In an unprecedented change in Mexican energy politics, the government has amended its Political Constitution to allow the participation of private capital in its upstream, midstream and downstream oil and gas businesses. The extraordinary step continues a liberalization trend that commenced more than twenty years ago when then President Carlos Salinas de Gortari privatized the banking industry, sold the State's majority equity stake in Teléfonos de México (then the only terrestrial telephone service provider in Mexico), and signed the North American Free Trade Agreement (NAFTA) with the United States and Canada, creating one of the largest trading blocs in the world. 

The amendments reflect an uncommon, joint effort between Partido Acción Nacional (PAN) and Partido Revolucionario Institucional (PRI), the latter being the political party with which current President Enrique Peña Nieto is affiliated and PAN´s traditional adversary on most any political matter. Each party had advanced a proposal for a bill to amend the Constitution. PAN, with its free-market view, advocated the implementation of a concession regime, one that would maximize hydrocarbon revenues to the State and gradually wean it from its well-known dependence on the cash generated by Petróleos Mexicanos (Pemex), to date the country's sole national oil company. In contrast, the President sought a contractual regime purely based on profit-sharing, maintaining for all practical purposes the use of Pemex as the most significant source of government revenue.

With the two sides at odds on the best policy solution, a congressional debate ensued. By mid-December 2013, the generally antagonistic congressional forces had unified their views, resulting in a new energy policy that is nothing short of remarkable for a country that has traditionally considered the use and exploitation of its natural resources as a prerogative reserved exclusively to the sovereign.

Under the amended Constitution all types of hydrocarbons under the soil continue to be owned by the Nation, but state and privately-owned domestic and foreign companies may now compete for and directly engage in the exploration and production (E&P) of liquid, solid and gaseous hydrocarbons, conventional or unconventional, pursuant to any type of host government instrument the State creates and implements, except for concessions. [1]These companies may also engage in the treatment and refining of petroleum and the processing of natural gas, subject to the issuance of a permit by the Secretaría de Energía, the federal government's department of energy. Furthermore, companies may also participate in the storage, transportation, and pipeline distribution of crude oil, natural gas, petroleum products and petrochemicals, and the first-hand sales of such resources and by-products, all subject to the issuance of a permit by the Comisión Reguladora de Energía (CRE), the midstream and downstream regulator.

E&P Regime

The State will now conduct oil and gas E&P through two specific legal schemes: it may assign a state company, including Pemex, its right to explore for, develop and produce hydrocarbons in specific areas; alternatively, it may enter into a contractual arrangement (other than a concession) granting such rights to a state, domestic or foreign contractor, each of which may upon government consent fulfill its obligations under the assignment or contract by subcontracting with another party.

Once implementing legislation is enacted, the Secretaría de Energía will establish, conduct, and coordinate energy policy, select assignment and contracting areas, adjudicate assignments and design the technical aspects of all E&P contracts. [2] The Secretaría de Energía also will have sole discretion to choose the type of contract it will implement in each of its projects, including, but not limited to:

  • a service contract, under which the contractor may be paid a fee for its services;
  • a production-sharing or profit-sharing contract, under which the contractor may be paid with a share of the production or its monetization, respectively; or
  • a license, under which the contractor may take at the wellhead title to the hydrocarbons it produces in exchange for the payment of royalties or other consideration to Fondo Mexicano del Petróleo (FMP), a Mexican trust that will be formed to administer all revenues generated from E&P activities. [3]

As allowed by most other hydrocarbon-producing nations, the contractor under a profit-sharing contract will be able to book for accounting and financial purposes its production-related economic right or revenue stream. Under a production-sharing contract, license, or other contractual arrangement under which it has a right in production, the contractor will be able to book reserves, provided the applicable instrument states that all forms of hydrocarbons in situ remain the property of the Nation. As expected, the contractor will not be able to book any economic right or reserves under a fee-based service contract under the premise that such interests are exclusively owned by the State.

The Comisión Nacional de Hidrocarburos (CNH), the upstream regulator, will award and enter into contracts with private parties and state companies through a tender process in which the most important award criterion will be the percentage of profit or production share the contractor proposes in its bid (in the case of a profit-sharing or production-sharing arrangement), the amount of bonus, royalty or other consideration payable to the State (in the case of a license), and the amount of the tariff payable to the contractor per barrel of crude oil equivalent produced from a contract area (in the case of a service contract). [4]

The Political Issue

One could reasonably question the legislature's wisdom in expressly prohibiting the granting of hydrocarbon concessions in the Constitution, while at the same time mandating that implementing legislation expressly permit the granting of licenses, particularly because in the oil patch, upstream oil and gas concessions and licenses are typically regarded as the same. Under both instruments, a concessionaire or licensee acquires the exclusive right to explore for hydrocarbons in a contract area, to develop any discovery made therein, to acquire ownership of most or all the oil and gas ultimately produced and to dispose freely of such production.

Some members of Partido de la Revolución Democrática (PRD), Mexico's major leftist political party and the energy reform's main detractor, share the view that licenses are for all practical purposes concessions in disguise, calling them a "simulation" that should not be tolerated by the Mexican people. Why if not for the sake of political correctness would PRI and PAN maintain in Article 27 the current restriction on the granting of concessions for oil and gas E&P? This animus, together with a noticeable ambiguity in Mexican legislation regarding the legal nature of both a concession and a license, may very well give PRD legal arguments to challenge the constitutionality of any implementing legislation that contemplates licenses as a host government instrument. [5]

But while Mexican legislation is indeed imprecise, well settled Mexican legal doctrine does differentiate licenses and concessions in terms of both the nature of the administrative act and the nature of the rights granted to the licensee and concessionaire. Under a license, the governmental authority merely removes a legal restriction to the exercise of a preexisting right. [6] Under a concession, the governmental authority grants the concessionaire a right it did not previously have and would not have had but for the granting of the concession. [7] In this doctrinal light, the license described in the amendments seems more like a concession than otherwise.

The legislators who voted in favor of the reform will argue that the nature of the constitutional prohibition regarding the granting of concessions does not rest on an administrative act or on whether or not a concessionaire has a pre-existing right to perform an act, but on the ownership of the resource under the ground, which, as expressly stated in revised Article 27, is at all times inalienable, not subject to adverse possession and vested in the Nation. This is a corollary to the views of President Lázaro Cárdenas, the architect of the celebrated 1938 nationalization of the oil industry and sponsor of the now infamous constitutional limitation: "a concession grants [its holder], in a very limited and precarious manner, rights to directly own and exploit the subsoil, making the State a mere regulator and policeman of an activity, a function that is wholly insufficient in hydrocarbons-related matters as a result of the expropriation." [8]

It reasonably follows that if a licensee acquires ownership to the hydrocarbons at the wellhead upon their production and the making of a payment to the State, the license cannot be deemed a concession under the Constitution. The issue is far from settled under Mexican law and jurisprudence, and will be debated at some point.

Opposing Strategy

Last December 15, PRD's national leader vowed to cause the party's militants to routinely engage in "actions for the defense of petroleum." The so-called "15-15 Strategy" would culminate in 2015, he said, with a popular rejection of an energy reform that hands over the Nation's wealth to foreign powers and capitalists, particularly the United States. In essence, PRD seeks to submit the energy reform to a process akin to a national election, a popular consultation under Article 35 of the Constitution and its proposed implementing legislation, which expressly grant registered voters the right to express a binding opinion in matters that are "transcendental" at the national level, including acts of Congress that are legislative in character. [9]

It's unclear whether the recent energy-related amendments to the Constitution could or would be subject to such a consultation. Though Article 35 is unambiguously clear that Congress must call for a popular consultation if at least two percent of the registered voters demand it, its subject matter must nevertheless be both transcendental and have a national impact. Proposed implementing legislation does provide guidance as to what is "transcendental throughout the Nation," but it focuses on when a matter has a national impact rather than on when a matter is "transcendental". Without full legislative guidance, the issue may well have to be answered at trial by the Mexican Supreme Court, who will have jurisdiction over the matter.

The future of an industry that is a source of national pride for many Mexicans is unquestionably transcendental to some, but then so are many other matters that could not be reasonably and practically left to the vote of the citizens. Does a matter become transcendental to the Nation simply because the required number of registered voters have requested the public consultation? Should the manner in which the State generates revenue with its natural resources to finance the expenditures budget be subject to a popular vote? [10] Further, should an adverse result from a public consultation override a law that has been properly legislated and enacted, and has created rights in the subjects being regulated? These and other questions will likely be asked, debated and answered by the high Court if the voter number burden is met, for a popular vote reverting the new regime to its former glory will surely trigger claims of expropriation and fair compensation by those who move forward and invest in Mexico once implementing legislation provides the ground rules.

Sink or Swim

Colombia's overwhelming recent success in the upstream oil and gas sector certainly inspired Mexico. Like Mexico, Colombia's crude oil production had declined significantly, falling from a peak of 830,000 bbl/day in 1999 to less than 600,000 bbl/day in 2003, mainly as a result the natural depletion of existing oil fields and a lack of investment. Facing an economic precipice, Colombia restructured its energy sector in many significant ways, including by reorganizing and transforming Empresa Colombiana de Petróleos, its national oil company, into Ecopetrol, a public corporation in which the Colombian State owns 88.49% of the total shares, and domestic and foreign pension funds and banks own the remaining 11.51%. [11] With greater managerial autonomy and its regulatory and natural resource-management functions stripped and given to the Agencia Nacional de Hidrocarburos, the Colombian upstream regulator, Ecopetrol gained the ability to better focus on its fundamental purpose: to explore and exploit hydrocarbons in an internationally-competitive market. [12]

Mexico now seeks to replicate the Colombian success, if not its precise methods. The implementation guidelines in the amendments indicate the CNH, a relatively new and formerly toothless agency, will be granted status as a legal person, technical and managerial autonomy, and the power to regulate all upstream activities, conduct tenders and award and enter into E&P contracts. The CNH will also function as the Secretaría de Energía's technical branch in all upstream matters, compiling geologic and operational information, administering the technical aspects of assignments and contracts, and approving and supervising the execution of exploration and development plans, all matters formerly under Pemex's control.

There are a number of reasons why Pemex did not live up to its expectations as a profitable company and successful oil and gas producer. A burdensome fiscal regime implemented to fund social programs and other non-economic endeavors, [13] a regulatory environment that restricted the manner in which it could transact, invest, explore, produce, refine and market hydrocarbons, [14] and a grossly inadequate corporate governance structure that affected its business judgment, mostly by influence of the oil workers union, [15] are just some of them.

The approximately 150,000 member union, which represents 72.6% of Pemex's workforce, has been the company's Achilles heel in many respects. It has too much corporate power exerted through the control of one-third of the company's board of directors, and its collective bargaining agreement has historically extracted employment benefits uncommon for international oil and gas practice. [16] The burden is so great that in 2012 Pemex's liability for employee benefits represented 56.14% of the company's total liabilities and 74.28% of its total sales, and exceeded the company's consolidated gross income by approximately $36,442,402 United States dollars. [17]

Recognizing the company's shortcomings, the transitional articles of the amendments mandate that implementing legislation grant Pemex and the other state companies engaging in oil and gas E&P, budgetary, technical, and managerial autonomy, subject only to their respective balance sheets and a ceiling for personal services spending. Each of them will be taxed and pay royalties and other consideration to the State as any other operator in the business and be free to structure its investments and enter into contracts under a special, more flexible procurement regime for the goods and services it needs. [18] Most importantly, Pemex will make business decisions through a ten-person board of governmental and independent directors which, although ultimately controlled by the President and Senate through appointment, removal, and voting power, will no longer house the representation and interests of the oil workers union.

The language in the amendments and their exposition of motives is clear that other than for the preferential treatment Pemex will be given in the assignment of areas, Pemex will be treated like any other E&P operator in Mexico. [19]This means Pemex will succeed in the new regime both as a state company and successful market competitor only if the government is able to change its nature from an instrument of social welfare to a true corporation with a clear business purpose and managers who seek to maximize shareholder value. There is nothing in the contemplated structure of the energy reform suggesting the government will let Pemex fail, but by the same token nothing therein prevents it from allowing Pemex to sink, spinning-off the company's various upstream, midstream, and downstream business segments into stand-alone state companies or creating new, competing state companies and instrumentalities, uncorrupted by the past, to take over or complement Pemex's activities. [20]

Caveat Emptor

By properly setting the basis for the liberalization of its energy sector, Mexico placed itself in a position to attract the risk capital and technology it needs to develop its significant hydrocarbon reserves, but its ability to access and profit over the long term from any incoming private investment will be determined by its future actions; in great part by how well it treats, protects and regulates inbound investment.

Though its treatment of foreign investment at different times has not been stellar, [21] Mexico has a fair track record of treating such investment in a non-discriminatory manner and in accordance with international private law. Its current economic and financial ties with major world powers, other developed countries, and strategic partners are also strong, and its laws include at least twenty-five bilateral investment treaties and twelve free trade agreements, most of which contain clauses for the protection of investments, including NAFTA. [22] Much of the Mexican risk, however, lies elsewhere and particularly in the country's social instability, inexperience in international oil and gas practice, and the greed the government may experience when it tastes the fruits of its work.

In 2006, former President Felipe Calderon sought to fight organized crime in an unprecedented manner, declaring war for all practical purposes on a drug trade that to date presumably had been controlled by few hands. But while the noble effort did shut down some established regional crime organizations, a plethora of other criminal groups emerged as stand-alone crime syndicates, seeking to take hold of the territory left behind by the former cartels. These groups have notably engaged in "express" kidnapping and extortion schemes to finance part of their activities, targeting in many cases oil and gas workers, including those laboring in the State of Tamaulipas, home of Mexico's largest dry gas reserves. [23]

To exacerbate matters, last December 15th the Fuerzas Armadas Revolucionarias Liberación del Pueblo, a newly formed and self-denominated guerrilla-type organization whose scope of influence and range of action is unknown at this time, publicly declared itself against the energy reform and announced that oil companies would be deemed military objectives. [24] These circumstances demand that the Mexican government put in place institutions, policies, and procedures that address issues beyond the oil patch such as low income, economic inequality, and corruption, all of which have led to Mexico's current insecure environment.

The crafters of implementing legislation and the regulators must also recognize their inexperience in matters relating to international oil and gas practice in a competitive market, look at Colombia as a role model, and take into consideration the expectations and suggestions of the intended target group: the oil patch. Just two and one half years ago, Poland, sitting on top of one of the largest shale gas reserves in Europe, dreamt of energy independence from Russia, attracting the likes of ExxonMobil, Talisman and Marathon Oil to their "shale revolution." Today, all such companies have abandoned their once-promising Polish projects officially citing unsuccessful attempts to find commercial levels of hydrocarbons, but mostly deemed by observers to be due as a result of delays in the enactment of meaningful fiscal and regulatory reform, inadequate contractual terms and an overly bureaucratic regulatory process.

In the Americas, Argentina, whose fundamental E&P regime has been in place since 1967 and provides for the granting of contractor-friendly exploratory licenses and production concessions, had until mid-2013 failed to attract meaningful foreign investment due to burdensome regulations and government actions negatively impacting such investment and investor confidence. [25] In contrast, Brazil had up to recently made all the right moves to attract big oil to its riches, awarding much desired concessions in most of its licensing rounds. Then came the late 2010 reforms for the pre-salt reserves, which in lieu of a concession for the Libra field (an approximately 600 square mile area expected to be a find larger than Mexico's Cantarell), implemented a production-sharing contract, one that in principle should not have been unappealing to the patch. [26] The round, however, attracted only one serious bidder, a consortium of Petrobras (40%), Total (20%), Shell (20%), CNPC (10%), and CNOOC (10%). Key players ExxonMobil, Chevron, BP, BG, and Statoil stayed away, perhaps signaling that the fiscal terms were too onerous and risky. [27]

The Polish, Argentine, and Brazilian experiences highlight Mexico's need to proceed in a carefully planned manner with the implementation of its energy reform, as interested investors will be watching with a critical eye. While the increase of oil and gas revenue sought by the reform is important and undoubtedly the most significant motive behind it, regulations should mainly focus on preventing waste of natural resources, protecting third party rights, preventing the contamination of the environment, and ensuring the safe conduction of all energy-related activities. In sum, regulations should let the free market play out.

Steps Forward

The Mexican government must now draft and enact implementing legislation by April 21, 2014, a tall order and no easy task considering more than 25 secondary laws will have to be amended or enacted. The mandatory guidelines set forth for such laws in the transitional articles of the amendments do provide a solid basis upon which the legislature can elaborate, but they are not all-encompassing and there is much to be done.

To succeed, the government must find a way to not limit unduly the broad and promising scope of the energy reform set forth at the constitutional level, through new laws or host government instruments containing provisions that discourage, rather than entice, an international oil company (IOC).

In the eyes of an IOC, the government take (whether in the form of up-front or back-end bonuses, royalties, taxes, profits or production share or carry) must be reasonable and balanced in light of oil price, cost (capital and operating), and risk (prospect size and probability of success) estimates, and the IOC's expected internal rate of return. The legal regime must also assure an IOC that the fiscal and other terms to which it has agreed up front will remain in place over the duration of its agreement. In other words, that an IOC will have legal stability in the context of a long-term, capital intensive investment in which returns may not materialize for many years.

Public pressure and the resulting temptation to coerce the renegotiation of a deal or assert windfall taxes as a result of high oil prices will be great, so it may be advisable to design a progressive fiscal system, one that can adjust to the recurring volatility of crude oil markets and a project's increase in profitability. True contractual stabilization in Mexico is rare, but if it were to be implemented, it would have to be conceived and tailored carefully to protect investors against changes in government administration and political goals and views, and to curb future government greed in the light of an IOC's E&P success.

Industry regulators also must strive to make all public tenders transparent and grant everyone equal access to all material information without preferring one investor over another. Part of the reform's success will lie not only in the ability of Mexican investors and companies to benefit from energy sector liberalization, but also in the IOC's confidence in Mexico's institutions and governmental authorities. The IOC will be part of Mexico's success only to the extent it is treated fairly and is able to bargain at arm's-length with all industry participants. To ensure this, regulators must be subject to internal and external controls and reporting, and be appropriately and effectively supervised and audited on a continuous basis in the areas of accounting and discipline. Citizens and market participants must also have an effective mechanism to express opinions and file grievances.

Pemex has until late March 2014 to request the assignment of areas it currently explores or exploits, and the Secretaría de Energía will grant such request if the former demonstrates it possesses the technical, financial, and operational capacities to explore and exploit hydrocarbons from such areas in an efficient and competitive manner. Once such areas are assigned, Pemex will be able to subcontract with third parties for the provision of oil field services under a more flexible procurement regime and enter into joint venture, operating, or other government approved upstream agreements under arm's-length terms to further explore, develop or increase production from such areas. These transactions could represent the first opportunity for IOCs to enter Mexico under the new oil and gas E&P regime.

The Mexican government has taken just one more step, albeit significant, to avoid becoming a net importer of crude oil and enhance its world-wide influence as a major exporter of crude oil. There is a bright light at the end of the tunnel, but it is still seen from afar. As previously stated, the reform's success or failure will lie in its detail.