Analysis of proposed hydrocarbon legal regime in Mexico

Dallas Parker
Jose Valera
Pablo Ferrante
Gabriel Salinas
John Furlow
Mayer Brown LLP 

President Enrique Peña Nieto has introduced to the Mexican Congress nine new bills, as well as proposed amendments to several existing laws, to implement the constitutional energy reform that became effective on Dec. 21, 2013. The constitutional energy reform eliminates a restrictive legal framework that has limited private investment and participation in Mexico’s energy industry for more than 75 years.

The nine bills introduced on April 30, 2014, are:

  • The Hydrocarbons Law
  • The Hydrocarbon Revenues Law
  • The Electric Industry Law
  • The Geothermal Energy Law
  • The Law of the Coordinated Regulating Agencies of the Energy Sector
  • The Law that Creates the National Agency of Industrial Security and Environmental Protection of the Hydrocarbon Sector
  • The Petróleos Mexicanos (PEMEX) Law
  • The Federal Electricity Commission (CFE) Law
  • The Law of the Mexican Oil Fund for Stabilization and Development.

It is expected that the Mexican Congress will consider the implementing legislation in a special session during the second half of June 2014. This legal update addresses the main features of the proposed Hydrocarbons Law and the Hydrocarbon Revenues Law.

Overview

Together, the proposed Hydrocarbons Law and the Hydrocarbon Revenues Law establish a new legal framework for all hydrocarbon-related activities in Mexico, including the following:

  • Surface and geophysical surveying
  • Exploration for, and extraction of, hydrocarbons
  • The treatment, refining, transportation, storage, marketing and sale of petroleum and petroleum products
  • The processing, compression, liquefaction, decompression and regasification, as well as the transportation, storage, distribution and retail sales of natural gas
  • The transportation, storage, distribution and retail sales of liquefied petroleum gas
  • Pipeline transportation and storage of petrochemicals.

The Hydrocarbons Law restates two of the main principles governing the Mexican energy sector as established by the Constitution (as amended on Dec. 21, 2013):

  • That the hydrocarbons in place within Mexico’s territorial boundaries belong exclusively to the state and, thus, no concessions may be granted
  • That the exploration and production (E&P) of hydrocarbons are state strategic activities.

For E&P activities, the proposed Hydrocarbons Law provides two different regimes to be regulated by the National Hydrocarbon Commission (CNH): entitlements (called “asignaciones” in Spanish) granted to State Productive Enterprises (wholly owned state entities, including PEMEX) and E&P contracts entered into with State Productive Enterprises or private parties. For midstream and downstream activities, the proposed law establishes a “permit” regime to be generally regulated by the Ministry of Energy (SENER) and the Energy Regulatory Commission.

 I. PEMEX Round Zero

The transitional articles of the constitutional reform establish the so-called “Round Zero” process, during which PEMEX has the right to request E&P rights over areas it currently has under production, or that it is actively exploring. Any E&P rights granted to PEMEX under the Round Zero process would be under the entitlement regime. One of the main objectives of the reform is that, after this initial round, PEMEX is to compete on an equal footing with other operators in obtaining additional contract areas.

On March 21, 2014, PEMEX submitted its Round Zero request to the SENER, requesting to retain the following:

  • 100% of Mexico’s producing areas
  • 83% of Mexico’s proven and probable reserves (2P Reserves)
  • 31% of Mexico’s prospective resources.

SENER has a 180-day review period (ending on Sept. 17, 2014) from the date of the PEMEX request to decide which areas will be granted to PEMEX under the entitlement regime. SENER’s decision will be made with the technical support of the CNH, taking into account PEMEX’s technical, financial, and operational capabilities.

II. Entitlements

An entitlement is the administrative act by which the executive branch grants PEMEX, or another State Productive Enterprise, the right to explore and produce hydrocarbons in a determined area and for a particular duration, usually under an onerous tax regime established by law.

SENER, with the favorable opinion of the CNH, will be the entity responsible for granting or modifying entitlements to PEMEX, or any other State Productive Enterprise, for the performance of E&P activities.

Article 6 of the proposed Hydrocarbons Law provides that entitlements shall be granted on an “exceptional” basis, which would seem to permit the granting of area entitlements to PEMEX even after the Round Zero process.

The Hydrocarbons Law provides that PEMEX (and other State Productive Enterprises, as applicable) may only assign or transfer an entitlement to another State Productive Enterprise with prior consent from SENER. To meet its obligations under the entitlements, PEMEX may only enter into service contracts with private parties in regard to entitlements, which may only provide for cash payments to the contractor.

III. Migration to Contracts

The Hydrocarbons Law provides that PEMEX may request the approval of SENER for the migration or conversion of entitlements into E&P contracts. In the migration process, the Ministry of Finance shall establish the fiscal terms relating to those migrated contracts.

SENER is to decide the type of E&P contract that an entitlement may be migrated to.

With respect to entitlements migrated into contracts, PEMEX (and other State Productive Enterprises) may enter into “alliances or associations” with private parties. The proposed Hydrocarbons Law also establishes that, where PEMEX decides to enter into associations with private parties with respect to a migrated E&P contract, a tender process will be conducted by the CNH to select PEMEX’s partner. The technical and economic terms relating to the tender process will be established by SENER and the Ministry of Finance, respectively. Article 13 of the proposed Hydrocarbons Law provides that this tender process shall be conducted in a way that is most beneficial for the Nation (and, notably, not PEMEX).

The proposed Hydrocarbons Law further provides that SENER will seek PEMEX’s favorable opinion with regard to the experience and the technical, financial and operational capabilities that bidders would need to meet in order to participate in the bidding process.

IV. Exploration and Production Contracts

E&P contracts shall only be granted through a competitive bidding process, organized and regulated by different State entities and regulators.

Under the constitutional reform and the proposed Hydrocarbons Law:

  • SENER is charged with selecting areas for public bidding and establishing the technical and financial requirements for bidders
  • The CNH is charged with conducting the bidding process, evaluating bids, and awarding contracts
  • The Ministry of Finance is charged with establishing the economic and fiscal terms of the E&P contracts.

The new contract models for E&P activities are: (i) licenses, (ii) production-sharing contracts, (iii) profit-sharing contracts and (iv) service contracts, among others that may be established by law. The constitutional reform establishes that the law shall provide that “maximizing the nation’s revenues” is to be the guiding principle in implementing this framework. The Hydrocarbon Revenues Law provides for the economic aspects relating to each of the
 contract models.

A. License Contracts

Pursuant to the Hydrocarbon Revenues Law, the license contracts shall provide for the following payments in favor of the Nation:

  • A signing bonus
  • Exploratory phase fees
  • Royalties
  • A payment that consists of a percentage of operating profits or the contract value of hydrocarbons.

After making these payments, the contractor may take the hydrocarbons in-kind at the wellhead. All of the above payments shall be paid in cash by the contractor. These payments are in addition to any taxes owed by the contractor pursuant to the Mexican Income Tax Law or other tax laws.

          i. Signing Bonus

The signing bonus amount shall be established by the Ministry of Finance in the bid terms for each tender process relating to E&P contracts. The signing bonus is to be paid to the newly established Mexico Oil Fund.

Pursuant to the statement of intent of the proposed Hydrocarbon Revenues Law, the signing bonus will be paid at the moment and under the terms established in the specific tender process. The signing bonus will be known before the bid submission and will not be considered a factor in awarding the contract. The signing bonus is not expected to represent a “significant” percentage of the resources to be received by the Nation. It is mainly a “mechanism to guarantee the seriousness of the economic bids.” The amount of the signing bonus would not be recoverable for purposes of determining operating profit.

        ii. Exploratory Phase Fees

License contracts shall establish a monthly payment during the exploratory phase with respect to non-producing areas. The concept is similar to the delay rentals usually established under oil and gas leases in the United States. The exploratory phase monthly fees are as follows: (i) $2,650 Mexican pesos (having a current value of approximately $205) per square kilometer during the first 60 months of the contract term and (ii) $4,250 Mexican pesos (having a current value of approximately $330) per square kilometer starting from month 61 of the contract term. These amounts shall be adjusted annually for inflation (using the Mexican National Consumer Price Index). The purpose of these payments is to incentivize the contractor to move promptly to a production phase. The amount of the exploratory phase fees would not be recoverable for purposes of determining operating profit.

The exploratory phase fees are to be paid to the newly established Mexico Oil Fund.

     iii. Royalties

License contracts shall establish royalties in favor of the Nation that shall vary depending on the type and market price of the particular hydrocarbon (crude oil, associated and non-associated natural gas or condensates) actually produced. Royalties are payable in cash.

Royalty rates shall be applied to the “contract value” of produced hydrocarbons, which is calculated by multiplying the measured volume of production by its “contract price.” The contract price for each type of hydrocarbon refers to its market price in US dollars, as adjusted pursuant to a mechanism to be established in each E&P contract. The mechanism will take into account the hydrocarbon’s quality, API gravity, marketing, and transportation and logistical costs, among other factors.

      iv. Payment that Consists of a Percentage of Operating Profits Or the Contract Value of Hydrocarbons

Finally, the license contracts shall provide for a payment to be established on a contract-by-contract basis by the Ministry of Finance, depending on the type of project, consisting of a percentage of:

  • Operating profits or
  • The contract value of hydrocarbons.

Pursuant to the Hydrocarbon Revenues Law, this payment will be the economic factor to be evaluated in the bid offers for the award of E&P contracts. Pursuant to the statement of intent, this payment (percentage of operating profits or contract value of hydrocarbons) is the principal mechanism by which the Nation will obtain economic benefits from hydrocarbon production.

The operating profits shall be calculated by subtracting the following amounts from the contract value of the hydrocarbons produced:  (i) the royalty amount paid by the contractor in the corresponding month and (ii) the capital and operating costs and expenses incurred in the corresponding month, as well as the proportional part of the investments that are required for the execution of the particular E&P contract.

B. Profit-Sharing and Production-Sharing Contracts

Pursuant to the Hydrocarbon Revenues Law, profit-sharing and production-sharing contracts shall establish the following payments in favor of the Nation: (i) exploratory phase fees, (ii) royalties and (iii) a payment that consists of a percentage of operating profits. As consideration, the contractor has the right to recover costs pursuant to rules to be issued by the Ministry of Finance, and to receive a payment, or a share of production, depending on the type of contract, that will consist of the balance of the operating profits after paying the specified percentage of operating profits to the Nation.

The exploratory phase fees and royalty provisions applicable to profit-sharing and production-sharing contracts are the same as those applicable to license contracts.

In profit-sharing contracts, the contractor will deliver all of the production to the marketing firm retained by the CNH, which shall deliver the sale revenues to the Mexico Oil Fund. The Mexico Oil Fund shall retain the amounts belonging to the Nation, and shall pay the contractor its share of profits in cash on a monthly basis.

In production-sharing contracts, the contractor retains in-kind production with a value equal to the recoverable costs and its share of operating profits. The share of production equivalent in value to the State’s profits is delivered to the marketing firm retained by the CNH.

These contracts will include an adjustment mechanism for the profit split rates, so that the Mexican state “may capture the extraordinary profitability” from production. It is unclear what this adjustment consists of and whether it could somehow limit the market price upside for the contractor.

C. Service Contracts

In service contracts, contractors will deliver all production to the State, and payments shall only be in cash as established in each contract. Exploratory fees and royalties will not apply to service contracts. Payment to the contractor shall be made by the Mexican Oil Fund with the proceeds from the marketing of the production derived from each corresponding service contract.

V. PEMEX Participation in E&P Contracts

The proposed Hydrocarbons Law establishes that PEMEX may participate in tender processes for E&P contracts (after the Round Zero process) and may freely enter into joint ventures with private parties to participate in those tender processes. Unlike in entitlements migrated to E&P contracts, when PEMEX is granted an E&P contract in a competitive tender process, PEMEX, like any other private party, would be able to assign its rights and obligations under such E&P contract to another party under the terms established by the law.

Pursuant to the proposed Hydrocarbons Law, SENER may establish, within the bidding terms of E&P contracts, that PEMEX’s participation in a contract is required in the following cases:

  • Where PEMEX has an entitlement that coexists, at a different depth, with an offered contract area
  • Where there are opportunities to foster the transfer of knowledge and technology for the development of the capabilities of PEMEX or another State Productive Enterprise (up to a maximum 30% required participation) and
  • For projects that are to be supported by a specialized financial vehicle from the Mexican state, such as the Mexico Oil Fund (up to a maximum 30% required participation).

SENER shall establish, within the bidding terms of E&P Contracts, that PEMEX is to have a required participation:

  • Where there is a possibility of discovering an international transboundary deposit (with a minimum required participation of 20%).

VI. National Content

The proposed Hydrocarbons Law provides that SENER, with the favorable opinion of the Ministry of Economy, shall establish a minimum percentage of national content in each entitlement and E&P contract. Transitory Article 25 of the proposed Hydrocarbons Law establishes that the minimum average percentage of national content for E&P activities shall increase gradually starting from 2015, reaching at least 25% by 2025.

The percentage of national content required shall be established in the bidding terms of E&P contracts. The Ministry of Economy shall establish the measurement methodology for national content entitlements and E&P contracts and shall monitor contractor compliance. The entitlements and E&P contracts will include specific penalties for not complying with the national content requirements.

VII. Midstream and Downstream Activities

As noted above, all midstream and downstream hydrocarbon activities are to be regulated by permits issued by SENER or the Energy Regulatory Commission.

The following activities will require a permit from SENER:

  • Treatment and refining of petroleum
  • Processing of natural gas
  • Import and export of crude oil, natural gas, liquefied petroleum gas, petroleum products and petrochemicals
  • Non-pipeline transportation and storage of liquefied petroleum gas, as well as its distribution and retail sales.

The following activities will require a permit from the Energy Regulatory Commission:

  • Transportation, storage, distribution, compression, liquefaction, decompression, regasification and retail sale of crude oil, natural gas, petroleum products and petrochemicals
  • Pipeline transportation and storage of liquefied petroleum gas.

Pursuant to the transitory articles of the proposed Hydrocarbons Law, any party that currently engages in transportation, storage, distribution and retail sales, in accordance with the applicable legislation and regulations, and which does not have a permit granted by the Energy Regulatory Commission or by SENER, will need to apply and obtain a provisional permit to continue its activities within three months of the enactment of the Hydrocarbons Law.

VIII. First-Hand and Retail Sales

The proposed Hydrocarbons Law generally provides the the State will generally continue to regulate first-hand and retail sales of crude oil, natural gas, liquefied petroleum gas, petroleum products or petrochemicals, until the Federal Economic Competition Commission declares that there are effective competitive conditions in the retail sale of these products in the relevant markets.

Conclusion

The proposed Hydrocarbons Law and Hydrocarbon Revenues Law establish a new legal framework for hydrocarbon-related activities in Mexico. These bills are yet to be addressed and negotiated in Congress, and there may be significant changes made before they are approved. For updated information regarding the Mexican energy reform and the status of the secondary legislation, please visit: http://www.mayerbrown.com/mexico-energy-reform/

Ku-Maloob-Zaap development
A production facility in the Ku-Maloob-Zaap development in the Bay of Campeche. (Photo courtesy PEMEX)

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