The New Upstream Sector in Mexico: First Steps by Héctor Arangua and Lorenza Molina I. Overview A. Now & Then We are being spectators of a historic transformation as one of the greatest changes in the country s economic landscape is now a reality. Now, it is time to embrace the changes that can transform the oil & gas industry and open a better future for the country. For almost 76 years, Mexico held a restrictive energy policy that kept private companies out of the oil and gas production. The energy sector was under a state monopoly by Petróleos Mexicanos ( PEMEX ) that for many was a symbol of national pride. However, the lack of foreign investment and participation led the country to production stagnation and decrease, which would have inevitably turn Mexico into a net importer of oil. On December 20, 2013 Mexican Congress passed the Constitutional Energy Bill, the changes include amendments to three key articles of the Mexican Constitution, which contained the main private investment restrictions for the oil & gas industry. The constitutional reforms set the framework for the participation of the private sector in activities throughout all the oil & gas value chain (upstream, midstream and downstream). We will further analyze the regime for upstream 1 activities below in this article. In reference to midstream and downstream 2 hydrocarbon activities, they now may be carried out under permits issued by the Ministry of Energy (Secretaría de Energía or SENER ), or the Energy Regulatory Commission (Comisión Reguladora de Energía). The reform aims at increasing a long-term economic growth and raising oil production. This reform represents the end of the restrictive laws and the state monopoly on oil and gas production. It is important to emphasize that hydrocarbons in the Mexican subsoil still belong to the Mexican State; nonetheless, there are new opportunities for the private sector through all the value chain, the government can now partner with private companies through different types of contracts, and PEMEX s monopoly over exploration, production and refinery of oil and gas has been ended. In August 2014, the secondary laws were enacted to implement the constitutional energy reform; amongst those secondary laws we can find the Hydrocarbons Law and the Hydrocarbon Revenues Law. These two laws establish a 1 Surface and geophysical surveying, exploration, and production of hydrocarbons. 2 Treatment, refining, transportation, storage, sale of oil and oil products; Processing, compression, liquefaction, decompression and regasification, transportation, storage and sale of natural gas; pipeline transportation and storage of petrochemicals. 1
new legal structure for all hydrocarbon activities; they also transform the role of authorities and create new regulatory bodies. The energy sector will be coordinated and regulated by SENER and the National Hydrocarbons Commission (Comisión Nacional de Hidrocarburos or CNH ). Other relevant authorities are the Ministry of Finance and Public Credit (Secretaría de Hacienda y Crédito Público or SHCP ) and the Ministry of the Environment and Natural Resources (Secretaría del Medio Ambiente y Recursos Naturales or SEMARNAT ), in charge of determining the energy-related tax policies and environmental guidelines, respectively. The bill also creates the Mexican Oil Fund for Stabilization and Development (Fondo Mexicano del Petróleo para la Estabilización y el Desarrollo) (the Mexican Oil Fund ), a public trust which trustee is Mexico s central bank (Banco de México), in charge of receiving, managing, investing and distributing the oil revenue derived from the entitlements and exploration and production contracts. B. The new regimes The Hydrocarbons Law provides two new regimes: (i) Entitlements (Asignaciones) granted solely to State Productive Enterprises (wholly owned state entities); and (ii) Exploration and Production Contracts ( E&P Contracts ) entered into with private parties or State Productive Enterprises. (i) Entitlements (Asignaciones) The entitlement legal regime was used before the reform by the Mexican government to grant areas for exploration and production. The concept is now being used again and, through this regime, State Productive Enterprises (i.e. PEMEX) will participate in upstream activities. Nevertheless, the terms have evolved and the new entitlements to these enterprises will be subject to work programs, relinquishment and termination. An entitlement is an administrative act by which the executive branch through SENER, and with the favorable opinion of the CNH, grants PEMEX or another State Productive Enterprise the right to explore and produce hydrocarbons in the area of entitlement, for a specific term. The entitled areas will no longer be open to any tender process, preventing private companies to explore or produce within that determined area except via joint ventures. The process of granting the entitlements to PEMEX is also called Round 0. PEMEX or the other State Productive Enterprises have different possibilities vis-à-vis the granted entitlements. PEMEX can assign or transfer the entitlements to other State Productive Enterprises, with prior consent from SENER; it can also decide not to continue a work program, and relinquish the entitlement and in this particular case the area will be returned to the Mexican State. In addition, when PEMEX is not complying with the work program or other obligations as provided by the law or the 2
entitlement, such entitlement may be revoked and the respective area returned to the State as well. Under the Hydrocarbons Law there is also a new legal structure referred to as the migration of entitlements into E&P Contracts. Under this mechanism, PEMEX may request the approval of SENER to migrate a particular entitlement into an E&P Contract, and the SHCP will set forth the fiscal and economic terms related to such migrated entitlement. Once an entitlement has migrated into an E&P Contract, PEMEX, with the authorization of SENER, may enter into joint ventures with private parties that have the technical and financial capacity to help PEMEX develop a specific project. It is important to mention that when PEMEX decides to partner with a private party via the migration process, a tender process is required to select PEMEX s partner. The tender process will then be carried out by the CNH, with the favorable opinion of PEMEX regarding technical, financial and operational elements. (ii) E&P Contracts E&P Contracts (Contratos de Exploración y Extracción) shall be executed by the CNH, and the contractors must undergo a public bidding selection process. SENER will determine the areas subject to the bidding processes and will also define the type of contract applicable to each area of exploration and production. The CNH will carry out the bidding processes and award the contracts accordingly. The E&P contracts can be entered into with: (a) private companies (these companies must be Mexican corporations and have their legal residence in Mexico, although foreign investment is allowed and not capped); (b) with PEMEX and other State Productive Enterprises. PEMEX may directly participate in tender processes for E&P Contracts, or enter into joint ventures with private companies to bid on E&P Contracts (this process being different from the migration of entitlements ). In addition, the Mexican State could reserve itself the right to participate (through PEMEX and with a fixed percentage) in E&P Contracts. As provided in the Hydrocarbons Law, the Mexican State will participate through PEMEX in the following scenarios: (1) when the contracted area coexists, at a different depth, with an entitled area; (2) when there are technology transfer opportunities for the benefit of PEMEX or another State Productive Enterprise; or (3) when projects are to be supported by a specialized financial vehicle from the Mexican State (i.e. The Mexican Oil Fund). However, PEMEX participation (of at least 20%) will always be required when there is a possibility to find trans-boundary oil deposits. The State objective in negotiating E&P Contracts is to maximize the nation s oil revenues, via the increase of the volume of extraction, collecting royalties, taxes, and duties, among others; as well as ensuring national supply. Consequently and pursuant to the Hydrocarbon Revenues Law, the terms to evaluate and award E&P Contracts shall be technical in nature. 3
Extraction and Production activities will be subject to new E&P Contracts: (a) licenses; (b) production-sharing contracts; (c) profit-sharing contracts; and (d) services contracts. The Hydrocarbons Revenue Law provides different fiscal terms to be applied to each type of E&P Contract and all payments shall be made to the Mexican State through the Mexican Oil Fund. (a) Licenses License contracts are similar to concessions, the nation will grant a right to explore and produce hydrocarbons, within a defined area and for a specified period of time, to a private company or a State Productive Enterprise, in consideration for specific payments in favor of the nation. Licenses shall include the following payments in favor of the nation: (i) a signing bonus (contained in the bid terms for each tender process); (ii) exploratory phase fees (a fixed amount per square kilometer with respect to non-producing areas); (iii) royalties (that will vary depending on the type and the contract value 3 of the produced hydrocarbon); and (iv) a consideration (consisting of a percentage of the contract value of Hydrocarbons). The contractor will receive the property of the produced hydrocarbons consideration for the foregoing payments. (b) Profit-Sharing Contracts Under Profit-Sharing Contracts the contractor will bear the financial risk of the exploration and production of hydrocarbons, in consideration for a share of the proceeds of the sale of the produced hydrocarbons. This type of contract shall include the following payments in favor of the Mexican State: (i) exploratory phase fees; (ii) royalties; and (iii) a consideration (payment that consists of a percentage of operating profits paid in kind). The contractor has the right to receive as consideration the cost recovery and the balance of the operating profits, 4 after paying the nation s share of the operating profits. The contractor will provide the entire production to a trading company retained by the CNH, which will then pay the sale proceeds to the Mexican Oil Fund. The Mexican Oil Fund will retain the nation s share and pay the contractor its consideration on a monthly basis as established in the contract. (c) Production-Sharing Contracts Under Production-Sharing Contracts the contractor will bear the financial risk of the exploration and production of hydrocarbons, in consideration for a share of the produced hydrocarbons. Production-Sharing Contracts shall establish the following payments in favor of the nation: (i) exploratory phase fees; (ii) royalties (paid in kind); and (iii) a 3 The contract value is calculated by multiplying the volume of production by its contract price (market price). 4 The operating profits shall generally be calculated by subtracting the royalties and the costs incurred by the contractor to the contract value of the produced hydrocarbons. 4
consideration (payment that consists of a percentage of operating profits paid in kind). The contractors will receive as consideration the recoverable costs and the balance of the operating profits, after paying the nation s share of the operating profits (the payment shall be in kind as well). The nation will determine the considerations (nation s share of profits) to be provided in kind by the contractor to a trading company retained by the CNH, which will then pay the sale proceeds on a monthly basis to the Mexican Oil Fund, as established in the contract. (d) Service Contracts Under Services Contracts the contractor will provide specific services, in connection with the exploration and production of hydrocarbons, to a State Productive Enterprise. All payments shall be made to the contractor in cash by the Mexican Oil Fund with the proceeds from the sale of the production derived from each service contract. (iii) Public Bidding Process As mentioned E&P Contracts shall, as a general rule, 5 always be subject to a public bidding process, as established in the Hydrocarbons Law. The bidding shall be done by the CNH in accordance with the following: (A) publication of notice (bidding rules); (B) pre-qualification of potential bidders (technical and financial elements, operation and experience); (C) bidding process; (D) award; and (E) execution of the contract. (iv) National Content There is a minimum local content requirement for upstream activities, ranging from 25% (by 2015) and gradually increasing to 35% (by 2025). Deep and ultra-deep water activities may have lower requirements. Some of the factors considered for local content are (A) the goods and services to be contracted, considering their place of origin; (B) the qualified local work; (C) the training of local work; (D) the investment in local and regional infrastructure; and (E) the transfer of technology. II. The New PEMEX Round 0 A. PEMEX, a State Productive Enterprise Before the reform, PEMEX was an agency of the federal administration with direct budget control. Now it has become a State Productive Enterprise ( Empresa Productiva del Estado ), which implies that PEMEX will have business and corporate goals, and corporate governance rules similar to those of a public company, even if it is a wholly owned state entity. As a State Productive Enterprise, PEMEX will have a flexible budget and a broader autonomy. 5 Exceptions: migrated contracts and coal mining fields in connection with associated gas production. 5
B. Round 0 The transitional articles of the constitutional reform set forth the so-called Round 0. It was a process in which PEMEX had the right to request exclusive exploration and production rights over areas it had been actively exploring, or that were currently under production. These rights to explore and produce are subject to the entitlement regime. After Round 0, PEMEX will be able to compete with other State Productive Enterprises and private parties to obtain additional exploration and production areas. On March 21, 2014, PEMEX submitted its Round 0 request to SENER, asking to retain 100 percent of its producing areas, which were integrated as follows: 83 percent of Mexico s proved and probable reserves, 6 equivalent to 20.6 billion barrels of oil equivalent. 31 percent of Mexico s prospective resources, 7 equivalent to 34.8 billion barrels of oil equivalent. On August 13, 2014, SENER announced the results of Round 0 and granted PEMEX the following: 100 percent of the requested proved and probable reserves (reserves 2P), equivalent to a volume of 20,589 billion barrels of oil equivalent, and almost 15.5 years of production, considering the current production level (2.5 million barrels per day). 67 percent of the requested prospective resources, equivalent to a volume of 22,126 billion barrels of oil equivalent, and approximately 5 years of production. PEMEX will have 83% of the 2P reserves and 21% of the prospective resources of Mexico. As a consequence, a minimum was set for PEMEX to produce 2.5 million barrels of oil equivalent per day for the next 20.5 years. In Round 0, PEMEX was granted a balanced portfolio of projects, both in the areas of exploration and production. With regard to the production areas, PEMEX was granted fields in the southeast basins, where its knowledge and experience has been tested, and in certain areas of Chicontepec, where important oil resources exist. Regarding exploration areas, PEMEX was granted fields in the southeast basins, as well as unconventional resources 8 and deep waters, where Pemex has demonstrated ability to discover oil deposits. 6 2P Reserves: The volume of hydrocarbons that may be more likely to be commercially recoverable than not being likely of recovery (at least 50% chance). 7 The volume of hydrocarbons that are not yet discovered, but they have been inferred and estimated potentially recoverable through the development of future projects. 8 They are found in oilfields where extraction is difficult and expensive. Extraction processes are designed specifically for the type of field required. 6
III. What s next Round 0.5 and Round 1 A. Round 0.5 PEMEX is expected to announce the first areas in which it will associate via joint ventures (under the migration of entitlement regime), with private parties, in order to strengthen its technical capacity and increase its levels of production and reserve replacement, this is known as Round 0.5. To understand Round 0.5 it is important to determine its spectrum, it will consist of ten projects that were assigned in Round 0 to PEMEX, they will require an investment of over 32 billion dollars and must be carried out in a period of 13 months starting in November 2014. The aforementioned projects will be grouped in four packages that include mature fields (terrestrial and off-shore), extra heavy-oil fields and deep waters. In addition, there will also be areas where PEMEX has not demonstrated that it has the technical and financial capabilities to operate, and so they will create Farm-outs, via migration of entitlements ; these associations will involve 1,556 million barrels of 2P reserves. In conclusion, it is forecasted that Round 0.5 will require an investment of 32,285 million dollars in a period of five to ten years depending on each project. B. Round 1 As part of the implementation of the Energy Reform, the Mexican government unveiled an approximation of the fields and areas in which private parties may participate in the exploration and production of hydrocarbons during the upcoming months. To select the areas the following criteria has been considered: (i) the potential to increase production of oil and natural gas in the short term, (ii) the potential to incorporate new reserves, and (iii) the potential to increase prospective resources in Mexico. The areas concerning Round 1 are the ones related to the exploration or production blocks that were not requested nor granted to PEMEX during Round 0. It is expected that during this round, 169 blocks will be offered, 109 of which will correspond to exploration projects and 60 to production projects. The blocks cover an area of 28,500 square kilometers. 9 These areas will vary in size and resources; they will include conventional onshore fields, shallow waters, extra-heavy oils areas, the Chicontepec fields, and areas with conventional and unconventional prospective resources. 9 91% exploration fields/9% production fields 7
These are the first steps to implement the energy reform. Mexico is aiming to improve (some may say create ) its oil & gas industry, and developing not only the sector and economic landscape connected directly to the industry, but many other sectors that can be impacted and benefited by this long awaited reform. This is the beginning of a transformation that could bring prosperity for Mexico as a country, but also an opportunity to develop alliances and mutual benefits for companies all around the globe. For any questions regarding the forgoing, please contact: Héctor Arangua (harangua@nhg.com.mx) Lorenza Molina (lmolina@nhg.com.mx) 8