Analysis: Energy reform in Mexico: Is it time?

Analysis: Perspectives

President Enrique Peña Nieto recently announced that he will send a “transformational” energy reform bill to Mexico’s Congress in the coming months in an effort to attract the private capital and expertise required to develop Mexico’s deepwater and shale deposits, and reverse the country’s declining energy production.

Although companies have been providing oil-related services to Pemex, Mexico’s state-owned national oil company, for several decades, private investment in Mexico’s upstream sector has been absent since the country’s oil industry was nationalized in 1938. The absence of such investment is due to constitutional limits on private involvement in the exploration and production of hydrocarbon resources. Such restrictions, together with Mexico’s massive Cantarell oil field discovery in the late 1970s, explain the very limited investment and attention to exploration activities in Mexico.

In recent years, Mexico has experienced significant declines in oil reserves, production and exports. At the same time, with the growth of the Mexican population, the country’s consumption of refined oil products and natural gas has increased significantly, causing Mexico to rely heavily on imports from the United States and other countries. Although Mexico has considerable natural gas resources, its production has been relatively limited. Since crude oil sales represent one of Mexico’s main sources of income, equaling nearly a third of the national budget, Pemex has never focused on natural gas development. Furthermore, partly because of the private investment restrictions, Mexico’s refining capacity is capped, with only six refineries and a total refining capacity of 1.54 million bbl/d, all operated by Pemex. As a result of these factors, Mexico, despite its status as one of the world’s largest crude oil exporters, is a net importer of refined petroleum products and an importer of natural gas. If these trends are not reversed, the country is expected to become a net importer of crude oil by 2020.

Mexico does not lack for resources. As of January 1, 2011, Mexico had 10.4 billion bbl of proven oil reserves and an estimated 46 billion bbl in 3P (proven, probable and possible) reserves, mainly located in the deep waters of the Gulf of Mexico. According to a recent US Energy Information Administration report, Mexico also has the world’s sixth-largest technically recoverable shale gas resources (see reference).

In an effort to uncap this potential and halt the decline in production and exports, Mexico’s previous presidential administration proposed comprehensive energy reform in 2008. However, that reform proposal was significantly diluted before being approved by Mexico’s Congress. The final 2008 energy reform established the legal framework for upstream service contracts with private companies for the development of mature fields that allowed for some limited performance-related bonus payments. While the 2008 reforms were a step in the right direction, they fell short of the expectations of many hoping to reverse the country’s declining production trend by bringing in private capital, technology and expertise. Notably, the profit-sharing and reserve booking restrictions were left unchanged by the reform. It is widely acknowledged that such restrictions would need to be lifted in order to attract the capital and expertise needed to develop Mexico’s deepwater and shale gas resources, which hold most of Mexico’s prospective reserves.

Legal framework

Mexico’s constitution, like the constitution of the majority of countries in the world, provides that hydrocarbons in the subsoil belong to the state. Article 27 provides that, when it comes to hydrocarbons, “no concessions or contracts shall be granted, …and the Nation shall carry out the exploitation of those substances, under the terms set forth in the respective Regulating Law.”

The constitution also stipulates that hydrocarbons and basic petrochemicals are “strategic areas” for which the public sector shall have responsibility “in an exclusive manner.” However, the constitution does not establish that only Pemex shall develop Mexico’s hydrocarbons. In fact, the constitution does not contain the words “Pemex” or “Petróleos Mexicanos.” Moreover, the constitution only limits the “exploitation” of oil and derived products and not other downstream activities.

The Regulatory Law of Article 27 (Ley Reglamentaria del Artículo 27 Constitucional en el Ramo del Petróleo) goes beyond the terms of the constitution in at least two ways. First, it establishes that all of the following, and not only the “exploitation” of oil, are activities that are reserved to the nation: exploration, exploitation, refining, transportation, storage, distribution, and first-hand sales of crude oil and refined products. The law creates the concept of a “petroleum industry,” defines the industry as including all such activities, and provides that petroleum industry activities are strategic within the meaning of the constitution. Thus, pursuant to the Regulatory Law, private companies are prohibited from participating in exploration, production, transportation, refining, and sale of crude oil and its products; all exploration and production of natural gas; and the extraction, transportation, storage, distribution, and sale of natural gas liquids as feedstock.

Second, the Regulatory Law provides that the nation shall carry out petroleum industry activities only through Pemex, thus sanctioning the monopoly of Pemex over all these activities. Only Pemex, and not private companies, may receive “assignations” of contract areas.

The Regulatory Law also restricts the consideration payable by Pemex under service contracts for the exploration and production of hydrocarbons, prohibiting payments in kind or otherwise sharing in production, and prohibiting any form of sharing or allocation of sales proceeds or profits. Thus, a private company may not own production, share in the proceeds from the sale thereof, or share in the profits from the project. The 2008 energy reform did not change the fact that only Pemex may carry out petroleum industry activities and that only Pemex may realize their upside.

The upstream service contracts resulting from the 2008 statutory reforms are, essentially, (1) for enhanced recovery operations on marginal oil fields, and (2) for natural gas development in areas previously explored by Pemex. So far, compensation under these contracts is in the form of cost recovery and is fixed, per-unit of production cash compensation (which is adjustable for inflation). The total compensation payable to the contractor in any one year may not exceed Pemex’s net cash flow from the same project during that year.

Energy reform

Mexico’s current administration is expected to propose an energy reform bill as early as September 2013. According to statements from the administration, the bill could call for amending the constitution and legislation to allow private companies to participate in profit-sharing arrangements and joint ventures with Pemex, and would lift the prohibition on booking hydrocarbon reserves. The bill is likely to focus on, and may be limited to, the development of Mexico’s deepwater and shale gas deposits, where most of the country’s untapped reserves are believed to lie and where Mexico lacks the expertise required for extraction. Other onshore and shallow-water reserves, where Pemex has expertise and lower costs, are likely to remain under the current regime.

Such a bill is likely to face some opposition, but President Peña Nieto’s administration appears confident that the so-called Pact for Mexico (Pacto por Mexico) among the country’s three major political parties—the PRI, PAN, and PRD—will ensure passage of an energy bill by year’s end.

Only six months into his term, President Peña Nieto has managed to push through two major constitutional reforms in the telecommunications and education sectors, has proposed a comprehensive financial reform, and is expected soon to propose both energy and fiscal reforms, all of which were agreed upon in the Pact for Mexico.

Passage of a constitutional amendment in Mexico requires a two-thirds majority in both houses of Congress and an affirmative vote of a majority of the state legislatures. The ruling party, the PRI, holds slightly less than 50% of the seats in both houses of Congress, and would need the cooperation of one of the two other major political parties—the PAN and the PRD—to pass a constitutional amendment. The PAN is expected to support the energy reform bill. Thus, even without the support of the PRD, which has traditionally opposed energy reform, the PRI and the PAN would have enough votes to pass the necessary changes to the constitution. Politically, however, and pursuant to the Pact for Mexico, a consensus between the three parties would be required.

Congress is prepared to debate the forthcoming proposal. Congressional leaders of Mexico’s main political parties have agreed to hold two special sessions during the summer to tackle outstanding initiatives so that they can focus on the energy and fiscal reforms in September. OE

Reference:

Technically Recoverable Shale Oil and Shale Gas Resources: An Assessment of 137 Shale Formations in 41 Countries Outside the United States. US Energy Information Administration. June 2013. Web: http://www.eia.gov/analysis/studies/worldshalegas/pdf/fullreport.pd .

Jose Valera is a partner in Mayer Brown’s global energy practice in the Houston office. He focuses on domestic and international energy transactions, and has more than 25 years of legal experience representing oil, gas, and electric energy companies throughout the United States, Central America, South America, Africa, Asia, and the Caribbean.
Gabriel Salinas is an associate in Mayer Brown’s global energy practice in the Houston office. He focuses on international corporate and energy transactions and projects. He has experience representing companies on cross-border mergers and acquisitions, asset and equity sales, joint ventures, and oil and gas exploration and production projects, with a focus on Latin America.