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Secretaría

de Hacienda y Crédito Público (SHCP) – Miguel Messmacher Linartas, Undersecretary for Revenues – Mexico

12.08.2014 / Energyboardroom

The Undersecretary for Revenues introduces the progressive tax framework that his Ministry has established for the upstream oil and gas segment and speaks out about the new fiscal pact and hydrocarbons revenues act. He also details how Mexico’s energy reforms will act as a catalyst to prosperity for the entire nation.

 

 

Your ministry has proposed a highly progressive tax framework for the upstream oil and gas segment, with levies rising for more productive fields or when oil prices increase. How will this raise the attractiveness of the Mexican energy market in the eyes of international investors?

The fiscal framework that is being proposed actually closely mirrors international best practices. There are obviously a number of very different mechanisms being deployed around the world whether royalties, production sharing, profit sharing or something more progressive. Each of these fiscal components entails pros and cons and our solution has been to blend a variety of different instruments so as to benefit from the pros while, at the same time, reducing our exposure to the cons. Our priority in establishing a sliding scale of adjustment has been to ensure that the Mexican governmentreceives the entire rent associated with oil reserves irrespective of the type of contract.

A second important consideration that will be of much interest to any kind of investors seeking to participate in Mexican oil and gas is that the contracts will remain stable over time. Typically what we have observed in other countries is that the fiscal terms are established for a certain level of expected production and expected prices. Afterwards, either prices or production tend to increase and these force the government of the country to modify the fiscal terms. We have been very keen to avoid this type of scenario by having an in-built adjustment mechanism that renders the contracts sustainable in the long run. This is a characteristic that potential investors have been advocating for and we are confident that by having this progressivity mechanism there will be no need for any sort of future renegotiation.

Mexico has been going through a period of Macroeconomic stability, yet its fiscal regime seems remarkably weak with heavy reliance on hydrocarbon revenues and low tax collection capacity. Is the Treasury too dependent on income from the oil and gas sector? And if so, what can be done to rectify this?

We have already implemented a couple of initiatives that should radically reduce this dependency. Firstly, a fiscal reform was approved last year which will have a positive effect on our non-oil taxes. This reform implies that government revenues unrelated to hydrocarbons increased 1 percent of GDP in 2014 and our intention is that this increase will reach 2.5 percent by 2018. That represents a significant increase in the space only five years.

A second element that was included in the constitutional reform and will be elaborated in greater detail in the secondary legislation currently under consideration concerns ring-fencing oil revenues. We actually want to limit the amount of oil and gas revenue that flows into the federal government budget to 4.7 percent of GDP which is broadly in line with today’s ‘government take’. Any additional income associated with higher levels of production will instead be diverted towards a new petroleum sovereign fund. This again will help wean the federal budget away from a dependency on the sector and encourage a diversification of revenue streams.

Can you please explain the economic rationale behind opening up the oil and gas sector to foreign multinationals and how this will directly translate into increased state revenues?

It is important to clearly understand how economic rent is generated in the oil and gas sector to see the sound fiscal logic behind these reforms. To use a basic hypothetical example, if you have a price of oil at 100 dollars per barrel, but you also have a production cost of 100 dollars then you have no economic rent. On the other hand, if at the same price, you can reduce your production costs to only 20 dollars then you are going to enjoy a rent of close to 80 dollars per barrel. Opening up the oil and gas sector will allow for the participation of new agents with enhanced technology for certain field types and other actors that are better equipped to share in the risks of exploration and production of complex reserves and that should imply that the costs of extracting the oil will drop significantly.

Hydrocarbon production has been declining in recent years and this has had a considerable effect on the public purse. What this reform will do, by allowing in new participants and new technology, is to reverse that decline by increasing investment and reducing costs associated with certain types of field. There are, of course, areas such as shallow water in which Pemex is highly efficient and excels. But in areas like deep water or shale, Pemex enjoys no such comparative advantage and it is only through allowing the entry of third parties that we can reduce production costs and thus simultaneously increase the amount of rent per barrel.

Former Chief of Staff to Pemex‘s General Counsel, Eduardo Núñez likens the transition from one fiscal regime where Pemex pays to another where the burden falls on the private sector to the “Paso de la Muerte”. How exactly does the ministry intend to smoothly execute such fiscal acrobatics?

We are very confident that we can bring about this transition in a stable and successful manner. To a large extent, much will depend on how much production is taking place through the contracts and how much revenues can ultimately be obtained from incoming third parties.There is, of course, an element of the unknown as to the levels of investment that will enter the market, but we do have in-built strategies to adequately deal with this uncertainty.

We will be very careful to ensure that the different bidding rounds constitute a sufficient volume of contracts, wide variety of contract types anda whole portfolio of different field categories. It would have been a mistake, for example, toconcentrate all the bidding on deep-water where the revenues are between five and ten years away. Our focus will be to cover the entire ecosystem of deep-water, shallow, mature and shale. This means that we can have projects coming on stream that lead to quick production increases such as  those in the more mature fields while, at the same time, putting the building blocks in place for the types of projects that will generate revenues further down the line. The logic is that the bidding rounds must be diverse enough to enact the transition smoothly and on a scale that will be sufficient to accomplish the task.

The new Hydrocarbons Revenues Act, currently under review in Congress, makes your ministry responsible for verifying the operations and capacities of private sector E&P companies. Just what expertise does your ministry have for undertaking such a technical function?

SHCP has actually been involved in reviewing Pemex’s revenues and operations for the past four decades so to some extent we already have a set of people specialized in monitoring and oversight of the oil and gas sector. Despite this historic legacy, however, we will need to reinforce these capabilities in important ways. The same applies not just to us, but also to SENER which is to take on new functions and the whole regulatory apparatus encompassing CNH, the CRE and some brand new entities that will be created from scratch. Building up a good specialist and technical knowledge base is a fundamental and necessary step in constructing a regulatory state.

What is your response to critics in Congress that claim that the SHCP is using the Hydrocarbons Revenues Act as a pretext for assuming sweeping new powers and establishing a super-ministry?

Much of this discussion is a product of our attempts to become more transparent under law. In reality, if you analyse the faculties of the Ministry of Finance prior to the reform, you will find that we are relinquishing a significant amount of power. For example, there has been much discussion about whether SHCP is really ‘getting out’ of Pemex when the reforms mandate in law that a member from the Ministry shall sit on the board of Pemex. Yet, if you look closely at the current set-up, you will find that we actually have two members, albeit not by law, as representatives on the board so here is a good example of the Ministry transitioning to a more moderate and less interventionist stance, and moreover one that is above-board and transparent to all.

With regard to Pemex’s budget, SHCP will retain two elements of control and oversight. Firstly, Pemex will have to comply with a target for it’s financial balance to make sure that the NOC does not incur in excessive indebtedness. Secondly we have the power to place limits on the company’s personnel costs. This is again with a view to ensuring the economic health of Pemex’s accounts and to prevent an explosion of hiring and all the consequences in terms of pension liabilities and escalating costs. We therefore jointly fix the goals for personnel expenditure and a financial balance. Beyond that, so long as Pemex complies on those two fronts, the company is empowered to make any adjustments they see fit without prior authorization by the Ministry. Once again, if you compare this with the present situation, SHCP is going to be much more ‘hands off’. Those who accuse us of power building simply are not taking into account the extent of what the ministry is capable of doing today and moreover what it has been actively doing for many years.

As a former IMF economist, what personal message do you have for the international markets in relation to the reforms sweeping across Mexico’s energy industry?

This energy reform is not taking place in a vacuum.  It is a critical part of a whole tranche of ambitious reforms that touch upon areas in which countries typically have a lot of difficulty in making progress. I am talking about reforms to education, telecoms, tax and anti-trust regulation. The core idea behind all of this is to inject competitiveness into the markets and generate higher sustainable growth rates. We are not endeavoring topush faster growth through an expansionary monetary policy or fiscal policy though we of course have to manage the business cycle. Instead we seek to open Mexico to business through a series of complementary reforms that will attract investment and translate into long term economic prosperity.

 

 

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