Mexico’s package of energy reform laws (“Energy Law” – nine new laws and amendments to twelve existing laws) became a reality with its promulgation on Monday, August 11, 2014. With the enactment of the Energy Law, Mexico finally joins the international mainstream of energy resource development and management. This alert addresses only the oil and gas aspects of the reform.
The Energy Law holds promise for almost everyone in the oil, gas, power, and manufacturing industries, as well as related support industries. So what does this mean to you and your clients?
Opportunity! For service, construction, equipment supply, infrastructure, pipeline, consulting, water treatment and supply, and products’ companies, among others, it means a multiplication of potential clients. Pemex and CFE have ceased to be the sole or almost sole sources of business for those sectors in Mexico.
For the first time since 1938, private industry will have access to exploration and production projects in Mexico with or without Pemex; and Pemex will be able for the first time to associate in a significant manner with the oil and gas exploration industry to develop the resources assigned to it. For E&P companies, this means new sources of production and revenue, whether as stand-alone or as part of a Pemex-partnered projects (in which Pemex may or may not be the operator), and the possibility to book reserves (but not own them in situ).
For financial institutions, private equity providers, and the public market, this means potential new markets to service the large capital and funding needs that Mexican energy reform will generate.
The significance of the Energy Law cannot be overstated: it is truly both historic and, for Mexico and the region, an economic game changer. By some estimates, the impact on GDP growth could be substantial: a gross increase of .5 percent in 2015, 1.5 percent in 2016 and 2017, and 2 percent per year between 2018 and 2025.
Pemex Round Zero
The so-called Round Zero properties assigned to Pemex were published on Wednesday, August 13, 2014, and the development and joint venturing of these projects will be the first focal point. Although much work yet remains to be done on the regulatory framework and the contract and bid designs, the pace is furious. Projects may be announced earlier than previously estimated.
For the official reports on the method employed to select the assigned reserves, what reserves and blocks were actually assigned to Pemex in Round Zero, the percentages represented, and the anticipated Bid Round 1 prospects, please refer to the web page of the Secretary of Energy (Secretaría de Energía -- “Sener”) at, among others, the following links:
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Reportedly, Pemex has already identified 10 or so potential joint venture partners for the various kinds of
projects for the blocks assigned by Sener to Pemex. Sener estimates that these projects will require
annual direct investments of between US$8 to $12 billion over the next 4 years. Others surmise that the
direct investments could be much more, when you factor in the possible shale plays (Mexico is estimated
to have the world’s sixth largest technically recoverable shale reserves in the world), and especially if the
target drill-out of 6,000 shale wells per year over the next 10 years is added to the estimates.
Energy Law Highlights
The Energy Law covers the full energy market spectrum, from upstream to downstream, and also
revamps the power generation and distribution sector. Some of the Energy Law’s principal features
E&P Contracts. The Energy Law provides for the issuance of exploration and production
contracts in the form of licenses, production sharing contracts, and profit sharing agreements to
the private sector, with or without Pemex as a participant. These contracts will be issued by the
National Hydrocarbons Commission (Comisión Nacional de Hidrocarburos − “CNH”). The first two
categories will enable private participants to take their share of production in kind. Common to
these contracts are combinations of a sign-on bonus, royalty, production share, state share, and
windfall profit adjustments. Permits from Sener will be required for midstream and downstream
activities, such as exportation, storage, and commercialization of production.
Revenue Terms of E&P Contracts. In all forms of E&P Contracts, the state is to receive an
acreage-based payment during the exploratory phase, a royalty, and an adjustment for windfall
profits. The state may also increase its share on any blocks assigned to Pemex in Round Zero,
and later migrated to E&P Contracts, if the state’s revenue under the E&P Contract is less than
what the state would have received had those blocks not been migrated. For licenses, the state is
to receive a bonus and a percentage of the value of production after royalty, with the contractor
retaining the difference. In profit sharing and production sharing contracts, the state is to receive
a percentage of “operating profit,” which is defined as the remnant after deducting from the value
of production, the royalty and contractor’s cost recovery. The contractor may receive some cost
recovery (subjected to a percentage limit and a carry-forward; and subject to whether the contract
provides for it) and what remains after the state’s share. Except for royalty, the Energy Law does
not specify the percentage(s) of the state’s share, and leaves it to the regulations and the
Royalty calculations are subject to inflation factor adjustments. Royalty for oil has a floor of
7.5 percent when the price of oil is less than US$48 per barrel; and a sliding scale for oil at or
above US$48 per barrel (for example, for US$100 per barrel oil, the royalty is 14 percent). For
condensates, the royalty is 5 percent when condensate prices are below US$60 per barrel; and a
sliding scale when condensates are at or above that price (for example, for US$100 condensate,
the royalty would be 10 percent). The royalty calculation for natural gas depends on whether it is
associated or non-associated. For associated gas, the royalty is 1 percent. For non-associated
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gas, the royalty is zero when the price per mmbtu is equal to or less than US$5; 1 percent when at or above US$5.5; and a sliding scale when in between those two prices.
In addition to payments to the state, there are additional carve-outs to contractor revenue in the case of operations on areas subject to mining concessions and, generally, in the acquisition of surface use rights, addressed further below.
Pemex Mandatory Participation. Pemex is obligated to participate in certain projects (for example, Pemex will be required to have no less than a 20 percent interest in blocks with potential trans boundary reserves), and Pemex or other state companies may have up to a 30 percent participation in other instances (such as projects entailing a high level of new technologies). Pemex’s obligatory participation will, of course, exert some pressure on the design of the appropriate operating agreements.
Associations with Pemex. The Energy Law contemplates that, subject to rules and guidelines to be issued by CNH, Pemex may, in the projects assigned to it in Round Zero, associate with private industry through farmout and operating agreement structures, or through corporate vehicles. What vehicle and industry partner is selected for each project will depend on the CNH selection rules and on the underlying form of contract issued by CNH.
Pemex and CFE as State Productive Companies.
Autonomy. The functional separation of Pemex and CFE from the government, which will be converted into stand-alone “state productive companies”. Pemex and CFE, though owned by the government, will enjoy greater operational and budgetary autonomy from the government than they did in the past; and will be exempted from the current government contracting laws. How much autonomy they will actually have will depend on how the Energy Law is actually implemented and the regulations yet to be issued.
New State Productive Companies. The government is authorized to create additional state productive companies for projects traditionally dedicated to Pemex and CFE.
Specialized Tax Regime. A specialized tax regime for the energy sector (in particular, on depreciation, among other fiscal attributes), which will apply also to Pemex, CFE, and other state productive companies.
Local Content Requirements – Not Yet Defined. The Energy Law leaves the definition of local content to the regulations and contracts, but does provide some broad criteria for a definition, such as origin and location of services and goods, the national labor component, local infrastructure investment, and similar. Local content can go up to 35 percent (with some exemptions for deep and ultra-deep water E&P projects), subject to trade treaty obligations (such as NAFTA). Today, it is unclear whether equipment fabricated, or services rendered in Mexico from foreign-owned service providers qualify as local content. Also unclear is whether treaty-qualified equipment fabricated abroad will qualify. The Energy Law does require the implementation of a third-party local content certification system.
Surface Use Rights. Contractors are able to obtain surface use rights through a negotiation, appraisal, and compensation system outlined in the Energy Law. A
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component of the compensation includes what should be a strong incentive for surface owners and communal land holders to cooperate, as it gives them an indirect stake in the projects on their properties. Similar to mining concessions, the contractors’ surface use payments will include, in the event of production on their properties, a component based on the pre-tax, post-burden net revenue of the contractor: in the case of non-associated gas, 0.5 percent to 3 percent; and in all other cases, 0.5 percent to 2 percent.
Environmental. The Energy Law creates a new environmental agency specifically for the hydrocarbons industry (the “Agencia Nacional de Seguridad Industrial y de Protección al Medio Ambiente” – the “Agency”), whose principal functions will include regulation, supervision, and sanctioning for violations of law of the hydrocarbons industry in the subjects of health, safety, and the environment, discharges and emissions, decommissioning of facilities, and abandonment. The underlying principle is that Pemex, other state productive companies, and the private hydrocarbons sector will be held responsible for remediation, restoration, and any damage caused by their pollution, discharges, and spills.
Information. CNH is required set up a “National Center of Information of Hydrocarbons” (“Agencia Nacional de Seguridad Industrial y de Protección al Medio Ambiente del Sector Hidrocarburos”) to receive and store exploration and production information and to make that information available to the public. This includes competitive information, subject to mechanisms to protect some of the more sensitive information. For example, CNH will keep and store all core cuttings, drilling related samples, and seismic interpretations. CNH is authorized to establish regulations for how, when, and under what circumstances CNH will make the information public.
Elimination of Foreign Investment Limitations. Various foreign investment limitations, such as the previous ownership limitation on drilling companies, are lifted.
CNH and CRE Permits. The Energy Law creates requirement for new permits, such as for the importation and transportation of natural gas, from CNH or the “Energy Regulatory Commission” (the “Comisión Reguladora de Energía” − “CRE”).
CNH Consents. The Energy Law provides for various consent and permitting requirements from CNH on a variety of subjects, such as exploration well drilling permits. Some of those consents and permits are subject to a “silence equals consent” regime. For example, CNH will be deemed to have given its consent if it fails timely to respond to a request to assign operational control from Pemex to its “partner” in a joint venture or farmout of a Round Zero block, or to a request to commence performing an exploration or development plan.
Mining Concessions. The Energy Law includes provisions related to natural gas exploration and production on mining concessions. A mining concession for coal is deemed to include the right to exploit coal seam gas. For other natural gas, a separate contract is required. The Energy Law addresses criteria for competing uses of the surface, and surface use payments. For example, when the parties cannot agree and the oil and gas development affects the miner’s surface use, CNH can require that the contractors pay in cash to the mining concession the functional equivalent of 0.5 percent to 2 percent of the contractors’ after tax profits.
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Retail Fuel. The phased-in opening of the retail fuel markets (gasoline, diesel, and LPG): prices will become market based (and unregulated) for LPG by January 1, 2017, and for gasoline and diesel by January 1, 2018; Pemex will not be the sole importer of gasolines and diesel, by January 1, 2017, and permits for foreign-owned (and other) gasoline stations will begin to be authorized by January 1, 2016.
State-Owned National Pipeline Company − CENEGAS. The Energy Law reorganizes the state-owned pipeline system into a new state-owned entity called CENEGAS, away from Pemex and CFE. CENEGAS will own and manage the national pipeline grid, under open access style rules; and private industry will be allowed to build and operate private pipelines also under open access style rules.
Petroleum Fund. The Energy Law creates a “petroleum fund” to be invested with the state’s share of production revenues, and to be used for certain social, economic, educational, and community development projects.
If you have any questions, please feel free to contact one of the attorneys listed below.
William (Hunt) Buckley +52.55.5249.1812 email@example.com
Ricardo Garcia-Moreno +1 713.547.2208 firstname.lastname@example.org
Alberto de la Peña
George Y. Gonzalez
Ariel Ramos +52.55.5249.1820 email@example.com