Jose L. Valera and Andrew J. Stanger,Mayer Brown LLP, Houston
On November 24th Pemex released in model form the first contract with private sector E&P companies implementing Mexico's 2008 legislative oil reforms. This contract is intended to increase production from existing, mature onshore oilfields.
Faced with rapidly declining crude oil production, Mexico is beginning to look for outside help. Averaging 3.3 million barrels per day (b/d) in 2005, Mexican crude production is now predicted to fall as low as 2.5 million b/d for 2010. Although such a production rate is still impressive and would be enviable for many countries, the rapidity of the decline—25% in six years—has sounded alarms in Mexico. This is because oil income is the lifeblood of the Mexican government (oil represents over 30% of federal revenues and more than 15% of Mexico's export revenues).
Petroleos Mexicanos (Pemex), the state-owned oil monopoly that controls all segments of the Mexican oil industry, initially hoped that crude oil declines could be offset by enhanced production from existing fields. Now it appears that the decline is evidence of a chronic condition requiring not only enhanced recovery efforts but leaps in new exploratory activity. However, it is widely acknowledged that Pemex lacks the funding, technology, and know-how to succeed in these efforts, at least in the near term.
President Felipe Calderon believes that the current situation requires greater cooperation with foreign companies. In 2008, he proposed to the Congress a series of substantive reforms relating to the oil industry, which included a measure allowing Pemex to enter into joint ventures with outside companies and to share in cash the value of production. The proposals were significantly diluted by the political opposition, and the allowed contracts, though broadening the scope of items for which a company may be compensated, do not constitute a radical departure from the previous Pemex contract regime of multiple service contracts.
The new law still does not allow private E&P companies to receive compensation in kind or tied to the value of production; rather they continue to be limited to receiving only fixed compensation paid in cash. The limited upside potential offered by such an arrangement is a significant disincentive for the undertaking of exploration risk by private companies, which is what Mexico needs the most.
Even these modest reforms have drawn street protests and incurred intense political opposition. Members of the center-left political parties staunchly oppose any increased participation by foreign oil companies, fearing that such an approach would divert funds from the Mexican people.
The urgent need to develop new sources of production will likely increase the pressure on Mexico to assess the fundamentals of its oil policy and decide whether keeping foreign companies at a distance will remain a tenable strategy.
A declining national patrimony
The barriers to private sector participation derive from a long-standing distrust of foreign oil companies and the belief that oil revenues are the true foundation for national economic development. Although foreign oil companies were heavily involved in the Mexican oil industry in its early years (by 1920 over 90% of investment came from abroad), they soon came to be seen as exploitative.
After a series of disputes, President Lazaro Cardenas decreed in 1938 the expropriation of foreign oil assets, which were immediately put into the hands of newly formed Pemex. For Mexico, this was a defining moment and continues to be a source of national pride, particularly on each March 18th when the country celebrates Expropriation Day.
If President Cardenas's decision to expel foreign interests from Mexico was controversial at the time, it proved to be an extremely fortunate choice decades later: in 1971 a fisherman noticed petroleum bubbling up from the Gulf of Campeche, and thereby stumbled across one of the world's largest oil finds—the supergiant Cantarell field. This and other discoveries made Mexico a leading oil exporter and launched Pemex to the ranks of giant oil companies.
But now that the prodigious discoveries of the 1970s appear to be in rapid decline, Pemex is beginning to look for the next generation of oil fields. Mexico still has significant oil reserves: according to 2009 Pemex estimates, the country has proven crude oil reserves of 10.4 billion barrels and possible crude oil reserves (3P) of 30.9 billion barrels. But with Mexican consumption increasing and production declining, in the absence of significant new discoveries the US Energy Information Administration estimates that Mexico will become an oil-importing nation by 2015 and will require net imports of 1.3 million b/d by 2035.
The recent decrease in crude oil production is largely due to the decline of the flagship Cantarell field, which produced on average 2.125 million b/d in 2004 but now, even with nitrogen injection recovery efforts, averages less than a quarter of that amount.
Other fields appear to be taking up some of the slack, but not nearly enough. The Ku-Maloob-Zaap field (KMZ), also located in the Gulf of Campeche, has more than doubled its production over the same period from 304,000 b/d in 2004 to 847,000 b/d as of October 2010, thanks to nitrogen injection recovery. However, many experts predict that production at KMZ is near its peak.
The Chicontepec oil field, which is Pemex's largest onshore project, has not produced expected volumes due in part to its complex reservoir geology. Faced with severe criticism over project costs from the National Hydrocarbons Commission (CNH), a government observer of Pemex, the company announced in September that it will reduce drilling on the project by 60% next year. Since Chicontepec's reserves comprise about 40% of Mexico's possible crude oil reserves, this is an enormous setback.
The problem of production is compounded because Pemex is only beginning efforts to find and develop new fields. According to CNH, 95% of current production comes from fields that are peaking or have already peaked, and enhanced recovery efforts have been made in only 16 of those fields. Rates of decline for Mexican oil fields are unusually high compared to international averages; large Mexican oil fields decline at a rate of 16.1% per year while the international average is 10.4%. Cantarell has declined at a rate of 16.3% per year, while other super-giant fields decline on average at a rate of 3.4% per year.
Despite significant efforts, Mexico's overall rate of reserve replacement has only climbed to 78% in 2010. Reserve replacement based on new fields is only 28%.
Pemex hopes to return to producing 3.3 million barrels a day by 2025, but as CNH explains in its 2010 annual report, this will require an "unprecedented effort in exploratory activity." By CNH estimates, Pemex will need to drill over 165 exploratory wells per year over the next fifteen years. That is a significant leap in activity given that Pemex has averaged only 68 exploratory wells per year over the last eleven years.
Moreover, Pemex must triple the number of shallow water fields (from the current 112 fields to 365) and increase its deep water fields tenfold (from the current 4 to 41). Deep water production is still entirely new to Pemex, which has drilled about 15 deep water exploratory wells since 2004 but has yet to develop any new fields.
New contracts
The Mexican constitution provides that oil and other hydrocarbons are the property of the state and prohibits private companies from holding concessions. In addition to this constitutional limitation, current Mexican law severely restricts the consideration payable by Pemex under contracts for the exploration and production of hydrocarbons, prohibiting payments in kind or otherwise sharing in production, and prohibiting any form of sharing or allocation of sales proceeds or profits. Thus, a private company may not own production, share in the proceeds from the sale thereof, or share in the profits from the project. The intent of the law continues to be that only Pemex may be in the "business" and only Pemex may realize the upside.
For much of its history, Pemex has operated under cash, fee-based arrangements with traditional service companies. The multiple service contracts introduced in 2003 were the first attempt to engage with E&P companies, but Pemex could not legally deviate from the service framework and could only offer compensation on the basis of units of work. Such arrangements did not adequately compensate for risk and were widely considered to be unsuccessful.
The contracts resulting from the 2008 statutory reforms are not expected to go much further. The contracts to increase production from existing, mature onshore oilfields following the model form released on November 24th are anticipated to be awarded by mid-2011 pursuant to a competitive bidding process. Compensation under this first contract may be determined based on several different variables, which are all tied to cost recovery and fixed, per-barrel cash compensation (which is adjustable for inflation).
The total compensation payable to the contractor in any one year may not exceed Pemex's cash flow from the same project during such year. Uncompensated amounts may be carried forward to following years, but are lost if they remain unpaid at the end of the contract term. Pemex may terminate the contract for convenience should it no longer fit within the economic goals for the project.
Regulations issued under the new law would allow Pemex to also enter into contracts agreeing to pay incentive compensation if the contractor (1) reduces budgeted costs, (2) increases reserves, or (3) otherwise increases profits for Pemex. In addition, Pemex may include clauses in multi-year works contracts providing for compensation adjustment if the contractor contributes new technology or experiences changes in the cost of materials. All such compensation must be "reasonable" and paid in cash pursuant to a threshold-based formula or by reference to indicators specified in the contract. Contracts cannot grant any preferential rights to acquire petroleum at an export point or allow the contractor to influence sales to third parties.
Pemex has not yet issued model form contracts utilizing this incentive compensation approach. A constitutional challenge by members of the lower house of Congress to the incentive compensation regime outlined in the regulations was declared without merit last December by the Mexican courts.
This compensation scheme may not be adequate for exploration projects—particularly in deep waters—where contractors would expect market-based upside potential to compensate for increased costs and downside risks. Not only is the compensation limited, but the downside potential is enhanced: the contracts must include penalty provisions to be triggered should the contractor's operations have a "negative impact" on "environmental sustainability" or if the contractor breaches the contract "in terms of opportunity, time, and quality indicators."
These terms are not defined in the statute and will likely be clarified through litigation or regulations that are yet to be enacted. Similarly, the requirement that all compensation be "reasonable" (at the risk of the contract being void) will require contractors to walk a fine line between being profitable but not too profitable.
The new contracts will also be subject to a high degree of political risk. Although many members of the center-left PRI have supported the idea of incentive-based contracts, others in the same party, along with other opposition parties, are fighting against them. These legislators take the position that incentive compensation paid to private companies takes profits away from Mexico. They would prefer reduced taxes to allow Pemex to keep a greater portion of its revenues to invest in exploration and production, rather than allow private companies to become more involved in Mexican oil.
Some legislators, including Cuauhtémoc Cardenas (the son of President Cardenas, who decreed the expropriation of foreign oil assets in 1938), demand that any contracts between Pemex and private companies be made public to ensure their legality. As parties position themselves ahead of the 2012 presidential elections, the degree of foreign involvement in Mexican oil is likely to remain a wedge issue.
Outlook
The rapid decline of oil production has left Mexico with no easy choices. On one hand, Mexico needs the technology, know-how, management capacity, and risk-spreading capability that large international oil companies could offer, and on the other hand, its legal and political tolerance for foreign involvement is still very limited (as the struggle over the 2008 reforms continues to demonstrate).
Ultimately, the 2008 contract reforms are little more than a tentative step toward greater engagement with private companies and have not changed the fundamentals of Mexican oil policy. While many support a more flexible oil policy, it remains to be seen whether Mexico, even in the face of declining production, will be able to adopt such an approach.
About the authors
Jose L. Valera is a partner in the Houston office of Mayer Brown LLP. His practice focuses on the development of energy projects in Latin America. Andrew J. Stanger is an associate in the Houston office of Mayer Brown LLP. His practice focuses on international energy transactions.
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