The Mexican Congress has just opened an Extraordinary Session to discuss the energy reform and its secondary, or implementing legislation. One political and four technical issues need to be addressed: the capacity of new regulatory agencies to act independently and competently in the new energy sphere; the lack of predictable tax rates for exploration and production; the exposure to liability for accidents in the deep waters of the Gulf of Mexico; and the rights of landowners to the surface property, beneath which abundant shale gas exists. Overhanging the debate is the opposition’s call for a consulta popular, or referendum, on the energy reform itself. The opposition parties claim that energy reform is precisely the type of national debate that should be submitted to a national referendum. The government insists that this reform is a constitutional issue which is explicitly excluded from referenda. The Supreme Court must decide. In this Extraordinary Session of the Mexican Congress, observers seek to understand the major issues and their challenges.
The publication of 21 laws that, if passed, will implement both the hydrocarbons and electrical energy sectors is under close scrutiny by Mexican legislators, as well as petroleum experts in the U.S. Five issues dominate the debate: the capacity of new regulatory agencies to act independently and competently in the new energy sphere; the lack of predictable tax rates for exploration and production; the exposure to liability for accidents in the deep waters of the Gulf of Mexico; and the rights of landowners to the surface property, beneath which abundant shale gas exists. Finally, overhanging the debate over the secondary laws is the political issue of whether the opposition, Partido Revolucionario Democratico’s (PRD) demand for a ‘consulta popular’ (referendum) on the acceptance or rejection of the energy reform is constitutionally permissible. In Washington, as well as in Houston and Mexico City, discussions are heated on these issues ahead of an Extraordinary Session of the Mexican Senate and Chamber of Deputies in the second half of June. It is expected that the draft secondary legislation will be amended to take into account the most critical issues, including those that influence private investors seeking to contract with PEMEX and with the Mexican government.
Three essential purposes drive this reform: attract private investment and stimulate growth; convert Petroleos Mexicanos (PEMEX) and the Comisión Federal de Electricidad (CFE) into efficient, productive and competitive enterprises; and transit from a fiscal regime that was dependent upon PEMEX for approximately 40 percent of government revenues to alternative sources of revenue to support desired improvements in health, education and infrastructure. It is not coincidental that the energy legislation was published two days after the National Infrastructure Program for 2014 – 2018. This Program outlines ambitious developments of broadband, roads, ports and a bullet train totaling $590 billion. A proportion of these funds will have to come from royalties and taxes paid by private investors in the reformed energy sector, as well as private/public/ partnerships in the infrastructure projects themselves.
The legislation on hydrocarbons lays out two principal forms of contracts:
“Entitlement” contracts: These are onshore or low risk contracts which PEMEX has identified as fields that it wishes to exploit in joint ventures with a selected, or number of selected companies. To accomplish this, PEMEX must have both the technical feasibility to exploit with a private partner and the capacity to determine the kind of contract it wishes to offer: a contract called “entitlement.” Within “entitlement” acreage, PEMEX may be the operator, or a private operator may work for PEMEX. These contracts will be paid for either in cash, or in the form of shared production.
“Assigned” contracts: Here, PEMEX holds no “entitlement.” Instead, the Comisión Nacional de Hidrocarburos (CNH) identifies extraction & production contracts in which private parties may invest because PEMEX lacks technical capacity. Then CNH, together with the Secretaría de Energía (SENER) and the Secretaría de Hacienda y Crédito Público (Hacienda) will establish terms for attracting new investment. The royalty and tax regime, as well as the award or denial of “ring fencing” still has to be determined, preferably before the bidding process begins. International oil companies (IOCs) follow these issues with microscopic attention. In these “assigned” contracts, issued under license, PEMEX will determine the parameters of the “assigned” contracts, but CNH will issue bid proposals and manage the auction. Thereafter, PEMEX can express an opinion, which maybe negative, but its role is significantly reduced from the monopoly position it held historically. The only assurance given in the law to PEMEX is that it shall hold a minimum of 20 percent of the joint venture assets in every “assigned” contract.
Under both regimes, the role of CNH is critical. It is responsible for managing the bidding process, awarding the contracts and supervising the implementation. CNH was founded at the time of President Calderon’s reform of the energy sector in 2008 to support SENER in the definition and implementation of those reforms. On paper, CNH holds autonomy in technical matters as well as the drafting of regulations, supervision and evaluation of energy related activities. However, its current staffing of approximately 80 persons is clearly insufficient to undertake all the tasks assigned to the regulatory agency under the energy reforms. Furthermore, Mexico lacks a culture of independent regulatory agencies and is expected in the future to rely on the political direction of SENER and Hacienda.
Under the proposed reform, SENER will provide the technical guidelines on all contracts. Given the responsibilities of CNH and SENER, a large pool of petroleum and civil engineers, as well as geologists is needed to staff both CNH and SENER. In Mexico, they are to be found within PEMEX, but the transfer from a national oil company to a state-owned, productive company may not be sufficiently attractive to siphon off quality engineers. PEMEX will start to offer competitive salaries to keep the best engineers. However, SENER and the regulatory commissions will be constrained by government pay scales. Observers will therefore watch closely CNH’s capacity to manage auctions and supervise contracts.
The responsibility for collecting taxes and royalties lies with Hacienda. Under the new laws, it will establish the “adjustment mechanism” (tax) with CNH. At present, the secondary legislation fails to provide long term predictable guidelines on the fiscal regime and the contract terms, but we may assume that these are being discussed in the Senate Committee, charged with developing the fiscal regime for the benefit of the state. Given the present reliance upon PEMEX for a significant chunk of government revenue – over 71 percent of PEMEX income is transferred to Hacienda to meet day to day expenses – Hacienda’s minister is expected to play a dominant role in the drafting of contracts and the establishment of royalty and tax regimes.
This raises the important issue of seismic data that should become available to private investors in the short term. PEMEX has entered into a multi-year service contract with GX Technology, a subsidiary of ION Geophysical. Using the parent company’s high performance computing center in Houston, GXT’s office in Villahermosa will provide a broad range of seismic data processing through advanced imaging techniques for multiple offshore and onshore surveys. The advantage of this independent data provider is that the seismic imaging collected by PEMEX over several years will be available to private companies through purchase contracts with GXT, a well-established and highly reputed company. This avoids the accusation that PEMEX favors certain investors over others.
Uncertainty exists on the liability for both exploration/production and service companies in the deep waters of the Gulf of Mexico. Will there be unlimited liability for gross negligence, i.e. BP for Macondo, or should a cap exist? There is also the question of who has the right to sue? These issues are expected to be clarified in amendments to the Secondary legislation which is expected to establish a liability system comparable to that in the USA.
Fourth, the issue of land ownership and surface rights could become troublesome if CNH sought to auction off exploration and production rights in the Burgos shale gas field, adjacent to the Texan Eagle Ford. While ownership of the subsoil remains the property of the Mexican people, no clear guidance exists as to ownership of the surface property. Could the Mexican government impose “temporary eminent domain” so as to permit extraction of gas through fracking? Private owners of otherwise barren lands will appear rapidly to contest this taking. Many of the owners of these barren lands are indigenous communities who are expected to resist transfer of their ancestral lands.
Former Brookings Expert
It is anticipated that these dry scrub lands will be bought and sold rapidly, including purchase by surrogates of drug cartels, to benefit from the anticipated boom. PEMEX chief, Emilio Lozoya has announced that Mexico has 460 trillion cubic feet of unexploited shale gas with an estimated worth of $2.2 trillion. But raising expectations of a shale boom must take into account the complexity of surface rights. Furthermore, given the low cost of US shale gas and the high costs and complexity of obtaining surface rights and financing, Mexico might chose to delay its development of the Burgos, Sabinas and Tampico gas fields and concentrate instead on deep water prospects.
Considerable experience exists among the majors in the extraction of oil and gas from deep water and below salt. PEMEX anticipates oil reserves of 26.6 billion barrels in the Gulf of Mexico. At current prices, these reserves are worth $11 trillion. Overtime, this offshore area of exploitation would provide the revenues needed to meet the national infrastructure plans, but time is needed and we may not see strong revenue flows until 2019, the year after President Peña Nieto steps aside for the next Mexican leader.
Overhanging the debate on the five critical issues is the uncertainty over the consulta popular. The PRD firmly opposes the energy reform and claims to have collected close to 4 million signatures – in excess of the 1.6 million registered voters required by the recently approved law controlling Mexico’s consulta popular. Sufficient support clearly exists among registered voters to petition for a referendum on an issue of transcendental national importance. However, that same law states that constitutional issues are excluded from a national referendum. It is therefore up to the Mexican Supreme Court to determine whether the energy reform is predominantly a constitutional issue which would deny the right to hold a referendum, or substantively an energy and economic reform which might be considered a legitimate subject for the consulta popular.
Several procedural steps must still be taken before this question is posed before the Mexican Supreme Court. Meantime, senior Mexican government officials are spreading the word that this reform is a constitutional issue, which required amendment to the Mexican constitution by two-thirds approval of the legislature, as well as the Mexican states. Suggestions that an independent Supreme Court might interpret the energy reform as anything other than a constitutional issue are dismissed. Based on these political assurances, rather than the decision of the Court, numerous interested parties have approached PEMEX quietly with a view to preparing “entitlement” contracts. Nevertheless, before approval of the secondary legislation it is premature to determine how the prospect of a consulta popular might affect the more financially burdensome, but lucrative “assigned” contracts.
The Extraordinary Session of the Mexican Congress this June will raise many of the issues discussed above. Foreign observers should expect the secondary legislation to become law in July. This opens the way for purchase of geological data, the publication of PEMEX fields and the start of bidding for joint venture partners. Soon thereafter, we expect the contracts for exploration and production in the deep waters of the Gulf of Mexico to be announced.
PRD leader, Jesus Zambrano Grijalva recently stated that his party will respect contracts entered into between PEMEX and private parties. Given, that the PRD is also determined to win the next presidential election, it may not wish to provoke moderate voters by reneging on private contracts and license agreements. Nevertheless, the PRD has promised its political base that it will seek a consulta popular which will ask voters to accept or reject the energy reform. Until the Mexican Supreme Court renders its decision on the admissibility, or not, of this referendum, major investors may seek to wait and see. Meantime, the Mexican government demonstrates a determination to move ahead with the energy reforms, all the while knowing that a decade or more is needed to fulfill citizens’ expectations of lower prices for energy and increased revenues to pay for the National Infrastructure Program.
 The reform of CFE is addressed in the secondary legislation, but this article will focus on hydrocarbons. Further articles will address the electrical industry and options available for private investment in the transmission and distribution to residential and industrial complexes. At present the reform of hydrocarbons is politically more heated, but we should expect electrical reform to become equally sensitive as investors look to the pricing mechanism and citizens wait for the promised reduction in electricity bills.
 Ring fencing determines the level at which each fiscal or administrative component of a contract is to be calculated and administered. Ring fencing allows the costs and production to be pooled along with certain exploration expenses. This removes some of the risk for contractors and encourages them to make additional expenditures. However, some governments are reluctant to allow such ring fencing because it may significantly reduce their revenue in the short term. The level of “ring fencing” is therefore important to major investors.
 It is estimated that PEMEX needed 1,000 petroleum engineers, but Mexico only produced 300 such engineers. http://www.dcne.ugto.mx/Contenido/MaterialDidactico/amezquita/Lecturas/Hijo_hazte%20petrolero.pdf
 Publication of Federal Law on National Consultation, March 2014. http://www.eluniversal.com.mx/nacion-mexico/2014/segob-publica-ley-federal-de-consulta-popular-995118.html
 Mexican Energy Reform; View from the Left. Woodrow Wilson International Center for Scholars, Washington D.C. May 28, 2014. http://www.wilsoncenter.org/event/prd-mexican-energy-reform