The 'energy reform' of 2013, as it became known, was not an isolated event, but rather part of a wide array of legal reforms implemented in Mexico by the Peña Nieto administration, such as educational, tax, political, antitrust, financial, criminal and labour reforms. All of these reforms attempted to create the legal certainty and business opportunities that would attract much-needed foreign investment in the sector, accompanied by natural efficiencies, best practices and technology.
The energy reform recognised the problems Mexico was facing as a result of the lack of investment in exploration for resources, which led to a dangerous decline in production, with no restitution of resources, meaning less revenue for the state and public spending. At the same time, Mexico forecast a substantial increase in demand for energy given the demographic composition of its population (which meant an increased need to import refined products). These needs could not be met by a failing national oil company (Pemex).
Constitutional amendments reinforced the historical principle that the Mexican nation is the owner of all solid, liquid and gaseous hydrocarbons existing in the subsoil, and that no concessions will be granted to exploit such resources (see Article 27 of the Mexican Constitution). It also states, under Article 28, that Mexico has the monopoly over hydrocarbon exploration and production activities. However, contrary to undertaking such activities only through a state-owned oil company (known as Pemex), Article 27 opened the door for the state to grant allocations to state-owned production companies, such as Pemex, or to grant exploration and extraction contracts (exploration and extraction contracts) to private entities.
In essence, the reform practically ends the state monopoly in the sector, opens the door to private investment (and thus new capital and technology), incentivises exploration and development, organises the supply of hydrocarbons and sets the basis for the development of a mature market under strict environmental rules: principles that protect vulnerable communities, and transparency and open access rules that aim to ensure the same playing field for all participants.
Midstream and downstream activities are also better regulated, creating clearer open market rules, pricing and tariff regulation. A new market and infrastructure operator was created (the National Center for Control of Natural Gas (CENAGAS)) to manage the whole natural gas and transport integrated system. Further, the transport, storage and commercialisation of liquids was liberalised, with a phased-out strategy to allow the rebranding, import and retail sales of gasoline.
The reform was implemented in a number of new laws enacted mainly during 2014, most notably through the Hydrocarbons Law (HL) and the Hydrocarbon Income Law (HIL), and heavy second-level regulation issued by existing and newly created regulators.
To properly regulate the changes introduced by the energy reform, a major restructuring had to be implemented within the regulators. Thus, the reform created a robust regulatory body framework with the proper checks and balances.
The design of the national energy policy was entrusted to the Ministry of Energy, which also determines the timing and determination of bidding areas for the exploration and production of hydrocarbons. The Ministry of Energy further issues treatment, refining and processing of hydrocarbon permits, and permits for the import or export of hydrocarbons and refined products.
The Ministry of Finance was entrusted with the design of the appropriate fiscal terms of exploration and extraction contracts, bidding variables, procurement and accounting standards, and auditing of financial terms and reporting of the contracts.
The Ministry of the Economy was entrusted to design a national content methodology to ensure compliance with general goals, set at a yearly percentage (except in the case of deep water exploration and extraction contracts).
The National Hydrocarbon Commission (CNH) was reinforced to conduct exploration and extraction contract-bidding processes, and manage awarded contracts from a technical perspective. The CNH also supervises performance, and approves development plans and work programmes under the contracts.
A new National Agency of Industrial Security and Protection to the Environment was created as part of the Ministry of Environment and Natural Resources, to issue regulations and guidelines on industrial safety and environmental protection regarding hydrocarbons, including the issuance of technical regulation, and its supervision.
The Energy Regulatory Commission was also strengthened as the regulatory body entrusted with issuing midstream and downstream regulation, and responsible for issuing and supervising natural gas transport, storage, distribution, compression, liquefaction and commercialisation permits (among other regulatory authorities with respect to the power sector).
A Mexican Petroleum Fund, managed by Mexico's central bank, was created, among other things, to receive and manage all income stemming from the sale of hydrocarbons, and paying to the state and contractors the corresponding compensation under the exploration and extraction contracts.
CENAGAS was created to operate the national gas transport system and to maintain and expand the pipeline assets inherited from Pemex. It is entrusted with ensuring open access to the system (not to be confused with the authority of the Energy Regulatory Commission (CRE) to enforce open access).
Under the HL and HIL, national and international oil companies now have access to exploration and production activities through allocations (in the case of state-owned productive companies) or production-sharing, profit-sharing or licence agreements. Most notably, oil companies are now able to financially record reserves, which was the main barrier to fostering investments under prior energy reform efforts (mainly that enacted in 2008). Technically, oil companies cannot book reserves per se, as the reserves are owned by the state. They can, however, report the expected economic benefits under the contracts (taking production as in-kind payment under production-sharing and licence agreements).
Exploration and extraction contracts are awarded through bid processes conducted by the CNH. The HL allows the state to bid for production-sharing contracts, profit-sharing contracts, licences and services contracts.
The fiscal terms of production-sharing contracts allow for a split of in-kind revenues stemming from production. Mainly, the state is entitled to receive (through the Mexican Petroleum Fund):
- a contractual fee to be paid by a contractor, based on a fixed fee per square metre of the contract area (contractual fee). The amount is increased per square metre that is not in production within the contract area as from month 61 in order to incentivise relinquishment for future bidding rounds;
- royalties are based depending on each type of hydrocarbon produced (i.e., crude oil, natural gas or condensate), and is based on a percentage of the value of the corresponding hydrocarbon; and
- a fee, equal to a percentage of the operation profit (determined as the difference between the contractual value of the hydrocarbons, less the royalty and the cost recovery of the contractor.
On the other hand, the contractors are entitled to receive cost recovery (if agreed) and a fee consisting of the remaining portion of the operating profit. The contractor's compensation is paid in kind, and the oil can then be commercialised.
Profit-sharing contracts have the same fiscal terms as production-sharing contracts, except that compensation to contractors is made in cash, not in kind.
Under licence agreements, the state is entitled to receive:
- a sing-in bonus (generally one of the bid variables) to be paid by the contractor;
- a contractual fee;
- royalties, based on a percentage of the contractual value of the hydrocarbons; and
- a fee, equal to a percentage of the contractual value of the hydrocarbons.
All such amounts are paid in kind with the production. Contractors are entitled to receive ownership of all hydrocarbons that are in excess of the amounts paid to the state.
In all cases, compensation adjustment mechanisms will be in place in order to ensure that windfall profits are caught by the state and not contractors.
Exploration and extraction contracts, regardless of whether they are profit-sharing, production-sharing or licences, need to include several common terms under the HL. These terms include national content requirements, change of control prohibitions, operator liability issues, early termination and administrative rescission clauses. These agreements are generally subject to international arbitration.
Particularly, the HL requires exploration and extraction contracts to include a minimum national content component so that local content requirements reach, on average, 35 per cent (starting with a 25 per cent minimum national content in 2015, to reach 35 per cent by 2025). This minimum is not required in the case of works to be performed in deep or ultra-deep waters. The idea is to force contractors to use (and consequently help to develop) local suppliers for the various equipment, materials, supplies and labour that are required to carry out the exploration and production activities, in order to create a national oil and gas industry. This requirement shall be progressively met by contractors pursuant to a compliance programme to be included at the beginning of the contract.
The HL prevents speculation with contracts by establishing restrictions to change of control, both at corporate and operational levels. Prior to suffering a change in control, authorisation will be required from the CNH, which will ensure that the new operator or controlling party has the necessary technical and financial skills to perform under the underlying contracts.
Operator liabilities are carefully considered in extraction and exploration contracts, so that it is clear that liabilities arising with respect to exploration and extraction activities are the sole responsibility of contractors, including environmental liabilities (which are material and not subject to any limitation). The standard of care and diligence imposed on contractors is, however, yet to be determined as the law imposes on contractors the obligation to perform their duties in accordance with international best practices. The HL expressly states, however, that contractors' liabilities will not be limited (for instance in the case of loss of production) in case of wilful misconduct or negligence (dolo or culpa).
The HL also includes a double regime for termination of exploration and extraction contracts, as there are specific mandatory causes for administrative rescission, and also the ability to include under the contracts other specific termination-for-cause provisions. The concept of administrative rescission is one that has posed material concerns for possible contractors and operators, as its application leaves contractors with few to no options if enforced by the CNH. Administrative rescission causes include lack of works for a period of 180 consecutive days, or non-compliance with minimum work obligations without justification, material accidents that cause loss of production and death, submission of false information, or not complying with judicial resolutions issued against a contractor.
Importantly, the HL allows exploration and extraction contracts to be subject to international arbitration, although the awards will need to be rendered based on Mexican laws, and the procedures should be conducted in Spanish.
The bid process for the awarding of exploration and extraction contracts is conducted by the CNH, and the HL has attempted to make the process swift and transparent, deviating from cumbersome, highly technical and often confusing contracting requirements that have traditionally been imposed under Mexican procurement processes. Notwithstanding the attempts at simplification, there is still much work to be done in order to streamline the process, and particularly to clearly answer questions from participants.
The process, however, has been simplified to a pre-qualification stage, in order to ensure that bids are received only from capable contractors, and to have a transparent bidding and awarding process where the only one or two bidding variables are submitted, and results can be transparently witnessed by all interested parties.
Other activities pertaining to the upstream sector, such as superficial exploration works, are now permitted from private parties, allowing them prior authorisation from the CNH to secure geological information, although all such information will be owned by the state. However, those securing the information will be able to temporarily commercially exploit the same.
Overall, the new legal framework for the upstream sector marks a major change in Mexican policy with respect to its traditional 'keep all' attitude, transforming it into an 'aligned interests' strategy. The benefits of the reform are not only an enhanced exploration and extraction policy, where Mexico will most probably find additional resources to exploit for years to come. The overall strategy also ensures restitution of now-depleting reserves, and boost investment in many other sectors (not only in direct services to oil companies, but also to infrastructure needs). Midstream activities such as transport, initial processing and treatment, and commercialisation of hydrocarbons are a new area of opportunity for the sector, where private investment will soon take over existing state-owned infrastructure.
For instance, much-needed investments will be made in the creation of roads and ports in order to ensure that supplies can reach work areas and production sites on time. Hospitality services will be needed in remote areas that are currently difficult to access. Companies investing in transport, construction, hospitality, power, telecommunications and many other related services will naturally benefit from the new investments in the sector, as it is expected that at least US$50 billion will have to be invested in the energy sector within the next few years.
The increase in production, and new competition existing among contractors to sell production both in Mexico and abroad, also creates the need for additional downstream infrastructure. Current midstream and downstream infrastructure (some owned by Pemex and some now owned by CENACE) requires maintenance and, in several cases, major overhaul. New midstream infrastructure is needed to ensure proper processing of hydrocarbons, and quality measurement, in order to ensure that each contractor is paid based on the actual hydrocarbons produced in their contract areas, and not based on the quality of hydrocarbons stemming from different contract areas. These needs create a vast array of new business opportunities that will be met by competitors.
By mid 2018, around 120 exploration and extraction contracts had been awarded, with a committed investment exceeding US$175 billion.
Midstream and downstream activities
Natural gas midstream investment has been open to private investment (both national and foreign) for several years now. Consequently, the private sector is familiar with this area. However, the energy reform also opened midstream and downstream activities in oil and refined products, along with a more transparent legal framework, and a new independent entity, CENAGAS, will ensure that the natural gas and pipeline systems work as an open-access, market-oriented system. The CRE will enforce the open-access obligation and CENAGAS will ensure that the open access principle is implemented.
A new area of opportunity in the midstream and downstream areas is the treatment, import, export, processing, transport, storage, distribution, refining, marketing and retail of refined products. Transport, storage and distribution of refined products are subject to the same type of 'economic regulation' as natural gas. CRE is also the economic regulator of these activities.
The granting of different permits for the treatment, refining, export, import, transport, storage, distribution, compression, liquefaction, decompression, regasification, commercialisation and retail sales is subject to permission either from the Secretariat of Energy (SENER), Mexico's energy ministry, or the CRE. In all cases, the permits are granted on a discretionary basis, considering the impact of each project on the efficient development of the corresponding activities, and the need for common infrastructure in each region. The regulators have the authority to request modifications to each project and underlying facilities, forcing open access and interconnection among systems (see Article 52 of the HL).
The energy reform has taken open access obligations seriously, imposing non-discriminatory open access obligations on hydrocarbon, petroleum products and petrochemical transporters and distributors through pipelines, as well as storage permit holders. This includes the obligation to disclose any capacity (and non-used reserved capacity), so that a spot market can be created, thus making all systems more efficient. This policy ensures that the infrastructure is constructed in those areas in which it is most needed. The regulators may also require open seasons prior to the analysis and issuance of the corresponding permits, so that projects actually cover the actual and estimated demand.
With regard to the diesel and gasoline, pricing of the same ought to move from a strict controlled pricing environment to a fully liberalised market, as follows:
- from 1 January 2015 up to 31 December 2017, the price of these products will be set by the executive through decrees. The prices will consider different concepts, such as logistics and inflation; and
- as of 1 January 2018, the prices will be fully liberalised.
Likewise, regarding the import of gasoline and diesel, private parties were originally able to engage in these activities as of 1 January 2017. However, the Federal Executive decided to liberalise the importation of gasoline and diesel in the second quarter of 2016, therefore, allowing private parties to import these products.
In addition, as of 1 January 2016, any private party can operate a gasoline and diesel service station with a different brand (other than Pemex).
The reform also included significant rules pertaining to land access and occupation, and social responsibility, imposing material obligations to contractors and permit-holders with respect to the manner of securing land access and occupation, including the manner of determining compensation to landowners (this includes, in the case of exploration and extraction contractors, compensation based on the net revenue stemming from the projects, which ranges from 0.5 per cent to 2 per cent in the case of oil, and up to 3 per cent in the case of natural gas). All contractual arrangements for the use or occupation of land shall be further submitted to the district or agrarian courts for validation. However, in the event that there is no agreement among the parties with respect to the areas to be accessed or occupied, or in the corresponding compensation, the federal authorities may intervene to create the corresponding access and occupation rights.
The existing natural gas transport system (previously owned by Pemex) is old and very limited in terms of size and reach within the Mexican territory. Industries and households are in need of proper and reliable natural gas deliveries, which will only be met by the creation of new infrastructure. Mexico's demographic composition ensures that investments in the midstream infrastructure sector will be rewarded, as it is certain that demand for the services will exist for decades to come. Thus, many companies are investing in the sector, even without compromised off-takers. Capacity availability is being reserved even prior to commencement of construction.
The composition of the hydrocarbon plays in North America also make it necessary to have a system that is integrated between the United States and Mexico. While natural gas production in Mexico will increase in the years to come, it is still necessary, and strategic, to have an integrated system between both countries to ensure Mexico receives the currently cheap natural gas being produced in the United States. This has resulted in the construction of many new trans-border natural gas transport pipelines, fostered principally by the Mexican Federal Electricity Commission (CFE): the state-owned, currently largest (but no longer only), power supplier in Mexico.
Seizing the opportunities and challenges
The energy reform has created an important momentum in the design and strategy to incentivise the required investment to secure energy needs in Mexico, considering not only current but also expected demand of fuels. Business opportunities exist in infrastructure greenfield projects, and also in making existing projects much more efficient and competitive.
Bid rounds for the granting of exploration and extraction contracts have been perceived as successful by the market, and the Mexican state has awarded several shallow water and inland contracts to a wide array of operators, some of which have participated in consortia with financial partners. This alone has prompted the creation of Mexican-funded companies that are already participating in the sector. Works under these contracts are just commencing, so the results of the investments made and their impact on the economy are yet to be felt.
In the midstream and downstream sectors, new investments are being designed, both in partnership with Pemex and through private investment alone. These opportunities are being seized by national and foreign investors, prompting a wide array of joint ventures.
Several funds have also been created to invest in all sorts of projects – mainly operating projects, taking advantage of government-created tax efficiencies under the FIBRA-E (an energy and infrastructure investment trust), which are investment structures through trusts that will have tax incentives to promote diversified investments.
The underlying challenges facing the success of the energy reform include, most importantly, a continued fight against corruption and security. In spite of the perceived corruption and transparency issues in Mexico, special care has been taken by the Mexican government to make contracting and permitting processes transparent. The energy reform included special rules of engagement with CNH and CRE officers in order to ensure full disclosure and transparency. However, this is an open item in the agenda that needs to be seriously addressed by the current administration. Security, which is still 'pending homework' for the federal government, often seems to be surpassed by organised crime, and represents substantial costs for investors.
The 2018 election resulted in the election of a left-wing government, and the expectation is that the implementation of the energy reform will happen at a slower pace. Existing contracts and permits will be reviewed, there may be an attempt to strengthen the regulation of Pemex in order to give the entity additional independence, and the rate at which contracts are awarded may slow. However, the signs to date indicate that the reform will not be reversed.
1 Carlos Ramos Miranda and Miguel Ángel Mateo Simón are partners at Hogan Lovells BSTL, SC.