Mexican energy reform: Awaiting secondary legislation and the first bidding round

Adrian Lara

February 3, 2014

Now that reform has passed in Mexico, GlobalData’s Adrian Lara weighs in on what to expect from the country’s budding energy industry.

Mexico has approved its most liberal reform concerning its energy sector. It introduces new arrangements such as profit-sharing contracts, production-sharing contracts and licenses and a complete opening for private participation in the downstream and midstream sectors.

Congress legislators now have 120 days after the promulgation date to pass the secondary laws that will include the terms and details for the new forms of private participation.

Pemex was given 90 days after promulgation of the reform to request, under preferential treatment, its chosen existing and prospective areas for exploration and production.

For accounting and financial purposes, the changes in the constitutional text will allow for the private sector and the state company to report any contract and its related benefits. It is still to be seen whether the secondary legislation and rules for implementation will allow for booking of reserves.

The path towards a liberal reform

In August 2012, the executive branch of the Mexican government sent to Congress a proposal for reforming the country’s energy sector. Concerning oil and gas, it argued that the bulk of the country’s remaining hydrocarbon reserves are located in challenging areas from both geological and engineering perspectives.

As a result, their recovery requires sophisticated and expensive technology. Pemex has ample expertise in shallow waters but does not have the expertise to enter more complex projects located in deep water or onshore shale plays. Moreover, the proposal established that, from a business point of view, it would be unwise to let Pemex assume the risk of such projects.

The ruling Institutional Revolutionary Party (PRI) put forward an original proposal that only considered a profit-sharing contract as the new addition to contracting options. However, the approved reform also includes the options of productionsharing contracts and licenses, which are generally considered much more attractive. These additions were pushed by the right-wing National Action Party (PAN).

From the beginning, the leftwing Party of the Democratic Revolution (PRD) never agreed with the idea of changing the Constitution. When they decided to leave the institutional channels for negotiation and declared that they would protest in the streets, PRI gave in to PAN’s demands for a more liberal reform.

The left-wing PRD has plans for organizing a referendum in 2015, seeking to invalidate the approved reform. They presented the case to the Supreme Court arguing that the right of citizens to decide on key national decisions should be guaranteed. It is now for the Supreme Court to approve or disaprove the possibility of organizing such a referendum.

Ambiguity in the new contracting schemes

According to the transitory articles that will modify the Mexican constitution, the contracting options for hydrocarbon exploration and production must include service contracts, profit or production-sharing contracts, and licenses. Nonetheless, the changed law does not specify which type of contract will be applicable to the different types of hydrocarbon exploration and production. Also, the inclusion of the words “among others” in the bill text may leave the door open for more tailored contracts which can give the State flexibility in terms of including the right fiscal incentives for private companies.\

However, Pemex’s financing and technological needs indicate the opportunities for private investment. Deepwater, shale and even shallow water areas can benefit from different combinations of technology transfer, capital expenditure in exploration and development, and managerial expertise.

For instance, Mexico’s deepwater prospective area in the Gulf of Mexico is considered underexplored. In this case, the licenses could be an appropriate type of contract for attracting the necessary capital while also compensating for a high exploratory risk. Profit and production-sharing contracts will most likely be intended for areas where the State and Pemex consider that capital has already been successfully invested but that a partnership can still be beneficial.

It seems fair to assume that the first bidding round for private investors will presumably include production and profit-sharing contracts, to test the waters.

The licenses will remain a politically sensitive and costly issue since they are associated with concession schemes and might, therefore, be more difficult to implement in an initial round. Furthermore, in subsequent rounds, the Mexican State could benefit from the interaction, feedback and results of any previous round. Service contracts will remain the preferred scheme for oil and gas services companies and some may also incorporate a risk or performance-related adjustment. These contracts were originally designed for use in rounds offering offshore mature fields and some areas in the resource-rich onshore Chicontepec play. However, since Chicontepec is also considered an unconventional play due to its geological characteristics and drilling requirements, it’s possible that the new contracts will be used for its development.

The new challenges for Pemex

As indicated in the approved reform bill, a Round Zero is expected to be held by mid-2014. As is the case in these initial rounds, preferential treatment is given to the national oil company (NOC) in proposing which existing and prospective projects they would like to keep out of future offerings.

This is important for two reasons: one is the obvious one of what will be left for private bidding, but it is also the beginning of a far more serious role on the part of the existing regulatory agency, the National Commission of Hydrocarbons (CNH) and the Energy Ministry.

The approved reform states that Pemex’s status will be changed from a Decentralized Public Organism to a Productive Public Company with the goal of greater autonomy and financial flexibility. However, modernizing Pemex would require more than just lowering its fiscal burden or giving the company the opportunity to associate with experienced oil and gas companies. Pemex is a company with severe operational and financial inefficiencies in its refining and petrochemical subsidiaries and many agree that their excess of labor is an issue that requires an urgent solution. In this context, one interesting turn of events during the reform negotiations was to strip the powerful Pemex workers’ union of its advisory board seats. As is evidenced by examples such as Norway’s Statoil, Brazil’s Petrobras and others, a competitive NOC can be a powerful tool, expanding the state’s reach beyond its own domestic resources. Getting this right will therefore be a crucial test for the approved reform.

The road ahead

Private participation in Mexico’s energy sector is expected to bring the necessary injection of capital and technology that could unlock vast hydrocarbon resources. What now follows, starting in 2014, is the modification of the related secondary laws. They only require a simple majority in Congress to be approved and therefore PRI’s political maneuver, as well as the policy directives of the Energy Ministry, will be influential in negotiating the content of this additional legislation.

A crucial test will be how international oil companies (IOCs) react when the new opportunities are offered, which will depend to a great extent on what they contain. In any case, there is still a long way to go before the approved reform materializes in actual new production or has a significant effect on the wider Mexican economy through lower energy prices.

To sum up, there is still a lot to be clarified in the secondary legislation, but for the moment, this reform seems to bring the opportunity for ending an inert situation that has lasted longer than necessary. After all, the current PRI administration seems to have a clear interest in expediting all of the pending procedures and testing the reach of the reform in attracting private capital as soon as possible. The most important point is that the passage of this bill removes the barrier of the constitution from a wide range of future reforms, allowing Mexico’s energy sector to adapt to prevailing conditions in the future.

 

Adrian Lara is a senior upstream analyst, Americas, for GlobalData. He has several years of experience as an oil and gas industry analyst, having held different positions within the trading arm of Mexican state-owned company Pemex. Adrian has a MS in Mineral and Energy Economics from the Colorado School of Mines, with a specialization in oil and gas from the Institut Français du Pétrole. He has a BA in Economics and Political Science from the Instituto Tecnológico Autónomo de México (ITAM).