Juan José Lopez de Silanes, Partner, Basham, Ringe y Correa: Viewpoint

Juan José Lopez de Silanes, Partner, Basham, Ringe y Correa, on the recent energy reform

In the 20 months to August 2014, Mexico enacted 11 structural reforms which are intended to provide a modern, flexible and reliable legal framework for both national and foreign investors and, in the long term, translate into a better quality of life for future generations. Most people will agree that the paramount part of the new legal reforms is the energy reform, and particularly the hydrocarbons reform, which will effectively allow private investment, both domestic and foreign, to flourish across the entire productive chain of the oil industry – upstream, midstream and downstream – while providing the Mexican government with a fair share of revenues.

With these ends in mind, in 2013 the Mexican constitution was amended to allow private oil and gas companies to compete with Pemex, the state-owned oil company, for the first time in more than 75 years. A series of statutory amendments were enacted thereafter, and on August 11, 2014, the last set of laws relating to the energy reform were published in the Federal Register’s evening edition. This move by Mexico was welcomed worldwide, as the Mexican oil industry had been closed to the private sector for more than seven decades.

The first challenge came much earlier than anticipated. When the Mexican energy reform was conceived, it was based on two key assumptions: an oil price of $100 per barrel, and the possibility of raising more revenues for the state – the so-called government take. However, in 2014 there was an oversupply of crude oil on global markets, resulting from increased exploitation of shale oil fields in the US, especially the Marcellus, Bakken and Utica plays.

The Arab OPEC countries were widely expected to adjust their production downwards, in order to stabilise the oversupply and support prices. This, however, did not happen, and the Mexican export mixture suffered a dramatic drop in its barrel price, which fell 60% from $101.13 on June 12, 2014 to $40.40 on January 30, 2015. This price drop poses a challenge for both the private sector and the world’s oil-producing economies, including Mexico.

One of the most important factors in managing an oil and gas company is its ability to handle price fluctuations. Other, related challenges are to forecast the responses in the market, to achieve financial stability and to maintain a positive circulating balance. Similarly, when creating policies for the oil and gas industry, government officials need to design attractive investment plans while still securing the government take. For instance, any tax regime designed when oil prices are lower than $55 a barrel most likely will not work well when the price is more than $100 a barrel – without considering the losses for the state on this particular item.

Regardless of the fall in oil prices, the game for Mexico will be the same. The first step is to transform Pemex from a state-owned monopoly into a “state productive company”. This will require a transformation of its current structure to make it more efficient, so that it can operate as any other competitor would, marketing its products to other private companies and even partnering with them. For this to occur, the company will need human, economic and natural resources to ensure production levels and adequate replacement of hydrocarbons reserves. This has been achieved in part by allowing Pemex to keep some of the most important oil and gas projects, which will not be offered to private partners – a policy known as Round Zero. The second step is to boost investments in exploration and production for oil and gas throughout Mexico, using as a vehicle various bidding rounds where Pemex and other bidders compete on an equal basis.

The Hydrocarbons Act establishes that Pemex can enter into alliances or associations with other companies in order to operate the fields that it decides to make available for contracts. By doing so, it is expected that Pemex will be able to accelerate development, increase production and access state-of-the-art technologies and practices. The company should also be better able to free some operating capacity and raise capital. In the short run, Pemex aims to establish around 10 joint venture agreements in fields or areas of expertise that are currently considered of high technical difficulty or that require large capital investments. The three models available for companies to enter Mexico’s energy industry are by licence, production-sharing contract or profit-sharing agreement.

The secretary of finance and public credit, and his team, have a huge responsibility regarding the sector, because they are in charge of administrating both the government take and the tax regimes for oil companies and Pemex for the upstream sector. Naturally, the secretary will be supported by various other federal government agencies.

From a tax perspective, there are a number of aspects which make the tax regime that governs the oil and gas industry rather complex. For example, it involves taxes that are levied on the general population, as well as some other payments that apply only to the oil industry and depend on the sort of contract involved. Further, the general tax regime has been amended in certain respects for the oil industry, particularly with regard to income tax.

On December 11, 2014, the National Hydrocarbons Commission published the first call for bids (Round One) in the Federal Register. This package was composed of 14 blocks located in shallow waters, to be awarded through the new production-sharing contract model for exploration and extraction, but also allowing participation by individuals, associations or consortia through joint proposals.

Nevertheless, it seems that given the current price for the Mexican mix, the invitations for the shale and deepwater plays will be delayed, and it is possible that the Ministry of Energy and the Ministry of Finance and Public Credit, which are responsible for the technical and economic aspects of the energy sector, will make important adjustments to maintain the competitiveness of the production-sharing contract, which at the time of publication was the only contract model included in the first call.

Mexico has certainly taken huge steps in trying to offer a modern, flexible and competitive framework for investors, especially in the energy industry. Yet the greatest test for energy reform has yet to come, as it must prove to be an effective and attractive alternative for the private sector despite the current oil prices. There are still a number of unsolved issues concerning both the legal framework and the tax regime. This is probably due to Mexico’s being a newcomer in welcoming private investment to this industry. Still, these issues need to be addressed as early as possible, not only by the government but also by the private sector and its advisors.

As regards the recent fall in oil prices, there are two widespread misperceptions to consider. First, people tend to think of the oil industry as restricted to upstream activity alone, and second, those unfamiliar with the oil and gas sector usually think in the short run only. However, during the last 35 years we have witnessed at least four other dramatic drops in oil price. This is a cyclical occurrence that is natural to the industry. As a whole, the oil industry is geared towards the long term, as the results of investments made today will materialise over time. Mexico has to learn to live with the volatility of oil prices, and this is true not only for the government but also for the new investors and their advisors.

The new legal framework provides an extraordinary opportunity for investment in the long run. The challenge for investors will be to receive accurate and efficient advice on the applicable legal provisions and the possibilities for implementing them. Just as in the gold rush, there will be many participants in all fields who will try to take advantage of the new opportunities. A crucial task for the investor is to identify reliable sources for any new ventures.

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