Mexican Congress to Consider Constitutional Oil and Gas Reforms: Bold Stride Forward or Half-Step?

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In what amounts to a sea-change in Mexican energy politics, each of a parliamentary group of Partido Acción Nacional ("PAN") and the President of Mexico, Enrique Peña Nieto, is sponsoring its own bill to amend the Mexican Constitution to permit, for the first time in generations, the participation of private capital in Mexico's upstream oil and gas business.

Article 27 of the Mexican Constitution and its regulation effectively ban "risk contracts" in the form of concessions, production sharing agreements and risk service contracts, and reserves all exploration and production activities (along with certain midstream and downstream activities) exclusively to the Nation, through the state oil company, Petróleos Mexicanos ("Pemex") and its subsidiaries. [1] While Pemex conducts many of these activities through service contracts, the contractor thereunder may never obtain ownership in hydrocarbons, nor receive compensation based on the value of hydrocarbons produced by it. [2] These restrictions have very purposefully discouraged traditional oil and gas companies, large and small, from participating in the development of Mexican hydrocarbons reserves.

Though it may have grown out of the purest of nationalist motivations, this unwillingness to allow private capital to share the significant risk and expense of finding reserves, and the potential reward, together with government policies that strip Pemex of a majority of its revenues each year, have resulted in a steady, and recently precipitous, decline in the Mexican reserve base, and commensurately declining production levels. At a time in Mexico of increasing demand for hydrocarbons, annual crude oil production is down from 3.2 million barrels per day in 2002 to 2.5 million barrels per day in 2012, condensate production is down from 408 million barrels per day in 2002 to 365 million barrels per day in 2012, and naphtha production is down from 3.2 metric tons in 2002 to 2.8 metric tons in 2012. Some claim that if new reservoirs are not discovered and developed quickly, Mexico's production of crude oil could drop below 1.5 million barrels per day by 2020, thus making the country a net importer of crude oil. [3]

This decline in reserves and production represents an impending economic tragedy for the Mexican government, which depends on oil revenues and which traditionally has enjoyed the influence that accompanies its position as a major exporter of crude. The seriousness of the situation is manifest in the fact that members of both PAN and Partido Revolucionario Institucional ("PRI"), the political party to which the President is affiliated and PAN's traditional adversary on major government policies, perceive a strong need to push for Constitutional change before the situation deteriorates further. [4]

Proposed Bills

PAN submitted its bill on July 31, 2013, twelve days before the President submitted his. In keeping with its free-market vision, PAN advocates a liberal approach: the simple deletion of the provision of Article 27 prohibiting the granting of "concessions or contracts" for hydrocarbon exploitation. With this simple deletion, the Mexican constitution would more closely resemble that of almost every other hydrocarbons-producing nation. The state would still own the resource in the subsoil, but would not be constitutionally prohibited from granting to oil and gas companies the right to explore for and produce oil and gas, or once produced, to take ownership of some or all production.

In fact, PAN advocates the adoption of a concession regime, the most politically liberal approach and one universally shunned by Latin American governments until Brazil, and then Colombia, adopted it 1997 and 2003, respectively, with spectacular results. [5] The concessions would be governed by secondary legislation and:

  • apply to hydrocarbons in both conventional and unconventional reservoirs;

  • be granted and administered by the Comisión Nacional de Hidrocarburos ("CNH"), a state regulator with Constitutional powers, financial autonomy and managerial independence from Pemex and the executive, legislative and judicial branches of the federal government;
  • be awarded by bid process to the best applicant among public and private companies, public/private partnerships and Pemex, though Pemex would be preferred in the initial assignment of contract areas; and
  • grant the concessionaire the right to obtain title to production at the wellhead upon its payment of royalties and taxes to the Fondo Mexicano del Petróleo ("FMP"), a Constitutionally-created fund with financial and managerial independence from the federal government modeled after Norway's Government Pension Fund Global.

The refining, processing, distribution, transportation and storage of crude oil and other hydrocarbons would be also subject to a concession regime, regulated by the Comisión Reguladora de Energía (the "CRE"), also a state regulator with Constitutional powers, and financial autonomy and managerial independence similar to the CNH and the FMP.

Followers of Mexican history know that the nationalization of the oil industry in the 1930s was a major historical event, celebrated even today by a national holiday. It has long been characterized as the Mexican sovereign act of taking back the national patrimony from exploitative foreign capitalists. Thus, the idea of allowing private capital back into the oil patch is without doubt the single most controversial idea in Mexican politics today. PAN's proposal is therefore provocative: it not only would take the bold step of re-establishing the concession concept in Mexican law, but also de-emphasizes completely the role of Pemex, for decades the only vehicle through which oil and gas exploration and exploitation has been permitted. The PRI, on the other hand, was until the election of the first PAN president in 2000 the party in power from the time of the Mexican Revolution and the chief political guardian of Article 27. While its time in the wilderness may have convinced PRI leaders that Constitutional change is necessary, it still represents the more ideological and statist view.

Thus, the President's bill is less liberal than PAN's, seeking to combine what he calls both "national" and "modern" sentiments. The President advocates a purely contractual regime, maintaining in effect the provision of Article 27 prohibiting the granting of concessions for the exploration and exploitation of hydrocarbons. This prohibition was the cornerstone of Lázaro Cardenas' energy reform in 1940, and could be said to preserve the core of the nationalist sentiment that is so protective of the role of the state. However, the bill would eliminate the constitutional provisions reserving to the state the exclusive right to exploit such hydrocarbons and restricting it from entering into contracts for the exploration and exploitation of hydrocarbons with third parties. The contractual regime, which would be further regulated by implementing legislation, would:

  • apply to hydrocarbons in conventional and unconventional reservoirs;
  • be administered by the executive branch or an agency thereof;
  • be entered into by the executive branch, or an agency thereof, with public and private companies, public/private partnerships or Pemex; and
  • provide for payment mechanisms based on production made in cash or an "equivalent to a percentage thereof" (e.g., in-kind production), among others. [6]

Not unlike the PAN's proposal, the President's bill would also reform the Constitution by eliminating Pemex's monopoly over the refining, transportation, storage, distribution and marketing of hydrocarbons, and all other activities in its value chain (including the processing of natural gas and petrochemicals), opening the traditionally-closed sector to private capital, subject to the granting of the applicable permit by the executive branch of the federal government.

The Proposals Compared: Is Mexico Ready for the Post-Pemex Monopoly Era?

The federal government has long financed the majority of the national spending budget (presupuesto de egresos) by taxing Pemex without regard to its corporate or investment needs. The Ley Federal de Derechos, which governs taxes for the use and enjoyment of hydrocarbons, currently allows the federal government to tax Pemex at a rate of 71.5 percent over the hydrocarbons it produces minus certain authorized deductions. It also allows it to assess against Pemex an oil export tax equal to approximately 13.1 percent of the difference between the weighted value per barrel of crude oil it produces and a set price, as estimated in the annual national income budget (presupuesto de ingresos), as well as a windfall tax between 1 percent and 10 percent over the difference between the weighted value per barrel of crude oil it produces and 22 dollars -- among other significant taxes. In all, Pemex has paid up to 70 percent of its gross revenue to the federal government during the last ten years, materially affecting its viability as a profitable company and successful oil and gas producer.

PAN´s proposal to sideline Pemex continues to challenge the status quo. PAN envisions a market where Pemex, freed from its burden to directly contribute to the budgets and with financial and managerial autonomy, competes for business with all other operators (albeit with certain preferences in the assignment of properties), and all of them pay taxes and royalties to FMP, the fund tasked with administering all income generated under the concessions. FMP's income would not be used to replace fully the government's loss of revenue, but rather to gradually wean the government from its dependence on hydrocarbons-related revenues to not more than 50 percent of all amounts deposited into the fund by the tenth year after its implementation. Moneys deposited into the fund and not funneled to the budgets would be used for a variety of future social and other budgetary purposes, such as relieving the burdens of a fiscal deficit. This is important, for a government's ability to access and profit from private investment depends in part on its ability to manage and administer the wealth created by such investment. On the other hand, PAN's proposal places substantial reliance on independent regulatory bodies that are as yet untested and may face substantial headwinds as they invade territory traditionally controlled by the PRI.

The President's bill continues to use Pemex as a major revenue-generating instrument for the federal government, though with an "acceptable, more moderate" tax burden to be specified in a separate fiscal bill.
[7] Any revenue that would be otherwise tendered over directly to the government as a tax payment under the current fiscal regime, the President proposes, would be reinvested by Pemex in exploration or exploitation projects or distributed to the government as a dividend for use at schools, hospitals or other infrastructure projects. To say the least, this regime may not give Pemex the funds it needs to be able to compete with other operators.

Outlook

The proposed bills are indeed a step in the right direction for a country much in need of a dramatic increase in hydrocarbons reserves and a legal structure that can promote a rapid and appropriate development of its natural resources. Though both bills recognize that the current system of non-risk service contracts is inadequate to attract risk capital and modern technology, they also reflect differing views regarding the manner in which to attain such goal.

Barring any unusual terms or conditions in the concession regime, PAN's proposal would be the one favored by those with the skills and capital Mexico needs, as a concession would grant the concessionaire the right to explore for hydrocarbons in an area, and to develop discoveries, acquire ownership of the hydrocarbons it produces and freely dispose of and monetize such production, even if minimum work commitments are required and a reasonable percentage of it must be sold in the national market. The alternative, which focuses on contractor compensation rather than on the right to acquire production, may be less desirable to those seeking the latter, though not dispositive of the issue if the contractor has the right to be paid in kind, purchase production preferentially or otherwise claim a revenue based on production. Therefore, much of the success or failure of the proposed energy reform vis a vis potential market participants will lie in the detail set forth in implementing legislation, and particularly, in the nature of the rights granted to the concessionaire or contractor under the host government agreement.

If the terms and conditions of either the concession or contractual regime allow the concessionaire or contractor to book reserves and the concessionaire's or contractor's expected internal rate of return in connection with the particular project justifies the associated geologic, operational, commercial and political risks, Mexico will attract the investment it purports to seek. If not, the proposals will fail, following the luck of all prior energy reforms.

The reform faces considerable obstacles in the Mexican congress. The Partido de la Revolución Democrática ("PRD"), Mexico´s third largest political party in terms of congressional presence and a considerable populist force, has unequivocally stated it will not support either bill and, if pushed far enough, may seek a popular referendum to "defend Pemex from privatization and prevent the sale of the nation's wealth to private interests, foreign and domestic." Not even the PRD, however, may be able to stop current reform. Any bill seeking to amend the Mexican constitution requires the affirmative vote of two thirds of the members of congress and a majority of the state legislatures, a requirement that will be satisfied if the PRI and PAN federal and state legislators, and their congressional allies, unite. At this time, the PRI and PAN collectively hold 92 out of 129 seats in the senate, equal to 71 percent of the seats, and control more than 17 of the 32 state legislatures. They also hold 327 out of 500 seats in the house of representatives, which together with 38 additional seats held by their political allies, equals 73 percent of the seats.

So now, the Mexican legislature has big choices to make: maintain current course, approve either of the proposed bills or approve a new, modified bill, which ultimately would have to be approved by the President. Opting for the first will do nothing and continue the current downward trend in energy production the country so desperately seeks to revert. Opting for either of the latter, will take the country a step closer to enacting meaningful energy reform; but only a step closer. Success or failure will lie in the detail.

____________________

[1] The Constitution in fact prohibits the government from granting "concessions or contracts", which would appear to exclude even service companies from acting on behalf of Pemex. However, the term "contracts" in the context of Article 27 has long been interpreted to exclude from its scope mere service contracts that do not grant contractors a percentage of the value of production. This interpretation was reinforced by the Law Regulating Article 27 of the Constitution in Regard to Petroleum, which states in Article 6 that Pemex and its subsidiaries may enter into service contracts, provided services payments are always made in cash.
[2] Any doubt about the interpretation of Article 27 in this connection was clarified by Article 6 of the Law Regulating Article 27 of the Constitution in Regard to Petroleum, which further states that Pemex is prohibited from entering into contracts under which the contractor is granted a percentage of production or a right to any profits made by Pemex from the sale of production.
[3] According to Pemex's 2012-2026 crude oil outlook (Prospectiva de Petróleo Crudo 2012-2026), heavy and light crude oil consumption by the national refinery system will increase from approximately 1.3 million barrels per day in 2012 to 1.7 million barrels per day in 2019. Mexico is currently a net importer of natural gas.
[4] It would be evident enough from the support for reforms by the PRI, which backed the great expropriations in the 1930s, and since then has perennially run (and almost always won) national elections on its slogan "The Oil is Ours!" (El Petroleo es Nuestro!).
[5] Brazil increased its proven reserves from over 8 billion barrels of oil equivalent to over 14 billion barrels in 2012, and its crude oil production from less than 750,000 bbl/day to over 2 million bbl/day in 2012. Colombia's crude oil production had declined from a peak of 830,000 bbl/day in 1999 to less than 600,000 bbl/day in 2003, mainly as a result the natural decline of existing oil fields and a lack of investment and sizable new reserve discoveries. The new regulatory framework, however, attracted private capital to the country and Colombia reverted the decline by 2008. It currently produces over 920,000 bbl/day and registers over 2 billion barrels of crude oil reserves.
[6] It is not clear at this time, perhaps purposefully, what the phrase "equivalent to a percentage thereof" means, and whether it refers to an actual percentage of production, a share in the profits from Pemex's sale of hydrocarbons, both or otherwise.
[7] This burden is estimated to be around 60 percent over gross hydrocarbons production under the proposed fiscal reform applicable to Pemex.

 Adrian Talamantes
 Houston
 +1 713 751 3253
 atalamantes@kslaw.com

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 Ken Culotta
 Houston
 +1 713 276 7374
 kculotta@kslaw.com

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Topics:  Constitutional Amendment, Mexico, Oil & Gas, Private Capital

Published In: Constitutional Law Updates, Energy & Utilities Updates, Finance & Banking Updates, International Trade Updates

DISCLAIMER: Because of the generality of this update, the information provided herein may not be applicable in all situations and should not be acted upon without specific legal advice based on particular situations.

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