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The Mexican Energy Reform – Deciphering the Secondary Legislation

10.06.2014 / Energyboardroom

Once again the Peña Nieto administration has exceeded all expectations in forging boldly ahead with its plans to shatter the 75-year-old oil monopoly of Petróleos Mexicanos (Pemex) and prise open Mexican oil and gas markets to private sector competition and investment.On April 30th, in a highly symbolic demonstration of unity and intent, the President himself, accompanied by the Ministers of Finance and Energy, unveiled a far-reaching and eagerly awaited package of bills aimed at implementing the unprecedented constitutional changes that were passed to much acclaim back in December 2013.

The so-called ‘secondary legislation package’ is of vital importance to the eventual success of the energy reforms because it essentially defines the mechanics of how to put into effect the broad objectives outlined under the original constitutional amendment. An inconsistent or poorly formulated tranche of secondary legislation would risk undermining those achievements hence the fears of backsliding on the part of many lawmakers and attorneys.Peña Nieto’s proposals, however, will reassure international markets about his government’s genuine commitment to real structural reform in the very same month that the state oil company, Pemex, reported a record sixth consecutive quarter of losses. Meanwhile the package also serves to shed much more light on the sort of Mexican energy sector that everyone can ultimately expect.

The proposed package of legislation, constituting no less than nine new bills and thirteen amendments to existing statutes, must now be reviewed by both the Senate and Chamber of Deputies and requires approvalby a simple majority vote in both Chambers to achieve final passage into law. In terms of timeframes, anextraordinary congressional session is expected to be held at the end of June specifically to address the proposed legislation rather than waiting for regular sessions to reconvene in September. Here’s what we know so far in its pure form before the horse-trading in Congress commences.

New Laws Mexico OG 2014

Cornerstone statutes will be a new“Hydrocarbons Law” and “Hydrocarbons Revenue Tax Law”. Together, these two bills will establish the overall framework by which the exploitation of hydrocarbons may be performed. They will define the types of E&P contracts that can be awarded, the nature of joint ventures with state-run entities and the rules of the game for bidding procedures. Meanwhile an upgraded “Pemex law” will form the blueprint for the entity’s restructuring and transition from entrenched state monopoly to productive national company status.

As widely predicted, the bills set in motion all the conditions for an exploration and production contract regime that allows the full spectrum of licenses, profit sharing and production sharing agreements, crucially permitting private investors to book reserves albeit with the proviso that the state retains sole ownership over the subsoil resource. This should, in conjunction with the parallel announcement that Pemex intends to relinquish at least 71% and 85% of its respective deep water and shale assets during round zero, be more than enough to entice the oil majors.

Power Shifts

What still remains opaque is where the real power will reside for implementing and enforcing the new laws. With a nod towards greater accountability and openness, much care has been taken to lock in checks and balances thus ensuring that no single agency has complete control over energy contracts. What was historically Pemex’s responsibility will, from now on, be shared across a triumvirate of power bases. The Energy Ministry (Secretaría de Energía – SENER) is charged withproviding technical guidelines, the Finance Ministry (Secretaría de Hacienda y Crédito Público – HACIENDA) tasked with establishing award variables and the economic terms of tenders, and the hydrocarbon regulator (Comisión Nacional de Hidrocarburos – CNH) entrusted with the contract processing and supervision functions.

Whether this will, in practice, result in the desired transparency or unwanted by-products such as bureaucratic dysfunctionality and infighting remains hotly contested. In the words of one CNH insider, “HACIENDA will continue to call the shots through its stranglehold over the purse strings; SENER is gaining in stature because Pemex’s has effectively traded its discretionary influence over the industry for enhanced internal autonomy, and against all of this we too must struggle to assert our authority and carve out our own future.”

The approval and selection process for Pemex joint ventures is equally inconclusive and will likely form another key fault line during the ensuing debates. The ruling Institutional Revolutionary Party (PRI), lobbied hard by Pemex unionists, is adamant that the national oil company itselfshould make the initial determination for farm-in partners and that CNH’s role should merely be confirmatory in nature. The opposition National Action Party (PAN)’s position, by contrast, is that CNH must not be reduced to rubber stamp and should instead enjoyexclusive determination powers.

The Tax Burden

Without doubt, one of the most eye-catching elements of the package was the announcement that Pemex’s fiscal burden will be reduced from 79% to 65% within a decade. This aims to enable the company to become more efficient by reinvesting a greater share of its profits in technological upgrades and growth hotspots. So that the Mexican state can continue to carry out its essential obligations with respect to public investment, health, and education, the deficit instead must be made up by correspondingly higher contributions from private sector oil and gas.

The proposals suggest that the government take of private sector profits for upstream contracts will come from both a tax and a royalty structure. The tax take will be over and above the standard 30% corporate tax applicable to all Mexican corporate activity and will specifically target oil and gas production. Royalties, meanwhile, would vary according to the type of field, the price of hydrocarbons and the level of production being realized so as to lower the risk of disincentivizing foreign investment in difficult fields such as deep water. Only base-level royalties would apply to those complex plays with narrower profit margins, whereas additional contributions would kick-in for fields in which production levels exceed certain thresholds.

Many commentators forecast that there will need to be some sort of transitory scheme stretching over a number of years to effectuate these changes.Guaranteeing an orderly fiscal transition could be difficult in the short term as no one knows how long it will take the private sector to properly engage with the Mexican market. Renowned former Chief of Staff to Pemex’s General Counsel,Eduardo Núñez, likens the forthcoming fiscal acrobatics to the “paseo de la muerte”, a Mexican cultural tradition in which a rider must pass from the saddle of one moving horse to another. “Because Pemex profits account for a massive 40% of the federal budget, this is going to be quite a balancing act to ensure that the nation can maintain its current levels of expenditure while at the same time rendering Pemex competitive enough to spar on a level playing with foreign multinationals”, he declares.

Local content

In an effort to generate burgeoning cluster industries and counteract widespread fears of energy windfall profits being repatriated abroad, the governing PRI has committed toensuring 25% “national content” in energy projects by 2025.Specific national content requirements would vary according to a flexible, sliding scale system and would be described in public bidding guidelines. The bottom end of the proposed scale contemplates minimal national content requirements for oil and gas fields where Mexico has little in-country expertise such as ultra-deep water or shale plays. The upper end, by contrast, envisions much higher quotas for local workforce and indigenous suppliers in shallow water and onshore oil blocks where Pemex is already considered globally competitive. The changes would be phased in over time starting next year.

Such a proposition will likely be amenable to both domestic and foreign enterprise alike. On the one hand, Mexican firms will appreciate the protection that local content affords them as they prepare themselves for exposure to international norms on quality and standards. On the other hand, multinationals will be highly relieved to have avoided a Brazilian-style scenario of draconian local content requirements in the development phase of the pre-salt offshore fields which is widely regarded to have been immensely detrimental to foreign investment. Out of those multinationals already present in the market, many will have been bracing themselves for much worse and will find the relatively innocuous target of 25% as broadly in line with the set-up for their existing operations. “We have been investing heavily in building up our local workforce and bringing in talented Mexican graduates, not only because we are committed to Mexico in the long term and view local content as a natural process of cultivating local industry, but also because we were anticipating this moment” explains David Pring of the geophysics leader, GPS.

Of course considerable political and technical challenges still lie ahead. Already there are signs that the remarkable pact concluded between the PRI and the PAN is fraying at the edges with the latter now seemingly making its support for the continued progress of the energy reform contingent on a parallel overhaul of the electoral system from which it seeks to directly benefit. This should hardly be surprising. It was always likely to be much easier for the two rival parties to agree on the sorts of nebulous macro-economic issues enshrined in the constitutional amendment, than to forge consensus on the fine detail of secondary legislation where interest groups are impacted-first hand. Nevertheless none of this should be allowed to overshadow the fact that a substantial hurdle has been now surmounted. Against expectations from many quarters, Peña Nieto and his coterie of radical reformers have remained true to their word and presented a legislative package consistent with the spirit and aspiration of December’s constitutional amendment. For now at least, Mexico’s historic energy reform remains very much on track.

To read more articles and interviews on Mexico, and to download the latest free report on the country, click here.

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