NAFTA and
Energy: A Bridge
not far Enough?

G. C. Watkins
DataMetrics Limited &
University of Calgary
I am indebted to helpful comments from André Plourde, University of Ottawa, and Steven Globerman, Simon Fraser University.

Introduction

THE NORTH AMERICAN FREE TRADE AGREEMENT (NAFTA) is intended to make the continent one economic zone. [See NAFTA, "Overview," p. i.] In effect, it would supersede the U.S.-Canada Free Trade Agreement (FTA). However, outstanding FTA obligations between Canada and the United States not embraced by NAFTA remain.

This paper deals with energy under NAFTA. It consists of four main sections. Section I provides background energy information for the three countries. Section II describes the provisions of the NAFTA agreement as they relate to energy. Section III assesses the treatment of energy under NAFTA. Concluding remarks are made in Section IV.

Direct energy trade between Canada and Mexico is minor and likely to remain so. Thus the significance of NAFTA for Canada lies in other aspects-what it does in the fulcrum energy market of the U.S.; what effect it has on the FTA; and what opportunities it provides for trade related to energy services.

Energy trade between the U.S. and Mexico is mainly one way-from Mexico to the U.S.-although of late the U.S. has been moving some natural gas to Northern Mexico. From a U.S. perspective NAFTA can be seen primarily as a vehicle that may open up energy related investment and service opportunities in Mexico and would enhance the development of Mexico's energy resources.

Mexico imports little energy but does have very considerable oil exports to the U.S., to which access would be secured under NAFTA. At the same time, modest participation by the U.S. and Canada in the Mexican oil and gas industry under NAFTA would represent a new departure for Mexico.

We shall see that the kind of arrangements prevailing for energy under the FTA have not been accepted by Mexico under NAFTA. Indeed, Mexico has been able to impose what is tantamount to an "exclusion zone" for some Mexican energy activities, an acknowledgement of its especial sensitivity-emanating mainly from Mexico's Constitution-to energy issues. This may be unfortunate. But the agreement is not immutable and its evolution could well see some relaxation of the energy provisions to yield further benefits from greater integration of North American energy flows and developments. Then the objective of a single economic zone would be achieved. In the meantime, the Agreement would open up opportunities for exports of Canadian and United States energy equipment and services to Mexico.

North American Energy Flows and Related Features

Several Tables in this section show energy flows among Canada, the United States and Mexico over the last decade or so. In addition, information is provided on the magnitude of fossil fuel reserves and the structure of energy demand in the three countries.

Oil

Both Canada and Mexico export substantial amounts of crude oil to the U.S.; flows in the other direction are minor or nil (see Table 1). In the first half of the 1980s Canada imported noticeable amounts of Mexican oil into eastern Canada, but as the decade progressed these fell to modest levels.

Click here to view Table 1: Crude Oil flows between Canada, the U.S. and Mexico

Canadian oil exports as a proportion of total Canadian production have doubled since 1980 and currently represent about one-half of domestic output. Growth in oil exports was particularly noticeable in 1985 when the Canadian oil production sector was deregulated. In contrast, the share such exports represent of U.S. demand for oil is quite minor at around six percent, notwithstanding the fact that at present close to one-half of total U.S. oil demand is met by imports (see Table 2).

Click here to view Table 2: Significance of Oil flows among Canada, the U.S. and Mexico

Exports of Mexican crude oil to the U.S. have been quite stable since the early 1980s and constitute about one quarter of Mexican production of liquid hydrocarbons. Similarly to Canada, about 50 percent of Mexican production of some three million b/d of liquid hydrocarbons is exported. In terms of volume, Mexican oil exports to the U.S. are about 80 percent of Canada's. Of late, Mexico has imported 100,000 b/d of gasolines (about 10 percent of the value of crude exports), indicating a lack of appropriate Mexican refining capability. Mexico is also a net importer of fuel oil.

Natural Gas

Natural gas flows between the three countries are displayed in Table 3. Fluctuations in Canadian exports to the U.S. have been primarily policy induced. The decline in the early 1980s was mainly attributable to the high export prices set by the Canadian federal government. [See Watkins and Waverman, 1985.] The strong recovery of export volumes after 1984 primarily reflected price deregulation. Indeed, Canadian exports to the U.S. have increased by a factor of about 2.5 in 1991 over the nadir in 1983.

Click here to view Table 3: Natural Gas flows between Canada, the U.S.A. and Mexico

Overall, Canadian natural gas exports currently account for 40 percent of total Canadian production (see Table 4). But in the context of the aggregate U.S. natural gas market they play a quite modest albeit growing role, with exports rising from five percent of U.S. consumption in 1985 to nearly 10 percent last year. On a regional basis, Canadian imports assume more importance, for example satisfying about 25 percent of Californian natural gas consumption. Since 1985, Canada has accounted for virtually all U.S. natural gas imports.

Click here to view Table 4: Significance of Natural Gas flows among Canada, the U.S.A. and Mexico

While gas flows have been predominantly in one direction-from Canada to the U.S.-deregulation has spawned increases in natural gas imports into Canada from the U.S.; virtually no gas was imported into Canada during the regulated era. In contrast, the past four years have seen noticeable volumes of U.S. gas enter Canada, with current annual shipments of about 20 BCF, mainly into Ontario.

Exports of Mexican natural gas to the U.S. peaked in 1981. Such movements-and total production of Mexican gas-fell sharply after 1982 with the contraction in upstream investment as financial constraints resulting from falling oil prices and the Mexican external debt crisis took hold. [A two BCF/day pipeline project to export Mexican gas to the U.S. was never completed as pricing disputes were not resolved (see Foss and Johnson, 1991).] Mexico absorbed small amounts of U.S. gas until the end of the 1980s; 1991 saw a substantial jump as demand from Mexican border states rose sharply. Note that the existing Mexican south to north pipeline has limited capacity and is fully utilized. [Foss and Johnson, 1991, p.158.]

Electricity

Table 5 shows electricity flows between Canada and the U.S. Up until 1989, the bulk of this trade constituted Canadian exports of electricity to the U.S. However, trade flows have become more balanced recently, in part because of Ontario Hydro's policy of buying electricity from the U.S. to cut emissions likely to provoke acid rain. [National Energy Board, 1991, p.17.]

Click here to view Table 5: Electricity flows between Canada and the U.S.A.

Of late, Canadian exports of electricity are appreciably less than in the early 1980s. Exporting utilities have had relatively little surplus available, given low water conditions in some provinces and restrictions on fossil-fuelled generation in Ontario.

Supplies of Canadian electricity play an even smaller part in the U.S. market than oil and gas, accounting for less than two percent of U.S. consumption during the 1980s although, as with natural gas, they are more noticeable regionally (for example in New York State). In 1991, Canadian electricity exports amounted to no more than about one percent of total U.S. demand.

No information was available on electricity flows between the U.S. and Mexico, but if any were recorded they would likely be minor.

Coal

As Table 6 shows, coal trade is predominantly one way-from the U.S. to Canada-with Canada importing in excess of ten times more coal than it exports to the U.S. [U.S. coal imports are equivalent to almost 20 percent of Canadian coal production.] Indeed, prior to 1981 Canadian exports of coal to the U.S were negligible. Most of the coal imported into Canada has traditionally supplied the steel and electricity generation industries in Ontario. Mexican coal production is minor; no cross border movements are reported. [Mexican coal production in 1991 was 15 million tonnes (Canada's and the United States' were 71 and 895 million tonnes, respectively); the Mexican coal reserves to production ratio is in excess of 100. Sources: BP, Statistical Review of World Energy; Statistics Canada, Canadian Economic Observer; and U.S. Dept. of Energy, Monthly Energy Review, various issues.]

Click here to view Table 6: Coal flows between Canada and the U.S.A.

Fossil Fuel Reserves

What of the size of current proved remaining reserves of fossil fuels for the three countries? These numbers are shown in Table 7. Mexico's oil reserves exceed those of the U.S. and Canada in combination. The combined natural gas reserves of Mexico and Canada are roughly equivalent to those of the U.S. The proved coal reserves of the U.S. dwarf those of the other two countries. Note that estimates of Mexican reserves of both oil and gas are subject to controversy. [Although estimates of Mexican proved oil reserves are subject to more than normal levels of uncertainty, it is likely they are still in the region of 50 billion barrels-but numbers as low as 35 billion barrels have been suggested; see Oil and Gas Journal, February, 1992, p. 17. On natural gas, see Foss and Johnson, 1991.]

Click here to view Table 7: Fossil Fuel Reserves, 1980

Energy Consumption

There are some significant differences in the structure of energy consumption among the three countries. Table 8 shows data on energy demand for the latest year for which Mexican information was available (1988). The U.S. places somewhat greater reliance on coal and oil than does Canada, which relies more heavily on natural gas and electricity. In contrast to both her northern neighbours, Mexico relies much more heavily on oils and less on electricity-a reflection in part of significant differences in stages of economic development.

Click here to view Table 8: Share of Secondary Energy Consumption, 1988

In summary, both Mexico and Canada ship substantial amounts of oil to the U.S., yet in combination they only account for about 10 percent of the U.S. market. Canada also ships a large proportion of its natural gas production to the U.S., but again only satisfies some 10 percent of U.S. consumption, although that share has been growing of late and assumes more significance on a regional basis. Trade in electricity and coal is minor. Mexican and Canadian oil and gas reserves exceed those of the U.S. The structure of energy consumption in Mexico is slanted more towards oils, compared with the U.S. and Canada.

Energy Related NAFTA Provisions
[This Section is predicated on the October 7, 1992 version of the NAFTA text.]

The energy provisions of NAFTA parallel those of the FTA and thus remain in large measure an extension and clarification of rights and obligations under the General Agreement on Tariffs and Trade (GATT) [Mexico joined the GATT in 1986.]. All rights and obligations under the U.S.-Canada Free Trade Agreement (FTA) of January, 1989 are to be "reflected in one form or another in the new agreement" (NAFTA "Overview," q.v). In effect, NAFTA takes priority over the FTA. Certain provisions of the FTA would be suspended where NAFTA repeats or amends FTA obligations.

This Section focuses both on the specific energy provisions of NAFTA (Chapter 6, NAFTA) and mentions other elements, such as the disputes mechanism, arrangements for government procurement and the like which also affect trade in energy and related services.

NAFTA provides a long-term framework for energy trade among the three countries. Moreover it by no means erases the border between the United States and Canada-which may afford some comfort to economic nationalists. And in the case of Mexico the border is not only visible but remains paramount in the energy context.

Before looking at Chapter 6 of NAFTA dealing specifically with energy, I mention pertinent aspects of the "Preamble" and "Objectives" of the Agreement. The "Preamble" refers to the three governments being resolved to creating expanded and secure markets, to reducing distortions to trade, to building on other agreements and to promoting sustainable development. [See NAFTA "Preamble."] Cited objectives include elimination of trade barriers, promotion of "fair competition" and increased investment opportunities, provision for elimination of disputes, and establishment of a framework for further cooperation. [NAFTA, Chapter 1, Article 102(1).]

Allusion is also made to relations with other extant agreements. Specifically, the parties affirm their existing rights and obligations with respect to each other under the General Agreement on Tariffs and Trade (GATT) and to other relevant agreements. In the event of any inconsistency between the provisos of NAFTA and other agreements, NAFTA prevails except as otherwise provided.

The Energy Chapter

Chapter 6 of NAFTA is entitled "Energy and Basic Petrochemicals;" the corresponding Chapter in the FTA (Chapter 9) was simply called "Energy." The distinction resides in Mexico's dirigiste policy towards the energy sector, as discussed later. [Throughout the Chapter the phrase "energy" used in the FTA is generally replaced by the phrase "energy and basic petrochemicals."] The ultimate intent of Chapter 6 is to entirely replace the corresponding Chapter of the FTA.

Scope

The parties confirmed their respect for their constitutions. This caveat did not appear in the FTA and has to do with the exclusive reservation on "strategic" grounds of the energy sector to the state under the Mexican Constitution. This relates both to resource ownership and exploitation. Mexican sensitivity to constitutional issues concerning energy accounts for the fact that the treatment of the Mexican energy sector under the Agreement does not parallel that between the United States and Canada.

These concerns go back to the 1917 Mexican Constitution which reinstated the traditional Spanish rule of sovereign ownership of mineral rights (Article 27). It also defined "forbidden zones" for any foreign ownership of lands or waters. At present, Mexico's sovereign ownership of resources includes "all natural resources of the continental shelf and marine shelf of the islands." Since its inception in 1917, article 27 has been amended, with each amendment extending the reach by exploitation of state owned resources by state owned entities (see Kimball Jr. [1990]).

The apparent scope of energy goods covered by NAFTA is marginally less generous than that covered by the FTA. The difference arises partly from the reclassification of certain products. And, as outlined later, Mexico has excluded many energy materials. Such Mexican exclusions do not apply to trade between Canada and the U.S.

However, the scope of NAFTA is in one way seemingly broader than the FTA in that it refers specifically to measures relating to investment and services associated with energy and petrochemicals. No such mention is made in the FTA's energy chapter, although provisions for services (but not investment) are subsumed elsewhere in that Agreement.

Quantitative Import and Export Restrictions

As in the FTA, the GATT prohibition of restrictions on trade in energy and basic petrochemicals is affirmed in NAFTA. In the event that one of the three NAFTA countries imposes export or import restrictions on energy and basic petrochemical trade with other countries, the other two NAFTA countries cannot be used as a conduit to circumvent the restriction (Article 603(3)). And where a party to the Agreement imposes import restrictions on non-parties, consultation with other signatories is required to avoid distortive impacts (Article 603(4)).

NAFTA allows parties to administer a system of import and export licensing for energy and basic petrochemicals if consistent with the Agreement. Allowance is also made for parties to designate monopolies or state enterprises, but such bodies are not to frustrate the intent of the Agreement nor to introduce anti-competitive practices in non-monopolized markets (Articles 1502 and 1503).

NAFTA permits Mexico to issue import and export licences to reserve foreign trade in certain goods to PEMEX, in recognition of the latter's monopoly position. These goods include virtually all refined petroleum products plus bitumen, oil shale and tar sands, and LPGs (Annex 603.6). However such restrictive licences are still subject to trade rules under the Agreement, and under the GATT for that matter.

The Agreement (Article 605) repeats the clause in the FTA (Article 904) that allows governments to impose export restrictions on other parties on the grounds of: i) conservation of exhaustible resources; ii) supply shortages; iii) price stabilization; and iv) national security. In turn, these provisos were fashioned on those in the GATT agreements, although the definition of what constitutes a national security criterion is more lax under the GATT. Moreover-and this is critical-the definition of "national security" differs as between Canada and the United States, and as between Mexico and the other two parties. These aspects are mentioned below.

Article 605 in NAFTA also repeats the key energy caveat introduced in the FTA: if supplies were restricted to one of the parties under any of the first three reasons (conservation, supply shortages and price stabilization), the share of total supply available for export purchase may not fall below the average level in the previous 36 months. This was the contentious "proportionality" provision of the FTA-which put some flesh on the GATT skeleton-but did not constitute a supply obligation. [The relevant GATT provisions are a lot more vague, referring to general exceptions allowing the imposition of import and export controls in certain situations; see Articles XI:2(a) and XX(g), (i) and (j) of the GATT.] Until such time as the conditions that might invoke the proportionality clause become apparent, its significance will remain hazy.

Note that the proportionality provision refers to government actions to restrict exports. There is nothing to stop markets constraining exports. Canadians could outbid Americans even for the proportional share of supply. Restrictions are not to disrupt "normal channels" of supply nor to involve imposition of higher prices on exports via licence fees, taxation and minimum prices.

However, an Annex to the Agreement reveals that Article 605 is bilateral: it only applies to trade between Canada and the United States. It does not hold for Mexico, although presumably the vaguer GATT measures remain. In short, Mexico has been able to opt out of the more precise expression of the GATT limitations on energy export restrictions established under the FTA-although these provisions would be reaffirmed between the U.S. and Canada.

National security is seen as possible grounds for import or export restrictions, but the actions to be taken are quite tightly specified, much more so than under GATT (Article 607). But again Mexico is exempt from these provisions and their narrow scope. Instead, broad provisions on national security (Article 2102)-which refer to the Agreement not precluding any party taking actions deemed necessary to protect its "essential security interests"-apply.

One interpretation of the U.S.-Canada arrangements on supply restrictions is to view them as reciprocal trade-offs. Canada granted "proportionality" for the conservation, supply shortages and price stabilization criteria to assuage U.S. concerns emanating from Canada's export restrictions in the regulated era of 1970 to 1985. The U.S. granted a narrow interpretation of national security to meet Canadian concerns about any revival of U.S. import constraints imposed under the guise of national security in the 1950s and 1960s. Mexico did not agree to "proportionality" and so did not qualify for (and perhaps did not wish) a tight national security criterion.

Pricing Provisions

Article 603(2) of Chapter 6 refers to the abolition of minimum and maximum export and import price requirements. This embellishes the corresponding clause in the FTA, which did not allude specifically to maxima. [This amendment is simply one of clarification.] Prohibition of export taxes in the FTA is confirmed in NAFTA (Article 604).

Other Features

Energy regulatory measures within the member countries are to observe GATT strictures awarding most favourable national treatment for traded vis-ŕ-vis domestic goods across provincial or state boundaries (Article 606 and Article 301). No specific provision is made under NAFTA for direct consultation if regulatory actions are seen by either party as discriminatory (in contrast to the FTA). However, NAFTA provides for energy regulatory bodies to "avoid disruption of contractual relationships to the maximum extent practicable" (Article 606(2)). While this is a soft "best efforts" type provision, nevertheless it was not in the FTA and thus represents a new obligation, one possibly urged by Canadian negotiators with an eye on ongoing disputes involving the California Public Utilities Commission-on which more later (see Section III). And it goes beyond a mere invitation to consult.

Perhaps of greater import is the definition of "energy regulatory measure" under NAFTA as any measure by "federal or subfederal [emphasis added] entities that directly affects the transportation, transmission or distribution, purchase or sales, of an energy or basic petrochemical good" (Article 609). What this definition does is make more explicit the need for provincial and state regulators to adhere to the obligations visited on the federal government by NAFTA. In other words, NAFTA obligations are to trickle (or cascade) down to state and provincial regulators.

Certain specific measures in the FTA between the U.S. and Canada laid out in Annexes in the FTA are reaffirmed in NAFTA (Article 608). These include the export of albeit only limited volumes of Alaskan oil to Canada, Canadian exemption from U.S. uranium enrichment regulations, U.S. exemption from Canadian uranium upgrading policies, and elimination of certain Canadian price tests on the export of energy goods. [See FTA, Annex 902.5 and 905.2. The key price test eliminated was that relating to the least cost alternative; beforehand, the Canadian export price was not to be less than the least cost alternative energy supplies in the market involved.]

NAFTA also repeats the article in the FTA that permits parties to indulge themselves in incentives for oil and gas exploration and development to "maintain the reserve base" (Article 608 (1)). And NAFTA reaffirms the primacy of the International Energy Program (IEP) on the sharing of oil supplies in the event of an emergency, at least between Canada and the United States (Annex 608.2). Mexico is excluded because it is not a signatory to the IEP.

Mexican Reservations

There is an important Annex in the Agreement (Annex 602.3) which defines the scope of the energy materials and activities over which the Agreement holds sway in the case of Mexico. The Annex is restrictive. It reserves to the Mexican State the exploration, exploitation, refining, processing and pipelining of crude oil, natural gas and basic petrochemicals. [The basic (protected) petrochemicals are butane, ethane, heptane, hexane and pentanes; fifteen petrochemicals are now open to foreign investment (see the list in the Globe and Mail, August 14, 1992, p. B-3).] It also reserves to the Mexican government all trade in energy and basic petrochemicals, including refined petroleum products. However, in the case of natural gas and basic petrochemicals, where end-users and suppliers find cross border trade "may be in their interests" these entities shall be permitted "to negotiate supply contracts." Such contracts may take the form of individual contracts between the "state enterprise and each of the other entities." The Annex also allows state enterprises to negotiate performance clauses in service contracts.

In Mexico, the generation, transmission, distribution, and sale of electricity is viewed as a public service and a "strategic area reserved to the state" (Annex 602.3 1(c)). However, opportunities are seen for private investment in Mexican electricity generation in terms of production for own use (self generation), co-generation and independent power production. But any surplus power is to be sold to CFE (Mexico's state-owned electricity firm). All nuclear power generation and associated activities are reserved to the Mexican state, without exception. However, independent power producers, CFE and electric utilities in the other two NAFTA countries have the right to negotiate power purchase and sale contracts.

In short, private investment is not permitted in "reserved" Mexican energy activities and any cross (Mexican) border trade in them is confined to contracts approved by the Mexican authorities (Annex 602.3). However, contract approval is not required for non-reserved activities.

Dispute Mechanisms and Government Procurement

Dispute mechanisms are dealt with in detail elsewhere in this volume. [See the chapter by Gilbert Winham elsewhere in this book.] The summary below focuses on those aspects that might be of particular relevance to energy. If a dispute, for example, about national security provisions between two countries arose and was not resolved bilaterally, the Free Trade Commission established under NAFTA would enter the fray and at this stage the other country could become involved. And arbitration could be invoked. There are also new provisions to help prevent one party's domestic laws delaying decisions. In the energy context this may well have relevance to disputes associated with the role of sub-federal agencies.

Trans-border investment in energy between Canada and the United States is sizeable and hence the recasting of the investment chapter in NAFTA (Chapter 11) in more generic and explicit terms than in the FTA has significance. It now includes procedures for resolving certain types of conflicts along the lines similar to Canada's foreign investment protection measures. And Canada may still review foreign acquisitions, as provided in the FTA. But, in large measure, Mexico's reservations on energy and petrochemicals exclude it from Chapter 11 provisions. However, if Mexico did choose to admit investment then Chapter 11 provisions would apply, including arbitration. In short, the protection for investors is more comprehensive than under the FTA. And in particular, provisions for placing foreign investors in Mexico on the same footing as domestic investors do represent a significant departure from traditional Mexican doctrines. This may be a harbinger of more foreign investment in Mexico's energy sector.

Involvement by a state enterprise in regulation would elevate it to the level of the government, where it would acquire the associated NAFTA government obligations (Chapter 15). This could be especially relevant to the activities of PEMEX. NAFTA also reaffirms in large measure the facilitation of temporary entry for business and technical persons afforded under the FTA (Chapter 16). This could have significance for any enhanced trade in energy services (see later).

NAFTA is intended to liberalize government procurement to provide non-discriminatory opportunities for suppliers from each of the Parties (Chapter 10). The procedures for procurement are covered in NAFTA with greater precision and obligation than under the current GATT code or under the FTA. The crucial point is that while Canada and the U.S. are signatories to both the GATT code and the FTA, Mexico-absent NAFTA-is not. NAFTA enhances the obligations applying to Mexican procurement procedures. This represents a very considerable change and one that offers opportunities for the U.S. and Canadian energy industries if Mexico were able to embark on a widespread energy investment program.

In summary, the energy provisions of the FTA are preserved in NAFTA and modestly strengthened or clarified in areas such as dispute settlement, the application of NAFTA provisions to "lower tier" regulators, and encouraging contractual observance. However, while Mexico has basically accepted the energy pricing provisions of the FTA-prices cannot discriminate against exports-it has largely opted out of the quantitative FTA provisions governing energy trade. Under the FTA, trade is to take place without government interference; and where restrictions are imposed there is provision for maintaining the share of exports in total supply. Under NAFTA, these arrangements do not apply to Mexico, although they are maintained for trade between Canada and the United States. To a degree, then, NAFTA has enshrined Mexico as a "distinct society" in terms of energy trade and obligations.

Assessment of the Energy Component of NAFTA

In broad terms, then, the FTA measures governing energy trade between the U.S. and Canada would be reaffirmed under NAFTA. The significance of these provisions at least for Canada and the U.S. remains more long than short run, given the deregulation of energy trade between the U.S. and Canada that dates back to 1985. I shall argue below that the significance of the energy arrangements is in all likelihood mainly long term in the case of Mexico as well, at least for energy commodity trade.

Mexico has been able to absent itself from some important provisions. The desire for exclusion arises from the role of energy resources under the Mexican constitution. Not only are all in-situ energy resources owned by the state, but the government via PEMEX is the sole owner of the petroleum industry that exploits the in-situ resources. [Energy's role in Mexico's fiscal structure is important: it generates about one third of the total federal government revenues, while accounting for a similar proportion of federal public investment (see Baker and Associates [1991].] PEMEX was established by decree as the only supplier of oil and gas and the only entity allowed to trade in oil and gas. The Agreement acknowledges and sustains this position, although there is some slight nibbling away at the edges in the case of trade in natural gas. Too much should not be made of Mexico's ownership of resources. After all, provincial governments in Canada enjoy a similar position. It is more the exclusivity provisions for investment and trade that are liable to erode any gains that may flow from greater integration of the energy economies of the three countries. This is discussed further below.

It is easy to suggest that Mexico's opting out privilege is a major flaw in the deal. Yet it is only in the last five years or so that Mexico has made fundamental changes in its economic policies, of which NAFTA is itself evidence. None but an inebriated optimist would expect NAFTA to trigger abrupt changes in the whole way that Mexico's energy sector is organised. As it is, some loosening of the straightjacket has been achieved. The list of petrochemicals on Mexico's protected list has been reduced from 20 to five. Some natural gas and electricity trade may take place without direct intervention by the Mexican government. Investment and the supply of services may be welcome in previously inhospitable areas, although this may mainly concern drilling or field development contracts rather then production sharing agreements. [The latter would seem to be precluded by the Mexican Constitution.] And the mere existence of NAFTA should create a more stable business environment. It is over the long term that a successful trade agreement would encourage gradual relaxation of remaining constraints. And it is then that more benefits may emerge.

The individual energy commodities, the scope for the supply of energy services, and other aspects are discussed in more detail below.

Oil

The firm grip that the Mexican government would retain on the disposition of Mexican oil mutes market imperatives that could encourage a more efficient system of oil supplies in North America. And this does not just apply to Mexico. The U.S. in 1980 blocked the export of Alaskan oil, reserving it for the domestic market. [Amendments to the (U.S.) Export Administration Act, 1979. NAFTA does provide for export of a modest amount of Alaskan oil to Canada, although this stands in stark contrast to the generous access for the U.S. to Canadian supplies.] (As an aside, the U.S. has complained about its trade deficit with Japan, yet paradoxically it has prevented Japan from purchasing Alaskan oil-which Japan would readily absorb.)

Forcing Alaskan oil into the lower mainland U.S. market has introduced distortions. Any surplus Alaskan oil production after satisfying U.S. west coast demand is delivered to the U.S. Gulf Coast. For Alaskan oil to compete in this artificial incremental market, the additional freight costs must be absorbed upstream. And since there is no FOB price discrimination for Alaskan oil, the landed price of Alaskan oil on the U.S. west coast market is below the world price. In turn, this effectively makes Canadian heavy oil unattractive on the west coast, forcing it to seek other markets in the U.S., or in the Pacific Rim. [Current (September 1992) price relationships are as follows. The price of Alaskan crude in the Gulf of Mexico is set by world prices of about US$19/barrel (27°API). Tanker rates (U.S. bottoms) for the Gulf to Alaska are some $4/barrel. This yields an Alaskan netback of $15/barrel. The laid down cost of Alaskan crude at Los Angeles (via U.S. bottoms) is $18.65/barrel. The laid down cost of Canadian heavy (26.5°API) at Los Angeles is about $19.50/barrel. And the netback from 27°API crude delivered to Japan is $16.70/barrel (all in US $). Sources for oil prices and tanker rates: Energy, Mines and Resources Canada; Alaskan Government, Oil and Gas Division; National Energy Board, Reasons for Decision, TransMountain Pipe Lines, Tolls RH-3-91, June 1992; and Bloomberg, Oil Buyers Guide, September 28, 1992.]

If the U.S. could place more reliance on Mexican oil during an emergency-as might apply if Mexico were eventually to accede to a proportionality type clause-then the U.S. might feel able to lift the export ban on Alaskan crude, although it would seem that the ban was partly imposed to mollify the domestic shipping lobby, rather than for strict security reasons. [Note that Mexico has supplied substantial amounts of oil for the U.S.'s strategic petroleum reserves (SPR).] Then a more efficient distribution of North American oil would prevail, with possibly more Mexican and Canadian heavy crudes sold in the U.S., while Alaskan crude might move to the Far East. At the same time, relaxation by Mexico of its marketing monopoly would provide more market sensitive opportunities for utilization of Mexican oil in the U.S. and in Eastern Canadian refineries, although this would require installation of more upgrading capabilities in these plants, given a preponderance of heavy gravity Mexican crudes. But as the Agreement stands, none of these things would happen.

The U.S. market is the crucible in which Canadian and Mexican supplies of mainly heavy oil compete, especially in the Great Lakes area and to the south of it. In the absence of NAFTA and in the presence of a U.S.-Mexican agreement, over the long term Canada might find Mexican oil in a preferential position in the U.S. market, one where Canadian marketers would have diminished recourse in the event of trade disputes. This is an example of NAFTA helping to protect the position of Canada in the U.S. market in comparison with a situation where the U.S. and Mexico had an Agreement excluding Canada. Of course, this comment would apply to all of Canada's trade with the U.S.

Natural Gas

The picture for natural gas is similar to oil in that the scope for a more efficient distribution of gas could be curtailed by constraints on the development of Mexican resources. However, as mentioned before, the Agreement does insert a chink in the door of exclusivity. This is the provision that would allow end-users and suppliers to write bilateral contracts, although Mexican government approval would still be required.

But it is over the longer term that a burgeoning demand for natural gas in Mexico-perhaps stimulated by NAFTA itself and by greater emphasis on environmental quality-would encourage a further opening up of Mexican markets and supply capabilities. In more detail: with NAFTA Mexico may become more receptive to proposals made in the past to develop Mexican gas resources. These include extension of a gas pipeline in northern Mexico to Tijuana, and construction of a gas-fired de-salination plant in the Baja, California. The Gulf of Cortez is an area known to contain natural gas, yet development has been precluded by PEMEX budget restrictions. NAFTA would provide a framework for some erosion of the PEMEX tutelage and hence could allow more gas development projects to go forward. However, prospective declines in Mexican gas production available for commercial consumption may spur foreign participation in Mexican development in any case without any major legal restriction through NAFTA. [See Baker and Associates [1991].]

To the extent more U.S. gas moves to Mexico-and there are expectations that by the year 2000 one bcf per day would be delivered to the Mexican border states [Current volumes (summer 1992) amount to some 250 mmcfd.]-Canadian companies would enjoy more opportunity for gas exports to the U.S. And of course the development of new gas markets in Mexico would assist in absorbing remaining surplus gas deliverability in Canada and the U.S. and so enable the industry in both these countries to operate on a more balanced basis. Thus NAFTA may provide a framework for more efficient linking of gas markets and supply "nodes," and would reinforce long run efficiencies that the FTA tends to stimulate.

Slack drilling efforts over the past five years or so suggest imports of natural gas by Mexico will persist (and grow) for some time yet. Their longevity will depend critically on the ability of Mexico to raise capital for investment in natural gas development and transmission. Ultimately, Mexico will need increased domestic gas production to meet its targets. And over the long run favourable reserves to production ratios for Mexico vis-ŕ-vis the United States suggest current trends will be reversed, possibly early in the next century. At that time, pipeline projects currently contemplated to bring U.S. (and maybe Canadian) natural gas to Mexico could be reversed to ship Mexican gas to the U.S. (see Foss and Johnson [1991]).

Recent comments by Adrian Lajous of PEMEX support the picture sketched above. He sees liberalized trade encouraging importation of U.S. gas by Mexico, with sharply higher imports in the second half of the 1990s necessary to tide Mexico over a period of flat domestic production. At the same time there will be a need in Mexico to accelerate the development of natural gas infrastructures by foreign participation in service contracts, leading to greater integration. And emerging Mexican demand will siphon off some southwest U.S. gas production, providing more opportunities for eager Canadian marketers. [Comments as reported in the Financial Post, September 15, 1992, p.5.] Indeed this eagerness has already reached as far as Mexico, with the recent announcement of the first direct sales of Canadian gas to PMI, the gas purchasing arm of PEMEX. [The October 1992 deal between Western Gas Marketing Ltd. and PMI is only for 30 days (but is renewable). The routing of the Canadian gas to northern Mexico is convoluted but does demonstrate the ability of Canadian gas to flow to Mexico by exchange even under prevailing transmission systems.]

Electricity

Although a Mexican state monopoly exists, apparently free trade across the border effectively prevails. [Public Utilities Fortnightly, July 1, 1991, p.35.] Any such electricity flows are in one direction at present-from the U.S. to Mexico. The ability under NAFTA to negotiate contracts between independent producers and the Mexican electric monopoly would smooth the path of any cross border transactions. However, the impact of NAFTA is more in terms of the fillip it may provide for U.S. and Canadian electrical equipment supplies than on transborder flows of electricity itself. Such opportunities, among other things, are discussed below.

All these comments on the outlook for various energy resources assume a liberal evolution of the Agreement over time. What does NAFTA mean for energy flows among the three countries as it is currently written? Prospective flows between Canada and the U.S. remain much as they would be under the FTA: deregulation made the FTA in large measure superfluous over the short term, but over the long term it will stimulate energy trade while by no means erasing the U.S.-Canadian border. In the case of Mexico, NAFTA would secure access by Mexican oil to the U.S. market and by providing a better framework for medium term reliance on natural gas imports it could free up some oil supplies for export. But overall, the impact of NAFTA as currently drawn up on energy commodity flows between Mexico and the U.S. and on Canadian energy flows is de minimus-at least over the balance of this decade.

Trade in Energy Related Goods, Equipment and Services

While this paper has to do with energy per se and not with the goods and equipment used in its provision and use, nevertheless it is a natural extension to talk about prospects for these activities generated by the Agreement.

PEMEX is intending to embark on a significant program of investment to upgrade and refurbish its petroleum facilities. Investment figures of $15 to $20 billion have been bandied about, [See Alberta Report, March 11, 1991, p.32 and Petroleum Economist, January, 1992, p.6. Also see the NAFTA "Overview," p.viii.] suggesting scope for large scale foreign technical involvement. In all probability an investment program such as this would provoke some loosening in Mexican trade practices irrespective of NAFTA. But undoubtedly the reduction of tariffs under NAFTA and changes in the rules for Government procurement would provide greater opportunities for the export of Canadian and U.S. petroleum equipment and services to Mexico. This would also be assisted by provisions for freer movement of professionals under the Agreement.

Opportunities will also arise for trade in electrical equipment such as switch gears, motor controls and transformers, given the proposed modernization and expansion of Mexico's electrical infrastructure. Again NAFTA would provide greater scope for these opportunities to be seized-including a lowering of tariffs-than in its absence.

In a broader way, the changes in rules and procedures governing trade between Mexico, Canada and the United States under NAFTA, with somewhat less nationalistic and discriminatory energy policies, cannot but stimulate trade. The transaction cost of conducting trade and investment relations may be reduced.

The significant reduction by Mexico in the list of petrochemicals protected from foreign investment ostensibly provides investment opportunities for Canadian companies. However, the importance of this relaxation is more in terms of its ability to establish market driven trade in North American petrochemicals. Significant direct investment by Canadian companies is unlikely, according to trade sources. [See the Globe & Mail, August 14, 1992, p.B-3.]

Overall, prospective participation in a large scale revamping of the Mexican petroleum industry could provide a considerable boost to Canadian suppliers, a boost that would in part be attributable to NAFTA. In fact it is this feature of NAFTA that would have the greatest impact on the Canadian energy sector in the medium term, not trade in the energy commodities themselves.

However, it is important not to lose sight of the fact that while NAFTA should stimulate Canadian trade with Mexico, increasing requirements by Mexico for technical assistance, equipment and the like would arise even in NAFTA's absence. Canada has already advanced lines of credit to PEMEX for $500 million which will encourage it to buy Canadian goods and services. And a memorandum of understanding on a framework for trade and investment consultation was signed prior to emergence of NAFTA. [See External Affairs and International Trade Canada [1992, p.3]. In March 1990 Canada signed 10 joint co-operation agreements with Mexico, of which that dealing with trade and investment consultation was one.]

Moreover, relaxation of Mexico's foreign investment regulations preceded negotiation of NAFTA. New regulation in 1989 constituted an "expansive liberalization of Mexico's generally restrictive foreign investment laws. [Kimball [1990, p.413].] " And in August of 1989 the Government issued a Petrochemical Resolution declassifying some petrochemicals and making them more amenable to foreign investment. In January 1990 a "By-Product Decree" was issued, removing administrative obstacles for investors in certain refined products. All these developments are not contingent on NAFTA and demonstrate that Mexico's foreign investment laws have been evolving to allow limited foreign investment in secondary (including petrochemicals) and tertiary petroleum activities, although primary activities would remain under the exclusive domain of PEMEX. [Ibid, p. 414.]

A wider issue is the relationship between NAFTA and PEMEX's prospective large scale investment program. Without significant, sustained increases in world oil prices or lower tax levies, it is not clear how PEMEX and the Mexican government will be able to finance such an ambitious scheme. This points to what can be regarded as a major deficiency of NAFTA: continued discouragement of foreign equity investment in the Mexican energy sector removes a potential source of funds for PEMEX to pursue its modernization and development projects. A corollary is that those in the United States and Canada anticipating some kind of bonanza in the provision of services and equipment to Mexico will find their expectations dampened by PEMEX's financial constraints.

Dispute Mechanisms and Related Matters

The dispute mechanism in the FTA has been maintained in NAFTA and strengthened somewhat-although it is easy to exaggerate the degree to which this has happened. Nevertheless, a continuing shift of economic relationships from the political to the contractual sphere is beneficial. It is generally to the advantage of smaller countries when a larger one is more subject to the rule of law-something that NAFTA (and the FTA) have codified. [Also, see the Financial Post, August 17, 1992, p.S2.] More stringent obligations on energy regulation should reduce the capacity of U.S. federal and state regulators to interfere in Canadian sales of natural gas to the U.S. Clarification in NAFTA that energy regulations are subject to the discipline of the Agreement not just at the federal level but at lower regulatory tiers is welcome.

The encouragement to observe contracts upgrades the FTA, although whether the impact will be visible remains to be seen. The embellishment was obviously inspired by the on-going imbroglio between Canadian authorities and the California Public Utilities Commission (CPUC). In 1988 the CPUC had supported an extension of long term natural gas export licences for the export of Canadian gas by Alberta and Southern Company (A&S) to California. But subsequently the CPUC saw the contracts as precluding competitive access, allegedly resulting in prices substantially higher than those in the Canadian market. The CPUC then invoked various regulatory measures to upset contractual arrangements between A&S and the main U.S. importer, Pacific Gas Transmission (PGT). In June of this year (1992), Canada's National Energy Board (NEB) took action to counteract what it saw as "detrimental effects" on the Canadian public interest of regulatory decisions by the CPUC. These were seen as undermining existing long-term commercial arrangements under which Canadian producers supply gas to Northern California. The NEB took action to prevent displacement of the long-term gas supply under contract to A&S by short-term (possibly cheaper) supplies. [It rescinded existing orders and issued new short term orders; see National Energy Board [1992, p.42].]

Not surprisingly, the issue arose of whether such initiatives would offend the FTA by constituting a restriction of exports. The NEB said its actions were consistent with FTA obligations. [Ibid.] The merits of that argument need not detain us. What is of abiding interest is this Californian dispute as the possible origin of the new stricture in NAFTA about the intent to honour contracts. I had argued elsewhere [Watkins and Jones [1991, p.13].] that the FTA still left a lot of scope for governments to influence trade. The NEB's amendment to short-term California export licence conditions is a good example of this kind of activity.

In an earlier paper I suggested that until various challenges to interpretation of the FTA were dealt with either through dispute mechanisms or through the courts, the full implications or modus operandi of the FTA will not become clear. [Watkins [1991, p.82].] This comment applies equally to NAFTA.

Concluding Remarks

NAFTA is intended to be a trade agreement to create a more integrated North American market-in fact one economic zone, to use the language of the NAFTA "Overview." While NAFTA may achieve this in terms of energy flows between Canada and the United States, it does not in terms of energy flows between Mexico and the other two Parties. This lack of symmetry can be viewed as a flaw. But the Agreement might also be seen as providing a lever to prise open the Mexican energy sector over time in a way that would lead to greater and more efficient integration of North American energy flows-the essential rationale for free trade. Such a process likely would be a slow osmosis. Indeed, the "Description" of the Agreement refers to enhancing the role of energy through "sustained and gradual liberalization. [NAFTA, "Description," p.5.] " It would be unlikely for Mexico to abruptly cast aside decades of control and state involvement. It is salutary to recall that negotiation of the energy provisions of the FTA were greatly eased by commitments to de-regulation on both sides of the Canada-U.S. border made in advance of the agreement. No such prelude for Mexico preceded NAFTA.

More success can be claimed at this time for the much greater access that suppliers of energy equipment and services to Mexico enjoy under NAFTA. To be sure, some improved access would in all probability have emerged irrespective of the Agreement. However, there is no doubt that NAFTA would reinforce such trends.

The maintenance of restrictions on foreign investment in Mexico's primary energy activities may well thwart PEMEX's ambitious investment plans. The absence in NAFTA of measures to alleviate prospective capital shortages facing PEMEX is a deficiency of the Agreement, and will also slow down efficient integration of Mexican energy resources in North American markets.

The "Description" of the Agreement refers to NAFTA's energy provisions incorporating and building on GATT disciplines "regarding quantitative restrictions on imports and exports." This is clearly an overstatement, given Mexico's exclusion from many of the provisions governing U.S. and Canadian energy flows. [NAFTA, "Description," p.5.]

NAFTA is unique in representing an Agreement subjecting the economy of a developing country to the rigours of competition with two fully industrialised countries. On a broader stage it may be a harbinger for corresponding Agreements with other countries in Latin America. Some have already evinced an interest in joining NAFTA. [See the NAFTA "Overview," p. v. Note that the NAFTA agreement does not require re-negotiation of Canada's terms of access to U.S. Mexican markets each time a new member joins.] The conclusion of similar trade arrangements to NAFTA with other countries in Latin America could lead to a more cohesive North and South American presence in world oil markets. It is not frivolous to suggest that such developments might affect the strategic balance of world oil.

The title to this paper indicates a realm of unfinished business under NAFTA. This is so. But NAFTA as currently written-if consummated-would remain an important milestone. It would also confirm and modestly strengthen the energy provisions prevailing under the FTA between Canada and the U.S. This is not enough to generate euphoria, but a sense of quiet satisfaction would be justified.

References

Baker and Associates [1991],"Prospects for Increased Gas Trade with Mexico," Testimony for the California Energy Commission, 1991 Fuels Report Hearing, Berkeley, California, June 6.

External Affairs Canada [1987], "The Canada-United States Free Trade Agreement (FTA)," December.

External Affairs and International Trade Canada [1992], "The NAFTA Partnership," August.

Foss, M.M. and W.A. Johnson [1991], "The Economics of Natural Gas in Mexico," Proceedings, International Association for Energy Economics 13th Annual North American Conference, Chicago, Illinois, November 18-20.

Government of Canada [1992], "NAFTA: Overview and Description" (NAFTA "Overview"; NAFTA, "Description").

Kimball, Dale. A. Jr. [1990], "Recent Development: Secondary and Tertiary Petroleum Operations in Mexico: New Foreign Investment Opportunities," Texas International Law Journal, Volume 25.

National Energy Board [1991], 1990 Annual Report, March.

--- [1992], Reasons for Decision, Canadian Petroleum Association Application for Review of Decision re: Alberta and Southern Gas Co. Ltd. (GH-5-88), GH-R-1-91, June.

Watkins, G.C. [1991], "The United States-Canada Free Trade Agreement: Implications for Oil and Gas," Proceedings of the Thirteenth World Petroleum Congress, John Wiley & Sons, New York.

--- and S.M. Jones [1991], "Free Trade in Energy Among the U.S., Canada and Mexico: State-of-Play and Prospects," Centre for International Studies/Fraser Institute Conference, Toronto, November 18 & 19.

--- and L. Waverman [1985], "Canadian Gas Export Pricing Behaviour," Canadian Public Policy, XI: Supplement.

info@fraserinstitute.ca You can contact us at the above email address for any comments or information requests. Please report any dead links or technical problems.

If you know someone who would be interested in this web page, please enter their email address below, and we will forward this URL to them: Email Address:

Last Modified: Wednesday, October 20, 1999.