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May 19, 2014 Articles

Mexican Oil and Gas Reform: Getting It Right This Time

Mexico opens up its state-run oil industry to private and foreign companies.

By John Cogan and Carlos Moran

While several Latin American countries have decided to increase state participation in their oil and gas industries, Mexico has decided to go in the opposite direction.

More than seven and a half decades after the nationalization of its oil industry, Mexico has finally decided to put an end to Pemex’s monopoly and open up its upstream, midstream, and downstream sectors. The scope of the constitutional reform enacted in December 2013 reached farther than expected. Most significantly, private and foreign companies will soon be allowed to engage in exploration and production (E&P) activities.

The Mexican energy reform has attracted the attention of the industry worldwide. Oil majors are interested in Mexico’s vast offshore reserves, while independent shale-focused companies are interested in the Burgos Basin, which is believed to be the continuation across the U.S.-Mexico border of the Eagle Ford shale play.

Besides having a stable economy in a strategic location, Mexico also continues to be blessed with abundant resources. Despite the fact that Mexican production has declined for the past 10 years, Mexico is still a world-class crude-oil producer and exporter. It has prospective reserves in the range of 45 billion barrels of crude-oil equivalent.

Mexico is equally interested in attracting international companies to reverse its declining production. Mexico’s oil-production rate is currently 2.5 million barrels per day, all of which are produced by Pemex, the state-owned enterprise that currently has a monopoly over the industry. The Mexican government expects new players to increase production by 500,000 barrels per day within the next four years.

The Mexican Ministry of Energy is hopeful that sustained shale-gas production will commence within the next two or three years. U.S. firms are keen to participate in such activities while at the same time they are concerned about security, lack of infrastructure, and land-ownership rights on the Mexican side of the border.

Increasing oil production would not only mean increasing revenues for the Mexican federal government (around a third of which currently come from oil production). It would also mean the creation of much-needed jobs, the reduction of natural-gas costs that adversely affect the competitiveness of Mexico’s important manufacturing industries, and the reduction of massive subsidies on gasoline. In selling its benefits to the Mexican public, the Mexican government has noted that the reform will increase investment in the country to US$50 billion per year.

The Reform at the Constitutional Level
The Mexican constitution was amended in December 2013 to remove the prohibition that prevented the Mexican state from entering into contracts with private E&P companies.

Previously, that prohibition was interpreted as forbidding licenses, production-sharing contracts, and the like. The only contracts that were permitted were service contracts, as long as the service providers always received their consideration in cash (as opposed to production). Furthermore, service providers were not allowed to benefit financially from any risks they assumed beyond agreed-upon dollar amounts that could not be related to market-type risks.

The Mexican constitution now expressly allows the following granting instruments:

  • entitlements (asignaciones) that would continue to be granted only to state-owned enterprises
  • the following contracts to be entered into with state-owned or private companies:
  • profit-sharing contracts
  • production-sharing contracts
  • license contracts

The decree amending the constitution even clarifies how consideration shall be paid under each contract. Under profit-sharing contracts, consideration shall be payable partially from the profits of the project. Under production-sharing contracts, consideration shall be partially in kind. And under license contracts, operators shall pay royalties to the state upon extraction of the hydrocarbons from the subsoil.

Different contracts will be used depending on the type of field, depending on the amount of information available and the expected profitability of the field. For instance, Pemex may still use service contracts in its best known and most productive fields.

The entitlements that will continue to be granted to state-owned enterprises might not only be granted to Pemex; new ones could be formed.

Pemex will continue to be wholly owned by the state, but it will face competition for the first time. To be ready to do so, it will be given budget autonomy, increased managerial freedom, and the ability to enter into contracts like a private company.

Either the state (i.e., the Ministry of Energy, through the National Hydrocarbons Commission) or the state-owned companies (e.g., Pemex) will be able to enter into such contracts with private entities.

Pemex will also be allowed to migrate integrated services contracts to the new contractual regime.

Another important feature of the constitutional amendment is that it expressly allows operators to book reserves, provided that they state in their report that the Mexican state is the sole owner of the resources while they are under the ground.

The Expected Reform at the Legislative Level
To implement the reform, legislation in many areas will need to be introduced or updated. To name a few:

  • how operators will be taxed
  • how the new contracts, permits, and authorizations will be awarded or granted
  • if it will be required that Pemex has a stake in all contracts
  • what the minimum national content and technology-transfer requirements will be
  • how Pemex will be turned into a productive state-owned enterprise
  • how Pemex will enter into partnerships with private companies
  • how transparency and probity in the awarding and management of such contracts will be ensured
  • how to reduce the exposure of the industry in Mexico to corruption (in both the public and private sectors)
  • how the environment will be protected
  • what the civil-liability regime will be for oil pollution
  • how mining concessionaries will coexist with E&P operators
  • who the owner of seismic information will be and how such information will be shared
  • if foreign investment restrictions in important areas that are related to E&P activities will be removed (e.g., marine services)

Due to space constraints, we cannot provide our view on each of those topics, but the following are our views on a few of them.

Provisions clarifying the constitutional decree opening the industry. The new legislation will need to clarify a few issues derived from the wording of the constitutional decree, especially because Mexico is a country where the literal interpretation of laws is preferred.

For example, the decree provides that during the transition period when Pemex will be transformed into a productive state company, Pemex may be granted entitlements and enter into new E&P contracts. The new legislation should clarify that Pemex will be able to do the same after the transition is completed.

The new legislation should also clarify when Pemex will be granted entitlements and when it will enter into new E&P contracts either alone or as party to a consortium. In some cases, Pemex might want to choose its partners to bid for those contracts (either by a direct selection or by some sort of bidding process). In other cases, the Ministry of Energy might want the winner of a bidding round conducted by the National Hydrocarbons Commission to partner with Pemex to develop a certain area.

Also, the legislation should clarify whether Pemex will only be able to enter into E&P contracts in its capacity as an operator/contractor or whether it will be able to do so on behalf of the state. In our opinion, Pemex should only enter into those contracts as an operator or contractor (either alone or as party to a consortium).

The new legislation should also clarify what kind of contracts Pemex will be able to award to other companies and which ones will need to be awarded by the National Hydrocarbons Commission. The constitutional decree states that the National Hydrocarbons Commission will award E&P contracts and even conduct the bidding rounds related to the migration of Pemex’s integrated service contracts into the new contracting models referred to in the decree. That may be construed as Pemex not being permitted to award service contracts anymore. Thus, it is necessary for the new legislation to clarify what service contracts Pemex will continue to be able to award by itself and which ones should be awarded by the National Hydrocarbons Commission.

With regard to the transfer or migration of entitlements to the new contractual models, it would be important to have more light shone on whether the integrated service contracts under previous legislation, or other types of service contracts under which the relevant areas are being developed, will continue in force or whether they will be terminated early. In the latter case, service providers will be interested in knowing what kind of compensation or reimbursement they will be entitled to.

Provisions related to competition, transparency, and corruption. Since the 1980s, Mexico has experienced a long privatization process, which has permitted the country to learn what it should and should not do for the opening of a sector to private participation. On this occasion, the new legislation should address competition, transparency, and probity concerns from the beginning for the energy reform to avoid the most recurring criticisms that other openings suffered.

National content and technology-transfer requirements. With regard to the minimum national content requirements, the new legislation is expected to be flexible so as not to hinder operations. One of the most important purposes of the energy reform is to avail Mexico of the technology and experience that it does not currently have. Imposing national content requirements that are impossible to meet would directly affect the potential success of the reform.

The new tax regime for E&P activities. The new tax regime is also expected to be flexible, with the government’s take being decided on a case-by-case basis depending on the estimated productivity of the field, the type of resources, commodity prices, and the type of contract. It is likely that a progressive tax system will be contractually imposed.

The government’s take will probably be composed of a standard 30 percent income tax, royalties, and a special tax on operating profits. Some taxes would be directed to the Ministry of Finance, while others would go to the new Mexican Petroleum Fund for Stabilization and Development, which will in turn be administered by the Mexican central bank.

The New Regulatory Framework

The Ministry of Finance (SHCP). The Ministry of Finance will have a very important role in the new framework as it will decide the fiscal and economic terms to be included in bidding procedures and contracts.

The Ministry of Energy (SENER). The Ministry of Energy will lead, establish, and coordinate the national energy policy.

It will also be in charge of selecting the areas to be awarded to private contractors for E&P activities, the technical design of bidding procedures and contract models for those activities, granting entitlements to Pemex or any new state-owned enterprise, and authorizing the migration of Pemex entitlements to the new contractual models.

In addition, the Ministry of Energy will also grant permits for oil refining and gas processing.

The National Hydrocarbon Commission (CNH). The CNH will be the regulator of upstream activities. Most importantly, it will conduct all of the bidding rounds for profit sharing, production sharing, and license and service contracts, even those to be migrated by Pemex from integrated service contracts to the new contractual models.

The CNH will manage and supervise all entitlements and contracts. It will also collect and administer all geological, seismic, and operative data.

The Energy Regulatory Commission (CRE). The CRE will grant permits for storage and transportation of oil, gas, and petrochemicals, and regulate third-party access to them.

It will also regulate the firsthand sales of oil, gas, and petrochemicals.

National Center for Natural Gas Control (CENAGAS). The CENAGAS will supervise the operation of natural-gas storage and pipeline networks.

Time Frame for the Implementation of the Reform
The decree containing the constitutional amendments required the Mexican Congress to pass the relevant legislation by April 19, 2014; however, this deadline was not met. The minister of energy recently declared to the press that the relevant bill would be submitted to the Congress during the week of April 28. It should be noted that Congress adjourned on April 30; so it is most likely that such a bill will have to be discussed during special sessions.

The constitutional decree also required Pemex to select, no later than March 21, 2014, the entitlements it wanted to maintain. Pemex met this deadline but did not reveal to the public what fields it intends to keep.

According to the press, Pemex intends to retain control of more than 83 percent of Mexico’s probable oil reserves and 31 percent of its prospective reserves, leaving private and foreign oil companies with around 4.2 billion barrels of proven and probable reserves to exploit. Pemex most likely tried to hold on to its shallow water fields (the area where it is more experienced and successful) and a few deep-water discoveries, while relinquishing most of its on-shore fields (some in the important but complex Chicontepec play) and unconventional hydrocarbon areas.

Pemex was required by the constitutional decree to provide a detailed development plan and show evidence of technical, financial, and operational capabilities to operate its entitlements in a competitive and efficient manner.

Pemex will have the right to continue exploration works for three years (extendable by another two years) in those areas where Pemex made discoveries prior to the constitutional amendment. If such exploration works are successful, Pemex will be allowed to initiate production works. Otherwise, those areas will be relinquished and will become available to new players.

By September 17, 2014, the Ministry of Energy will decide which entitlements will be kept by Pemex. This allocation procedure is known as the Round Zero. The Ministry of Energy has the difficult task of striking the right balance to enable Pemex to become a strong company while attracting new participants to boost the country’s production output.

As noted above, Pemex will be allowed to enter into partnerships with private companies to develop the entitlements it retains, and even to migrate its current integrated service contracts to the new contractual regime. Therefore, there should be plenty of opportunities for private companies to participate in E&P activities in the areas kept by Pemex. For example, Pemex’s CEO has expressed that the company will seek foreign partners with deep-water experience and technology to develop its entitlements in the Perdido Fold Belt, a deep-water play located across U.S.-Mexico waters in the Gulf of Mexico and which Pemex believes to represent 30 billion barrels of oil reserves.

After the legislation implementing the reform has been passed, the executive branch will need to bring the relevant regulations in line with the new legislation. Pemex, the Ministry of Energy, and the National Hydrocarbon Commission, among others, will also need to issue new guidelines, internal rules, and contract models that will concern the companies interested in participating.

It is expected that the first bidding round for E&P contracts (Round One) will be launched in the first half of 2015 and that five annual bidding rounds will be conducted between 2015 and 2019, with each round covering 20,000 square kilometers.

Keywords: energy litigation, Burgos Basin, Eagle Ford, Ministry of Energy, Pemex, E&P, exploration and production

John Cogan and Carlos Moran are partners at Cogan & Partners LLP in Houston, Texas.

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