The Mexican Congress has passed a sweeping energy constitutional reform bill that will open the country’s energy sector to competition. The bill calls for amending articles 25, 27 and 28 of the Mexican Constitution, and for adding 21 “transitional articles” detailing the regulations to be implemented. To become law, the bill now needs to be approved by a majority of Mexico’s state legislatures, which is expected soon. The key features of the bill are as follows: Allow licenses, production-sharing contracts and profit-sharing contacts to be granted by the government either directly to private parties or under association with the stateowned oil company, Petróleos Mexicanos (PEMEX); Allow private parties to book their reserves or economic interests; Open the oil and gas downstream and midstream sectors to private investment and competition; Open the power sector to further private investment and competition to encourage a competitive wholesale power market and private investment in other electricity activities; Create the Mexico Oil Fund to administer, distribute and invest the country’s oil profits; and End the monopolies of PEMEX and the Comisión Federal de Electricidad (CFE), converting them into “productive” companies with PEMEX to receive rights to certain oil and gas areas in a “Round Zero.” Once the bill is enacted, which is widely expected very soon, Mexico’s energy sector will be fundamentally transformed. The bill is the product of negotiations between the two main political parties in Mexico (the Partido Revolucionario Institucional or “PRI” and the Partido Acción Nacional or “PAN”). The bill requires the Mexican Congress to pass secondary laws within 120 calendar days detailing, among other things, the applicable terms, conditions and framework that will govern contracts with private parties. The following are the main features of the bill. Oil and Gas Upstream Sector The bill would end the restrictions on private investment in Mexico’s oil and gas sector. The proposed amendment to Constitutional Article 27 establishes that the nation may grant oil and gas rights to private parties or to its state-owned companies. The amendment would also allow state-owned companies to joint venture with private companies. The proposed contractual frameworks applicable to upstream activities would allow: 12 Mayer Brown | Sweeping Reforms Expected to Revolutionize Mexico’s Energy Sector Licenses, where private parties would be able to own hydrocarbons at the wellhead after the payment of all relevant fees and taxes; Production-sharing contracts; Profit-sharing contracts; and Service contracts. The bill provides that the State will choose the contractual framework best suited “to maximize the Nation’s profits.” 2 Congress is required to pass secondary legislation, including legislation to regulate each contractual framework within 120 calendar days after the enactment of the bill. 3 The bill provides that the contractual framework governing upstream oil and gas production and development “shall” (instead of “may”) include licenses, production sharing, profit-sharing and service contracts. 4 Also, it establishes that the list of contracts in the bill is not exclusive and that those named in the article are “among others” available for use by the Nation in developing the country’s oil and gas resources. 5 These provisions underscore that in passing secondary legislation Congress is not limited to choosing between licenses, production-sharing, profit-sharing and service contracts but has the flexibility to choose among contractual frameworks. The Ministry of Energy, with technical assistance from the National Hydrocarbon Commission, will be charged with granting oil and gas rights, selecting contractual areas for public bidding and awarding contracts, and establishing the technical and financial aspects in contracts and public bids. 6 The bill also provides for the creation of the National Agency of Industrial Security and Environmental Protection of the Hydrocarbon Sector (Agencia Nacional de Seguridad Industrial y de Protección al Medio Ambiente del Sector de Hidrocarburos). 7 This would be an independent and decentralized agency in charge of regulating and supervising operational security and environmental protection, including well decommissioning and abandonment and waste disposal. 8 Booking of Reserves. The bill establishes that private parties that execute oil and gas contracts with the government or with state-owned companies may “report for accounting and financial effects, the corresponding assignation or contract and their expected benefits,” 9 in the understanding that the hydrocarbons in the subsoil belong to the state. Accordingly, this provision in the bill would effectively end the ban on the booking of reserves, 10 a reporting practice that is essential to international oil companies (IOCs). Under international practice, IOCs can show the quantity of reserves they control in a supplement to their financial statements even though they do not technically own them. Indeed, companies typically do not own hydrocarbons in the subsoil, other than in the United States, and companies can book reserves based on their reasonably anticipated production under contracts around the world. In the United States, the US Securities and Exchange Commission (SEC) has published accounting guidelines for the reporting of reserve estimates by US public entities. The SEC defines “proved reserves” as “the estimated quantities of crude oil, natural gas and natural gas liquids which geological and engineering data demonstrate with reasonable certainty to be recoverable in future years from known reservoirs under existing economic and operating conditions….” Thus, whether a company will be able to report proved reserves will largely depend on what rights the company has, or what its economic interest is, in the subject hydrocarbons upon extraction. Where the company participates and derives an economic interest in the hydrocarbons produced like a producer, and is exposed to technical, environmental and commercial risks like an ordinary producer, then the operators should be permitted to book reserves under applicable SEC3 Mayer Brown | Sweeping Reforms Expected to Revolutionize Mexico’s Energy Sector guidance. If any applicable contract expressly prohibits operators from reporting reserves, then this treatment may be entirely different. By ending the ban on the reporting of reserves, the proposed reforms further open the door for the participation of IOCs in the Mexico energy sector. Midstream and Downstream Sectors The bill seeks to open the midstream and downstream sectors to private investment and competition. The Energy Regulatory Commission (CRE) would be in charge of granting permits for the storage, transportation and distribution of oil, natural gas, oil byproducts, ethane, propane, butane and naphtha. The CRE would issue regulations for the first-hand sales of these products. The Ministry of Energy would be in charge of granting permits for oil treatment and refining and natural gas processing. 11 The proposed bill mandates that, within 120 calendar days of its enactment, Congress shall adopt required secondary legislation to effect the above measures. Currently, the Regulatory Law of Article 27, a federal statute, bans private participation in oil midstream and downstream activities and the extraction of liquids from natural gas. Moreover, the bill provides that 12 months after its enactment, the Executive Branch shall issue a decree to create the National Center of Natural Gas Control (Centro Nacional de Control del Gas Natural) to oversee the operation of the national pipeline network. PEMEX is required to transfer the necessary resources to the National Center of Natural Gas Control so that it may carry out its objective. 12 In addition, PEMEX must transfer all relevant contracts to the National Center of Natural Gas Control, so that agency may administer those contracts. 13 Electricity Sector The bill seeks to open the electricity sector to greater private participation and investment. The proposed amendment to Article 28 of the constitution removes the reference to power generation as an activity which is reserved to the State. Power generation would not be designated as a “public service,” thereby allowing private sector investment. Electricity transmission and distribution, as well as the planning and control of national electric grid, would remain public service activities reserved to the State; however, State entities would be able to enter into agreements with private parties in those areas. 14 These reforms would open the door to a competitive wholesale electric generation market, which would represent a fundamental departure from the current regime where parties may only participate in limited power generation activities. 15 Within 120 calendar days of the enactment of the bill, Congress is required to adopt secondary laws regulating private participation in the electricity sector. 16 In addition, the bill provides that 12 months after its enactment, the Executive Branch shall issue a decree creating the National Center of Energy Control, which will control the national electricity network and the wholesale electricity market as well as ensuring open access to the transmission grid and distribution channels. 17 CFE is also required to transfer the necessary resources to the National Center of Energy Control so that it may carry its objective. 18 State electricity transmission and distribution activities, as well as petroleum exploration and production activities, shall have “preference” over any other activities affecting the surface or subsoil, a concept similar to the right of a dominant estate in the United States. 19 Secondary laws shall regulate compensation for surface use. 204 Mayer Brown | Sweeping Reforms Expected to Revolutionize Mexico’s Energy Sector Mexico Oil Fund The bill proposes creating a new entity, the Mexican Oil Fund (Fondo Mexicano del Petróleo), a public trust to be administered by Mexico’s central bank (Banco de México). The new entity would be entrusted with receiving, administering and distributing oil revenues. 21 The Mexico Oil Fund, modeled after Norway’s sovereign natural resources fund, would invest part of the oil income into long-term savings and pensions. 22 The fund would be subject to transparency rules to be established by secondary laws. 23 It will be controlled by a technical committee comprised of three representatives from the government and two independent members appointed by the President and approved by two-thirds of the Senate. 24 PEMEX and CFE The bill seeks to end the PEMEX and CFE monopolies and convert them into “productive” State-owned companies that would compete in the marketplace. 25 Under the bill, PEMEX and CFE’s main objective would be “creating economic value and increasing the Nation’s profits, following the principles of equity, and social and environmental responsibility.” 26 Their budgets would be proposed by the Ministry of Finance and approved by Congress. 27 The bill further provides that PEMEX and CFE should adopt industry best practices in terms of their organization, administrations and corporate structures. 28 Both companies would also have special regimes for contracting goods and services in order to “efficiently compete” in the relevant industry or activity. 29 Each company would have a new board of directors composed of five independent members and five members of the federal government, including the Secretary of Energy who will preside over the boards. In addition, the Secretary of Energy as the president of the boards, will have the power to cast a deciding vote in the event of a tie, giving ultimate control to the Nation. Among other things, this revision removes the requirement of including representatives of the PEMEX union in the PEMEX board of directors. The members of the boards are to be appointed and removed by the President. 30 The Ministry of Energy is charged with assigning certain exploration and production areas to PEMEX in a “Round Zero.” PEMEX shall request the Ministry of Energy to assign to it certain exploration and production areas based on its operational, technical and financial capacities. 31 In assigning areas to PEMEX, the Ministry of Energy shall take the following factors into consideration: In areas with exploration investments, PEMEX shall continue exploration activities for three more years, which may be extended up to two more years. In case of successful production, PEMEX shall be able to continue the development of those areas. PEMEX shall maintain its rights in all productive fields and shall deliver a development plan for those areas, which shall provide for efficient and competitive production. 32 PEMEX may also request that the Ministry of Energy convert the company’s existing contracts to licenses, production sharing contracts or profit sharing contracts, so that PEMEX may, in turn, contract with private parties, including in joint venture or other risk/profit sharing arrangements. The National Hydrocarbon Commission is required to provide technical assistance in this process and conduct public bids to offer these opportunities. 33 In addition, the bill provides that Congress must adopt secondary laws and regulations to prevent the corruption of public officials. Any party involved in acts of corruption shall be “indentified and seriously sanctioned.” The anticorruption language is modeled after the US Foreign Corrupt Practices Act (FCPA).5 Mayer Brown | Sweeping Reforms Expected to Revolutionize Mexico’s Energy Sector Conclusion The energy reform bill represents the most significant opening of the Mexican energy industry in 75 years. The reform comes at a pivotal time for Mexico, which is experiencing a steep production decline and an economic slowdown. The transitional articles of the bill (which were heavily negotiated by the PAN) establish a clear and precise roadmap of the steps ahead, including the content of secondary legislation and creation of key regulatory agencies. The bill represents the culmination of several energy proposals (including proposals by the PAN and the PRI), academic and industry reports, debates, surveys, which have materialized into reforms of the type that have proven to be successful in countries such as Brazil, Colombia and Norway. With the reform, Mexico will be able to attract the private capital, technology and technical expertise needed to develop Mexico’s abundant energy resources, particularly its deepwater and shale resources. We believe that the benefits to Mexico and Mexicans will be very significant and result in the desired long-term growth and development of the entire Mexican economy, as well as usher in a geopolitical shift to North America (the United States, Mexico and Canada) as energy powerhouses.