March 01, 2014

With decreasing production, increasing consumption, and nearly depleted reserves, Mexico is on track to become a net importer of oil by 2020, despite the wealth of untapped natural resources still within the country. To avoid this scenario, Mexico’s Congress, in December, took ambitious yet necessary steps to pass constitutional amendments to begin implementation of its energy reform agenda.

This reform movement does not seek to privatize the state-owned Petroleos Mexicanos (Pemex), but to end the 75-year-old ban on foreign involvement in Mexico’s energy sector. The reforms remove Pemex’s monopoly on oil and natural gas extraction and production, and allow private investment to revitalize the country’s ailing energy industry.

Prior to its nationalization in 1938, the Mexican oil industry was dominated by foreign-owned companies, such as the Royal Dutch/Shell Company and Standard Oil of New Jersey, and supplied one-quarter of the world’s oil. By the mid-1920s, however, political instability and geographic limitations for new extraction caused oil production in Mexico to decline substantially. In the following years, tensions flared between the oil companies and the Mexican government, primarily due to oil taxes, property rights, and wage disputes.

Then, in 1938, spurred by prolonged civil unrest, an increasing budget dependency on oil revenues, and an emerging nationalistic political agenda, President Lázaro Cárdenas signed an order expropriating nearly all the foreign oil companies operating in Mexico. Cárdenas later created Pemex as the state-owned firm that would hold a monopoly over the Mexican oil industry and barred all foreign oil companies from operating in the country.

Post-nationalization, the Mexican energy industry predominately focused on easily extracted oil and natural gas, which, in line with worldwide trends, has become increasingly harder to find. As a result, Mexico has faced declining production levels and increased exploration costs and today imports
two-thirds of its petrochemicals, half of its gasoline, and one-third of its natural gas.

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Internationally, oil companies have embraced new technologies and unconventional methods of extraction, such as fracking and deep-water drilling, to satisfy demand. Yet, with Mexico’s Pemex contributing 90 percent of its annual profits to the government, revenue that comprises about one-third of the country’s federal budget, the company has been unable to afford investments in these new technologies.

The amendments to articles 25, 27, and 28 of the Mexican Constitution, passed in December, create transitory articles to allow foreign involvement in the energy sector through production-sharing, profit-sharing, and licensing contracts. While these reforms maintain that the Mexican government continues to be the sole owner of Pemex as well as Mexico’s subsurface resources, the new laws are designed to incentivize foreign-owned companies to contribute to upstream (drilling and extraction), midstream (pipelines), downstream (refining and petrochemical), and electricity-producing activities. The laws also aim to repeal natural gas price regulations to open the sector fully to market conditions.

Within these structural reforms, the Mexican government has also created the National Agency of Industrial Safety, which, along with the Secretariat of Environmental and Natural Resources, the Commission of Hydrocarbons, and the Energy Regulatory Commission, will be responsible for regulating the industry.

Agreement Structure

With the constitution amended, the spring of 2014 will be a crucial time as legislation outlining the implementation of the reforms is proposed. During this time, the lease allocation period of Pemex’s current asset base and the establishment of joint ventures will be underway. The nine-month lease allocation period allows Pemex to decide what part of its current acreage it wishes to keep and which portions will be available to investors.

By law, Pemex will be required to demonstrate that it has the fiscal and technological capabilities to develop the resources within three years or lose the right to do so. Therefore, tremendous opportunities for industrial development and investment in Mexico’s oil and gas development are expected
to open in early 2015.

The largest question about the reform still up for debate in the Mexican Congress is what structure the agreements with foreign investors and energy firms will take. The amendments leave this question wide open, laying out the following alternatives:

1I Cash for service contracts, which would be similar to a vendor or subcontractor relationship

2I Profit-sharing agreements, under which both parties would participate in all costs and revenues based on contractual divisions

3I Production-sharing contracts, which would shift the risk of exploration and development to foreign oil companies in exchange for a larger percentage of profits and production to cover their investments

4I Transfer of title of produced hydrocarbons for licenses or concessions. Under this type of agreement, which would resemble U.S. offshore lease agreements, Mexico would receive a royalty as its share of the revenue

5I Any combination of these alternatives

Each of these types of arrangements can be defined by its risks and rewards (Figure 2). As Mexico considers which of the arrangements to institute, it is important to remember that the country will want to maximize revenue from its natural
resources while at the same time providing sufficient incentives to foreign investors.

Most countries with exploration and development needs use production-sharing agreements, but those looking to exploit discovered and proven reserves typically opt for profit-sharing agreements. Worldwide, many large energy companies are watching to see what Mexico proposes to determine if the opportunities would fall in line with their overall strategy and provide required returns on investments.

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The most complicated of these arrangements is the production-sharing agreement. Figure 3 shows a simplified flow chart of the structure of a typical agreement. Over the years, these agreements have become much more sophisticated, with sliding scales of what percentages might be used at each point based on both the volume of reserves and the price of oil. Therefore, negotiating and managing these agreements requires significant analysis and oversight by a company considering operating under such a structure.

It is imperative to its economy that Mexico begins to develop its vast oil and gas reserves, thus opening the market to both investment dollars and technology. This is a top priority of the Mexican government. Marco Bernal, a PRI leader of the Energy Committee in the country’s lower Congress, was quoted in news reports saying the government was open-minded on potential.

“This includes all kinds of contracts. We’re not closed to any of these schemes. We would prefer profit-sharing. But if there are other types that are working in the world too, one needs to adopt them and not be closed to one single scheme,” he said.

The upcoming implementation legislation will hold the details to these contracts as well as how these agreements will be initiated, maintained, and regulated. At this critical juncture, Mexico has become the focus of the world’s energy companies to see if involvement in Mexico will be beneficial for all parties.

Concerns with Corruption

To smooth this transition and to secure faith in its new system, Mexico has pledged to crack down on corruption to ensure arm’s length transactions and fair regulation. However, in view of the country’s history and its perceived high tolerance for corruption, energy companies looking to conduct business in Mexico should be aware of the risk of corruption as well as the U.S. federal anti-bribery provisions and best practices, which can help companies comply with those provisions.

Corruption levels in Mexico have historically been high relative to other large economically developed countries. In its Bribe Payers Index (BPI), Transparency International ranks 28 of the world’s largest economies based on foreign direct investment according to whether firms from these countries are likely to engage in bribery when doing business abroad. In the latest BPI, Mexico ranks 26th ahead of only China and Russia.

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The perception of corruption in Mexico is also evident from a survey of its residents. Transparency International research indicates that at least 80 percent of Mexican respondents believe that civil servants, public officials, and the judiciary are “corrupt or extremely corrupt.” In the same survey, 55 percent of respondents reported that they, or someone in their household, had paid a bribe to a member of the judiciary in the previous 12 months. This data points to the population’s lack of faith in its public institutions, as well as the risk of foreigners doing business with Mexican foreign officials.

Intending to halt widespread bribery of foreign officials by U.S. companies, Congress enacted the U.S. Foreign Corrupt Practices Act (FCPA) in 1977. Legislators viewed corruption as imposing enormous costs on countries and businesses, leading to market inefficiencies and instability, substandard products, and an unfair playing field for honest businesses.

FCPA anti-bribery provisions prohibit companies and individuals from making corrupt payments to foreign officials to obtain or retain business. It applies to:

  • U.S. individuals and businesses (domestic concerns)
  • U.S. and foreign public companies listed on U.S. stock exchanges and those required to file reports with the Securities and Exchange Commission (SEC) (issuers)
  • Certain foreign individuals and businesses acting while in U.S. territory (territorial jurisdiction)

A “corrupt” act is an offer, promise, payment, or gift intended to induce a foreign official to misuse his or her official position. Examples of actions taken to obtain or retain business include winning a contract, circumventing rules for importing products, obtaining exemptions from regulations, or gaining access to non-public bid information. The FCPA focuses on intent and does not require that the prohibited activity succeed in its purpose.

Foreign officials under the FCPA include officers or employees of a department, agency, or instrumentality of a foreign government. What constitutes an instrumentality requires a fact-specific analysis of the entity’s ownership, control, status, and function, but would logically extend, for example, to a state-owned national oil company.

Preventing FCPA violations requires a well-designed, consistently enforced compliance program. Furthermore, when deciding whether to investigate, charge a corporation, or negotiate a plea, the Department of Justice considers a number of factors, including “the existence and effectiveness of a corporation’s pre-existing compliance program.”

Hallmarks of an effective compliance program include a commitment by upper management and a clear policy against corruption. Regulators look for compliance programs that are not only strong on paper but that are also implemented effectively. They look for a strong culture of compliance promoted by senior management who clearly articulate company standards and scrupulously adhere to them.

Looking to the Future

Faced with the prospect of importing a majority of its energy in the future, Mexico is taking steps to reverse the current downward trajectory of its energy industry. With its recent constitutional amendments, the country is poised to implement new laws governing its relationship with foreign investors in the hopes that they will present incentives for both international and domestic firms to help relieve its ailing oil, natural gas, and electric sectors. Legislators are considering several types of contracts that will govern all parts of the industry.

To this end, Mexico must ensure that its current corruption tolerance decreases so that foreign firms do not face the additional risk of prosecution by other governments though the FCPA and other laws.

Guest author:

Mark R. Patten