TRANSACTIONAL: Upstream Developments -- Latin America Overview of PEMEX’s 3rd Round Model Service Contract

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On October 18, 2012, Pemex Exploración y Producción (PEP) published a model contract to be used in the bidding for E&P contracts in Chicontepec (the “Model”), an area in the eastern coastal plains of Mexico estimated to contain 33 percent of the country’s total hydrocarbons reserves. A total of six areas, representing 3,195 mmboe and 15 percent of Chicontepec’s total reserves, are now being offered to interested parties. PEP will prequalify bidders in the month of May and make an award on July 4, 2013.

The Model, referred to by PEP as a contrato de servicios integrales or full service contract, is the third contractual instrument issued by the national oil company as part of its broad business strategy of increasing production from mature fields, developing unconventional resources, and establishing commercial production in the Mexican deep waters of the Gulf of Mexico. The Model is fundamentally identical to the models developed for the first (2011) and second rounds (2012):

  • it is risk-based and covers exploration, development and production services;
  • a contractor may not claim any ownership over the hydrocarbons in situ or produced from the contract area, nor register any reserves as an asset in its financial statements; and
  • PEP may not make payments in-kind or grant a contractor a preferential right to purchase any hydrocarbons it produces under the contract.

The following sections summarize its key provisions:

a. Term

The contract term is 35 years divided into (a) a transition period of three months in which PEP will transfer to the contractor all assets and materials currently used in its operations, if any, (b) an initial period of 24 months in which the contractor will provide exploration services and commit to a minimum amount of investment, and (c) a development period in which the contractor will develop fields and produce hydrocarbons pursuant to a development program.

b. Work Obligations and Performance Guarantees

The contractor will have minimum work obligations for the initial period and for each year during the development period. Its failure to perform such obligations at or prior to the end of the applicable period, or the contractor’s relinquishment of the contract area (which may be accomplished in the contractor’s sole discretion upon a 3 month’s notice), will require that it make a payment to PEP in an amount equal to the value of the committed activities under the initial plan or annual work plan that remain unperformed.

To guarantee the performance of its obligations, including payment, the contractor must provide at the execution of the contract (a) an irrevocable and unconditional parent guarantee, in an amount equal to 100 percent of the value of the initial program, and (b) a stand-by letter of credit or bond for the same amount. The contractor must also provide guarantees during the development period in amounts equal to the value of each annual work program.

c. Notice of Continuation and Relinquishment

The decision to move forward with the development of the contract area rests with the contractor. To trigger the development phase, the contractor must deliver to PEP a “notice of continuation” before the date that is 30 days prior to the expiration date of the initial period. Failure to deliver the notice within the stated period of time will be deemed a waiver of the contractor’s right to provide the services, thus terminating the contract and triggering the contractor’s obligations to make the termination payment described in (b) above, if applicable, and relinquish the entire contract area. Note, however, that while no other provision in the Model requires further relinquishment, the contractor “must endeavor” to relinquish portions of the area in which it is not providing services, an obligation the scope of which has not been tested by Mexican courts in the context of upstream contracts. Partial relinquishments may be made by the contractor, provided they consist of one or two sub-areas of adjacent 1x1 minute geographic sectors organized in a polygon.

d. Development Plan

Once it delivers a notice of continuation, the contractor will have 90 days to deliver a development plan for the remaining portion of the term. Failure to deliver such plan within the stated period of time will be deemed a waiver of the contractor’s right to provide the services, and trigger the same consequences for a failure to deliver the notice of continuation.

PEP will have 45 days to approve or disapprove a development plan. The period, however, seems to be a target rather than an actual deadline, as there is no penalty or adverse consequence to PEP for its failure to take action within the 45-day period.

Disputes regarding a development plan, including one resulting from PEP’s failure to approve or disapprove the plan within the required period, may be submitted to a steering committee of two contractor representatives and two PEP representatives, an independent expert, or an arbitration tribunal (unless, in this last case, the dispute has been previously submitted to an independent expert), whose decisions will be final and binding. Failure to implement the independent expert’s determination will be deemed to be a waiver of the contractor’s right to provide the services and trigger the same consequences provided for a failure to deliver the notice of continuation or development plan.

e. Abandonment

The contractor is responsible for decommissioning and abandonment, and liable for all costs and expenses associated therewith. To fund abandonment operations, the contractor must establish and fund an interest-bearing account that will be managed jointly by PEP and the contractor. In lieu of establishing an abandonment account, the contractor may provide a stand-by letter of credit to secure the performance of abandonment obligations. The contractor’s liability for abandonment operations will survive 10 years after the termination of the contract.

f. Remuneration and Cost Reimbursement

Remuneration is still calculated by reference to an “available income” model, albeit the term “Available Cash Flow” used in prior round contract models is not used in the Model. As formulated, the contractor’s remuneration for any given month is equal to the amount of crude oil production from the contract area in such month (q) times an estimate of available income (in $/bbl) in such month (s) times the tariff bid by the contractor, expressed in terms of its net present value at the time of calculation (r).

PEP will reimburse the contractor 100 percent of recoverable expenses during the first ten years of the term, after which, a sliding scale reduces the percentage annually by two to three percentage points to a minimum of 75 percent in year 20.

g. Assignment and Change of Control

The contractor’s assignment of the contract, or of its rights or obligations thereunder, including its right to receive payments from PEP, requires the prior written consent of PEP, which may not unjustifiably deny its consent if the proposed assignment is to an affiliate of the contractor or another party to the contract. Changes in the control of the contractor also require PEP’s consent.

h. Subcontracting

Subcontracts are allowed for any type of activity, provided the contractor does not delegate the direction or control of the project. Any subcontract of services over USD$10 MM must be presented to the steering committee and follow a bidding process.

i. National Content

The contractor must prefer Mexican goods and services over foreign ones. The minimum national content of the services, including workforce and products, is set at 25 percent.

j. Termination

PEP may terminate the contract for cause, including the contractor’s failure to perform the initial work program or an annual work program, modification of the development plan without PEP’s authorization, failure to provide the performance guarantees, fraudulent reporting of eligible expenses, fraudulent making of representations, loss of financial capacity, insolvency or general assignment for the benefit of creditors, and failure to comply with the minimum level of environmental protection (established on the basis of acceptable levels of soil and water contamination). The contractor lacks a right to cure its breach, but PEP has the discretion to grant the contractor a cure period.

PEP may also terminate the contract for causes beyond the control of the parties, such as the occurrence of a force majeure event forcing the contractor to suspend the performance of a significant portion of the services for more than 180 continuous days.

k. Force Majeure

Neither the contractor nor PEP shall be liable to the other for the failure to perform its obligations under the contract, if such failure is caused by an unforeseeable (or if foreseeable, inevitable) event beyond its control. The following events are excluded from force majeure: the contractor’s lack of funds or a delay in the delivery of materials, and a strike by or conflict with the oilfield workers union (Sindicato de Trabajadores Petroleros de la República Mexicana). The party claiming force majeure has the burden of proving the existence of the event and causal effect.

l. Stability

The Model requires an amendment to the contract if a new or amended law (a) contains contractual conditions or rules more favorable than the ones contained in the law applicable at the time of execution, (b) affects the original economic equilibrium bargained by the parties, or (c) increases or decreases the taxes solely payable by oil and gas service providers, provided the amendment is agreed by, and “convenient” to, all parties.

m. Governing Law and Dispute Resolution

The contract is governed by the federal laws of Mexico, as amended from time to time.

Disputes relating to technical, security, health, environmental protection, operational, accounting and tax matters, or the manner in which contractor payments are calculated, may be submitted to an independent expert, whose decisions will be final and binding on the parties. All other disputes must be submitted to final and binding arbitration at law in accordance with the Rules of the International Chamber of Commerce.

Most of the terms and conditions of the Model are similar to those prevailing in international practice. However, even if projections of available cash flow were sufficient to generate an expected internal rate of return, contractors interested in maintaining a meaningful reserve replacement ratio could be discouraged by the contractual limitations on the ownership of hydrocarbons or the booking of Mexican crude oil reserves.