As the world “drowns in oil,” it’s fight or flight for Mexico’s oil sector

As the world “drowns in oil,” it’s fight or flight for Mexico’s oil sector Credit: shutterstock.com/Anton Watman

Mexican state-owned oil giant Pemex dominates its nation’s oil industry, but it’s also the world’s most indebted company. The global oil crisis, in part triggered by the covid-19 pandemic, spells disaster for the government’s controversial plans for the industry, but more private sector involvement could be the silver lining to come.

For 15 years, Mexico has suffered a continued decline in oil production. The covid-19 pandemic has made a terrible situation for the country’s oil sector worse, but its government, some argue, is approaching the situation with blinkers on. The global demand for oil has been consistently low since widespread lockdowns brought most of the world to a standstill. But Mexico’s President Andrés Manuel López Obrador (known as AMLO) seems to have continued funnelling all his efforts – and much of taxpayers’ money – into oil production projects.  

While other OPEC+ countries agreed to make oil production cuts of 400,000 barrels per day (bpd) from May onwards, Mexico only reluctantly consented to cut its national production by 100,000 bpd.

This is while AMLO continues his mission to boost the country’s “energy sovereignty” by increasing the number of processing and refining plants within Mexico. He aims to put an end to the country’s historical dependence on foreign midstream infrastructure. This was ambitious even before the covid-19 crisis, given Pemex’s spiralling debts over the last decade. At the end of April, Pemex announced a US$23 billion quarterly loss; it has sat on some US$105 billion in debt since the end of 2019, making it the oil company with the highest debt in the entire world. Now, as Mexico grapples with covid-19, the flaws in AMLO’s approach have been amplified.

Business as usual?

There’s a paradox at play, says Baker McKenzie Mexico partner Daniel Sánchez. “AMLO wants to boost production at all costs and heavily invest in new projects, but there are limited resources and revenue is expected to drop dramatically because we are facing an unprecedented global crisis,” he says.

At the end of March, the government announced a state of emergency across Mexico, allowing only essential works to continue during the pandemic. Oil production was deemed essential by the federal government, and the construction of the new Dos Bocas refinery in Tabasco, as well as planned rehabilitation works at several Pemex refineries, are continuing despite unprecedented low oil prices and reduced demand.

The Mexican price mix has dropped by almost 80% since January, causing many production fields to become economically unfeasible. “The cost of production per barrel in some of the fields is much higher than [the oil’s] price in the market,” explains César Fernández Gomez, a partner at Norton Rose Fulbright and former legal vice president for projects and businesses at Pemex. Combined with the country’s lack of midstream infrastructure – notably storage units – it looks likely that much of this oil, if not sold, will lose value and be unusable if not stored correctly. It will then likely fall to Mexico’s government to bail many production field operators out. “Mexico’s public deficit will inevitably increase,” adds Fernández.

The world is drowning in oil, says Deloitte Mexico’s Valeria Vazquez, but it is Mexico’s lack of midstream infrastructure that could be the country’s tipping point. “Mexico’s lack of storage infrastructure is creating a much more expensive profit-loss disaster than in other key oil-producing countries,” she explains. “As a result, exploration and development plans are suffering delays, [and] costs and investments are being cut down; the postponement of several projects included in the [government’s] so far undisclosed energy infrastructure plan and other operational disruptions must be expected.”

Others back Vazquez’s concerns about lack of investment in upstream and midstream ventures. “An important amount of resources is being distracted in non-profitable projects such as the new refinery, instead of redirecting them to the more valuable business of exploration and extraction,” says an anonymous lawyer.

Meanwhile, the delivery of equipment and other supplies has been affected by stay-at-home measures. Mayer Brown LLP partner Vera de Gyarfas highlights that oilfield service providers under contracts with Pemex are likely to be impacted during this time, given the national oil company’s spiralling debts. “They may expect delays in payment [from Pemex] and renegotiation of service fees,” she says. “This occurred in the downturn in 2014 and it is likely to occur again.”

Delays in payment are less likely for service providers contracted with private oil and gas players in Mexico. In the private sphere, minimum work programmes have been agreed and private companies have prioritised keeping up to date with payments they owe in these projects; the penalties for breaking private contract obligations, in the long run, would cost these companies more. “The alternative is for [these investors] to pay compensation for work that is not completed,” says Mayer Brown’s Gyarfas.

Prepare for change

Pemex has announced a reduction of about US$1.6 billion in its 2020 investment budget as a result of the oil crisis. This will harm oilfield service contractors since their budgets are likely to be reduced. The increasing use of force majeure in contracts will further disrupt the supply chain, says Deloitte’s Vazquez, adding that the low oil price and demand will impose long-term strain on project developers, too.

The drafting of contracts and their small print will be heavily scrutinised as a result. What might have worked in the past won’t necessarily work now. “From the legal perspective, operators, contractors, subcontractors, suppliers and permit holders may take some additional precautions in the drafting of force majeure, material adverse change and other unforeseen events clauses,” says Vazquez.

The Mexican government’s approach to the oil sector might evolve, too. There are no signs so far that AMLO’s landmark projects, including the Dos Bocas refinery, will be called off or suspended. But this may change. “On the one hand, one may assume that investments in the primary and secondary oil sectors still may come and so the industry will not be affected that much, but on the other hand you have the covid-19 pandemic affecting demand, and we also have the commitment with the OPEC+ countries to decrease production to 100,000 bpd from May onwards,” says Baker McKenzie’s Sánchez. “Most experts agree that investment intended for the salvation of Pemex and AMLO''s landmark projects will eventually be directed to other primary necessities or programmes to jump wire the economy, but that at this point is uncertain.”

The future of Pemex

Sources with knowledge on the matter reveal to LACCA that approximately 16% of Pemex’s production fields are currently profitable. At this time, the government is still prioritising production over profitability; it issued some US$6 million-worth of debt internationally in April to maintain its original production goals for 2020. But not everyone thinks this is enough to save Mexico’s oil sector. “These measures, combined with those agreed in the OPEC meeting, have proved insufficient to deal with the current scenario for the oil and gas industry,” says Norton Rose Fulbright’s Fernández.

AMLO’s plan to increase Pemex’s oil production will soon likely be forced to come to a halt. “A pause is necessary to analyse the strategy and reformulate it,” says one legal counsel at Pemex who wishes to remain anonymous, adding that exploration and production projects that require a lot of government investment are particularly at risk, considering that Pemex, and subsequently the government, is now reconsidering its budget.

The wider sector

Fiscal benefits worth around US$2.6 billion have been granted to Pemex during this crisis, but no similar aid has been given to the rest of the sector, which has left a bitter taste in the mouth of some lawyers. “The whole sector should be considered and not just one company,” says Diana Pineda Esteban, partner at González Calvillo, SC. “Mexico has signed trade treaties that say Mexico will treat foreign investors equally to local investors, but only Pemex so far has been given special treatment.”

There are plans, supposedly in the pipeline, for Mexico’s energy sector growth; businesses and investors are waiting with bated breath for these to be revealed. “The infrastructure plan for the energy sector should be released soon if we want to recuperate some credibility within the oil and gas industry stakeholders,” says one anonymous lawyer.

Many in the legal industry are calling for the Dos Bocas refinery – as well as the Maya Train and the new Santa Lucia airport projects – to be postponed in favour of directing government investments into more profitable business ventures. “Mexico has a privileged geographical position and resources – it has some of the best solar radiation and is highly resourced in lithium,” says Baker McKenzie’s Sánchez. “The government needs to deeply re-think their policy, diversify and shift to other more prosperous businesses that make better sense in the mid to long-term, such as renewables, electric power storage and batteries.”

But there seems to be no sense of urgency from the government, according to our Pemex source, who believes action must be taken to save the country’s oil and gas industry. “If urgent measures are not taken, such as promoting private participation, the result for the Mexican economy will be irreparable.”

A window of opportunity

The oil crisis could be an excellent opportunity for AMLO to reconsider his government’s position on what shape Mexico’s energy sector should take. “It is important to be pragmatic at this point and acknowledge that Pemex does not have the financial capability to invest to increase oil and gas production and that, in association with other oil and gas companies, it could increase such production in the long-term,” says Meyer Brown’s Gyarfas.

In April, the Mexican government announced plans to reconsider reopening the Pemex farm-out agreements, which are joint operation agreements between Pemex and private oil and gas companies to develop fields that Pemex does not have the money to do alone. Since AMLO came to power, these kinds of agreements have been few and far between, but their revival could be an invitation to the private sector to bring the industry a much-needed boost. It could also save Pemex. “Pemex may be carried – meaning that it will not need to pay for the costs of development until there is production – in what is a win-win situation,” says Gyarfas.

Though the oil crisis will likely limit the number of companies in a financial position to take this kind of work on, in the long-term these kinds of farm-outs could be the solution Mexico’s oil sector desperately needs to recover from the covid-19 crisis and indeed the mess it was in long before the pandemic. “In the long run, it would be a good decision for Pemex and the Mexican oil and gas sector in general,” adds Gyarfas.

Being a company’ first line of defence

The situation in Mexico is precarious right now, which means businesses have to prepare for the unexpected. Operators in exploration and production activities are keen to understand more about the possible side effects of the force majeure clause in their contracts. Legal teams must ensure they are fully versed in the different options available when implementing such clauses, as well as getting clued up on what legal instruments they can use to amend or adjust contractual obligations that operators might wish to change. “Companies need to be very careful in documenting all situations that are occurring so that if they need to declare force majeure, they can support their case,” says Meyer Brown’s Gyarfas.

Timing is also important for legal teams to consider, explains González Calvillo’s Pineda. “Also, check whether your company’s obligations will be suspended or cancelled under the force majeure, making sure you know how much time you have to provide any required notice to counterparts.”

During lockdown, government agencies have suspended their terms and proceedings, but they continue to be open with their agents working from home. From permits to advice on when and how to operate during lockdown, legal teams have to be proactive in seeking these agencies out. “I suggest legal teams reach out to any required government agencies and be persuasive in explaining the importance of the continuation of their business’ activities,” says Pineda. “The energy sector, in general, is considered an essential activity, but if legal teams don’t reach out to government agencies, these agencies won’t know how they can best help businesses. Be persuasive over what it is you need from them.”

During these unprecedented times, legal teams need to anticipate creative solutions for their businesses. “In all the cases [we have worked on], we have found areas where good may be taken out of the bad and have come to agree to terms for the benefit of a certain project or as a mutual benefit for all contracting parties,” says Baker McKenzie’s Sánchez. “Nothing is set in stone.”

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