Mexico: U.S. Oil & Gas Lease vs. Mexican Service Contracts

Last Updated: 23 November 2015

The Mexican Energy Reform that is currently being implemented introduced a paradigm shift in the hydrocarbons sector of our country that allows private investment in upstream activities, previously reserved exclusively to the Government. The series of constitutional, legal and regulatory changes derived from said Reform give way to exciting, new investment opportunities, especially for Texans who have a privileged geographical location as our northern neighbors and are close to Mexican areas that are rich in hydrocarbons. However, it can be overwhelming for any investor to move their capital and efforts to another jurisdiction, even if it is their backyard. Therefore, I would like to take this opportunity to depict some of the legal differences between the Mexican and U.S. hydrocarbons legal regimen from a business perspective, in an attempt to shed some light on the nature of the opportunities that are currently available for Texan oil & gas investors in Mexico. Specifically, I will compare and contrast the way profit is made under U.S. Oil Leases and Mexican Service Contracts.

Mineral Rights

The first fundamental difference between the U.S. and Mexican oil & gas regimes is the ownership of mineral rights. While landowners in the U.S. own their mineral rights and may specifically lease them, such rights under Mexican Law are reserved to the State, which only allows private parties to exploit them through: (i) assignation titles (asignaciones) granted to Productive State-owned Companies (i.e. PEMEX) or (ii) hydrocarbons exploration and extraction contracts tendered by the National Hydrocarbons Commission. In that regard, Service Contracts do not grant mineral rights, but rather are entered into to render services to a party that holds an assignation title.

Parties to the Contracts

From that first fundamental difference, an important distinction between U.S. Oil and Gas Leases and Mexican Services Contracts can be made: While U.S. Oil and

Gas Leases are entered into between E&P companies and landowners, Service Contracts are executed between E&P companies and Mexican Productive State-owned Companies, of which there is currently only one: PEMEX. This translates into a different negotiation process for the definition of the terms and conditions and the scope of the corresponding contracts. To exploit a field in the U.S., a company would probably have to enter into several Oil & Gas leases with different landowners, while in Mexico such company would enter into a single Service Contract with PEMEX.

Economic Terms

The economic terms by means of which a field is exploited are essential to the profitability of the operations on that field, and therefore deserve the attention of investors. Under U.S. Oil & Gas Leases, a company usually pays the landowner: (i) a rent per acre of land leased, and (ii) a royalty which consists of a percentage share of the economic proceeds derived from the oil & gas production generated in the leased land. Such amounts are paid in consideration of the exclusive right to explore, drill and produce oil & gas in the land and the title to the hydrocarbons produced. In comparison, under Mexican Service Contracts PEMEX pays a cash amount to the company in consideration for the services rendered for the exploration and production of oil & gas, but keeps the title of any hydrocarbons produced under the contract. Contractors under Service Contract have no title to the production and may not keep or retain any of the oil & gas produced on the field.

Regarding the definition of the cash consideration of the Contractor of Service Contracts, certain clarification points are worth mentioning. Foremost, it should be noted that a cash consideration does not necessarily imply a lump sum of cash for the contractor. Service Contracts have been evolving in recent years and have allowed such consideration to be determined taking into account the costs incurred by the contractor in the development of the field, subject to certain restrictions. More importantly, it is imperative to take into account that prior to the Energy

Reform there were severe legal restrictions that did not allow the consideration to be determined as a percentage of the production, revenues, value, income or profit of the extracted hydrocarbons. Such restriction is no longer applicable, and consequently, a consideration mechanism that allows the contractor to participate in the profitability of the field, sharing risks and aligning incentives between PEMEX and the contractor could be negotiated.

Other Contracts

Service contracts are only one way in which U.S. investors and other private parties may be involved in the new Mexican upstream sector which has opened up as a result of the Energy Reform. Another option to consider is the several types of hydrocarbons exploration and extraction contracts:

The license contract does give the contractor ownership and possession of the extracted hydrocarbons in exchange for the payment of certain hydrocarbons taxes, which include a royalty (determined as a percentage of gross revenues derived from the field).

Production sharing contracts also give ownership and possession to the contractor of part of the hydrocarbons production (the portion that belongs to the State pursuant to the hydrocarbon taxes is delivered in kind to the State).

Finally, profit-sharing contracts do not give title or possession of the hydrocarbons to the contractor, but only cash considerations.

Other restrictions applicable to exploration and extraction contracts (license, production sharing, and profit sharing) are that the exploration and development plans of the field must be approved by the CNH prior to being executed.

In this regard, please note that the first set of production sharing contracts shall be awarded by the National Hydrocarbons Commission on July 15th, 2015 after a six month bidding process, and another two sets of contracts are currently being tendered by such Commission.

This document is not intended to create an attorney-client relationship. You should not act or rely on any information in this document without first seeking legal advice. This material is intended for general information purposes only and does not constitute legal advice. If you have any specific questions on any legal matter, you should consult a professional legal services provider.

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