Mexico - A Pathway to the Prize?

Mexico - A Pathway to the Prize?

24th August 2016

Ever since the announcement of the 2013 Reforma Energética in Mexico, the international energy industry has held its collective breath for the opportunity to invest in the so called “Pemex Farmouts”.  This article explains the challenges that the process has faced, and offers some suggestions to try and help PEMEX, and the regulators involved in the process (Secretaria de Energía (SENER), Comisión Nacional de Hidrocarburos (CNH), Secretariat de Hacienda y Crédito Público (SHCP) forge a path forward. 

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Experts in Mexico Brochure

Background

In August 2013, Mexico passed constitutional reforms that allowed direct private investment into the upstream sector of the oil and gas industry for the first time since 1937.  Prior to this change, investment was limited to service contracts with Pemex that acted as “paid in kind” transactions for outside firms.  While these Contratos Integrales Exploraciones y Producciones (CIEP) and Contrato Obra Pública Financiada (COPF) contracts did in fact attract investment, most of the investors were:

      1) US oil field service (OFS) companies Schlumberger, Halliburton and Baker Hughes;
      2) Foreign companies such as Petrofac, Lewis Energy,and TecPetrol; and
      3) Mexican OFS companies, including Grupo Diavaz, GPA Energy, and CP Latina. 

This was an important first step, but did not do enough to attract the billions in exploration, appraisal, and development dollars needed to arrest Pemex’s rapidly declining production (Figure 1). 

Figure 1: Mexico Production Rate & NYMEX Oil Price

With the passing of the Reforma Energetica in 2014, Mexico could award contracts to foreign firms in the form of Production Sharing Contracts (PSCs), Profit Sharing Contracts (in essence very similar to PSCs, but with the sharing being in the form of cash rather than oil or gas), or Exploration and Production Licenses.  These contracts could, for the first time, allow for investors to “book” reserves. 

The next stages of the reform progressed with special consideration paid to the strengthening of the regulatory bodies and the division of responsibilities within the various state agencies. 

As part of the reforms, PEMEX submitted to SENER and CNH its plan for development of the hydrocarbon resources in Mexico.  As a result, in August of 2014 PEMEX was granted 83% of the 2P reserves in Mexico in what was referred to as “Round Zero”.  These “Asignaciónes” came with the condition that PEMEX must carry out the work plan they had submitted to justify the assignment.

Both the government and PEMEX realized that there existed considerable challenges in order for PEMEX to succeed in developing its “Round Zero” Asignaciónes.  Some of the blocks that were granted to PEMEX were in challenging areas or required technology/processes that PEMEX does not currently possess.  Other blocks would require significant allocations of capital that would pressure PEMEX’s already strained capital budget.

The Mexican government and PEMEX decided that the best solution for these pressing issues was to put in place a strategy to attract partners to invest with PEMEX in the blocks that either required new technology or significant capital.  Thus the “PEMEX Farmout” was created.

Later in 2014 SENER announced “Round One” of the Mexico Energy Reform.  This “Round One” consisted of 169 blocks, comprising 109 exploration and 60 production blocks, plus an additional 14 blocks (in 10 contract areas) as Asociaciónes Pemex (Pemex Farmouts; Figure 2).  

Figure 2: Location of Round One Pemex Farmouts

Source – Comisión Nacional de Hidrocarburos (CNH)

Description of PEMEX Farmouts

The Round One offering can be categorized into 3 different types of assets.  

      - Deep Water Perdido Area (Table 1)
      - Shallow Water & Heavy Oil (Table 2)
      - Onshore (Table 3)

These blocks comprise a wide range of maturity, from newly discovered fields requiring further appraisal, to developed producing blocks that require investment in EOR technology in order for the blocks to reach their full potential.  PEMEX also elected to include some Extra Heavy Oil blocks in the shallow waters as well as some new gas discoveries.  While diverse in nature, they all share a need for the application of both technology and capital.

Table 1: Pemex Farmouts (Round One) – DEEPWATER (Perdido Fold Belt)

Table 2: Pemex Farmouts (Round One) – SHALLOW WATER & HEAVY OIL

Table 3: Pemex Farmouts (Round One) – ONSHORE

What has Changed?

The entire oil and gas industry is still reeling from the effects of the oil price crash that started in late 2014. 

One direct consequence of the oil price collapse was the impact on PEMEX’s already limited capital budget.  With budget constraints and production declines, revenues available to invest in new projects and existing projects were even more pressured than they had been before the crash and the increased volatility made forecasting future plans even more difficult.  The original strategy to roll out these blocks as part of Round One (Figure 3) quickly fell to the wayside.

Figure 3: Original Round One Bidding Process 

Just as periods of price uncertainty and volatility depress transactional/M&A activity in the private sector, for the Mexican government and regulators developing acceptable farmout terms and a contract structure to attract foreign investment became much more difficult.  Lower oil prices coupled with the reaction of international oil and gas firms (sharply lowered capital budgets) increased the scrutiny placed on investment decisions.  Whereas, before the crash, Mexico could possibly afford to be a bit more aggressive in its terms, after the crash pursuit of these farmouts would have to pass a (much) greater level of both competition for investment dollars and due diligence on the part of potential investors.

Farmout Factors Unique to Mexico

Complicating the depressed liquidity and interest in the farmout market resulting from the oil price collapse, the new constitutional reforms and enabling laws promulgated in Mexico present some particular challenges to the Farmout process, chief among which is Article 14 of the Hydrocarbon Revenue Law.

This law states that SHCP cannot authorize a migration from an Asignación to a production contract until it can be demonstrated the value to the State will not change.  In simple terms, the “value” to the State resulting from the Farmout process cannot be lower than that expected at the time PEMEX was awarded the Asignación in Round Zero.

One of the key elements in this determination is the concept of “value” in a “but for” circumstance.  A central tenet of this assessment is the recognition of the likely value that would have resulted (in this case from the Asignación) “but for” the change in terms to a production contact.  One of the challenges arising here can be summed in up the “pie concept”; when does a small slice of big pie become larger than a big slice of a small pie?  Currently, PEMEX pays roughly 70% royalty on its production. The absence of clear mechanisms for the Article 14 value determination is proving a major stumbling block in defining both the smaller slice and the larger pie. 

Additionally, significant challenges remain as to the mechanics of operating a PSC when the operator is not PEMEX, including their incorporation into a Joint Operating Agreement (JOA).  The Trion JOA, which was validated by Amexi, is a critical first step and PEMEX is to be applauded for this historic achievement.  However, other issues remain for onshore assets in particular, with significant existing production infrastructure, midstream gathering systems, environmental regulations (yet to be defined), surface agreements, and third party service contracts.  

How Has the Quest for Transparency Impacted the Farmouts?

Transparency is critical for the success of the Reforma Energética.  By stipulating a requirement that the Pemex Farmouts be bid rather than directly negotiated, the Government is hoping to eliminate the perception of “backroom deals” and “selling the future of Mexico to foreigners”.  All will be public, all will be open, and all will be subject to review with multiple checks and balances.   Paradoxically, these measures to ensure transparency and fairness add significant complexity to the process.  

In late 2014 SENER released the process for the Farmouts (Figure 4).  The complexity is readily apparent with no less than eleven steps involving four state agencies and PEMEX, illustrating the challenges the parties are facing in bringing these Farmout blocks to fruition. 

Figure 4: Outline of Original Farmout Process

Source: SENER

What are the roles of each of the Parties?

In order for the Farmouts to move forward, three (of the four) state agencies and PEMEX have been assigned important roles related to first two phases.  In summary:

      - PEMEX and CNH must recommend and approve the overall work program and level of investment required.
      - SENER and SHCP (Hacienda) must approve the fiscal terms and contract structure of the farmout.

Modifying the linear nature of the steps to be followed is perhaps the key to making progress.  Work program, investment, fiscal terms, contract structure are not independent variables, but interlinked and interdependent parts of a single process.  This could be accomplished by the creation of a joint working group to understand and define the nature of current (“but for”) value, to understand the potential for future value, and define the terms and conditions under which that future value may be achieved.  It is a process frequently undertaken in licensing rounds in other countries when establishing minimum bid criteria.  Whether undertaken by the state agencies and PEMEX alone, or with the assistance of an experienced independent advisor, it is the key to unlocking this particular door onto the “Path to the Prize”.

Decisions, Decisions

Recent announcements related to the status of the Trion farmout are lending some credence to the idea that PEMEX and the regulatory agencies are making the tough decisions in order to move the process forward.  While details should be forthcoming in the next few weeks, what is known is that the form of contract is to be a license, the bidding for the partner will take place concurrently with the Round 1.4 Deepwater Exploration Round, and that “more Farmouts are coming”.

The complexity of these Farmouts have exacerbated PEMEX’s financial situation.  Much hope was put on the Farmouts as being a source of capital for PEMEX, technology for their upstream sector, and a direct investment in appraisal and development activities.  Clearly, one or more of the stakeholders in the Mexican Energy Reform must make some difficult decisions in the weeks and months ahead if these Farmouts are to move forward.

At the Association of International Petroleum Negotiators 2016 International Petroleum Summit, Keynote Speaker former Secretary of State, James A. Baker III outlined the key elements of his “The Art of Negotiation” – one of them was what he called “Principle Pragmatism” or “don’t let the perfect be the enemy of the good”.  It’s a lesson that might well inform deliberations within PEMEX and the Mexican State entities on this progress-retarding issue.  

After all, PEMEX’s CEO, Jose Antonio Gonzalez Anaya summed up the current situation quite well.

Source Bloomberg

“If Pemex cannot find partners in the coming year, we are going to have serious problems.” 

GCA will be providing a follow-up article later this quarter outlining our thoughts on the potential of the acreage released for bidding on July 19th:

Round 2.1 – Shallow Water Offshore (15 Exploration and Extraction blocks) – Released July 19

Round 2.2 – Onshore (14 Exploration & Extraction Blocks) – Upcoming

For further information please contact, Scott Monette.

Authors

Mexico - A Pathway to the Prize?

Scott Monette

Senior Business Development Manager: Mexico and Commercial - scott.monette@gaffney-cline.com

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