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Aug 16, 2013 | 10:20 GMT

Mexico: Energy Reforms Could Prove Effective

Mexico: Energy Reforms Could Prove Effective
(Ronaldo Schemidt/AFP/Getty Images)
Summary

Many observers have prematurely dismissed recently proposed reforms to Mexico's energy sector as insufficient. While much will depend on secondary legislation, the reforms may well enable Mexico to achieve two seemingly mutually exclusive goals: retaining symbolic ownership over its oil and giving foreign firms incentives to expand investment.

When Mexican President Enrique Pena Nieto announced his party's plan for energy reform Aug. 12, he very carefully specified that the Institutional Revolutionary Party was proposing a profit-sharing model, not a production-sharing or concessions regime. Ambiguities surrounding these terms have given rise to some confusion, leading some analysts to question the breadth and future effectiveness of the reform. Upon closer inspection, however, the profit-sharing contract will allow foreign firms to report reserves as assets with expected cash flow, potentially providing sufficient incentive for foreign firms to invest on the scale needed to stabilize Mexico's falling production.

Based on preliminary information, the profit-sharing model proposed by Pena Nieto is similar to a production-sharing agreement but with one crucial distinction: Whereas in a production-sharing agreement firms are granted ownership of the commodity itself, in a profit-sharing agreement they are compensated in cash for the oil they produce. This is an important difference because firms need the ability to book reserves on their balance sheets to incentivize making large-scale investment in risky exploration projects — something that has traditionally depended on ownership of the asset itself.

In order to claim reserves to investors in financial statements, the U.S. Securities and Exchange Commission requires any publicly traded company to have four things: a clear mineral interest, a right to extract oil and natural gas, a right to take volumes in kind and exposure to risk and potential reward. Not all four are necessary, but the more ownership indicators, the greater the likelihood firms will be able to include reserves in their financial statements.

Because firms will not be able to own volumes but rather values under the profit-sharing model, this originally called into question whether the firms would be able to book the reserves. The fine print of the SEC regulations, however, specifies that in cases where direct acquisitions of mineral interests are forbidden, the so-called economic interest method is the preferred system for determining bookability. This system is more holistic, and it allows firms to report reserves on financial statements even if they do not own the oil itself. 

Varying Degrees of Success

Energy officials have worked to balance the need to convince Mexicans that foreign firms will not capture an unfair share of oil rent against the need to persuade foreign firms and investors that the terms will be sufficiently generous to spur them to invest. In an Aug. 13 interview, Finance Minister Luis Videgaray said contracts would be progressive, meaning the bigger the discovery, the bigger the percentage of profit will go to the government, and that in certain fields, less than 50 percent of profits will go to the company. He added that companies would take on some of the risks of failure that state-owned oil firm Petroleos Mexicanos, or Pemex, previously assumed.

The next day, Deputy Energy Minister Enrique Ochoa publicly stated that firms will be able to register the value of the contracts with the SEC under the economic interest system. According to some reports, Mexican officials have been in negotiations with the SEC for months to guarantee that companies will be able to report reserves under their profit-sharing model. 

The value of the contract that firms will be able to report will be determined by the price the government pays the foreign firm for oil, among other factors. Until secondary legislation is crafted that will address the specifics of the reform, uncertainties regarding its effectiveness will remain. Nonetheless, transitioning from service contracts to profit-sharing contracts is an important step, since it allows producers to at least partly report reserves.

This arrangement has been used in other countries, albeit with varying degrees of success. Profit-sharing systems are in place in Iran, Ecuador and Bolivia, but broader political issues, not the profit-sharing model itself, have limited foreign involvement. In Iraq, supermajors have signed service contracts and profit-sharing contracts in the northern Kurdish regions — even though the Iraqi Constitution specifically states that the people own the country's oil and natural gas resources. Referring to this arrangement, Shell Mexico President Alberto de la Fuente said in a Reuters interview in February that "we work in Iraq, where in the final analysis we receive payment per barrel of the petroleum we extract, but the reserves aren't ours, they belong to Iraq." This suggests that when the conditions are right, a production-sharing or concessions agreement is not necessarily a precondition for significant investment.

While oil companies prefer the production-sharing model or the concessions model, they are adjusting to the new realities of being oil producers, not owners. Ultimately, how the Mexican reforms go will largely depend on secondary legislation and the degree to which Mexico can provide the economic terms and judicial certainty needed to get the supermajors to buy in — but nothing intrinsic to the profit-sharing model suggests that they will not be able to do so.

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