Will Mexico be Competitive? Part 2: Fiscal Balance and Stability

Will Mexico be Competitive? Part 2: Fiscal Balance and Stability

27th August 2014

Despite recent increases in exploration expenditures, Mexico’s 3P (Proved + Probable + Possible) reserves have been in steady decline since the 1980s. Reversing this decline will require a substantial level of foreign investment that can be sustained for decades. This week, Gaffney, Cline & Associates (GCA) provides an overview of the fiscal balance and stability factors potential investors are likely to consider when comparing Mexico to regional competitors for upstream investment.

Key Facts

  • Secondary legislation outlines tax structures for license concessions, profit sharing agreements and production sharing agreements.
  • Overall fiscal regime is “progressive” with variable profit and production splits based on product prices and operational profits.
  • Work programs and profit/production splits are expected to be the primary bid variables.

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Figure 1 shows the 3P Reserves decilne since the 1980s.  Some analysts have estimated that as much as US$60 billion per year of upstream investment will be required (a three-fold increase over current spending); but recently, Mexican authorities have suggested that US$50 billion in non-government investment, between 2015-2018, is a more realistic target.

Figure 1. Exploration Spending and 3P Reserves

Will Mexico be competitive in attracting the long-term levels of investment needed?  GCA believes the answer to that question will depend on how companies assess conditions in Mexico in three areas:

  • Resource Potential

  • Fiscal Balance and Stability

  • Ancillary Factors

In this article, GCA provides an overview of the fiscal balance and stability factors potential investors are likely to consider when comparing Mexico to regional competitors for upstream investment.

After resource potential, fiscal balance and stability is the factor most often cited by investors as an important criterion for investment decisions.

From the investor’s perspective, fiscal balance and stability is typically assessed by comparing the economic attributes of a project (such as the net present value, rate of return, payback period and profit to investment ratio) against the long-term risk variables of a project.  Investment opportunities are evaluated on both a stand-alone basis and in comparison to investment opportunities in competing jurisdictions.

From a country’s perspective, fiscal balance and stability is typically assessed by evaluating the range of “state take” (the government’s share of revenue or production divided by net revenue) expected to be generated by projects under a variety of product price and service cost assumptions.

Figure 2 illustrates thet studies have shown that jurisdictions that shift toward a more “regressive” fiscal regime (i.e., emphasizing bonuses, fixed royalties, duties) tend to see diminished licensing activity, in contrast to countries that shift towards more “progressive” regimes (i.e., emphasizing work programs, R factors, income tax).

For Mexico, the decision regarding the fiscal regime elements to utilize also requires that consideration be given to other factors, including:

  • Federal government’s reliance on petroleum revenue as a source of funding

  • Desire to ensure transparency in the petroleum licensing process

  • New administrative burdens associated with the reform

  • National employment objectives of the government

Figure 2. Blance Between State Take and Investor Economic Objectives

Not surprisingly, Mexico decided to go with a variety of contractual and fiscal arrangements, each with characteristics often linked to different petroleum risk environments.  Taking these factors into consideration, GCA believes the most likely utilization of the contractual and fiscal flexibility provided for in the reform legislation will be as shown in Table 1.

 

Table 1. Reform Contract Options

A summary of the key fiscal components of each contract type is shown in Table 2.

Table 2. Key Fiscal Components

While there are some “regressive” components in the fiscal terms, these components are anticipated to be relatively minor in their economic impact.  The more impactful elements of the overall fiscal system are “progressive”, with variable state/contractor shares of profits or production linked to product prices and operational profits.  Importantly, these elements will also be competitive bid factors, leaving potential investors free to propose economic parameters that they believe will match the risk profile of the specific investment opportunities.

The spectrum of contractual systems authorized for use by the reform legislation gives authorities the flexibility, with some limitations, to mix and match contract types in future bid round offerings.  However, as reflected in the commentary leading up to the reform enactment, petroleum “concessions” will not be used, and the use of petroleum licenses is expected to be limited.  This decision is in contrast to Mexico’s regional competitors, most of which utilize royalty/tax fiscal regimes in concession agreements, as shown in Table 3.

Table 3. Regional Contract Forms

While any form of contract can be used to generate the same economic split under a given set of project assumptions, investors typically prefer concession agreements because of the greater operational and product marketing rights and the risk/reward balance granted to them in this form of agreement.

For more information on the nature of Mexico’s petroleum fiscal regime, contact Alan Cunningham or Scott MonetteDownload an invitation to the September 3, 2014 GCA-Squire Patton Boggs luncheon seminar, “The Mexican Energy Reform: Interested in Doing Business Under the New Rules?”

Check the GCA website next week for an overview of other country-specific factors that will also impact Mexico’s competitive position.

Authors

Will Mexico be Competitive? Part 2: Fiscal Balance and Stability

Alan Cunningham

Technical Director: Commercial - alan.cunningham@gaffney-cline.com

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