexican officials seem dangerously oblivious — can be gleaned from America’s increasingly onerous and unpredictable regulatory regime. From the Clean Air Act to the approvals process for major energy projects such as the Keystone XL pipeline, federal regulators in the United States have been delegated expansively vague and often overlapping authority. Under the Obama administration, regulators have used that authority in ways that Congress never intended and that those subject to the regulations could never have anticipated. New federal regulations on coal production, for example, are designed not to make the coal industry cleaner but to drive it out of business altogether, despite tens of billions invested in clean-coal technology to meet the standards set just a few years ago. As this experience shows, Mexican legislators should be very careful about the precise language they devise to delegate regulatory authority, because regulatory uncertainty can be crippling, and reining in regulators run amok can be nearly impossible. 

Another major concern is that Mexico remains rife with corruption. The problem is as much economic as cultural. Mexico’s economic-growth model has depended on cheap labor far more than on productive labor, and opportunities for economic advancement therefore remain out of reach for much of the population. Faute de mieux, the only reliable way to wealth is through political power — and corruption. Anti-corruption measures will be a significant part of the secondary legislation, which is set to create one of the most transparent bidding processes in the world. But, as Juan Pardinas tells me, “the bridge between public exposure of corruption and prosecution of the guilty is broken.” Scandals are reported, but nobody is prosecuted. If bribery becomes a factor in winning bids, investors are likely to shy away from Mexico’s energy sector.

“The rule of law has been and will continue to be a persistent challenge that Mexico faces as a society, as a government, and as a nation-state,” admits Arturo Sarukhan, former Mexican ambassador to the United States. Ultimately, the reforms can succeed only if government institutions weed out corrupt practices and establish the rule of law. If that happens, the reforms could become a lever for change throughout the government. But if instead kickbacks and the like become the norm in the new energy sector, it will only further entrench corruption as the modus operandi of the entire state.

Can political support for the reforms be sustained? That is yet another worrisome question. President Peña Nieto’s approval ratings have already dipped. What’s worse is that Mexicans simply don’t trust their government: Polls show that people in Argentina, Venezuela, and Ecuador have far more confidence in their government than Mexicans have in theirs, despite the fact that those governments are embarrassing clown shows compared with Mexico’s. But in truth those polls highlight a congenital weakness of democracies, one that was clearly visible throughout the 20th century: When it comes to popular support, demagogues have a decided advantage over regular democratic politics with its endless infighting.

“Demagoguery works very well for a while,” says Juan Pardinas, “but destiny always catches up to the demagogues and presents them and their people with a very high bill for their immoral irresponsibility.” As Argentina and Venezuela enter a period of painful dislocation, and perhaps major upheaval, one is tempted to think Pardinas is right. “The best way to consolidate democracy is through economic growth,” he says.

In the long term, the former ambassador Tony Garza believes, transformation in Mexico’s political culture will be the key. “Mexican society is aligning itself very rapidly with U.S. values,” he says. “Middle class. Free trade. Justice and the rule of law. These are all things that Mexican society has fully embraced.” Once Mexico doubles its production and “starts punching above its own weight,” he adds, “Mexico will be able to bolster U.S. strategic interests simply by following what it perceives to be in its own interests.”

Because of government policy, Mexico was left behind by the North American oil boom of recent years, and its leaders are determined not to let that happen again. As Treviño tells me: “The Left wanted to be an icon of oil isolationism. That wasn’t our vision. We needed to be part of the new energy revolution in North America. Among other things, because of dropping energy prices, we are seeing the reindustrialization of North America, and Mexico needs to be a major player in that.”

Mexico’s oil reforms could thus benefit America in ways that go far beyond the millions that U.S. investors stand to make in Mexico in the years ahead. By setting an example, Mexico could help revive the model of small government and free-market competition among developing countries. Hence the oil reform could be a milestone not just for Mexico but for the world. With any luck, it will also remind an increasingly forgetful America of the principles that made it great.

– Mr. Loyola is a former counselor for foreign and defense policy to the U.S. Senate Republican Policy Committee.

Mario Loyola — Contributing editor Mario Loyola is senior fellow and Director of the Center for Competitive Federalism at the Wisconsin Institute for Law and Liberty. He began his career in corporate ...

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