Mexican and Brazilian Midstream: Project Financing in an Evolving Sector

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The O&G sector, considered globally, has traditionally offered prolific opportunities to project finance bankers. Developments in the North American midstream market over the past five to seven years, driven by the upsurge of production from shale formations, have been especially tantalising for funds providers and financial arrangers. Even more striking from the point of view of project finance bankers focusing on Latin America, however, is the vast extent of North American energy infrastructure, both facilities already installed and greenfield or expansion projects, subject to ordinary-course funding from all corners of the debt markets – non-recourse bank loans, project bonds, MLP financing, and term loan B. All manner of pipelines, processing plants, and storage facilities are regularly constructed and operated with the support of non-recourse financing. Impressive, as well, is the profusion of market participants: private equity firms, MLPs, utilities, O&G producers and consumers of all descriptions figure as project sponsors, borrowers and shipper-offtakers. Also striking is the variety and flexibility of financing structures generally accepted as bankable by lenders and ratings agencies. Financiers have learned to adapt terms and conditions to the complex realities of dynamic O&G markets – common carriage, multiple shippers, relatively short tenor of capacity or usage contracts, variable dispatch and nomination patterns.

By contrast, Latin American project finance bankers have been functioning in a narrower, more constricted market spectrum involving far fewer participants, a limited range of project or asset types, and fairly rigidly defined transactional structures. As we shall see in the following brief account of the Brazilian and Mexican midstream markets, recent developments in the energy sector in the two largest hydrocarbon producers and energy consumers in the region are opening up new financing opportunities – but also increasing the demand for flexible and (for Latin America) innovative transactional structures. Bankers and their legal advisers, credit departments and syndication teams will have to move up a learning curve to stay abreast of market changes.

This chapter describes the evolution of midstream infrastructure financing from the project finance lender’s perspective and examines some of the challenges and opportunities that banks will likely have to consider while assessing project financing within the new, open midstream sector in Latin America’s two largest economies.

Midstream project finance from closed monopoly to open access

This chapter will consider midstream in an expanded sense, to include both classic midstream assets (those built for transportation and storage of crude oil, natural gas, refined products and LPG/NGLs) and certain fixed infrastructure assets that support O&G production but are susceptible to outsourcing on long-term contracts from third-party owner-operators. In developed markets (the United States and Canada serving as the model here), gas gathering and gas processing infrastructure (including fractionation) is also added to the midstream mix. Taken in this wider sense, the midstream sectors in both Brazil and Mexico have been transitioning unevenly from 100 per cent direct or indirect control by their respective state-owned national oil companies, Petrobras and Pemex, to a new open-market landscape. Recent changes are intended to make room for private investors to compete and play a major role in owning and operating critical midstream infrastructure by opening up more segments for such investment and tapping into a client base of new shipper-offtakers other than state-owned companies. As discussed below, Mexico is further advanced in this process, but current indications are that Brazil intends to follow a similar path.

Midstream assets, with their required high capital investment, contracted revenues, and relative low operating risk profile are naturally suited to project finance, especially in contrast to the more volatile commodity price-driven upstream and downstream segments. Given the capital intensive nature of midstream infrastructure, moreover, large volumes of project finance loans are a required ingredient in the development of the sector. But the very nature of midstream assets requires cash flow support from one side or the other of the O&G equation – upstream or downstream. As will be seen below, where project finance has been available for midstream projects in the past, it has been supported by ship-or-pay contracts with upstream-heavy state-owned monopoly companies. Regulators, developers, offtakers and lenders are now adapting to the new, more open regime.

Until recently, the bulk of midstream assets were either owned and operated by Petrobras and Pemex, or subject to monopoly offtake from these companies (and in Mexico, from CFE, the state-owned electrical company). In both countries, midstream assets were effectively embedded in an integrated monopoly spanning all segments from upstream E&P to downstream. Lacking commercial exposure to the needs of a larger base of consumers and offtakers, the demand for logistical services of midstream assets such as pipelines, storage facilities, and terminals was largely unattended by state-owned monopolies, especially as Pemex and Petrobras came under increasing pressure to focus their efforts, and budgets, on the upstream. Pricing for infrastructure capacity was not transparent, risk allocation was distorted, and investment incentives undermined. Midstream system build-out and improvement of operating efficiencies were neglected.

In the downstream sector of both countries, refined products prices were controlled or directly subsidised by the government using the NOCs as a tool to control inflation at the cost of profitability. Both Petrobras and Pemex have suffered crippling losses as a result, and Mexico is in the throes of a supply shortage of these products as its refineries are all undergoing overdue upgrades, and gaps in the import infrastructure are only now being addressed.

Both Mexico and Brazil have been forced by developments since the oil price collapse of 2014 to accelerate reforms in their hydrocarbons sectors. This process has advanced further in Mexico and now encompasses the full spectrum of midstream activity. The lesson learned in Mexico is that attracting significant levels of new private sector investment in the midstream sector requires reforms and opening in the upstream and downstream markets as well.


Mexico presents a mixed history of openness in the midstream. On the one hand, natural gas pipelines have been open to private sector operation and ownership – and have attracted generous project financing from the bank market – for more than 20 years. Certain production infrastructure assets – a gas compression platform and a nitrogen injection project – have also been contracted to private operators and project financed. It is important to note that virtually all of this financing has relied on the comfort of CFE or Pemex offtake – the ‘security blanket’ of quasi-sovereign, investment-grade payment risk. Private investment in these projects, especially natural gas pipelines, has been robust – a genuine, if limited, success in market opening. It has been clear for some time, however, that, with the successful build-out of the cross-border gas pipeline network, the low-hanging fruit has been picked. What remains to develop – and be financed – are projects, many of them serving markets formerly served exclusively by Pemex, and almost all not anchored by Pemex or CFE offtake.

Fortunately for the sector (and for the Mexican economy), regulatory reforms are keeping pace with market needs. Declining oil and gas production, deficient sector infrastructure, lack of funds and limited debt market liquidity for Pemex, combined with a growing demand for natural gas and refined products have provided the impetus for a wide-ranging sector opening. It was no longer viable for Mexico to reserve control of the whole O&G value chain to Pemex. Feeling the urgency to reverse production declines, maintain reliable energy supply and security, as well as develop storage capacity required to avoid major disruptions in the Mexican economy, the government implemented a far-reaching Energy Reform Law in 2013, followed by a succession of regulatory changes and policy initiatives covering virtually all of the segments of the energy markets. In addition to allowing Pemex to form strategic alliances in the E&P segment (certainly, the most well-publicised initiative), the market reorganisation also allows investors to develop, own and operate a wide range of midstream infrastructure. Non-natural gas pipelines and other midstream assets still controlled by Pemex are now governed by open access rules that require spare capacity to be offered to all qualified shippers and offtakers. Importantly, the reform also extends to the downstream space. Prices for refined products are undergoing rapid liberalisation, creating a dynamic market that is attracting strong interest from private investors, including an impressive range of international oil and gas producers, trading companies, and local firms active in retailing and logistics.

The gas market opening of the early 1990s, although limited in its reach (privately owned local distribution companies were created, but Pemex retained a monopoly on ‘first-hand sales’ from local and foreign supply sources) did provide one very important avenue for private sector initiative: ownership and operation of natural gas pipelines. By the early 2000s, at least five substantial privately owned pipeline projects were in operation, several of them beneficiaries of project finance in the bank market. This activity slipped into high gear in the years following 2010, when the government announced a policy of encouraging private sector investment for over US$10 billion in natural gas infrastructure, particularly cross-border trunk lines connecting US gas hubs with Mexican load centres. The new projects were well-received by project finance lenders who responded favourably to the strong economic rationale – CFE’s push to convert power plants from environmentally noxious fuel oil to inexpensive and cleaner-burning US shale gas. Pemex Gas also anchored the Los Ramones mega-project, including three segments in Mexico and a lateral pipeline on the US side.

Support for these projects from equity investors (developers and private equity funds) and in the bank market has been strong. CFE’s investment-grade credit rating, coupled with bankable, long-term transportation service agreements (TSAs), has attracted virtually all of the banks active in the project finance market in Mexico. The single-shipper 25-year TSA has allowed for straightforward – even orthodox – transaction structures, including such lender-friendly features as strict limitations on the right to assign the contract and a termination payment obligation on the shipper sized to cover debt. The most competitively priced financings have been structured as mini-perms, with the expectation of potential bond refinancing shortly after COD. While there has been some bond refinancing activity, the bank market has been hungry for more deals and some sponsors have been able to refinance their project debt in the bank loan market at more attractive rates than those in the capital markets.

Following the example set by the financing of several CFE- and Pemex-anchored connector laterals in the US, lenders to the Mexican projects have increasingly accepted the looser EPC provisions typical of North American pipeline project finance, principally, the lack of an LSTK wrap. On the TSA side, lenders have focused on ensuring anchor shipper termination payment obligation in every eventuality except operator breach of the TSA. Lenders have sought, and achieved, limitations on offtakers’ rights to transfer TSA obligations, as well as the comfort that early termination of the TSA will require offtaker payment sufficient to cover outstanding debt obligations, including swap breakage costs.

Although the major cross-border projects and the related financings are behind us, there may be some life left in the single-shipper model for natural gas pipeline projects. This will, however, no longer involve Pemex. Pemex Gas, the original anchor for Los Ramones and other projects, was eliminated in the 2014 reorganisation of Pemex, taking the parastatal out of the gas transportation business. Pemex transferred its obligations under the TSAs for Los Ramones and other projects to a new entity set up by the Mexican government, the National Gas Control Centre (CENAGAS).

CENAGAS is a new kind of player in the market, with a number of different roles: (1) owner-operator of an extensive gas pipeline network, the legacy assets of Pemex Gas, as well as the holder of 100 per cent of the capacity previously contracted by Pemex Gas on Los Ramones and certain other pipelines; (2) system agent for the entire natural gas pipeline network, including privately owned pipelines contracted to CFE, in charge of conducting open season campaigns for spare capacity on all of these pipelines, thereby ensuring that transportation capacity is available to all comers and encouraging more companies to participate as shippers; (3) promoter for a strategic underground gas storage facility; and (4) counterparty and payment support for certain new pipeline projects, especially those with a social or policy rationale. In these cases, the agency’s credit profile, generally assumed to benefit from its quasi-sovereign status, will be subject to project lender scrutiny.

Implementation of the energy reform in the midstream sector has now extended to segments other than natural gas transportation: permits to import refined products and LPG are now widely available; prices for refined products are undergoing rapid liberalisation (LPG prices are already market-based); open season for non-gas pipelines operated by Pemex Logistica is being implemented; a public policy of minimum storage requirements has been announced but has yet to be finalised and implemented. Finally, the Energy Regulatory Commission (CRE) has or will publish regulated tariffs for a wide variety of energy infrastructure from pipelines to terminals to storage facilities.

Probably the most dynamic market segment currently is refined products – gasoline, diesel, and kerosene (jet fuel). Surging demand in Mexico has coincided with constraints on domestic production, principally, the need to overhaul all of Pemex’s six refineries to enhance capabilities to process heavy crude oil into lighter grade fuel products. The growing local deficit in production (exacerbated by a spike in fuel thefts from Pemex pipelines) has created a surging demand for imported product. US-based refineries, especially facilities clustered around Houston and Corpus Christi, are expanding their market into Mexico. This market initiative is being led by the biggest names in the industry. In March 2017, BP cracked the exclusive Pemex retail fuel market by opening its first of 1,500 gas stations planned for Mexico. Shell, Exxon Mobil, Total and Chevron expect to open their first of many gas stations in 2017. Chevron is partnering with a local gas station network, and Exxon Mobil has disclosed US$300 million of investments in the downstream pipeline. Valero Energy, who has been selling refined products to Pemex, plans to increase the unbranded business and sell under its own brand as well. Notable, as well, is the interest of major international trading companies – Trafigura, Glencore, and other traders are all active in importing products, and some are entering the downstream arena, partnering with gasoline retailers. New international players entering the Mexican fuel market will need access to reliable infrastructure in Mexico in order to bring their products from the United States to Mexico to ensure a continuous supply of product to the local market.

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