Exploration and production in Mexico

Upstream sector regulation

"Round Zero" and entitlements

While a major goal of the reforms is to end the Pemex monopoly, a transitional "Round Zero" period will occur. During Round Zero, Pemex has a right of first refusal to retain development rights to areas in which it already has production or is actively exploring. Pemex submitted its Round Zero request in March 2014 asking to retain 100% of producing areas, 83% of proven and probable reserves, and 31% of prospective resources. SENER must respond by September 17, 2014.

Through the entitlement regime established by the Legislation, the executive branch will grant Pemex or another "State Productive Enterprise" the right to develop certain fields for a set term. SENER will review requests and grant entitlements on an "exceptional" basis, which implies that Pemex could receive additional entitlements even after the Round Zero period. Private parties will still have a role to play in this entitlement regime as they will be permitted to enter into service contracts with Pemex on a cash payment basis.

SENER can also approve a transformation of entitlements into exploration and production contracts. Should Pemex choose to migrate an entitlement into a contract, following approval of the SENER, it would then be permitted to form a partnership with private parties for the purpose of developing the field. A bidding process to establish those partnerships would occur under the management of the CNH, which would determine the terms of the partnership. Pemex would not be authorized to choose its partners or conduct the bidding process.

Exploration and production contracts

Unlike entitlements, exploration and production contracts will be granted to private parties through a competitive bidding process. SENER will select the field for public bidding and determine the technical and financial requirements for bidders. CNH will manage the bidding process and ultimately award contracts. The Hydrocarbons Law envisions the following contract models: (a) service contracts; (b) licenses; and (c) profit- and production-sharing contracts.

A: Service Contracts

Under a service contract, the private company will deliver the hydrocarbons production to the government of Mexico in exchange for cash payments to be provided in each contract. Payment to the contractor shall be made by the Petroleum Fund. No other fees or royalties will be included in service contracts.

B: Licenses

A private exploration and production company can obtain a license (similar to a lease of mineral rights) either directly through a bidding process for non-Pemex controlled fields or through a joint venture with Pemex for fields Pemex has acquired under an entitlement. The private company would have the right to the minerals once the minerals have been extracted from the ground, but would first be required to make economic payments to the Mexican government as follows: (i) an upfront signing bonus to be determined by the Ministry of Finance (Secretaría de Hacienda y Crédito Público "SHCP"); (ii) a monthly quota during exploration of $1,150 pesos (approximately US$100) per square kilometer which increases after 60 months to $2,750 pesos (approximately US$200) per square kilometer to incentivize the company to drill; (iii) a royalty payment on production once production begins; and, (iv) compensation to the government based on either operating profit, or the contractual value of the hydrocarbons produced. The amounts referred to in (i) and (ii) above will be annually updated in accordance with the Mexican Consumer Price Index.

The compensation to the government under clause (iv) above is determined by applying a percentage or rate to the operating profit, or value of hydrocarbons determined by multiplying the price per barrel and the volume in barrels produced. The rate and the price will be determined in each contract according to its terms. The value of the hydrocarbons can be reduced by the royalties paid and the costs and expenses of exploration and production.

C: Profit-Sharing and Production Sharing

With respect to profit- and production-sharing contracts, a private company will have to pay: (i) a monthly quota during exploration which increases after 60 months as described above; (ii) royalties on production once production begins; and (iii) compensation determined as a percentage of operating profit. With respect to clause (iii), the private company can recover its costs as a deduction from operating profit and can keep any operating profit in excess of the percentage paid to the Mexican government.

In profit-sharing contracts, the private company will deliver all of the production to the marketing company hired by the CNH, which shall deliver the sale revenues to the Petroleum Fund. The Petroleum Fund will distribute to the private company its share of profits on a monthly basis.

In production-sharing contracts, the contractor retains in-kind production equivalent to recoverable costs and their share of operating profit, delivering the remainder to the CNH marketing firm.

The applicable royalty rate for petroleum described above in regard to licenses, profit-sharing and production-sharing contracts will be determined based on whether the price per barrel is below $48, or equal to or above $48. If the price per barrel is below $48, the royalty rate is 7.5%. If the price per barrel is $48 or above, the rate is equal to [(0.125 x price per barrel) + 1.5]%. For example, if the price of oil is $100, the rate is 14%.

For gas mixed in with oil coming out of an oil well, the royalty rate is the price of gas divided by 100. For gas coming from gas wells, there is a formula. First, if the price of gas is equal to or below $5, the rate is 0%. If the price of gas exceeds $5, but is less than $5.50, the rate is = [((price - 5) x 60.5) divided by the price]%. When the price exceeds $5.50, the rate is equal to the price divided by 100.

A significant component of this reform process will be the requirement that energy projects must be comprised of 25% national content by 2015, a target that is expected to rise to 35% by 2025, except for deep and ultra-deep water projects that will be evaluated by the Ministry of Economy with advice from the Ministry of Energy.

Finally, private parties will be allowed to book for accounting and financial purposes their exploration and production contracts, as well as the expected benefits from such contracts; provided however, that at all times, the hydrocarbons located in the subsoil will be considered property of the Mexican State.

Midstream and downstream regulation

In the midstream and downstream markets, permits will be granted for oil refining, natural gas processing, manufacturing petrochemicals, and transportation, storage and distribution of hydrocarbons and petroleum products, which will be fully open to private investment through the granting of permits by SENER or by the Energy Regulatory Commission (Comisión Reguladora de Energía "CRE") as follows:

The CRE will issue permits for transportation, distribution, storage, compression, regasification, and retail sale of crude oil, natural gas, petroleum products, and petrochemicals.

SENER will issue permits for, among other things, (i) import and export of crude oil, natural gas and petrochemicals; (ii) refining of petroleum; and (iii) processing of natural gas.

The Hydrocarbons Law calls for open access and competition for midstream activities. Specifically, the law states that all providers of transportation, distribution, or storage services shall provide open and non-discriminatory access to their facilities. Moreover, the law seeks to encourage competitive pricing and competition among market players.

About the authors

WoodMac: Energy reform in Mexico almost approved; now for the hard part...

In December 2013, the Mexican Congress approved a historical constitutional amendment that ends the state's monopoly of oil, gas and power activities by opening up the entire energy sector to private investment from Mexican and foreign companies. According to Wood Mackenzie, this overhaul has the potential to revitalize the country's oil and gas sectors and effective secondary legislation, including competitive fiscal terms to attract investment, are essential to its success.

The approval process for Energy Reform in Mexico is at its final stage as the Mexican Congress has initiated the passing of secondary legislation. Political opposition to the reform has been negligible and no major modifications are expected as the reform passes through the Lower Chamber.

President Enrique Peña Nieto faces a challenge in implementing four major reforms, in additions to energy, simultaneously. The government is already committed to delivering lower power and gas prices by 2016 and any failure to meet this commitment will trigger a wave of negative sentiment towards the Reform.

Wood Mackenzie has analyzed the implications of the proposed secondary legislation that could open up the country's energy sector, which are highlighted below:

Upstream

• Once the secondary legislation is approved, the attention will shift towards the Energy Ministry's ruling on Pemex's Round Zero requests and the subsequent Round One.
• Wood Mackenzie expects Round One in 1H 2015. Companies will be able to form JVs in Pemex's assets, and also to pursue opportunities independently.
• Wood Mackenzie expects a variety of assets to be made available during the round, including deepwater exploration acreage, existing deepwater discoveries, as well as Chicontepec fields and extra-heavy oil assets.
• The proposed local content rules with a target of 35% by 2025 (excluding deepwater developments) will not be an issue.
• Deepwater projects, originally excluded, now include a local content target determined by the Economics Ministry.
• Wood Mackenzie still maintains that the success of the Energy Reform will be dictated by the attractiveness of the fiscal terms to be set in place. Mexico is aware of the need to strategically position itself with competitive government take levels to attract investment.

Midstream

Midstream investors will benefit from operating pipeline and storage capacity as joined networks called Integrated Systems. The existing gas network will operate as a National Integrated System. New private projects could opt to join or to be operated independently.

Downstream

• Energy reform in Mexico is expected to revitalize declining crude production by opening the oil and gas industry to private investors.
• Mexico has the largest gasoline deficit in the Americas, but despite forecasts for growing product demand leading to larger deficits it is unlikely that a new refinery will be built by the end of the decade.
• Low refinery margins, high investment costs, and proximity to growing product supply from the US Gulf Coast discourage new refinery investments.
• Investments in the existing refineries could yield increases in net cash margins.
• The introduction of free market pricing of petroleum products could make the refining industry more attractive to private investors.

Gas & Power

• Investment into gas pipelines and power generation should flow more rapidly. While local content provisions were included in the legislation, no targets are in place yet, only preferential access to rounds.
• The new legislation also provides stability as permits for current private generators remain in place and a five year transitioning period is provided.
• The government optimistically expects 35% of domestic power generation will be from renewables.
• The Energy Ministry will organize a geothermal Round Zero at the end of 2014 to promote private development of sites relinquished by the Comisión Federal de Electricidad (CFE).
• Trading of Clean Energy Certificates will be promoted to achieve the target. Wood Mackenzie forecasts that most of the additional power generation will come from gas-fired capacity and not renewables.
• The reform will be successful in attracting investment in gas and power, but a revision of the current tariff system is still required.