Mexico’s Energy Reforms Become Law

Petróleos Mexicanos (PEMEX) drilling rig.On August 11, 2014, President Peña Nieto signed into law the 21 component parts of a comprehensive energy reform. Eight months after introducing constitutional amendments to radically transform Mexico’s hydrocarbon and electricity sectors, private investors and Petróleos Mexicanos (PEMEX) can leave the starting gate. 

Peña Nieto was among the first to make the dash, announcing that he would speed up the creation of a new power-grid and advance the date for declaring which fields would be available for bidding by private and foreign companies. In signing, he announced that "This is the moment to put the energy reform into action."

Passage and signature of the secondary, or implementing, laws address critical issues that were important both to PEMEX and to private investors seeking to invest in Mexico’s hydrocarbon potential.[1] Investors now have detailed elements of the new fiscal regime that will impact any contracts with PEMEX, as well as bids for production sharing contracts, known as "asignaciones," with the Mexican government. The oil industry has responded positively, giving a “fairly pro-market” grade to the new regime. Furthermore, PEMEX acquires a legal framework that enables it to become a competitive and productive national oil company.

Since the secondary laws were introduced into the Senate on April 30, 2014, intense discussions have taken place with both potential investors and PEMEX. Total S.A. demonstrated early interest by agreeing to strengthen its technical cooperation with PEMEX. Pacific Rubiales, Latin America’s largest non-state hydrocarbon producer, noted its intention to be among the first oil companies to sign on. Noble Energy, a U.S. independent with 70 years experience in global exploration and production, expressed interest in contracting with PEMEX for deep-water exploitation in the Gulf of Mexico. Meantime, PEMEX shared with the government the list of projects, known as Round Zero, that it wished to continue developing either alone or in joint ventures with private entities. The Round Zero was due to be published on September 15, but in signing the legislation, Peña Nieto advanced that date to the week of August 18. PEMEX directors are eager to follow up the expressions of commercial interest and begin to contract with service providers for the development of Mexico’s estimated 10.073 billion barrels of proven reserves of crude oil.[2]

The viability of PEMEX is critical to the success of this reform because the government cannot succeed in these radical changes without the buy-in of an institution which holds both national and historical significance for Mexican citizens. PEMEX was created to replace the U.S. and British oil companies of 1938. In the intervening 76 years it has faced constitutional constraints from working with international oil companies and taking advantage of the technology and finance available to owners of significant proven oil and gas reserves.

Two categories of critical issues can be distinguished in the implementing laws, namely the tax and financial obligations; and second, the governance and political responsibilities.

Tax and Financial Obligations


First, the fiscal regime for international oil companies (IOCs) and service providers is intended to attract their investment and participation. The Mexican regime maintains flexible rates for royalties, as well as for oil and gas taxes. Differentiating between royalties, corporate tax and cost deductions, the implementing legislation provides the following:

Royalties: The Senate has agreed that sliding-scale royalties will exist with varying rates according to the type of field, its production and the price of oil and gas. A royalty discount will exist for the production of shale gas where profits are narrower. Royalty rates will rise if production or price goes above a certain threshold.[3] The exact amount will only be known when the contracts are drafted. Royalties will be paid to the Mexican Petroleum Fund a trust fund designed for long term savings.

Corporate income tax: The standard 30 percent corporate tax will apply to all investors, including PEMEX. This tax will continue to be paid to the Ministry of Finance.

Second, PEMEX’s cumbersome fiscal regime is simplified. Instead of income tax plus 10 additional taxes, the law follows international practice and establishes income tax plus three additional taxes. These will apply to asignaciones, and contracts with PEMEX:

• Profit sharing tax is reduced from 71.5 percent to 65 percent of the spot oil price.

• Taxes upon the extraction of hydrocarbons are based on a sliding scale, depending upon the international price of hydrocarbons. The law specifies a monthly tax of $450/km2.[4]

• Taxes for the exploration of hydrocarbons, known as surface rental fees, are lower at $110/km2 in order to incentivize companies to fulfill their exploration plans within a specified time frame.

Third, cost deductions are capped at $6.5 for each barrel of oil produced. In the case of the asignaciones, a cap of 12.5 percent of oil revenue exists for onshore and shallow water. A cap of 60 percent of oil revenue will exist for deep water production and for the Chicontepec field with its geological difficulties. A cap of 80 percent of gas and condensate revenue will also apply. For PEMEX this increases significantly their permitted deductions and allows it to compete with IOCs “nearly” on an equal basis.[5] As a consequence of the changes to this fiscal regime, PEMEX anticipates paying 36 percent less in taxes and royalties each year. This is anticipated to reduce PEMEX tax liability from $5.2 billion in 2012 to $1.896 billion each year for the next five years beginning in 2015. This permits the state-owned oil company to invest in fields which previously were not profitable for lack of technology, as well as provide for the training of petroleum engineers, acquisition of equipment and development of new fields. PEMEX should now have the capacity to increase its oil production.

In theory, over the next five years the Secondary laws establish that PEMEX will contribute to the Ministry of Finance 11 percent less tax than its high average of 69 percent of total income. On paper, PEMEX’s tax rates are reduced, but elsewhere in the reformed laws, the Ministry of Finance retains the right to adjust tax rates to ensure sufficient revenue for public expenditures.[6] Thus, despite claims that PEMEX will be treated as an autonomous, productive and competitive company, the government could continue to draw on the state oil company’s profits for national purposes. This could severely constrain PEMEX's long term investment plans.

Fourth, the secondary laws provide details on how income from the asignaciones (production sharing contracts) for the exploration and extraction of hydrocarbons shall go to the Mexican Petroleum Fund. This fund will act as a bank, or sovereign wealth fund, in parallel with the Ministry of Finance. The directors of this fund must ensure that sufficient monies are transferred to the ministry so as to assure that the national treasury enriched by hydrocarbons does not fall below 4.9 percent of Mexico’s GDP. Furthermore, after payments to the Ministry of Finance, if and when the Petroleum Fund’s income rises above 3 percent of GDP, the fund will recommend to Mexico’s Chamber of Deputies how the excess should be distributed, or saved. As in the case of the Norwegian Pension Fund, we should expect the Petroleum Fund to focus on the long term economic benefits for Mexico and avoid rapid depletion to meet immediate needs.

Fifth, the law reforms PEMEX pension fund liabilities. Liability for PEMEX’s pension fund has produced a burden that could have limited the company’s capacity to emerge as a profitable entity. In conjunction with the passage of the secondary laws, the government has proposed to assume one third of PEMEX’s liability for the labor and social responsibilities of its 15,000 employees. According to the Ministry of Finance, these obligations amounted to $127 billion and equaled 49.8 percent of PEMEX overall debt. In terms of pension benefits, a PEMEX worker retiring at 55 years old was entitled to half his salary, life insurance and free medical care that covered the worker and his spouse. This was calculated to amount to 18,000 pesos, or $1,353 per month.

Three conditions exist before the government will assume PEMEX pension obligations:

  1. PEMEX must enter into negotiations with the Union of Petroleum Workers (STPRM) to raise the retirement age from 55 to 65 years, equivalent to the age of other retiring Mexican government employees.
     
  2. The union must agree that its pension fund will be audited on an annual basis and criminal sanctions applied for fraudulent payments.
     
  3. The reform of the pension scheme anticipates transition from a defined benefit plan to defined contribution, or individual accounts for PEMEX workers.

At this point it is hard to anticipate the difficulties presented by these conditions. Senator Carlos Romero Deschamps, the current head of the Sindicato de Trabajadores Petroleros de la República Mexicana (STPRM, or the Union of Oil Workers of the Mexican Republic) was not in the chamber when the final vote to approve the energy laws took place. (He also announced that he would not run for the Senate at the next elections.) However, negotiations and changes to the pension fund should not affect the implementation of both the hydrocarbons and electricity reforms.

Governance and Political Responsibilities


To implement the hydrocarbon reforms, three major institutions have to reach agreement: the Ministry of Finance, the Ministry of Energy and the newly created Comisión Nacional de Hidrocarburos (CNH, or National Hydrocarbons Commission). This could prove to be challenging. Finance is the most important ministry within the Mexican government; it establishes the tax and royalty rates and holds those payments. Energy acquires new authorities which should strengthen its relative weakness in relation to PEMEX and, among the new regulatory bodies, CNH is yet to be tested. It will have responsibility for the technical matters in both designing contracts and the bidding process. These three agencies will determine the revenues and taxes, criteria for bids, allocation of projects and distribution of the income stream from the reformed hydrocarbon sector. Important changes to both the powers of the Energy Ministry, as well as the CNH are made in the law which should strengthen capacity to act independently and effectively. Also, the newly created Mexican Petroleum Fund will play an important role in determining the use of funds collected from asignaciones. The structure and coordination among all four institutions is built upon the assumption that new investments from international oil companies and independents will provide significant additional revenues for the Mexican government.

Furthermore, PEMEX as the reformed state oil company has a critical role to play. PEMEX’s historical role as the defender of the national petroleum resource has the capacity either to encourage support for the reform, or to act as a laggard making service contracts and joint venture agreement bureaucratic and unnecessarily lengthy. It was thus critical for the legislatures to meet most of PEMEX’s demands and ensure the long-term viability of the emerging state oil company.

The level of national content produced in Mexico and committed to each project had been of serious concern to foreign observers who considered that it was too high. The issue is now resolved satisfactorily by emphasizing flexibility in determining "national content." Until 2025, Mexican national content will equal 25 percent of the assets, a percentage that can vary between zero national content for complex deep-water projects to higher national content—in excess of 25 percent—for shallow offshore and onshore basins. These include the Southeast basin, Mexico’s most productive area, where PEMEX intends to produce an estimated 12.3 billion barrels of oil equivalent.

After 2025, the energy law prescribes that national content shall rise to 35 percent based on two presumptions: significant private investment from Mexican and foreign companies, and reduced dependence upon foreign sources for technology and management. We might assume that if private investment proves to be insufficient and dependence on foreign sources endures, commencement of the 35 percent national content can be postponed.

Development of shale deposits in the Burgos basin which abuts the U.S. fields at Eagle Ford will require significant infrastructure and Mexican government support. The reason is that Mexico’s north eastern, sparse and dry area will be changed dramatically with the management of water, construction of roads, housing, medical and educational facilities, electrical generation and provision of public safety. In the current absence of local governments to regulate behavior, there is considerable doubt as to the short term economic viability of shale projects in the Burgos basin. Consequently, PEMEX has indicated that it will pursue only 10 test wells in this area at this time.

Environmental concerns may also limit the development of the Macuspana basin which lies beneath sensitive wetlands. PEMEX is not likely to pursue exploitation of gas in this area and local citizens are expected to protest development.

Assurances and appropriate compensation for holders of communal and privately held lands may prove to be the most contentious issue. Landowners from the Burgos basin, as well as "campesino" farmers from the center and eastern parts of Mexico have demonstrated throughout the country seeking assurances that they will not be driven off their land and that compensation will be appropriate. Mexico's Permanent Congress of Agrarian people is contesting the energy reform and is committed to continue protests which may include a case before the Mexican Supreme Court. Campesino farmers hold a special place in Mexican life; they help citizens recall the decade long revolutionary struggle. Consequently, they form the backbone of the leftist party, the Partido de la Revolución Democrática (PRD, or Party of the Democratic Revolution), which continues to oppose the energy reforms.

The secondary laws establish that compensation must be based upon negotiation between the parties based on market forces. Also, the law gives preference to the need to exploit the hydrocarbon resources over other uses. This is likely to result in local conflicts. Although PEMEX has experience in negotiating with indigenous communities in the tight sands of the Chicontepec region, other private enterprises may be reluctant to assert their legal rights in the face of local protest. PEMEX developed a cadre of experienced social workers to engage with each of the communities throughout Chicontepec. Therefore, it would be advisable to enter into joint ventures with PEMEX for the development of onshore fields where the potential for social conflict with local communities exists.

Going Forward


The next stage is for the Ministry of Energy to reveal the list of offshore and onshore fields that PEMEX wishes to develop itself or in joint ventures. This could be published as early as the week of August 18. The Energy Minister will decide which blocs PEMEX keeps and which blocs must be released; decisions with both technical and political consequences. PEMEX is already in preliminary discussions with potential joint venture partners and the opportunities for joint production, as well as service contracts in the upstream sector, will be plentiful. However, it remains to be seen how the Energy Ministry, together with the CNH manage the numerous bids. The timetable and the auction process have yet to be announced thus adding a layer of uncertainty for any future contracts. The commitment of the Mexican ministries and regulatory bodies to transparency is key; a process required by law but complex in its application. International investors may judge the management of the initial bidding process as indicative of what lies ahead when exploration and production in off shore fields, as well as shale basins become available through asignaciones in the first half of 2015.

Enactment of the energy reforms has two important implications: President Peña Nieto’s determination to balance the interests of potential investors versus the ongoing viability of PEMEX, and the success of the reforms measured by increased production and greater revenues for the government. To accomplish both, the drafters of the legislation have consulted widely to determine the best international practice. The government has publicly announced that it has learned from the experiences of Angola, Brazil, China, Nigeria and others with high petroleum reserves. The new fiscal regime is taken from the experience of other newly industrialized countries. The intent is to avoid mistakes. Reforming the energy sector is the jewel in Peña Nieto’s reform process and it must not be derailed. This is a defining moment for Mexico as it enters the global age of technological advantage and commits to raising the monies from foreign investors to pursue the development of infrastructure, quality education and social progress for its citizens.



[1] Also enacted were secondary laws reforming Mexico’s electricity industry.

[2] U.S. Energy Information Administration, www.eia.gov

[3] Royalties for oil with price greater than $48 billion barrels = 8 percent. Oil with price lesser than $48 billion barrels = 0.125 percent - 1.5 percent.

[4] Ley de ingresos sobre hidrocarburos, Article 55. Km2 refers to square kilometers

[5] PEMEX is still concerned it remains at a disadvantage in competing with private oil companies.

[6] Ley Federal de Presupuesto y Responsabilidad Hacendaria.