Frac water in Mexico - fracking or frustration?

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Juan Ibarra Frac Water in Mexico – Fracking or Frustration?

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October 28, 2014

Frac Water in Mexico – Fracking or Frustration?

By: Juan Ibarra, Associate, OFSCap, LLC, Houston

Given the recent changes in the Mexican energy laws a fundamental challenge will become even more apparent, that challenge: water, in particular, frac water for oil and gas development. It takes water to make energy and energy to make water and Mexico will need a lot of water for oil and gas and industrial purposes over the next 10 years. Having enough water to support the expected energy production in Mexico in the future is a substantial challenge and one that needs to be addressed now. The following discussion paper will focus on the current market, restrictions and regulations and some of the various solutions to Mexico’s challenge of water for its ambitious energy future.

Summary/Highlights Topic Takeaway

Water Scarcity The central, northern and northwest area of the country is experiencing 47 percent water stress, which is a strong degree of stress. That is where a vast amount of drilling will be happening, in the Burgos Basin.

Government Rules Government officials have forbidden the use of fresh water aquifers for drilling. Water will have to come from other municipal or third party sources.

Planning There is tremendous opportunity for operators and investors, but this takes time and will need planning ahead to make the right decisions.

Investment Opportunities There are large investment opportunities for any type of water infrastructure. Any company in the trucking, water recycling, or pipeline construction business has tremendous growth potential.

Size of Market Difficult to assess exact size but could easily exceed $5 billion. Fracking requires millions of gallons of water per well. For example, in the Permian Basin of West Texas, it takes 4,000 barrels of water to drill a single well and another 200,000 barrels of water for fracking a horizontal well. There is a wave of activity and production hitting Mexico that will last for 10+ years and water is going to be a critical part of it.

Operator Steps for water Operators will have to submit for permits with the correct state authority, and pay a different price per gallon depending on the zone they are in. Water use and wastewater discharge duties are paid to CONAGUA.

Mexico is the third-largest exporter of petroleum to the United States after Canada and Saudi Arabia, Mexico’s production has declined from 3.4 million barrels per day in 2004 to 2.5 million barrels in 2014.1 Thus for the country to recapture its presence in the oil production world it needed to change its laws, having done that, it now begins the difficult challenge of a new way of working and increasing production. The oil reform will be the beginning of a huge boom of production in Mexico that will most likely last for 10+ years. This increase in production brings up the topic of hydraulic fracturing or “fracking” that will require significant water resources. No matter where you are, when talking about fracking, there is controversy about the safety of the environment and people’s health. This same topic came up with all the production that is coming to Mexico. Mexican federal officials have stated that the water used for fracking will not come from aquifers. "(Fracking) does not require fresh water, you can use wastewater, you can use seawater and you can use the same water utilized for the drilling," National Water Commission, or Conagua, director David Korenfeld said. The drilling technique will be regulated by the same rules for industrial water use, requiring firms to adhere to the same standards, the Conagua chief said. "What Conagua will do is to precisely monitor the amount of water (used), so any public, private or joint operator will have to get a permit to drill wells, which will not interfere with


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aquifers because they are deeper down," Korenfeld said.2.

With Mexico opening to international Operators for exploration and production, it brings up more questions than answers. An appropriate level of infrastructure investment needs to be set up for the amount of drilling that is expected in Mexico. With onshore drilling comes fracking and with fracking there is a need for an incredible amount of water, especially in the arid areas of the Burgos Basin. The question is where will all this water come from? Can a country with scarce water supplies already, supply the freshwater supplies needed for the fracking operations needed? What are the new rules and regulations being put in place? How will the water be transported and how much will it cost?

Scarcity

Fracking, especially in the large scale that will take place in Mexico, requires millions of gallons of water per well. For example, in the Permian Basin of West Texas, it takes 4,000 barrels of water to drill a single well and another 200,000 barrels of water for fracking a horizontal well. Without the correct resources/logistics and the geographic limitations (no infrastructure) the cost could be excessively high.3 This additional strain creates an immense issue for a country that already has water problems with agriculture and basic fresh water needs for their population. The demand for water in Mexico greatly outweighs the supply. Mexico has uneven water availability, with an arid northern half that is seriously water constrained, and a southern half that is less constrained but still suffers from the problems that affect the entire country such as pollution and inefficient use of water.4 This low level of availability in the north, combined with high demand, leads to a significant level of water stress. On the whole, Mexico is experiencing 17 percent water stress, which is moderate; however, the central, northern and northwest area of the country is experiencing 47 percent water stress, which is a strong degree of stress.5 Unfortunately, that is where a vast amount of drilling will be happening. The Eagle Ford shale formation runs a few hundred miles south into Mexico were it is called the Burgos Basin. This will be a hot spot for drilling and is one of the highest areas of water stress in the country. A new study by the global research organization World Resources Institute (WRI) found that the best shale deposits where the fracking would be done are in places like China, Mexico and South Africa, locales that are already facing water challenges.6

With the extensive scarcity of water in Mexico, this opens up opportunities for companies that provide any type of water source or water recycling. Whether it’s building pipelines from the ocean or any type of water reclamation technology, there is an open market with nothing but opportunity.


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Sources

Mexican government officials have stated that the water used for fracking will not come from fresh water aquifers. With this source being removed from use there are few alternatives, even though fracking doesn’t necessarily require fresh water*. Listed below are the potential sources of water for fracking:

1. Surface water 2. Groundwater 3. Municipal water suppliers 4. Treated wastewater from municipal and industrial treatment facilities 5. Power plant cooling water 6. Recycled produced water and/or flow back water

Recycled water will have a huge impact in Mexico and in the oil & gas industry. Companies are doing more to

recycle water and introduce technologies that cut down on water in the process. Apache, for example, is recycling 100% of produced water in the Permian Basin, according to the Ceres report. Anadarko and Shell are buying effluent water from local municipalities. Chesapeake is reusing nearly 100% of its produced water and drilling wastewater in the Marcellus region.7 With water scarcity in Mexico already, the industry will be investing heavily in finding solutions for the water demand. There are multiple options to fill this demand. The right pipeline company could build a cross-border pipeline to supply water from the US or a pipeline that goes to the ocean. Another, more environmentally safe source would be some type of on-site water recycling; just like many companies are already doing in Texas and Marcellus regions of the US. This can come with a high cost also, but can save a vast amount of money and water in the long term. It just depends on the right people investing in the right source. Investments in Mexican water projects and sources will be enormous in the near future. However, water projects take time and planning with countless stakeholders and hurdles. So for an oil and gas operator it seems like the first option would be to truck water from an existing source for drilling and fracking. This will create a large amount of truck traffic for supplies and stress an overused Mexican road infrastructure. If the Eagle Ford experience in Texas is a proxy for Mexico then the outlook is unattractive on trucks, operators, roads and highway fatalities. Transportation

Trucking seems to be the most reasonable source for water, which can come with a high cost. Mexico’s transportation infrastructure still has many obstacles and logistics problems. A panoply of factors contribute to these high costs, including poor road conditions, inadequate rail infrastructure, a disconnect between transportation modes, and the resulting need to carry more safety stock.8 Mexico’s poor and overused road infrastructure can come with high opportunity for contractors, but if this problem is not taken care of quickly, it will bring tremendous problems for anyone trying to move water or any other resource by road. Eighty percent of Mexico's domestic transport and 70 percent of international transport moves over the road. Non-toll highways are often of poor quality, and only 25 percent of Mexico's roads are paved.9 Even more problems arise from the roads that were built with low quality materials and bring a danger factor to driver and others near the roadway. Locals warn carriers to limit their speed on some stretches. Poor road quality creates maintenance problems and the need to replace trucks more frequently.10 This will be a sizeable concern, especially with the high amount of truck traffic that comes with drilling and production.

* 10 pound.brine - water containing more dissolved inorganic salt than typical seawater, is the industry standard for water being used in drilling. Brines are preferred because they have higher densities than fresh water but lack solid particles that might damage producible formations. Various classes of brines include chloride brines (calcium and sodium), bromides and formates.


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Truck Traffic Estimates for Vertical and Horizontal Wells

Source: ALL Consulting (2010) and Dutton and Blankenship (2010), as reported in NYSDEC (2011)

US and other international companies will have to understand the similarities and differences in the trucking system between Mexico and their respective country. Due to truckload and less-than-truckload (LTL) ownership limitations, U.S. shippers and third-party logistics providers (3PLs) face the challenge of finding Mexican carriers with business processes, technology, safety, equipment, and service quality equivalent to carriers in the United States.11

Mexico's upper echelon carriers are on par with the US carriers and truck operators. However, with the country's highly fragmented carrier market, it could take five different carriers to cover one long route, and every handoff introduces the potential for security risks and transit time delays. In addition, Mexico's informal, cash-only trucking industry retains a strong presence in the market.12 Companies have larger concerns over risk, theft and ownership in Mexico then compared to the US.

Even with all the potential obstacles, there will be a tremendous market for any services company that

provides trucking. Any long-term solution for providing water will take time and companies are ready to start drilling. Trucking, while costly, will be the fastest solution for providing water for any E&P company that is trying to move quickly in this economic boom. Infrastructure/Cost

Having insufficient water sources means the cost for obtaining water for fracking will be high. Stakeholders play a major role in managing water resources. Mexico has handed down many water resources administration functions to local bodies centered on river basins, with 13 hydrological-administrative regions defined by the river basin boundaries. The hydrological-administrative regions are governed by 13 river basin organizations, which are comprised of various government and water user stakeholders, who make decisions on allocating abstraction rights and investing in water resource management infrastructure. Stakeholders also participate in water resource management through a variety of other groups, such as the Irrigation Water User Groups, which are responsible for managing large investments in irrigation infrastructure, including planning investments, operating the infrastructure, and collecting fees from users.13


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Mexico’s strategy for managing water resources is defined in the Government’s six-year National Development Plan, The National Water Program (PNH—Programa Nacional Hídrico) and the National Infrastructure Program (Programa Nacional de Infraestructura). The National Water Program lays out a defined set of goals for the sector over the period from 2007 to 2012, which include improving water productivity, increasing water quality, promoting sustainability in water management, and creating a culture of paying fees.14

A key element for meeting its goals in the water sector is undertaking more investment in water resource management infrastructure. The lack of cost recovery through user fees is one major impediment to meeting investment needs in the sector. As a result of the lack of cost recovery, third party financing is difficult to raise, and the sector relies almost entirely on government subsidies to meet its investment needs. The funds for these subsidies come from a variety of sources such as tax revenue and petroleum royalties, and are disbursed through a variety of programs, the largest of which are programs managed by CONAGUA.15

CONAGUA collects fees for water abstraction and discharge and redistributes the proceeds of those fees to be used to develop water resource management infrastructure.16 The Mexican federal government provides most funds for managing water resources, but many decisions regarding allocation of funds and infrastructure planning take place at the sub-national level, including states, municipalities, and river basin committees. This opens a huge opportunity for the private sector to work with local parties to find solutions for water resource/recycling. Some form of water recycling investment that can supply water for drilling while at the same time provide water for the local communities can have a tremendous upside. Mexico has taken some steps to introduce commercial financing, but overall use of private sector participation (PSP) has been concentrated in wastewater treatment plants, and subnational financing is not generally accessed directly by water and sanitation providers.17

Major Players

Mexico has a well-developed network of entities with responsibilities in the water sector. CONAGUA is the institution with responsibilities for coordinating the water sector, interfacing with decentralized river basin organizations and other bodies with various sector and regional responsibilities. The following government, quasi-government, and non-governmental bodies have key responsibilities for managing water resources in Mexico:

1. The National Water Commission

2. Other Institutions and Organizations with Responsibilities for Managing Water Resources

The National Water Commission

The National Water Commission (CONAGUA—Comisión Nacional del Agua) is the federal government body with the greatest responsibility for water resource management in the country. CONAGUA is in charge of managing water resources in the country, and its main functions include the development of the national water policy; administering the rights for water use and wastewater discharge; planning, irrigation and developing drainage systems; managing emergency and natural disasters and managing investment in the water sector in Mexico.

CONAGUA is a decentralized agency under the mandate of the Ministry of Environment and Natural Resources (SEMARNAT Secretaria del Medio Ambiente y Recursos Naturales). It carries out its functions through 13 river basin organizations (organismos de cuenca), each of which is responsible for one of the hydrological-administrative regions.

CONAGUA funds the majority of its activities with direct budgetary transfers from the Federal Government and it also with the payments it receives for water use and wastewater discharge duties. It disburses those funds back to states and municipalities through a variety of programs.

Other Institutions and Organizations with Responsibilities for Managing Water Resources

While CONAGUA is the agency with the greatest responsibility for water resource management, many other government entities have some role in the sector, in areas from environmental and health regulation to providing subsidized financing. Here we detail the other agencies that have some responsibility for managing water resources according to the following categories:


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• Federal government institutions with primary responsibilities for managing water resources • Federal government institutions with secondary responsibilities for managing water resources • State, municipal, and other entities with responsibilities for managing water resources

Federal government institutions with primary responsibilities for managing water resources

The following Federal Government can be understood to have primary responsibilities for managing water resources in Mexico:

• Ministry of Finance and Public Credit (Secretaría de Hacienda y Crédito Público)—This Ministry defines the budget that is allocated to the water sector, coordinating with institutions in the water sector on the corresponding scheduling, and authorizing multi-year investment programs.

• The Federal Congress (Congreso Federal)—The Federal Congress sets policies and approves budgets for the water sector, assesses and approves amendments to the National Water Law and its regulations

• Mexican Institute of Water Technology (IMTA—Instituto Mexicano de Tecnología del Agua)—The Mexican Institute for Water Technology is a decentralized public organization that is responsible for producing, implementing and promoting knowledge, technology and innovation for the sustainable management of water resources in Mexico.

• National Infrastructure Fund (FONADIN—Fondo Nacional de Infraestructura)—The National Infrastructure Fund (FONADIN) is the coordination vehicle for funding and developing infrastructure in the communications, transport, water, environment and tourism sectors. The Fund provides financing for planning, design, construction and transfer of projects in the water and sanitation projects that demonstrate positive social impact, reasonable profitability, and include private sector participation.

Federal Attorney for Environmental Protection (PROFEPA— Procuradoría Federal de Protección al Ambiente)—conducts environmental studies and monitors the quality of rivers, lakes and groundwater. The agency applies sanctions where violations of environmental regulations are discovered.

• Ministry of Social Development (SEDESOL—Secretaría de Desarrollo Social)—provides support to rural communities in developing water supply, sewerage and sanitation infrastructure

• Ministry of Agriculture, Livestock, Rural Development, Fisheries and Food (Secretaría de Agricultura, Ganadería, Desarrollo Rural, Pesca y Alimentación)—Taking actions to achieve more efficient and productive water use in agriculture for meeting the country’s food needs and ensuring the sustainable use of soil and water resources

• Federal Electricity Commission (CFE—Comisión Federal de Electricidad)—Builds and operate dams which are used for generating electricity, supplying water to cities, irrigation and flood protection.

• National Forestry Commission (CONAFOR—Comisión Nacional Forestal)—funds and undertakes efforts to reduce soil erosion in upstream areas of river basins

Federal government institutions with secondary responsibilities for managing water resources

The following Federal Government institutions can be understood to have secondary responsibilities for managing water resources in Mexico: Ministries of Foreign Affairs (Secretaría de Relaciones Exteriores); of the Interior (Secretaría de Gobernación); of Health (Secretaría de Salud); of Economy (Secretaría de Economía); of Public Education (Secretaría de Educación Pública); of Civil Service (Secretaría de la Función Pública); of Tourism (Secretaría de Turismo)

State, municipal, and other entities with responsibilities for managing water resources

In addition to the Federal Government agencies described above, state and municipal governments, as well as other entities, plan an important role in managing water resources in Mexico.

• State governments—State governments have responsibilities for planning, regulating, developing infrastructure for water resources, and in some cases, directly providing water and sanitation. In most states, State Congresses are responsible for setting the tariffs charged by water and sanitation providers; in some cases the states have delegated this authority to state water commissions (comisiones estatales de agua). The state water commissions are organizations that coordinate between municipalities and the federal government to improve water management and water and sanitation service provision. State governments also can formulate their own development plans,


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similar to the National Development Plans, and carry out the objectives of those plans through state-level planning and development ministries.

• Municipal governments and water and sanitation providers—In Mexico, municipalities are responsible for providing water and sanitation services. In addition to providing the service directly (for example, through providers that are part of the municipal government or legally separate entities that are wholly-owned by the municipality) or through delegation to others (for example, to private operators through concession contracts or to utilities owned and operated by the state government).

Rules and Regulations

The National Water Law establishes that the right to use the nation’s waters will be provided through a concession granted by the Federal Government, through CONAGUA, by means of its river basin organizations, or directly through CONAGUA when appropriate, according to the rules and conditions set forth in the Law. Similarly, for wastewater discharges, it is necessary to obtain a discharge permit issued by CONAGUA.18

All entities that use water or discharge wastewater must pay a duty. For the purposes of charging these duties, Mexico has been divided into nine availability zones. In general, the cost per cubic meter for a particular area increases as the availability of water falls. For example, the range for water used for supply of drinking water is from about 0.08 to 0.72 Mexican pesos per cubic meter (equivalent to about US$0.01 to 0.06 per cubic meter).19

According to Article 278C of the Federal Duties Law, the duties for wastewater discharges are related to the volume of wastewater discharged and the load of the pollutants. The duties charged on wastewater discharged also depend on the body of water into which the discharges are made. For this purpose, the bodies of water are classified into three types: A, B, or C, according to the effects caused by the pollution, with the C-type receiver bodies being those in which the pollution has the strongest effect. The Federal Duties Law sets forth the list of the bodies of water that belong to each of these three categories. The Law creates exceptions for payment for certain users and categories of use.

CONAGUA is responsible for billing and collection of the duties for water use and wastewater discharge. Of approximately US$859 million collected in 2008, US$633 million (or about 74 percent) was from duties for water use. The payment of duties for wastewater discharges was significantly less, accounting for only US$5 million (or less than 1 percent).

Conclusion

There will be a large market for water resources and management in Mexico as this economic oil and gas boom starts to hit. With the booming market will come many challenges with infrastructure and transportation. Also, all players will have to learn all the rules and regulations to avoid violating the labyrinth of rules in a new system. There is a massive market for water resources, transportation, and financing of these required projects. Many private sector companies avoid investing in water, however the upside is tremendous for anything dealing with water in Mexico in the near future.

Trucking companies will have a tremendous upside in the first leg of the economic boom in Mexico. Overall

though, any company that does any type of water recycling and reuse management will be the real winner. If a company can provide water resources it should have tremendous profits, but the big picture is in saving (recycling) water for the long term. This will shorten costs of transportation and worries about where the next gallon or liter of water originates. Even though water is scarce in Mexico and fracking is seen as having an impact on the environment, the advantages that this boom will have on the economy undoubtedly outweigh the negatives and the challenges, especially for water activities.


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OFS Overview

OFSCap is boutique investment bank that has a unique position of being able to bridge multiple countries in multiple energy disciplines. Raising capital and placement is our specialty. OFSCap can manage and assist either private or public companies regarding capital raises or M&A activities. Regarding M&A, OFSCap provides both buy-side and sell-side advisory services. Our relationships, country and market knowledge with target entities have expedited strategic acquisitions and transactions. Our areas of expertise include:

Financing Sell-side Exploration & Production

Capital Raise Buy-side Oil Field Services

Placement Power Renewables

• We work with capital sources to provide funding for Mexican companies: o Small to medium companies with Pemex contracts to fund o New project companies in the energy sector o Bi-national companies looking to participate in the new energy reforms

• Direct support from our Mexico City office for contractors, operators, service companies, equipment manufacturers and investors

• Transactional support (deal structuring, advisory, finance, legal, tax) for oil and gas, and power projects • Commercial representation for companies that are not prepared to open a full-time office in Mexico • Development and implementation of market access and country strategies • Create and implement government relations and advocacy strategies • OFS Team members have Pemex, CFE and private sector Mexican experience

Sources

1. http://www.eia.gov/tools/faqs/faq.cfm?id=727&t=6 2. http://latino.foxnews.com/latino/news/2014/08/20/drinking-water-will-not-be-used-in-gas-production-mexican-

govt-says/ 3. http://www.forbes.com/sites/doliaestevez/2014/06/11/fracking-could-mexicos-water-scarcity-render-its-energy-

sector-reforms-self-defeating-2/ 4. http://www.conagua.gob.mx/english07/publications/OECD.pdf 5. http://www.conagua.gob.mx/english07/publications/OECD.pdf 6. http://fortune.com/2014/09/02/fracking-drinking-water/ 7. http://fortune.com/2014/09/02/fracking-drinking-water/ 8. http://www.inboundlogistics.com/cms/article/mexico-paves-the-road-to-properity/ 9. http://www.inboundlogistics.com/cms/article/mexico-paves-the-road-to-properity/ 10. http://www.inboundlogistics.com/cms/article/mexico-paves-the-road-to-properity/ 11. http://www.inboundlogistics.com/cms/article/mexico-paves-the-road-to-properity/ 12. http://www.inboundlogistics.com/cms/article/mexico-paves-the-road-to-properity/ 13. http://www.conagua.gob.mx/english07/publications/OECD.pdf 14. http://www.conagua.gob.mx/english07/publications/OECD.pdf 15. http://www.conagua.gob.mx/english07/publications/OECD.pdf 16. http://www.conagua.gob.mx/english07/publications/OECD.pdf 17. http://www.conagua.gob.mx/english07/publications/OECD.pdf 18. http://www.conagua.gob.mx/english07/publications/OECD.pdf 19. http://www.conagua.gob.mx/english07/publications/OECD.pdf 20. http://www.conagua.gob.mx/home.aspx 21. http://www.energyfromshale.org/environment/fracking-fracturing-water-supply 22. http://pacinst.org/wp-content/uploads/sites/21/2014/04/fracking-water-sources.pdf


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Frac water in Mexico - fracking or frustration?