Foreign Relations of the United States, 1969–1976, Volume XXXVII, Energy Crisis, 1974–1980

174. Memorandum From Secretary of Energy Schlesinger to President Carter¹

Washington, December 14, 1978.

SUBJECT

• Mexican Gas—A U.S. Strategy

The purpose of this memorandum is to present a proposed strategy and analysis regarding negotiations on the possible purchase of Mexican natural gas.

Background

In August, 1977, Pemex signed a Memorandum of Intent with six U.S. gas transmission companies for the sale of up to 2 billion cubic feet per day (BCFD) of Mexican gas. At a time of perceived gas shortages, these predominantly production-poor companies reached agreement with the Mexicans on a price that was simply too high from a national perspective. This price, for example, would have created serious political difficulties with the Canadians from whom we currently import about 1 tcf of gas annually.

The initial border price and subsequent escalation were tied to the equivalent price of #2 fuel oil. President Lopez-Portillo has publicly cited $2.60 as the Mexican asking price, but the actual formula price has not been below $2.70 over the past year and is currently at approximately $2.90. The price and escalation clauses would have come into effect when the purchase contracts were signed—some 18 months before we would have begun to receive significant quantities of gas.

The Mexicans and the U.S. companies were advised by the Administration before the memorandum was signed that the price/escalation formula was unacceptable to us because (1) it was substantially higher than the price we were proposing to pay for new U.S. gas; (2) it would have threatened the $2.16 price we pay Canada for even larger volumes of gas; and (3) it would have tied the price of the gas to OPEC oil pricing decisions.

In October, 1977, Senator Stevenson² introduced a resolution in Congress blocking an Ex-Im Bank credit to Mexico for financing a gas pipeline to the U.S. on the grounds that the Mexican price was too high. The Mexicans reacted sharply to this, charging that the U.S. was trying to blackmail them on the price issue.

In November, 1977, direct discussions were initiated with the Mexican Government aimed at reaching policy agreement on the general outlines of a gas transaction. The fact that the actual contracts would still be subject to U.S. regulatory approval was stressed. During these discussions, the Mexican negotiators accepted a U.S. proposal for a $2.60 price, to begin when substantial volumes of gas begin flowing, with escalation tied to a general price index (WPI) rather than No. 2 fuel oil. However, this proposal was subsequently rejected by Lopez-Portillo who had come under domestic political pressure over the proposed export of Mexican gas to the U.S. In view of the continuing debate on the National Energy Act, it was jointly agreed by both governments to indefinitely suspend the gas discussions, allowing the Memorandum of Intent to expire on December 31, 1977.

In your letter to Lopez-Portillo in August (Tab A),³ you stressed our continuing interest in importing Mexican gas, but indicated that the matter should be deferred until Congress had completed action on the energy bill. There have been no formal discussions with the Mexicans since the passage of the energy bill.⁴

Lopez-Portillo has said publicly that because he was unable to reach an acceptable agreement with the U.S., Mexico would complete the pipeline from the Chiapas-Tabasco fields only to Monterrey and restructure its industry to expand domestic gas consumption. Natural gas, which in fact is now being flared, would replace residual fuel oil used in industry. Thus, the maximum value of this gas in Mexico, if it is not flared, is equivalent to lower-priced residual fuel oil even though the Mexicans propose to charge U.S. companies the btu equivalent of higher-priced distillate oil.

The residual oil displaced by gas would be exported. Estimates indicate they could expand domestic consumption by perhaps 1 BCFD, although at some cost in terms of infrastructure investment and foreign exchange losses arising from the lower export value of the residual fuel oil they would free for export. The Mexicans could also reinject limited quantities of associated gas in the Chiapas-Tabasco field and shut in the non-associated gas fields in Northern Mexico. But our intelligence reporting and private remarks by other Mexican officials confirm that the Government recognizes the substantial costs associated with a domestic option. The Mexicans also appear to realize that as oil production rises toward the 1982 target (2.0–2.5 mbd), they will have substantially more associated gas available than they had earlier anticipated.

In view of the current surplus of domestic gas, the projected surplus of Mexican gas, and the rising price of domestic gas supplies, it is inevitable that sometime in the mid-1980’s Mexican gas will flow into U.S. markets to the economic advantage of both countries. In view of these realities, it is important that the United States not find itself in the position of over-paying for this gas by being too anxious to conclude an agreement. It would not be in the long-term interests of either country to rush into a gas sales agreement that contains inappropriately high prices.⁵

Analysis

Domestic Gas Market: With the Natural Gas Act now in place, there has been a major shift in the U.S. domestic gas market. Up to 1.0 trillion cubic feet annually (2.7 BCFD) of gas which was formerly locked up in intrastate markets is now available to the interstate system. To attain the projected savings on imported oil, it is important to ensure that this gas is used. Those industrial customers who went off gas in the winter of 1976–77 must come back on over the next several months. A substantial volume of new gas is expected to be produced over the next several years in response to the price incentives in the Natural Gas Act. But the U.S. must ensure that potential investors in new gas exploration and production are confident that there will in fact be a market for that gas.

The U.S. companies would contract for the Mexican gas on a take-or-pay⁶ basis. Therefore, there would be a strong tendency for the high-cost Mexican gas to be sold first, with new U.S. gas (including Alaskan gas) taking the role of residual supply. This would be contrary to both domestic energy objectives—to maximize U.S. gas production—and the nation’s balance of payments interests. Under the provisions of the Natural Gas Act, a portion of the Mexican gas price will have to be paid by industrial customers, but the bulk of it will be paid by all consumers on a rolled-in price basis. Thus, as long as the price of Mexican gas is substantially above the average price of U.S. gas, residential consumers would be, in effect, subsidizing the consumption of high cost imported gas by industrial users.

In general, the large volumes of old, lower-priced gas in the interstate market will be available for many years to subsidize higher cost gas supplies. To the extent possible, that subsidy should not be used extensively for imported natural gas. The gas price proposed by Mexico would absorb a substantial portion of this subsidy.

The U.S. gas companies are willing to pay virtually any price to Mexico as long as their average price (Mexican gas plus all other gas in their systems) remains competitive with the cost of alternative fuels available to their industrial customers. They believe that #2 fuel oil is the most likely alternative fuel against which they will be competing and are, therefore, comfortable with the Mexican price formula.

The longer-term view of the U.S. gas market is less clear. Estimates of domestic gas supply and demand through the 1980’s vary. But it seems likely that by the mid-1980’s, Mexican gas would displace not domestically produced gas, but rather alternative fuels—largely oil. For the foreseeable future, the marginal natural gas supplies in the U.S. will compete with residual fuel oil rather than higher-priced distillate oil. In most markets, if the delivered price of the gas exceeds the price of residual oil there would be a sharp reduction in natural gas demand and a consequent increase in oil imports. Over the longer-term, and depending on the volumes of gas coming from Mexico, Mexican gas would be competing for those industrial markets where lower-priced residual fuel oil is used.

Because residual fuel oil is the most likely substitute fuel in the U.S. and represents the highest value for use in Mexico, the U.S. should seek a Mexican gas price no higher than the btu-equivalent of residual fuel oil. That price would be approximately $.70 per MMBTU less than the distillate price proposed by Mexico.

Canadian Gas: In addition to these domestic considerations, the U.S. must be sensitive to the possible impact of a deal with Mexico on the price of gas imports from Canada. The Canadian gas price is now $2.16/mcf for about 1 tcf per year. The Canadians are likely to raise this price next year, possibly to the $2.35 to $2.45 range. But that price will still be substantially lower than that sought by Mexico. It is not likely that the Canadian government could long resist domestic pressures to bring its export price up to the level obtained by Mexico.

In addition, Canada’s National Energy Board (NEB) is currently considering a number of proposals for the export of additional gas to the U.S., including a proposal for delivery of new supplies of Canadian gas through pre-building the southern legs of the Alcan line—a move which we favor because it would enhance significantly the financiability of the Alcan project.⁷ Agreement in the next few months to the Mexican asking price would impact directly on the price which Canada might demand for these incremental exports.

Alaskan Gas Project: Some U.S. gas transmission companies view Mexican gas as an alternative to Alaskan gas. The Alcan project is already suffering from uncertainty over the marketability of the Alaskan gas in the lower-48. One of the keys to the success of the Alcan project will be the ability of the project sponsors to negotiate firm contracts for the Alaskan gas with U.S. gas transmission companies. To the extent that U.S. companies give priority to Mexican gas, the failure of the Alcan project becomes an increasing possibility.

This is particularly important in view of the fact that it is clearly in the long-run energy and economic interests of the nation to bring Alaskan gas to market. While it is true that the cost of the Mexican gas will be less in the mid-1980’s than the cost of delivered Alaskan gas, the costs of Alaskan gas will decline significantly over time as the capital costs of the pipeline are amortized. The Mexican gas, on the other hand, will continue to increase in price as the world oil price increases. Since the incremental cost of producing Alaskan gas is low, the Alaskan gas will require a lesser expenditure of our real resources and therefore will have a higher national economic benefit than Mexican gas. These long-range considerations underscore the undesirability of a Mexican gas price that would subsidize imported gas at the expense of the Alaska project.

Next Steps

The Mexican position has been based on the premise that the U.S. is desperate for Mexican gas. That is clearly not the case. Based on our current domestic supply situation, the U.S. can afford to wait a significant period of time before purchasing Mexican gas. In fact, the rising domestic price for gas coupled with the growing Mexican surplus will inevitably draw Mexican gas into the U.S. market by the mid-1980’s.

On the other hand, the U.S. should also stand ready to accept Mexican gas at an earlier time if a reasonable price can be negotiated. This country has a strong interest in rapid Mexican industrialization which will impact on virtually all areas of our relationship. We also want to assure that an inability to dispose of associated gas—other than by flaring—does not become a potential constraint on Mexican oil production in the late-1980’s.

There are also substantial economic costs to Mexico in foregoing gas sales to the U.S., both in terms of lost foreign exchange earnings and the investment expense of increasing domestic gas consumption. It would not be economically prudent for the Mexicans to continue flaring increasing volumes of their natural gas production. Lopez-Portillo wants to maximize foreign exchange earnings by accelerating the oil production schedule—and if possible by selling gas—in order to finance a greatly expanded industrialization effort. His recent initiative in suggesting⁸ new discussions confirms that the gas transaction is at least as important to Mexico as to the U.S.

Therefore, I believe that we should try to negotiate an agreement with Mexico which would:

1. Meet Lopez-Portillo’s political problem;

2. Assure us of the availability of Mexican gas at a price competitive with the btu equivalent of the most realistic long range substitute fuel—residual fuel oil; and

3. Minimize any adverse impact on our present and future imports from Canada.

Negotiating Strategy

With these objectives in mind, I would propose to negotiate with the Mexican leadership in an effort to see if an acceptable agreement can now be achieved.

Starting Price of $2.60

In view of the importance of the $2.60 price to the Mexicans, the initial U.S. position could be a $2.60 per MMBTU price when the gas starts flowing in 1980, escalated by the world price of crude oil, or distillate, or a combination of one-half the GNP deflator and one-half the price of oil. In the 1985 timeframe (the longest term the Mexicans are likely to accept), the difference between these escalators will be insignificant as long as world oil prices do not rise faster than inflation. This formula would also include a limitation of 15 percent⁹ on the price increase in any given year.

This approach addresses some central Mexican concerns and is acceptable from the U.S. point of view. It allows the Mexicans to cite a $2.60 starting point, a number which for them has assumed political significance. Given his public statements, Lopez-Portillo cannot accept a lower price and may seek a higher level.

As shown on the attached table,¹⁰ the $2.60 starting price in 1980 is $.59 below the current Mexican proposal. It is also at the low end of the residual fuel oil price range in 1980 ($2.69 compared to $2.60–$2.85) and $1.55 less than the current Mexican formula in 1985. In 1980, however, this price would be approximately $.30 higher than the current Canadian price adjusted for a 7 percent inflation rate. If the Canadians raise their price to $2.45 sometime next year, then the difference declines to $.15.

Modifications

Because this price trajectory is substantially below the initial Mexican proposal and similar to the last offer made to the Mexicans in September of 1977, this proposal may be difficult for the Mexicans to accept.

Modifications to this initial proposal might include adding a provision that in no event could the Mexican price be lower than the Canadian border price. The Canadian price, however, is not likely to exceed the $2.60 price. The Canadians are having difficulties in finding markets for existing export commitments at the current price of $2.16 per mcf. Since they are currently reluctant to press for still higher prices, it is more likely that the Canadian price will follow the Mexican price.

Another modification might include offering the Mexicans the highest of the $2.60 price, the Canadian border price, or a third option such as the onshore production well price under the Natural Gas Policy Act (today $1.98 per MMBTU; in 1980, $2.19 per MMBTU) at the wellhead in Mexico, plus transportation charges to the border. At constant world oil prices, this price trajectory is very close to the $2.60 option. Under this approach, an expected negotiation point would be the appropriateness of the transportation charge used in this formula. The Mexicans can be expected to claim the transportation charge is in the range of $.80, while our estimates, depending on rate of return and other variables, might range as low as $.30. For purposes of this calculation, a declining rate starting at $.50 per mcf was used.

The U.S. onshore production well price plus transportation option offers added flexibility in minimizing potential Canadian price increases. Allowing for a $.30 or more transportation charge for Canadian gas from Alberta to the border compared to the estimated $.50 Mexican charge reduces the differential between the Mexican gas price and the Canadian price to less than $.20.

Residual Oil Price

If any or all of these options prove unsatisfactory, tying the gas price to the btu equivalent of residual fuel oil would meet a large portion of the U.S. and Mexican objectives.

Because of continuing surpluses brought on by increasing use of heavier crude oils and growing demand for lighter products, the residual oil market over the course of the next few years will in all likelihood rise at a slower rate than that of distillate.

Because the best estimates of residual oil prices in 1980 are above both the $2.60 starting point and the onshore production formula, this price closes about 40 percent of the gap between the proposed U.S. starting position and the original Mexican position, as indicated on the attached chart. This option brings the gas purchase price up to the btu equivalent of the appropriate substitute and may provide the Mexicans with a politically feasible starting point. However, it leaves a gap of approximately $.30 to $.40 per mcf between the 1980 inflation-adjusted Canadian price and the Mexican price.

Possible Additional Incentives

—The Ex-Im Bank credit to finance U.S. sales of additional pipe and other equipment needed to complete the line to the U.S. could possibly be re-established.

Mexico has not had difficulty obtaining financing elsewhere, but Ex-Im Bank credit could be politically useful to Lopez-Portillo. I will consult with Senator Stevenson on this.

—Front-End Payments for future gas deliveries.

Front-end Payments maximize Mexican earnings in the short-term when they are of greatest interest to Lopez-Portillo. The Japanese have obtained access to the Mexican oil market through such front-end payments. Tenneco¹¹ officials have indicated in confidential discussions with me that they would be willing to enter into a $1 billion advance payment arrangement. Regulatory and contractual mechanisms for completing such arrangements on both sides of the border would have to be explored.

—An offer could be made to transport Mexican gas on a reimbursable basis through the U.S. pipeline system from Eastern to Western Mexico.

This transportation option would permit the delivery of gas to the Mexican cities along the border at a substantially lower cost of service than through the construction of a new line through Mexico and could be presented to Lopez-Portillo as a significant side benefit to Mexico of the overall deal with the U.S.

Conclusion

Mexican gas at an appropriate price can be a desirable source of U.S. energy supply. Since there is a great likelihood that this gas will in any event flow into U.S. markets by the mid-1980’s, it is important that contracts for earlier purchase of this gas not be at disadvantageous prices.

This proposed mix of negotiating options offers the opportunity to conclude an agreement that would be beneficial for both countries while meeting a major portion of our negotiating objectives. The most difficult objective to meet satisfactorily will continue to be minimizing the effect of any final Mexican settlement on Canadian gas prices.

During any preliminary discussions, it will be important to remain flexible within the framework of this negotiating strategy, since it will be difficult to make a more specific assessment of the best approach until actual discussions have progressed. I would try to reach agreement in principle with Mexican leaders based on this proposed strategy. You could then conclude the matter during your visit in February with a public announcement either then or later in the year.

1. Source: Carter Library, National Security Affairs, Staff Material, North/South File, Box 29, Pastor Country Files, Mexico, 12/1–14/78. No classification marking. Copies were sent to Vance and Brzezinski. At the top of the first page, the President wrote: “No copies to be made except the 3.” He also wrote: “Jim—Good summary. Get State and NSC comments to me.”
2. Senator Adlai Stevenson (D–IL).
3. Sent August 18; attached but not printed.
4. See Document 164.
5. Carter wrote “I agree” next to the last sentence of this paragraph and underlined “either country.”
6. Carter underlined “take-or-pay” and wrote a question mark next to it.
7. A pipeline project that would follow the Alcan Highway across Alaska and Canada to deliver natural gas to the continental United States.
8. Carter underlined “recent initiative in suggesting” and wrote a question mark next to it.
9. Carter underlined “15 percent” and wrote “Too high?” next to this sentence.
10. Entitled “Projected Mexican Gas Prices”; attached but not printed.
11. A U.S. oil company (taking its name from Tennessee Gas) that in 1978 converted its Louisiana refinery to process the lower grades of crude oil that were exported from Venezuela and Mexico.