Mexico's energy reform has launched an ambitious process to end the long-standing state oil monopoly, holding the promise to increase oil production and bolster the overall economy. It also presents tremendous opportunities for private energy companies with expertise in mature fields, unconventional development, and offshore drilling.
However, since August 2014 when the Mexican Congress approved secondary legislation to permit private investment in the country's oil and gas sector, crude prices have plunged more than 50%, dimming-at least for now-the appeal of investing in Mexico's resources. With companies' cash flow and capital spending to be squeezed in 2015, investment opportunities-particularly in exploration-will be inevitably reconsidered with greater scrutiny.
The new market paradigm will put pressure on the Mexican government to make it more attractive for private companies to invest, especially in the first round of contracts up for grabs. Cost-recovery considerations, involving fully competitive terms and conditions, are of particular importance given the current low oil-price environment.
Shallow-water circumstances
On Dec. 11, 2014, the Mexican National Hydrocarbons Commission (CNH) released the bidding and contract terms for the first 14 shallow-water blocks in the Gulf of Mexico, kicking off the long-awaited first phase of the so-called "Round One."
These shallow-water areas are very mature. Most of them lie in the prolific Cuenca Salina geological province and contain light crude oil resources with low production costs. The costs could be below $20/bbl, according to a recent report of Credit Suisse.
Government officials believe that the relatively low production costs for the first shallow-water blocks should provide enough upside for would-be investors. However, as state oil firm Petroleos Mexicanos has already discovered and developed the most attractive shallow-water fields-including giant Cantarell field-the potential of discovering large and low-cost oil and gas fields in Mexico's shallow-water regions is low.
"While significant exploration potential remains, it is likely that most discoveries will be smaller fields with relatively high costs," said Pedro van Meurs, president of Van Meurs Corp. This disadvantage, combined with low oil prices over a prolonged period, could put off oil majors, which tend to seek the biggest and most profitable projects.
Fiscal terms
Along with the announcement of preliminary contracts for the shallow-water exploration blocks, details concerning fiscal terms have also been released.
These production-sharing contracts (PSC) will operate a return-based adjustment mechanism. Companies will receive relatively high profit split until a 15% internal rate of return (IRR) is reached. Between 15% and 30% IRR, the profit split reduces linearly. After 30% IRR is reached, profit split is set to 20% of the original bid of the contractor's profit split, making it hard to earn a higher return.
Using its Global Economic Model, energy research and consultancy Wood Mackenzie demonstrates the economics of Sinan field under the proposed terms, showing company IRR at different oil prices and contractor's profit split bids.
"Overall, we believe the terms manage to combine a reasonable amount of royalties while still remaining profitable in the case of negative price moves-a key consideration. However, at low oil prices and low initial profit share, royalties may impair the ability of companies to recoup their costs," WoodMac said.
WoodMac pointed out that in these times of reduced cash flow, contractors may be concerned by the relatively low cost recovery ceiling and the effect of the IRR-based profit share on projects in the final years of the contracts.
According to another analysis conducted by van Meurs, the proposed fiscal system is too tough for small fields, such as a 20-million bbl field in Mexico's shallow water. "Because of the very unfavorable terms under so-called 'upside' conditions, and the unattractive exploration economics, the terms proposed in the Model PSC are not competitive for the shallow water opportunities offered in the first bid round," he said.