More than six months have passed since the Comisión Nacional de Hidrocarburos (CNH) published the bidding terms and conditions of Round One, including a single form of production-sharing contract (PSC) for all shallow-water blocks under auction. CNH has revised the PSC three times, the last being on June 9, 2015; and it intends to award all contracts by July 15, 2015.

Of the 49 companies that expressed some form of interest in Round One shallow-water contract areas, 39 gained access to the data room and 26 prequalified to bid. One could say these figures foretell that a good number of companies will actually bid for one or more of the 14 blocks CNH intends to award this July, but it is unclear whether their interest is evenly spread across all contract areas. All fields are mature and the contract areas are small, ranging from 116 to 501 square kilometers, nine of them being under 310 square kilometers. It is noteworthy that Pemex has previously explored most of the attractive shallow-water areas in the southern Gulf of Mexico, suggesting the probability of finding easy oil is low. If true, it is likely that most fields containing hydrocarbons in commercial quantities will be small and command a high development cost.

The foregoing scenario underscores CNH's need to make an offer to the oil patch that is competitive against other E&P opportunities around the world, particularly in the current low oil and gas price environment. In the Americas, Argentina is continuously lobbying for investment in its upstream sector, though the political risk is high. Colombia's oil patch is generally considered a good bet, but the regulatory process -- especially as it relates to environmental permitting -- continuously challenges operators. Brazil, a once promising international oil and gas market, is now embroiled in an unprecedented corruption scandal that has stifled development of its reserves. Will Mexico take advantage of the other countries' shortcomings and seize the opportunity before it?

Mexico's insecurity and recent corruption scandals at various levels of government do not help its cause, and could seriously undermine the effective implementation of the country's energy reform. Moreover, the international oil industry is aware of such problems and recognizes their possible ramifications. But the oil patch is accustomed to working in such an environment, and it may take more than crime and procurement irregularities in other sectors to halt what is now an irreversible process into Mexico's modern age of international petroleum transactions. Thus, the terms and conditions of the PSC will be the most significant factor affecting the degree to which Mexico will be able to develop its oil and gas resources under the new liberalized sector.

The following are a few thoughts regarding the PSC.

Exploration and Development Periods

Length of Exploration Period

As is typical of many upstream government petroleum contracts (UGPCs), the PSC grants the contractor an initial four-year exploration period in which to carry out an approved minimum work program. The initial period may be extended for two additional years if the contractor has completed the approved minimum work program and complied with its obligations under the contract, among other conditions. Mexico's geology is less known than others; it is unclear whether the potential six-year exploration period will be sufficient for contractors to fully perform an effective program that maximizes the recovery of hydrocarbons from Mexico's shallow-water mature fields. A further two-year optional exploration period would have given the parties much-desired flexibility in this respect.

Force Majeure

The contractor may also extend the exploration period as a result of a force majeure event. While a good right in principle, the PSC does not properly address it. The PSC extends the exploration period and any evaluation period therein for any delay to the contractor due to a force majeure event, which by definition is outside a party's control. This extension, however, is not automatic and may be lost if the contractor fails to provide CNH notice of the event within five days of the date on which the contractor knew, or should have known, of its occurrence. 

Such notice requirement for all practical purposes penalizes the contractor for a failure to perform a ministerial act within an uncommonly short period of time (i.e., provide notice within a five-day period), and disregards the possibility that the contractor could have been actually prevented from doing work as a result of force majeure. Given the limited time contractors will have to conduct costly exploration activities in the mature fields under auction, the absence of any actual damage to the government for any delays in performing the minimum work obligation (which is guaranteed to the government through letters of credit), and the vast acreage Mexico has for further E&P activities, the above result is quite harsh and most likely unwarranted. A less punitive alternative would have been to allow the contractor to claim force majeure commencing on the date on which it actually provided notice to CNH if notice was not timely given in the first place.

Delays in Permitting

The PSC also lacks any automatic extension in the event of delays by the Mexican governmental authorities in issuing the necessary permits, which must be obtained prior to any exploration by the contractor. For instance, it would have been advisable that an extension automatically be granted in the case of delays in the issuance of environmental permits (a problem that is common in Colombia and has hampered the much-needed development of the country's reserves) -- provided the contractor has timely complied with the applicable requirements and submitted all necessary documents. The length of the extension would be equal to that of the delay.

Minimum Work Commitment

Scope

The PSC provides for a minimum exploration work commitment, which the contractor must agree to fully perform. If the contractor fails to fulfill its commitment, it will be in breach of the contract, risk its termination and be liable for liquidated damages. The minimum work commitment for each block generally includes the performance of studies; the acquisition, processing and interpretation of seismic data; and the drilling of a minimum number of wells. It is thought that this work will further CNH's goal of gathering critical information (and complementing information it already possesses) about the hydrocarbon resources located in the contract areas.

Work Units

The PSC employs the construct of a "work unit" to quantify a contractor's obligation to perform its minimum exploratory work. This has been used in other places around the world such as in the San Juan Province of Argentina in 2006 and offshore Pakistan in 2001. Under this construct, specific types of exploratory activities are allocated a contractually-agreed number of work units, the accumulation of which will be required to proceed to the development phase. Under some UGPCs, work units afford the contractor an opportunity to determine what exploration activities to perform; and, thus, the contractor's commitment is only to achieve a number of work units within the exploration period. The PSC limits the contractor's flexibility in several important ways: it must achieve a certain number of units for exploratory studies, seismic and the drilling of wells1 (albeit it may select which types of exploratory studies and seismic it wishes to perform from an exclusive list); it cannot pay, without defaulting, an agreed sum of money in lieu of performing the work; and it must obtain CNH's approval of its annual work program. Furthermore, the contractor cannot fix the cost of its commitment, a problem inherent to the work unit regime.

Definition of Well

The obligation to drill wells, given the expense involved, also presents issues in the context of the minimum exploration work obligation. Host governments typically seek a narrow definition of "well"; whereas, contractors prefer a broad definition that results in any well operations satisfying the commitment (e.g., deepening, sidetracking, etc.). The broader the definition, the greater the flexibility the contractor will have in fulfilling its minimum exploration commitment. In the PSC, although the term "well" or "pozo" is defined fairly broad (i.e., as any opening on the ground through perforation or any other means for the purpose of discovering, evaluating or extracting hydrocarbons), the minimum work commitment is set forth in terms of "exploration Wells". If under the PSC evaluation activities are "exploration" activities and the drilling of an evaluation well will occur within the exploration period, did CNH intend to include an evaluation well as part of the contractor's minimum work commitment? That would not be typical.

Prospective contractors must recognize that an ambiguous requirement will grant CNH greater latitude in refusing to approve an annual work program and budget. Conversely, CNH must recognize that the intent-based definitional approach of "well" looks to the subjective intent of the contractor drilling the well. This definition will cause CNH to have difficulties proving with objective evidence that a well is or is not of a certain type.

Deemed Satisfaction

There is no provision in the PSC whereby the contractor's minimum well drilling commitment is deemed satisfied when the occurrence of a qualifying event inhibits completion of the well. This raises the obvious concern that the contractor could be in breach if the well portion of the exploratory commitment is unfulfilled, regardless of the reason. "Deemed satisfaction" provisions are not uncommon, and effectively balance the host government's desire to gather information about its hydrocarbon resources and the contractor's willingness to explore for it on what amounts to a contingent fee, sole-risk basis (i.e., the contractor recovers its costs and any profit only upon commercial discovery).

Any number of events could result in the contractor being deemed to have satisfied its well drilling commitment. These include drilling the well to its objective formation; making a commercial discovery before drilling to the required formation or specified depth; discovering conditions that make the likelihood of commercial production unlikely; or encountering technical problems rendering drilling imprudent. Some of these events were contemplated in a prior draft of the PSC if only to reduce the contractor's exposure to liquidated damages for failure to fulfill the minimum work commitment. But the current draft of the PSC only provides, vaguely, that the contractor will not be obligated to perform its obligations within the technical specifications required by a work program if it encounters an obstacle to the continuation of drilling, such as impenetrable rock being encountered at a lesser depth or the finding of conditions which make the continuation of drilling an obvious danger due to the existence of abnormal formation pressure.

Commercial Discovery

Veto Power

As with most host government agreements, the contractor under the PSC must notify CNH of all commercial discoveries it makes. CNH will not have an approval right with respect to such declaration, but it will effectively have a veto power during its analysis of the contractor's development plan, which requires CNH's approval.

Exploration Commitment

One could expect that a declaration of commerciality in a small contract area, such as those up for bid under Round One, would release the contractor from further exploratory obligations under the minimum work program or exploration plan. After all, the contractor's ability to recover its costs and the government's desire to promptly receive it share under the PSC are tied to commercial production. This means that each party has a strong interest in commencing development and commercial production as expeditiously as possible. Why then require that the contractor sink additional exploration costs into a project when those funds could eventually be unrecoverable or, more beneficially, used to develop the commercial discovery that ultimately leads to cost recovery and production share for both parties?

Perhaps an elastic minimum exploration commitment would have been more appropriate; one that would change or evolve upon the occurrence of certain exploration results or the occurrence of a specific event such as a commercial discovery. If a contractor makes a commercial discovery, why not release it from its remaining exploration commitments, monetize such commitments and transfer them to the development program? This would give the contractor, the operator and party which are in a better position to maximize production from the contract area, the much desired flexibility to decide whether to continue exploration operations, to proceed with developmental activities, or both.

Gas Discoveries

Gas discoveries also require the granting of additional time for the contractor to develop a market suitable for a profitable exploitation. Sometimes the sale of gas will not only require the construction of additional processing and transportation infrastructure by the contractor and its customers, but also the implementation of an adequate legal or regulatory framework that permits making long term commitments required to amortize such investment. Given low prices of gas in North America and virtual absence in Mexico of the sale, marketing and export of natural gas by private parties, these issues can take years to resolve. Absent a contrary understanding at the outset, the contractor arguably has a legitimate interest in retaining its rights over gas discoveries and receiving meaningful extensions (to avoid mandatory relinquishment of acreage) while it develops such a framework and suitable markets.

Early Termination

Administrative Rescission

Most Latin American host government contracts grant the governmental party a termination right upon the occurrence of stated events. Some events are classified as contractual and others by legal mandate as administrative. The intrinsic nature of all such events relates to the contractor's failure to perform an obligation. The classification rests on the varying degrees of severity the government assigns to each event of default—a method that serves the interests of the host government. It matters to the contractor whether an event of default is classified as administrative because the occurrence of such an event will entitle the government to unilaterally terminate the contract and preclude the contractor from disputing such termination through judicial or conventional dispute resolution procedures. Administrative termination arises under statute as a creature of administrative law and, though it finds its way into a contract, is not contractual in nature nor will a contractor be able to bargain itself out of it. There is a view that this unfair advantage given to the government by law would be null and void under the private law of contracts. However, it is valid in Mexico and deeply-rooted in the country's public administration laws.

Burden of Proof

Following the Latin American trend and in compliance with the new Mexican Hydrocarbons Law, the PSC enumerates seven events of default that upon their occurrence will entitle CNH to terminate the contract through an administrative process. Under such process, the contractor has the burden of proving to the sole satisfaction of CNH that an event of default has not occurred, is excused or has been cured. If not met, CNH will be entitled to terminate the contract with immediate effects and without judicial declaration, much in the same manner in which the government of Ecuador terminated Oxy's Block 15 production sharing contract in 2006. Once the administrative process is concluded, the contractor's sole remedy will be to appeal CNH's decision to the Tribunal Federal de Justicia Fiscal y Administrativa, an administrative tribunal, without further recourse to arbitration or even judicial courts. Consider that upon the termination of a PSC for an administrative event of default the contractor will be required to pay damages (excluding indirect or consequential damages), perform abandonment operations and transfer to the State all machinery, tools, equipment, platforms, infrastructure and any other facilities acquired, leased or possessed by the contractor in the contract area -- all without any right to payment or indemnity from the government.

Materiality of Breach

Because of the magnitude of their investments, contractors have a legitimate interest in seeking a clear definition of the events that grant a host government the right to terminate a UGPC. Most importantly, early termination events should be limited to those that have a high level of materiality and can be measured objectively. Under no circumstances should a party be entitled to terminate a contract based on that party's subjective assessment of an event.

The PSC does not clearly define "material breaches", the uncured occurrence of which grants CNH the right to unilaterally terminate the contract. Under U.S. state law-governed contracts, the failure to define "materiality" may not be a concern to some because its meaning and scope has been thoroughly litigated in state courts and is fairly well settled. The PSC, however, is governed by the federal laws of Mexico, which has never clearly defined or regulated the term; nor does any Mexican jurisprudence address or provide guidance on its interpretation. Will a contractor's breach be material enough to warrant termination if CNH is deprived of the benefit of its bargain under the PSC or can be adequately compensated for the breach? To what extent may an arbitrator take into account the contractor's good faith and fair dealing? How will arbitrators interpret a concept that is not clearly defined in the PSC?

Other events listed in the PSC as grounds for termination are arguably not material and outside customary provisions in UGPCs: a negligent act that causes an accident resulting in damages to facilities, death and loss of production; unjustified delays in the implementation of a work program or development plan beyond 180 days; and not delivering to CNH for its approval the exploration plan or first exploration work program within 45 days of the applicable date, are just a few examples. Under many UGPCs a "material breach" is an uncured fundamental breach that frustrates the contract or destroys the commercial purpose of the agreement of the parties. Is the failure to meet a deadline really material? Should the host government be able to terminate a contract due to an accident that claims a life or damages facilities in the context of an industry where such accidents are not uncommon?

Final Thoughts

The PSC is a wonderful instrument in terms of the Mexican government's effort to attract investors to the country's upstream oil and gas sector. It incorporates structures that have been widely accepted under other UGPCs and has many provisions that adequately balance the interests of the government and contractor. The form of contract for the shallow-waters of Round One, however, does have deficiencies and has much room for improvement. There are other areas of the contract, in addition to the issues raised above, that could have been revised to make it more competitive vis a vis other UGPCs. Some may view the fiscal terms and significant number of non-recoverable cost items, which are perhaps a clear reflection of Mexico's burdensome tax laws, as unduly onerous in light of the auctioned properties. Others may view the administrative and reporting requirements placed on the contractor as unduly burdensome. CNH also retains quite a bit of discretion with respect to matters that may affect petroleum operations, negating any flexibility that would be afforded to the contractor by not having an operating committee.