Oil production in Mexico has been declining for some time. Hydrocarbon production declined to 3.78 million barrels of oil equivalent per day in 2009 from 4.4 million BOE per day in 2005. To confront this challenge, the government approved in 2010 an energy reform package first submitted by President Felipe Calderón in April 2008. The changes are meant to strengthen corporate governance and create a new contractual framework for operating companies.

Pemex seeks to turn its attention to fields that present complex technical challenges, including low well productivity, and to search for commercial deposits in new basins and geological horizons that until now have been unexplored or underexplored.

That's why, in a series of new public tenders, state oil company Petróleos Mexicanos is seeking the help of operating companies with expertise in field redevelopment to bid on three onshore blocks: Magallanes, Santuario and Carrizo. These contain six mature fields, in the southern state of Tabasco. The three blocks have average estimated 3P reserves of 207 million BOE and average production of 14,000 barrels per day.

This field rejuvenation program is one of three strategic initiatives of Pemex E&P. Later this year, it will hold an auction in a different onshore region, in Chicontepec, and, by the end of this year or the beginning of 2012, there will be a tender for some deepwater blocks.

Pemex is offering compensation through a complex formula based on a fee per barrel produced, plus partial cost recovery. It expects to grant the first onshore awards in August. "We expect companies to start operating existing production right away, and to start drilling by late 2012," Pemex chief executive officer Juan José Suárez Coppel told attendees during a road show in Houston in early March. Pemex retains the right to join any winning bids, depending on the field, "with 10% to 25% working-interest participation, paying its share of costs, to have a closer relationship and…get on a faster learning curve," he added. The core of this discussion, however, is about the mechanics of the formula by which the calculation of available cash flow is made—and from which the contractor is paid fees and recoverable costs.

Progress since 2003

This new round of upstream tenders offered by Pemex to E&P companies creates an investment opportunity that is strikingly different—and yet strikingly the same—compared with the one offered to oil companies in the first round of international public tenders from 2003 to 2005. (See "Mexico," Oil and Gas Investor, July 2003.)

Pemex was moderately successful in its multiple-service contracts (MSCs) in northeastern Mexico's Burgos Basin offered in 2003, exclusively targeting natural gas development. It received bids on four of the six blocks offered, netting commitments of about $4 billion.

The contractor was paid for discrete "services" performed from a long price list for the everyday activities that take place in oilfield operations. The winning bidders were the ones who offered the greatest discount to that price list. It was a very inefficient system, but it was the best that could be done under the limitations of Mexico's Public Works Law at that time.

The new EP Integrated Contract, as it is called by Pemex, differs from the MSC in several key respects. First, it is about targeting crude oil (and any natural gas that comes with it). Second, the bidding will be on the basis of a fee per barrel. The contractor who offers the lowest fee wins. Third, there is cost recovery of 75%.

In some respects the two contract models are the same. Neither offers the contractor (the E&P company) a share of the hydrocarbons for which it is responsible, nor is the contractor paid directly from the revenue that the oil production generates at market prices. And the contractor is not given economic title to the new reserves that are discovered (although having a 20- or 25-year contact does give the contractor reasonable assurance that it will have the legal right to produce those reserves).

Mexico is different

Mexico is complicated, in its laws, history and, as will be seen, oil contracts. To understand Mexico's oil patch, one has to be clear about three aspects. The first is that Mexico is one of a half-dozen countries on the planet in which the state sets the prices of all energy products, from the wellhead to the light bulb.

The second is Mexico's "petroleum narrative," that is, the story that Mexico tells about its own national experience in relation to the oil industry. Mexico presents its oil industry as a chapter in the history of the Mexican Revolution, an epic peasant uprising and civil war that lasted for nearly three decades, from 1910 to 1929. In 1922, Mexico was second—after the U.S.—in oil exports worldwide, but disagreements over laws, wages and judicial rulings in the next 15 years would ultimately lead, in 1938, to the expropriation of all foreign oil interests.

The third feature that must be understood is the singular role of Pemex and its unique place in the national psyche. Created as a practical necessity after the expropriation, the company was run by members of the national oil union that had been formed only a few years before, in 1935. The oil union, then as now, sees itself as the oil conscience of the revolution.

The growth of the national oil company, with its closed-shop, unionized workforce, is represented in the national narrative as a validation of the Yes-We-Can spirit of 1910, 1938 and 2000, three key dates in Mexican history. The latter is the year in which seven decades of one-party rule by the post-revolutionary system came to an end.

The contract

During Pemex's international road shows, starting with the one held in Houston on March 8, there were three break-out sessions: one dealing with geology, another with the legal framework, and a third with the contract's economics. This article is limited to the computational gymnastics built into the contract in the Annex 3 Remuneration.

Simply stated, Pemex will pay the E&P contractor on several accounts. The three principal ones are 1) managing established production that had been brought on earlier by Pemex in the contractor's block; 2) developing new, or incremental, production; and 3) partial cost recovery. The contractor will also be paid for the use of his infrastructure for oil produced outside his block.

There is, however, a caveat. Payments to the contractor will be made from what is called "available cash flow." (The language of record for the contract is Spanish, where the term is flujo de efectivo disponible, or FED.) In other words, the contractor is not paid from the gross revenue generated from the sale of hydrocarbons, but from the escrow account that is funded by Pemex from such sales, minus Pemex taxes and royalties.

The mechanism to fund the escrow account is predictably complicated, as it takes into account the different tax treatment given to two types of fields—those designated by the Finance Ministry as "marginal" and those termed "ordinary." A marginal field has a 57% tax rate in 2011, while the ordinary field is taxed at 72.5%. It is easy to see that Pemex will have more money to pay the contractor if project revenue is taxed at a lower rate.

It turns out that even in a marginal field there is a tax wrinkle: existing, or base-line, production is taxed at the ordinary rate while the incremental production (achieved by the contractor) will be taxed at the lower, marginal rate. What this means is that in any given month (which is the time period for payments by Pemex to the contractor), the taxes applied to production must differentiate between the share that receives the ordinary rate and the share that receives the marginal rate.

And there is one more wrinkle. The funds available to the escrow account are additionally constrained by the deemed market value of oil and gas production (referred to as p in the contract), where "deemed" refers to another formula that takes into account the API gravity or quality of the crude oil produced, and the monthly price index for West Texas Sour (WTS) crude.

The contract, without explaining any of the coefficients, provides this formula for p:

p = [0.00838 (°API) + 0.68] times WTS + 0.1607 (°API) – 6.03.

The taxes on base-line production (ZF) as well as on incremental production (Zi) vary discontinuously, under three distinct oil-price conditions.

The combined calculations for the operator's contribution to production (?) plus the tax on base-line production (ZF) and the tax on incremental production (Zi) yield the aggregated tax liability (Z) for that block's production under that month's oil-price conditions. For the purpose of the formula, this aggregated liability is expressed not in dollars but as a decimal value, which requires the arithmetic step of multiplication, not subtraction (as would be the case if the tax liability were in dollars).

As indicated, Z has a lot of work to do: it must take into account the contractor's share of total production (?) plus the applicable taxes on base-line and incremental production, according to the market price of oil:

z = ?zF plus (1-?) zi.

In words, the escrow account will be funded on a monthly basis in this way:

Available cash flow (ACF) volume = Volume (q) x Deemed price (DP) minus Aggregated tax liability (ATL); or, in terms of the contract, ACF = (q) times (p) times (z).

Pemex will offer blocks in mature fields, Chicontepec and the deepwater.

Observations

It is unlikely, except at the clarification meetings at which representatives of companies who have bought the bid packages may ask questions, that Pemex will provide further clarification regarding the complex arithmetic of the remuneration formula. It would be nice to know what the coefficients in the deemed price (p) formula mean, but Pemex has no obligation to provide such information.

Up to a point, that is. What's really going on is that the contractor is taking a risk that the economic model of the contract, with its econometric representations, will be inadequate to fund his investment in a timely manner. Not knowing the risk, the contractor accepts the possible role of being a mezzanine lender who, from month to month, lends Pemex money (by dint of his expenditures in his capex and opex accounts) that will be paid back by Pemex, with interest, in the future.

There is no reason to doubt that Pemex has done its homework on the contract model, so, to some extent, it should be given the benefit of the doubt. Pemex badly wants this iteration of the contract model to work, that is, to attract mid- and small-cap E&P companies having an appetite for a field-rejuvenation project in Mexico. Pemex needs to have success at this stage if it is to have credibility for more ambitious projects, such as further development of onshore Chicontepec and offshore Perdido fields, which will require larger-cap operating companies.

Working in Mexico, as many others have observed, is not for the faint of heart.

Pemex and the government have not offered a traditional production-sharing agreement, but they hope they have put enough on the table to attract new investors.

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