Energy Reform Hydrocarbon Sector

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Asher Rice
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Petróleos Mexicanos ( Pemex ). The enacting of this reform package is the second important step after the December 2013 constitutional reform regarding the energy sector.

1 Energy Reform Hydrocarbon Sector On August 12, 2014, the energy reform package of secondary laws became effective. It revolutionizes and permits private participation in the up-, mid- and downstream of the entire Mexican hydrocarbon sector which was managed for more than 70 years by a government-owned monopoly, Petróleos Mexicanos ( Pemex ). The enacting of this reform package is the second important step after the December 2013 constitutional reform regarding the energy sector. There are still many regulations, rules and model contracts to be issued for this reform to become reality. Following is a summary of what we consider the most relevant aspects of the enacted legislation as it refers to the oil & gas sector. - Upstream The most important change in the new legislation is the opening of exploration and production of hydrocarbons to private companies. The participation in exploration and production ( E&P ) is structured through two types of legal figures: (i) E&P assignments granted to Pemex and its subsidiaries and (ii) E&P Contracts awarded to private parties. - E&P Assignments and Round Zero In the past, Pemex obtained all its E&P rights through E&P assignments granted by the Ministry of Energy ( SENER ). The process used to be a rather rubber-stamp process. The new legislation changes that and provides that Pemex has to have the technical, operational and financial capacity to perform the proposed E&P. Furthermore, an assignment is granted by SENER only after the National Hydrocarbons Commission (Comisión Nacional de Hidrocarburos - CNH ) issues a favorable technical opinion. Assignments will be granted only for a limited period of time, refer only to a certain subsoil area and contain other conditions. Pemex must submit to the approval of the CNH an exploration or production plan. Pursuant to the constitutional reform of December 2013, Pemex has submitted to SENER in March 2014 the request for the assignment of all the E&P areas it wants to keep ( Round Zero ). On August 13, 2014, SENER announced that Pemex s request was approved, resulting in 83% of proved and probable reserves and 21% of prospective reserves being assigned to Pemex.

2 Pemex may enter into service contracts with private parties for services related to the E&P of an assignment, provided such services are paid in cash. Pemex may not enter into joint ventures or consortiums to perform E&P assignments. However, it may do so if the assignment is migrated to an E&P Contract; in such case, the private joint venture party will be selected through a tender process conducted by the CNH and not by Pemex, which only has the right to opine during the preselection process. On August 13, 2014, SENER has announced that certain E&P assignments will migrate into 10 E&P Contracts to be tendered in early E&P Contracts E&P Contracts are to be tendered by the CNH for a certain area for which there will always be a pre-qualification process. An E&P Contract may be awarded to a single company, a consortium or a partnership (asociación en participación), provided that the contractor or all members of the consortium or partnership are residents of Mexico for tax purposes and sign the relevant Contract. Pemex may form a consortium with private parties in order to participate in a tender for an E&P Contract. At the request of SENER, the tender documents may include the requirement that Pemex or another government owned entity must have a participation of up to 30% of the investment in the project. E&P Contracts under the new laws are: (i) service contracts, (ii) profit-sharing contracts, (iii) production sharing contracts and (iv) license contracts. SENER will determine for each E&P area which type of contract will be put out for tender. The model contracts and tender documents are to be issued by the CNH, must be governed by Mexican law, and may be subject to arbitration, provided that the early termination of a contract by CNH is subject to administrative laws and judicial procedures, which may not be arbitrated. Interestingly, E&P Contracts may only be awarded through a tender process and not by means of direct awards. CNH is not only in charge of conducting the tender process for the E&P Contracts but also of executing such contracts (on behalf of the Mexican Nation) and administering and supervising the performance by contractors; CNH will be joined in that task by the Mexican Petroleum Fund which will be in charge of all payments to be made by and to contractors; furthermore, the Ministry of Finance will be competent for supervising the financial aspects of the E&P Contracts. E&P Contracts will establish requirements as to national content which in average should reach 35% by 2025, provided that such target shall not apply to deep water E&P. 2

3 - Compensation under the E&P Contracts As a general principle, there will be no payment or advance payments to contractors under E&P Contracts unless and until hydrocarbons are actually produced in accordance with the Contract. Compensation under service contracts may only be paid in cash. In case of profit sharing and production sharing contracts, the consideration in favor of the government will consist of: (i) an exploration fee of MXN$1,150 per km2 during the first 60 months and MXN$2,750 thereafter, (ii) a royalty (see below) and (iii) a percentage of the operating profit to be determined through the tender process. The consideration in favor of the contractor will be: (a) the recovery of costs and capital expenditures recognized in accordance with the guidelines to be issued by the Ministry of Finance and the limitations established in the law and subject to a cap equal to the percentage set in the relevant bidding documents times the contractual value of the hydrocarbons produced (with the possibility to defer any excess to the subsequent period), and (b) the remainder of the operating profit after payment of the percentage owed to the government (see (iii) above), provided that in case of production sharing contracts the consideration in favor of the contractor will be paid in kind with a portion of the hydrocarbons produced. The production sharing contract may require the contractor to deliver the hydrocarbons produced to a trader appointed by the CNH which will sell such product and deliver the proceeds to the Mexican Petroleum Fund which will settle the compensation. In case of license contracts, the consideration in favor of the government will consist of: (i) an exploration fee (see above), (ii) a bonus payable upon execution of the contract, (iii) the royalty (see below) and (iv) a percentage of the value of the hydrocarbons produced. The consideration in favor of the contractor will be the title to the hydrocarbons produced, provided the contractor is complying with its payment obligations under the contract. The Royalties payable to the government shall be calculated as follows: (i) For crude oil: (a ) 7.5% if the price per barrel is below US$48, and (b) if the price per barrel equals or exceeds US$48, the result of multiplying a percentage equal to times the price per barrel plus 1.5. [Royalty = (0.125 x price per barrel) + 1.5]. As an example, in case of US$100 per barrel, the royalty would be 14%. (ii) For natural gas produced with crude (associated gas): the price per MMBTU of natural gas divided by 100. [Royalty = Price per MMBTU / 100]. (iii)for natural gas not produced with crude (non-associated gas): (a) 0 if the price of natural gas is equal to or less than US$5 per MMBTU, (b) the price per MMBTU of such natural gas minus 5 times 60.5 and such result divided by the price per MMBTU of such natural gas, if the price of gas exceeds US$5 but is less than US$5.5 per MMBTU, [(Royalty = (Price per MMBTU 5) x 60.5 and 3

4 such result divided by the price per MMBTU] and (c) if the result of dividing the price of such natural gas by 100, if the price per MMBTU of natural gas is equal or exceeds US$5.5,. [Royalty = Price per MMBTU / 100]. (iv) For natural gas liquids (pentane and other components): the calculation is the same as for crude oil, provided, however, that the rate is (a) 5% if the price per barrel is below US$60 and (b) times the price per barrel minus 2.5 if the price per barrel is equal or exceeds US$60 [Royalty = (0.125 x price per barrel) 2.5]. - Round 1 On August 13, the government announced that Round 1 will start in the next months with tenders of E&P Contracts covering a portfolio of conventional and non-conventional reserves totaling 169 areas, of which 109 are exploration projects and 60 production projects. SENER will determine the type of E&P Contract to be used for each such project, provided that the Ministry of Finance has to determine the terms of the contractual consideration to be included in the tender documents. - Booking of Reserves Contractors may report for financial and accounting purposes the E&P Contract and the expected benefits thereunder, provided that it is made clear that the hydrocarbons located in the subsoil are owned by the Mexican nation. That should allow to book reserves on an expected cash flow stream basis. The Mexican Petroleum Fund The reform creates the "Fondo Mexicano del Petroleo para la Estabilización y el Desarrollo" (the Mexican Petroleum Fund for the Stabilization and development - the Fund ) as a trust administered by the Mexican Central Bank (Banco de México). The Fund will receive and administer all payments to be made by (i) Pemex under E+P assignments and (ii) contractors under E+P Contracts, excluding in each case taxes. The Fund is governed by a technical committee formed by three governmental officials (the ministers of finance and energy and the Governor of the Central bank) and four independent members appointed by the President and ratified by the Senate. The Fund will not only receive payments from Pemex and Contractors but also pay them the amounts owed under E+P assignments and contracts. After making such payments, the Fund will make distributions to several public funds, including for research and development in the area of hydrocarbons, and the Federal Treasury. Once such distributions reach 4.7% of the GDP, the remainder will be kept as reserve in the Fund as long term savings. If such reserve exceeds 3% of the GDP, extraordinary transfers to the Federal Treasury may be made. - Midstream and Downstream Refining of crude and processing of natural gas as well as the import and export of hydrocarbons and gasoline are now open to the private sector subject to a permit to be issued by SENER. 4

5 Transportation, storage, distribution, compression, liquefaction, regasification, trading and sale to the public of all types of hydrocarbons, gasoline and petrochemicals are activities open to the private sector, subject to permits to be issued by the Comisión Reguladora de Energía ( CRE ). Certain of those activities were already open to private investors, such as transportation, storage and distribution of natural gas and liquefied petroleum gas. There are no restrictions on foreign investment in these activities. Prices for gasoline and diesel will be set by the government (as before) through December 31, 2017; thereafter, such prices will be market prices. Pemex s monopoly to import gasoline and diesel will end not later than December 31, 2016 and permits for the sale of such products to the consumer public will be available beginning 2017 and the current franchise agreements between Pemex and the gas stations will terminate by the end of The deregulation of the LP gas market has similar transitory rules except for a shorter timeframe. Integrated Transportation Systems CENAGAS SENER shall promote the development of integrated pipeline transportation and storage systems for natural gas, gasoline and petrochemicals, such as the integrated system already in existence for natural gas. Each such system shall be operated by an operator which may be a public, private or public-private entity. The creation of an integrated system, the incorporation of new infrastructure and the operator of the system need to be approved by the CRE. The CRE is also competent to regulate tariffs for the services rendered on such systems. The new legislation specifically regulates the independent operator of the integrated natural gas transportation and storage system, called Centro Nacional de Control de Gas Natural ( CENAGAS ). The President has announced that the presidential decree incorporating the CENAGAS as a public decentralized agency will be issued within a month. One third of the board members of the CENAGAS will be independent members. The CENAGAS has to submit to SENER a five-year expansion program and will be the entity to conduct the tender process for strategic projects to be built by private investors. Projects which are not considered to be strategic may be developed by private or public entities, provided that the public entities have to do it through tenders of transportation capacity for projects which have to be built by private parties. The natural gas pipelines currently owned by Pemex, as well as transportation service agreements Pemex has entered into with users and those entered into with permit holders in which Pemex is or will become user or shipper will be transferred to the CENAGAS. Equally, the Comisión Federal de Electricidad ( CFE ) will have to transfer to the CENAGAS transportation services agreements it has entered into with private permit holders. The aforementioned transfer of contracts by Pemex and 5

6 CFE, however, will not be a transfer of title to those contracts but only of administrative functions to CENAGAS, to enable CENAGAS to operate the whole capacity available in the pipelines currently owned and/or contracted by Pemex and CFE. Both entities will maintain the capacity reserved for their own use; any excess capacity is to be offered on a non-discriminatory basis. Transparency and Anticorruption The new laws include extensive transparency and anticorruption provisions. The government will publish, on a monthly basis, information about the assignments and permits in effect and the areas to be tendered, as well as detailed information for each E&P Contract, such as volumes produced, amounts paid to the contractor for each concept, revenues received by the government, etc. Land Rights and Social Aspects The new law includes an extensive chapter regulating the contracting of land rights for E&P and pipeline projects. Such chapter caused many controversies during the legislative process. It mandates certain formal steps to be taken during the negotiation of land rights, such as giving notice of commencement of the negotiation to the federal authorities and the obligation to inform the landowner about the project and to deliver an appraisal. The consideration to be paid to the landowner has to be between 0.5% and 3% of contractors revenues (net of payments made to the Mexican Petroleum Fund) in case of natural gas produced without crude oil, and between 0.5% and 2% in other cases. If the parties cannot agree on the land contract, the party interested in contracting the land use may initiate a mediation process before the federal authorities or request the competent judge to order the constitution of a legal easement. The effectiveness of those new devices in practice is still to be tested, as the federal and judicial bureaucracies are typically slow in acting. Furthermore, a very burdensome new requirement is introduced, since all land agreements have to be validated by a judge who has to order the publication of an extract of the agreement in a local newspaper and at the community billboard. That will make the development of E&P and pipeline projects and their financing more time consuming and challenging, considering the increase in the workload of the judges. Furthermore, any person applying for a permit or any E&P contractor has to present to the SENER a social impact study which has to comply with the regulations which are to be issued; the approval by SENER is a condition precedent for the approval of the environmental impact study. New Safety and Environmental Agency The National Agency for Industrial Safety and the Protection of the Environment of the Hydrocarbon Sector (Agencia Nacional de Seguridad Industrial y de Protección al Medio Ambiente ANSIPA ) has been created as a decentralized agency of the Environment Ministry ( SEMARNAT ). The ANSIPA has very broad powers to issue rules and regulations for all activities of the hydrocarbon sector and to supervise and enforce compliance. The ANSIPA is now the competent authority to approve environmental impact statements and to issue all environmental permits and 6

7 licenses for hydrocarbon projects. The ANSIPA is managed by an executive director appointed by the President and therefore does not report to the minister of the SEMARNAT. Certain decisions will have to be approved by a technical board of the ANSIPA on which representatives of several ministries are represented and the chairman is the head of the SEMARNAT. SEMARNAT and the other involved governmental agencies will have to transfer to the ANSIPA the human, financial and material resources related to the matters for which the ANSIPA is competent. Petróleos Mexicanos The new law includes extensive provisions about a new corporate governance regime for Pemex with a board of directors composed of 10 members, five of which are independent board members to be appointed by the President and ratified by the Senate. The other members are government officials. The union has no representative on the board. Pemex is converted into a productive state enterprise and its corporate structure will be reorganized in a manner to be determined by its board. Until then, the current subsidiary entities continue to exist. Under the new structure, the E&P activities in which Pemex is not entering into a joint venture will be performed by one or more productive subsidiaries. All other functions may be carried out by affiliate companies of Pemex which are incorporated and governed by private law and not subject to administrative laws. Pemex and its subsidiaries will no longer be subject to the public sector procurement and works laws, but rather will have their own rules as approved by the board of directors. There will be a new budget and public debt regime applicable to Pemex and its entities with the purpose to allow greater autonomy in the management of their affairs. For any further information please contact: Thomas Mueller tmueller@ritch.com.mx Federico Santacruz fsantacruz@ritch.com.mx Gabriel del Valle gdelvalle@ritch.com.mx Jorge Oria joria@ritch.com.mx Asaf Jiménez ajimenez@ritch.com.mx 7

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