On August 6, 2014, both houses of the Mexican Congress passed the secondary laws needed to make the long-awaited energy reform in Mexico a reality. The bills have been sent to President Peña Nieto for execution, who has indicated he expects the same to be published in the Official Gazette next week, making the laws effective. As a result, private participants, both foreign (through wholly-owned Mexican subsidiaries) and domestic, will soon (most likely by mid-2015) be able to participate in upstream, midstream and downstream activities in Mexico. As discussed in a prior Energy, Oil & Gas Newsletter (Mexican Congress Opens the Door for Private Investment in Energy Industry), in December 2013 both houses of the Mexican Congress passed reforms to Articles 25, 27 and 28 of the Mexican Constitution (the “2013 Amendments”) ending a 70-plus year PEMEX monopoly over all hydrocarbon activities in Mexico and beginning this historic and market-changing process. The 2013 Amendments required the passage of secondary laws dealing with the energy sector as well as amendments to many other existing laws necessary for implementing the new energy regime. A summary of the amendments and new laws we believe most relevant to the oil and gas industry follows. Although not addressed here, Mexico’s electric power generation laws have also undergone historic changes. Participants in the private sector will now be allowed to generate and sell electricity directly to very large consumers or to the Mexican government-owned utility, Comisión Federal de Electricidad. We plan to address those changes in one or more subsequent publications. THE SECONDARY LAWS The 2013 Amendments called for the implementation of new laws such as the Hydrocarbons Law (Ley de Hidrocarburos) and the Law Relating to Income From Hydrocarbons (Ley de Ingresos Sobre Hidrocarburos) (“Hydrocarbons Income Law”) and amendments to various other existing laws, such as the Foreign Investment Law (Ley de Inversión Extranjera), the Law Regarding Public Private Partnerships (Ley de Asociaciones Publico Privadas) and the Mining Law (Ley Minera) and the Law Regulation PEMEX (Ley de Petróleos Mexicanos), among others. The new regime separates upstream activities from the midstream and downstream sectors. The new Hydrocarbons Law authorizes the Ministry of Energy (Secretaria de Energía) (“SENER”) to regulate all hydrocarbon activities in Mexico, either by itself (for permits dealing with the refining of hydrocarbons or the processing of natural gas as well as export and import of hydrocarbons) or through the National Hydrocarbons Commission (Comisión Nacional de Hidrocarburos ) (“CNH”) for upstream activities or the Energy Regulatory Commission (Comisión Reguladora de Energia) (“CRE”) for midstream and downstream activities (other than refining and processing undertakings). UPSTREAM ACTIVITIES Under the new regime, the CNH may grant Asignaturas (designations of specific blocks of production) to State Productive Enterprises (Empresas Productivas del Estado), including PEMEX, or enter into contractual arrangements with private parties that allocate the right to carry out specified exploration and/or production activities in a stated territory. Unlike Asignaturas to State Productive Enterprises, contractual arrangements with private parties will be awarded through a public bid process to be overseen by the CNH. Designations to State Productive Enterprises (Including PEMEX) As for Asignaturas, the secondary laws have now clarified certain questions left unanswered when the 2013Amendments were initially passed. For example, the Hydrocarbons Law makes it clear that State Productive Enterprises (namely PEMEX) cannot transfer an Asignatura granted to it to a third party absent the approval of the SENER and the recommendation of the CNH. Furthermore, State Productive Enterprises can only enter into service agreements in relation to an Asignatura if such agreements would be expected to result in proven higher production and higher profits. Service providers must be paid a specified amount set forth in the service agreement, in cash, and may not receive in-kind payments such as a portion of hydrocarbons produced. The Hydrocarbons Law also clarifies that if a State Productive Enterprise elects to transfer an Asignatura, the SENER must undertake a bidding process with respect to such Asignatura. State Productive Enterprises may lose an Asignatura if they fail to meet criteria set forth in the Hydrocarbons Law, including following the applicable plan of operations provided to the SENER upon the Asignatura being granted. Contracts with Private Parties The CNH is also tasked with bidding out, entering into and regulating contracts with private sector parties for exploration and production activities. The nature of the blocks to be auctioned and which of the contracts created under the new regime will be entered into for such blocks will be determined by the SENER in consultation with the CNH. Similarly, the economic terms of such contracts will be determined by the Taxing Authorities (Secretaria de Hacienda y Crédito Publico) after consulting with the CNH. Once these terms have been determined, the CNH will set the parameters of the bid, select the winner, enter into a contract with the winner and regulate the resulting contracts. The Hydrocarbons Law provides limited guidance regarding the public bidding processes, establishes certain circumstances under which contracts may be rescinded and explains procedures for appealing any such rescission. The Bidding Process The Hydrocarbons Law provides little guidance as to how any bidding process will be carried out. The law gives ample authority to the CNH to conduct public bids in connection with the upstream activities. The CNH is required to publish all public bids in the Official Gazette. Parties must pre-qualify to bid. Prequalification will depend on each potential contracting party meeting certain criteria, including that the bidding party is a Mexican entity (whether wholly-owned by foreigners or not), meets certain financial thresholds (to be established at the time the public bid is made public) and other requirements. All parties wishing to bid will have at least 90 days from the date that the bid is published to respond to the CNH. The Hydrocarbons Law makes clear that the CNH is required to carry out bids in the most transparent way possible but the process by which the bidding will be conducted is at the discretion of the CNH. The Contracts There are four main types of contracts that will allow private sector parties to engage in exploration and production activities relating to hydrocarbons: license agreements, profit sharing agreements, production sharing agreements and services agreements. The following summarizes each: License Agreements. License agreements will grant the licensee the right to freely carry out exploration and production activities in the area contracted for, including the operation and commercialization of hydrocarbons extracted in the contracted area. Under license agreements, Mexico retains all mineral rights and title to the hydrocarbons produced by the licensee will pass to the licensee at the wellhead. However, licensees may book the value of their economic rights under the agreements and the potential reserves, as long as their financial statements make clear that the minerals are owned by Mexico. Production Sharing Agreements. Production sharing agreements would be entered into between a contractor and the Mexican government, through the CNH. The parties will divide the oil and gas produced within the area contracted for at the wellhead according to percentages specified in the agreement. As with license agreements, Mexico owns the minerals, and ownership of the produced hydrocarbons passes at the wellhead, but unlike license agreements, only for that percentage of the hydrocarbons agreed to in the contract. The rest of the oil and gas production remains the property of Mexico and will be transferred to the Mexican Petroleum Fund (Fondo Mexicano del Petróleo) or its designee. Profit-sharing Agreements. Profit-sharing agreements will likely be based on the premise that a portion of the profits the contractor makes upon the sale of the hydrocarbons is payable to the government, based upon a contracted division of profits. Under profit sharing agreements, once the hydrocarbon is produced, it is delivered to an authorized broker for sale. Once sold, the proceeds are delivered to the Mexican Petroleum Fund, which in turn will pay the contractor its portion of the proceeds. Services Agreements. Service agreements will resemble the current services agreements that exist with PEMEX (known as “Multiple Service Contracts”). Service providers will be paid an agreed fixed price for their services in cash. Economic Terms Under License, Production and Profit Sharing Arrangements: Economically, each of the license, production and profit sharing agreements summarized above is similar, with a few notable exceptions. The following summarizes the economic structure set forth in the Hydrocarbons Income Law for each such contractual arrangement. First Payment (For License Agreements Only) - Upon execution of the applicable agreement, an execution fee would be payable, with the fee to be established by the Taxing Authorities after consultation with the CNH, for each such agreement. Second Payment - During the exploration phase, the contractor would be required to pay a deferral fee as follows: I. During the first 60 months of the contract, the payment will be 1,150 Mexican pesos per square kilometer. II. As of month 61 of the contract the payment will be 2,750 Mexican pesos per square kilometer until production starts. Third Payment - A royalty based on the following parameters: I. For oil produced, a rate equal to: a. If oil is below USD$48 per barrel, 7.5% per barrel; and b. If oil is at or higher than USD $48 per barrel: percentage rate = [(0.125 x Price of Contract Value) – 1.5] For example, if crude is at USD$75 per barrel, then the royalty payment would be [(0.125 x USD$75) – 1.5] or 7.875%. II. For natural gas produced, the following rates will apply: a. For associated natural gas (dissolved in oil deposits): Rate = Price of the Natural Gas 100 For example if natural gas is at USD$4 per MCF, then the rate payable would be 4 cents per MCF. b. For non-associated natural gas (natural gas found in deposits without oil): i. When the contract price of the natural gas is equal or lower to USD$5.00 per million BTUs, 0%; ii. When the contract price of the natural gas is higher than USD$5.00 per million BTUs but lower than USD$5.50, a rate equal to: Rate = [(Contract Price of Natural Gas– 5) x 60.5] % Contract Price of Natural Gas iii. When the contract price of natural gas is equal to or higher than USD$5.50 per million BTUs, a rate equal to: Rate = Contract Price of Natural Gas 100 III. The following rate shall apply to the Contract Value of Condensed Gas: a. When the contract price is below USD$60 per barrel, 5%; and b. When the contract price is equal to or higher than USD$60 per barrel: Rate = [(0.125 x Contract Price) – 2.5] % Fourth Payment - An additional payment equal to a percentage of gross income set forth in each applicable agreement will be due. This additional payment may be paid in kind with a portion of actual production going to the Mexican Petroleum Fund (or its designee) or as a portion of profits. The determination of profits will be limited by allowed deductions defined in the Hydrocarbons Income Law and the specific agreements. For instance, expenses such as consulting and legal fees, financing costs, real estate and right of way costs, donations, penalties and risk management costs, some training costs, some research and development costs, some reserve funds, broker fees, royalties and other government fees incurred during exploration and other contractual exclusions cannot be deducted. Additionally, all profits, regardless of the type of agreement, will be subject to applicable Mexican taxes such as income taxes (Impuesto Sobre la Renta). Contractual Arrangement Generally Although the above structure sets forth relatively clear guidelines as is always the case, the proof of the pudding will be in the eating—most specifically the negotiation of the fourth payment due to government. Private parties must determine whether the total monies payable to the Mexican government under an agreement will be within the range of international standards for the specific contracted activity. Another important component to consider is that all upstream activities will require the use of 35% “national content” (except in deep water). The SENER, in consultation with the CNH and the Ministry of Economy (Secretaria de Economía), will determine whether the requirement is met. Criteria for that decision will include: goods and services contracted (taking into account their origin), labor (skilled and unskilled), training of local labor, investment in local and regional infrastructure, and technology transfer, among others. The foregoing merely summarizes certain of the main concepts of the available contractual options. Exceptional situations exist. For instance, companies with current mining permits may engage in production of natural gas without bidding for and entering into an agreement with the CNH as long as (with certain exceptions) the production is related to mining of carbon. Midstream and Downstream activities The CRE will regulate and award permits for engaging in midstream activities. Parties who transport oil and gas products, including through pipeline, will apply to receive permits to be issued at the discretion of the CRE. Furthermore, the CRE is required to create a national integrated system for the transportation of natural gas. The system will be run independently and include pipelines, storage facilities, and all equipment and installations involved in the transportation and storage of natural gas. The CRE may also designate other private integrated systems that may or may not be connected to the national system. The national system, along with independent private systems, will be required— without exception—to allow public access to their systems to those who prove ownership or rights to the natural gas being transported or stored. In the case of pipeline activities, parties granted permits will be responsible for the infrastructure cost in connection with building a pipeline network and may charge market prices for the use of such pipelines. Although there are certain exceptions, pipeline permittees generally may not use their pipelines to transport oil and gas products produced by them. As previously mentioned, the SENER will be the body that grants permits for the refining of crude oil or the processing of natural gas, as well as permits to export or import the refined products. Property Rights and Use of Surface Estates In an attempt to make the process as straightforward as possible, the Mexican Congress included provisions in the secondary laws making clear that any and all activities in connection with the energy sector are of public interest and therefore take priority over any other use, whether commercial or otherwise, of surface estates. Thus, lawmakers established a procedure by which private landowners MUST enter into agreements with contractors or permittees, as applicable, to rent, obtain a right of way, or acquire the properties in question, for all oil and gas activities. If, however, the parties cannot reach an agreement within 90 days from the date that the contractor or permittee, as applicable, provides a written proposal to the landowner, the contractor or permittee may seek a legal servitude for use of the land for hydrocarbon-related activities be established by a district court (or, if the land is subject to the Agrarian Law, with the applicable Agrarian Tribunal). Interestingly, contracts for land use in connection with hydrocarbon activities may not contain confidentiality provisions and must provide for payments as result of any damage from hydrocarbon activities. Additionally, all contracts in connection with the exploration and production of oil and gas in marketable quantities must contain a royalty payment provision (in addition to royalties paid to the Mexican government as set forth above). Royalties payable to land owners may vary in terms of percentages paid but may not be less than 0.5% of gross income or more than 2.0% of gross income in the case of oil, or 3.0% of gross income in the case of natural gas. All determinations of gross income for purposes of these royalty payments are made after all payments have been made to the Mexican government. Payments made in connection with use of the land may be made in cash or other arrangements such as the hiring of labor, acquiring goods or services from the land owners, commitments to invest in local or community projects or developments or a combination thereof. FINAL THOUGHTS The steps taken by both houses of Mexican Congress to pass the secondary legislation opening the energy sector to the private sector are without precedent. Based on how quickly the laws passed, the fact that the laws were passed without major debate by the PRI and PAN parties, and that the provisions of the laws establish relatively clear guidelines, the Mexican government appears to have a great deal of interest in attracting foreign investment in the energy sector. As with any new laws, however, the devil will be in the details. Questions regarding exactly how private parties will be able to take advantage of the opportunities, including the specifics of the public bidding process, will follow and the economics of the contracts will remain unknown until the first public bids are published. Specifically, although the components on deferral fees and royalties are clear, the fourth payment component creates uncertainty as to the economics of the agreements. Further, in the case of license agreements, parties should be ready to make an unknown execution fee payment upon entering into the license agreement with the CNH. This overhaul will be for naught if, taking into account all monies payable to all parties including the government and landowners, exploration and production activities are not economically competitive. Mexico has taken a great step towards creating a new industry, and U.S. and other foreign companies should consider whether it makes sense to be at the forefront of this great opportunity. However, we will not know until the actual bid packages are released whether the new legislation will actually be the expected transformational change.