In August 2010, Pemex, Mexico’s national oil company, awarded its first-ever incentive-based service contracts for upstream activities. The contracts, known as the “Integrated E&P Contracts” (IECs), were awarded as part of an international bidding round for upstream exploration and production (E&P) projects covering three mature fields in southern Mexico. With the second bidding round expected to begin in early 2012 (terms scheduled to be released very soon) and at least two more upcoming bidding rounds for upstream projects, Pemex expects this new contractual framework to attract the investment and expertise needed to revamp the country’s declining oil production.
This article examines the current upstream opportunities in Mexico, and provides an overview of the Mexican energy sector as well as a description of the key terms of the IECs.
Public bidding rounds
In 2010, Pemex announced it would hold the following bidding rounds for upstream E&P activities:
Mature Fields in the Southern Region
In August 2011, Pemex awarded the first IECs for the development of three mature fields in the state of Tabasco that have not been developed since the 1970s with the expectation of reactivating their production. This bidding round successfully attracted the attention of several international energy companies, especially independent upstream companies and service companies.
Mature Fields in the Northern Region
With the contract terms expected to be released any time now (terms were approved by the Pemex Board of Directors on November 15, 2011), this second bidding round will cover two offshore areas (Arenque and Atun) and four onshore areas (Altamira, Panuco, San Andre and Tierra Blanca) located in the northern region of the Gulf of Mexico in southern Tamaulipas and northern Veracruz. This bidding round is expected to begin in early 2012. A positive economic factor for these areas is that contractors will be entitled to recover 100% of their exploration costs (cost recovery was capped at 75% per year in the contract terms of the first bidding round).
The onshore basin of Chicontepec is one of Mexico’s main sources of future production growth, holding an estimated 17.7 billion barrels of oil equivalent (approximately 39 percent of Mexico’s total reserves). Chicontepec is a complex production area with technical challenges because of its shallow sands and low permeability. The bidding terms for this area are expected to be released during 2012.
Deepwater Areas of the Gulf of Mexico
The Mexican side of the Gulf of Mexico is estimated to hold 28 billion barrels of oil equivalent, representing more than half of Mexico’s long-term prospective production. Although the precise timing remains unclear, the terms for deepwater blocks are scheduled to be released during 2013. It is clear that the participation of the major international E&P companies will be required to develop Mexico’s deepwater reserves.
Overview of the Mexican Energy Sector
Companies have been providing oil-related services to Pemex for several decades, but they have not been involved in upstream operating activities since the country’s oil industry was nationalized in the 1930s. This is mainly due to a constitutional limitation that bans the private ownership of hydrocarbons, thus excluding the possibility of oil and gas concessions, production-sharing agreements and reserve booking. This constitutional restraint has historically created a restrictive oil and gas contractual framework which has limited the role of the private sector in Mexican E&P activities.
Mexico has experienced a 24-percent production decline since 2006; nonetheless, there is consensus about its reserve potential. As of January 1, 2011, Mexico had 10.4 billion barrels of proven oil reserves, and an estimated 46 billion barrels in 3P reserves (proved and unproved reserves), mainly located in the deep waters of the Gulf of Mexico.
In an effort to uncap this potential production and stop production decline, the Mexican Congress approved a very controversial energy reform package in November 2008, which established the legal framework for the IECs. The IECs, which are a product of a significant collaborative effort led by Pemex E&P, represent a material improvement from the prior contracts used for oil and gas activities in Mexico. Although the Mexican Constitution and legislation still bans the private ownership of hydrocarbons (and thus, oil and gas concessions, production-sharing agreements and reserve booking), the IECs feature a compensation provision with production incentives for contractors, which materially improves the economic terms for contractors from prior contracts.
Key Issues Regarding the IECs
The incentive-based compensation represents one of the most significant reforms to the Pemex contractual framework; this provision was the subject of much debate and opposition during the 2008 energy reform, which was settled after the provision was upheld by the Mexican Supreme Court in December 2010.
Under the IECs, although contractors still get paid in cash, their compensation is based on a fixed-fee-per barrel formula (adjustable to market conditions) plus cost recovery, subject to available cash flow from the block. This formula is expected to act as an incentive for contractors to maximize production.
The term of the IECs is generally 25 to 30 years, but it varies per block. Pemex has the option to acquire a ten-percent working interest on the blocks, the purpose of which is to gain technological and operational knowledge.
Under the IECs, Pemex’s approval is not required for technical, engineering, design and construction issues, which represents a major improvement from the previous contracts. Contractors are required to submit development plans, budgets and annual work programs for Pemex’s approval under specific rules and limited discretionary power by Pemex.
The IECs are divided into two periods: a two-year initial evaluation period and a development period. During the development period, contractors are required to carry out minimum work commitments on blocks that are declared to be commercial.
Under the IECs, the parties may rescind the contract for material breaches with a 60-day cure period. The IECs grant Pemex an early termination right in the following specific instances:
- An act of God or force majeure;
- If it is impossible to determine the duration of a suspension pursuant to the contract;
- If there are causes that prevent the contract execution;
- Because it is inconvenient or unprofitable to continue with the contract according to the economic model thereof.
Under the IECs, there are multiple securities required including proposal, corporate and performance guarantees, which may be satisfied by standby letters of credit. Contractors are required to guarantee 100 percent of minimum work commitments. All consortium parties remain joint and severally liable for all contractual obligations.
Although the IECs do not provide for consequential or indirect damages, contractors have strict environmental liability for all operations to the extent they do not comply with environmental regulations and contractual terms. Companies are required to submit a baseline report to avoid environmental liability for pre-contract operations.
From a labor standpoint, the IECs specifically provide that the Contractor is not responsible for Pemex personnel, a significant improvement from previous contracts.
The IECs provide for shared responsibility between Pemex and Contractor for obtaining regulatory permits. The contractor has the right to rescind the contract in case the necessary permits are not obtained.
Subcontracting and National Content
Under the IECs, subcontracting that exceeds a certain value must follow special contracting procedures. Also, Mexican subcontractors are given preference if prices, capabilities and other issues are comparable. Additionally, the IECs require a 40-percent minimum national content on an added-value basis.
The contract may be modified only to the extent that a change in law is favorable to both parties.
The dispute resolution basically consists of a three-tier mechanism: a direct consultation period, an independent expert process and, as a last resort, Spanish-language arbitration in Mexico City under ICC procedural rules.
The IECs represent a significant step in the right direction for the Mexican oil and gas industry and an important departure from previous Mexican oil and gas contracts. Although there are important legal issues and risks to consider, companies seem to be more focused on the economic aspects of the IECs. There is consensus that the economic terms of the IECs will need to be revised to attract the investment and expertise required to develop Mexico’s deepwater reserves. This will probably require further legal reforms.