A new test for the Pacto por México: energy reform – key points for energy companies

Energy Alert

President Enrique Peña Nieto has submitted a sweeping Energy Reform Bill (ERB) to Mexico’s Congress.

 

In his recent State of the Union Address, President Peña Nieto confirmed his commitment to move forward decisively with this energy reform and to move it through Congress within 180 days.  The ERB would amend parts of the Mexican Constitution to open  the basic petrochemical industry to private investment through licensing and to permit profit-sharing agreements.  In addition, the ERB lays the groundwork for greater private investment in the power sector with the aim of spawning a competitive market while still maintaining state control over the power transmission grid.

 

The significance of this reform may not be evident for some time.  First, the administration must tackle certain practicalities such as the implementing regulations that will define the new legal framework in which the energy sector will operate. Certain proposed tax reforms aimed at making the energy reform attractive were unveiled on September 8 but also must be approved by Congress.

 

The Pacto por México, an agreement entered into by the  country’s three major political parties and providing for wide-scale structural reforms, survived its first test this spring with the passing of telecom and media reform.  It will be tested anew with the ERB bill.  Key to the success of the energy reform will be the ability of companies, particularly US public companies, to book interests in reserves for financial reporting purposes.

 

COMMITMENT TO REFORM BY THE PEÑA NIETO ADMINISTRATION

 

One of the most important commitments of Mexico’s new presidential administration has been to implement reforms in sectors deemed key to national development.  The ERB addresses two of these key sectors: hydrocarbons and power.

 

The ERB aims to address the need to expand and increase the competitiveness and expansion of the energy and power sectors, the treatment of which historically has been the subject of heated debates.

 

In contrast with the recent telecom and media reform, which implemented specific changes to the regulatory framework at the constitutional level, the ERB is conceptual in nature, lacking regulatory details, which are left completely to the implementing legislation that is to follow. Additionally, the ERB is an initiative of President Peña Nieto, and the Mexican Congress will have to consider competing proposals from at least two other political parties (PAN and PRD) for the passing of the ERB and the subsequent enabling legislation. 

 

As in the case of the telecom and media reform, once approved by the Mexican Congress, the constitutional reforms described in the ERB will require the approval of a majority of the state legislatures to become effective.

 

HIGH POINTS OF THE PROPOSED REFORMS

 

1.  Continued government control

 

Under the ERB, the Mexican government will maintain ownership of, and control over, all forms of hydrocarbons.  The reform does not contemplate the issuance of concessions to private parties. Rather, Pemex will retain its role as the government-run oil company and will continue to be a 100 percent government-owned entity.  However, it will be restructured in order to operate two divisions: exploration and production (upstream business), and processing.

 

2. Private sector involvement

 

The new bill opens up the possibility for private companies, and government‑owned entities other than Pemex, to enter into exploration and exploitation agreements, allowing increased and more efficient extraction and production of oil and gas.

 

While the ERB does not set forth any parameters with respect to the nature or characteristics of these exploration and exploitation agreements, in President Peña Nieto´s presentation of the bill (and on his administration’s official Internet page) it is clear that the intent is that the enabling legislation would provide for profit-sharing, rather than production-sharing, agreements.

 

It is unclear whether such profit-sharing agreements would permit private parties to book reserves. Providing for the ability to book reserves would greatly facilitate the success of the reform. Historically, the service contract regime designed to conform private party rights to the constitutional mandate that hydrocarbons belong to the Mexican people prevented any booking of reserves by private parties. If the reform is to be effective, the implementing legislation must address this issue so that: the reserves will continue to be owned by Mexico, but exploration and exploitation agreement participants will be permitted to book interests reserves for which they have extraction rights for financial reporting purposes.

 

According to SEC sector guidelines,1 the booking of interests in reserves is permitted under the economic interest method, pursuant to which the estimated value of contracts may be converted into barrels and recognized on a company’s balance sheets as if they were reserves, without the transfer of ownership of the petroleum.

 

The resolution of the booking-of-reserves issue requires two things: the ERB enabling legislation (the law, regulations, RFPs and ultimately the template agreements) must expressly permit the booking of interests in the reserves granted under profit-sharing agreements on the one hand, and any such booking must ultimately be sufficient to comply with accounting standards2 (and the SEC regulations in the case of publicly traded companies), on the other. 

 

In addition, in order for profit-sharing agreements to be attractive to private investors, Mexico must revamp the royalty and tax regimes imposed on Pemex and the current Pemex exploration and production cost structure, and pricing, to make Pemex internationally competitive. It is worth noting that Pemex’s current cost structure is widely recognized as not up to international standards and Pemex will be required to overhaul its structure in order to attract foreign investment.

 

President Peña Nieto has unveiled a newly proposed economic package3 that addresses the fact that the current Pemex tax regime only recognizes approximately one-third of the real costs of exploration and production, distorting the decision making process. The new regime, as set forth in the proposed Hydrocarbons Revenues bill (HRB), is predicated on five principles:

 

  • payment of quotas for fields which are not in a production phase (to foster development)
  • royalty-based fees for the value of production
  • distribution of profits (as pre-established percentages, subject to adjustment depending on the operating profits which will consider all the costs associated with exploration and extraction)
  • payment of income tax by Pemex (like any other corporate taxpayer) and
  • payment or reinvestment of dividends (beginning at 30 percent – and subject to a gradual reduction over time – of the income generated by the profit-sharing agreements).

 

This new regime is expected to come into effect in 2015, and, while the HRB is silent on the subject, it is anticipated that Pemex may implement the new oil and gas tax regime sooner in connection with the implementation of profit-sharing agreements.  However, this will have to be addressed in other implementing legislation.

 

The new tax regime contemplated by the HRB is intended to provide flexibility to Pemex’s tax burden. For the first time, Pemex will be permitted to recuperate the totality of the costs incurred in the exploration and extraction of hydrocarbons, and tax revenue will grow as operations become more profitable, whether through price increases, cost reductions, or larger oil fields.

 

The following chart compares aspects of the current and new tax regimes.

 

 

The HRB provides for the creation of a trust, which will serve as a revenue administration, to monitor prices, and administer volumes, contracts and the proceeds from the sale of hydrocarbons.  The trust will act as a “transparent” clearing house for the allocation of oil revenues.  Hydrocarbons will be commercialized by a government entity.

 

Finally, under the ERB. the work of the basic petrochemical (midstream and downstream) sector will no longer be regarded as strategic activities of the federal government, thus permitting the granting of licenses for  refining, transport, warehousing and distribution and sale of petroleum products, as well as for natural gas processing, to private parties.

 

ELECTRIC POWER

 

1. Government will keep control of the electrical power grid 

 

Under the ERB, the government will maintain control of the national electrical power grid and will regulate interconnections, tariffs, universal service and expansion of the power network. The grid will be operated by a government entity, separate from the Federal Electricity Commission (CFE).

 

2. Continued control of distribution 

 

The government will also maintain ownership of transmission and distribution services, but will increase the participation of the private sector in the industry in order to generate a competitive market.  Significantly, CFE will now compete with private parties. Both CFE and its private competitors will be required to transmit and distribute energy through the grid operator.

 

3. Prioritizing green energy

 

Priority will be given to investment in green energy (such as wind or photovoltaic).

 

4. Strengthening regulatory authorities 

 

Regulatory agencies will be strengthened in order to foster the promotion and development of the industry through private and public investment.

 

COMING NEXT: IMPLEMENTING LEGISLATION

 

In both the hydrocarbon and power sectors, implementing legislation will be required to address specific terms and conditions applicable to exploration and exploitation agreements and licensing requirements for midstream and downstream petrochemical activities, as well as the rules under which the private sector will be permitted to participate in the process of power generation, distribution and sale.

 

For more information about these coming reforms, please contact  Miguel de Erice, Carlos Valencia, Robert Gruendel or Jack Langlois.

 

Please also see our alert Comprehensive tax reform is coming in Mexico: key highlights for businesses.

 

FROM THE ARCHIVE

Mexico's telecom reform: the acid test of the Pacto por México



1 Regulation S-X.

2 FASB; Accounting Standards Update No. 2010-03

3 General Criteria of Economic Policy 2014, submitted by President Peña Nieto as part of his Economic Package and proposed bill on Hydrocarbons Revenues submitted to Congress on September 8, 2013.