Mexico: Mexico's First Call For Bids Of Round 1: Analysis Of The Results And Challenges Going Forward

The opening of investment opportunities in Mexico's upstream sector, after a 75-year State Monopoly by PEMEX is arguably the most relevant part of the Energy Reform. After finally opening up this branch of the industry to private investment, the map of E&P activities in the country was supposed to change forever; however, the results of the First Call for Bids of Round 1 for the awarding of production sharing contracts in shallow waters were unexpected and quite disappointing. Said results are worth analyzing in order to understand the challenges and opportunities of the sector in the future.

First of all, it should be noted that out of a total of 25 prequalified participants (18 individual and 7 consortiums) only 9 turned up to present their economic proposals for the corresponding blocks. That means only 36% of all the companies who paid the corresponding fees and went through the whole prequalification process actually wanted to contend for this first group of blocks. This is indicative that after careful analysis of the data room information, the provisions of the contract, the hydrocarbons taxation regime, and other relevant factors, most of the interested companies did not see an attractive enough opportunity for them to present a bid to contend for those first blocks.

Now to look at the final outcome of the bidding process, out of a total of 14 blocks, only 2 blocks were awarded, and both of them went to the same consortium formed by Sierra Oil & Gas, S. de R.L. de C.V. (interestingly enough, a Mexican company), Talos Energy LLC and Premier Oil PLC. Out of the remaining blocks, 8 were declared deserted for lack of any bids, and 4 were declared deserted for having received bids which were lower than the minimum economic values determined by the Ministry of Treasury and Public Credit (SHCP). For 3 of these contractual areas, the minimum economic value (expressed as a percentage of the operating profit to be given to the State) was 40% and for the last one it was 25%.

It is interesting to note that in three of these deserted block cases the spread between the actual bid(s) presented by the bidder(s) and the minimum requirement was 5%, while in the remaining one the spread was of 20%.

Summarizing these results, only around 14% of the blocks were awarded, when a realistically successful percentage, according to the CNH, would have been between 30-50%: a poor outcome of what was supposed to be a major, industry changing event for Mexico.

These results concern all three main regulatory bodies of this branch of the hydrocarbons industry: the Ministry of Energy (SENER), the National Hydrocarbons Commission (CNH), and the SHCP. In the future, if there is to be an improvement, changes will have to be made. Here are a few suggestions of what these authorities could change/do in the future to make investment in Mexico's upstream sector more attractive for private investment.

The SENER could better trace and define the blocks, especially in exploration contracts where the risk of not finding commercially viable hydrocarbons is considerably high. More ample blocks would mean greater opportunities to carry out exploration efforts within the same contract.

The other major variable of which the SENER has control of is the type of contracts that shall apply to each block. This is important because whether or not the contractor company will have possession and ownership of the resources and not just the economic benefits derived from the hydrocarbons extracted therefrom may be fundamental, depending on the plans of each company.

The type of contract selected for the extraction of hydrocarbons for different blocks can be especially relevant in the case of License Contracts, where the main bidding variable is not a percentage of the operating profit but an additional royalty percentage of the gross revenues derived from a block. This is a tax instrument that does not share the risk between the Government and the Contractor, but rather allocates all the risk to the contractor and thus, may reduce the interest of potential investors in certain blocks.

Now, as for what the CNH can do in the future, it should foremost be noted that the main variable companies take into account in their upstream investment decision making is the prospective geology of the subsoil. Poor or deficient quality of the data could have affected the companies' perception of the geology, contributing to the deficient results.

In this regard, it should be noted that hydrocarbons superficial exploration and recognition activities may now be carried out by private parties, prior authorization by the CNH, and even on commission by the CNH, albeit that companies that carry out these activities must submit a copy of all their information to the CNH. The more superficial exploration and recognition is performed, the better repertoire the CNH will have, and the better geological data there will be to influence the perception of potential investors.

Another way the CNH could attract investment would be to lighten prequalification requirements, especially the financial ones. The 10 billion dollars in assets and 1 billion dollars in owners' equity that apply to the First and Second Calls for Bids are considerably high, although it is worth mentioning that for the Third Call for Bids of Round 1, these requirements have been reduced considerably to 5 million dollars in owners' equity for type A blocks (which contain less than 100 million barrels in reserves) and 200 million dollars for type B blocks (which contain more than 100 million barrels in reserves). This is in part because the purpose of the Third Call of Round 1 is to incentivize national investment in the industry.

Regarding other limitations that have been set by the CNH, a special prohibition set forth in all the Bidding Guidelines for the three calls of Round 1 published so far is especially restrictive, and the CNH should consider removing it for later rounds, particularly for deep waters exploration. This prohibition allows no two companies that produce more than 1.6 mmboepd to participate as a consortium in a bidding process. This limits "great scale oil companies" from associating to participate jointly in a bidding process, and technically also prohibits PEMEX from associating with another major international oil company.

Deep waters exploration activities are extremely capital intensive, and may only be carried out by a small number of companies worldwide that have the technology and resources to do so. In order to distribute and mitigate the risks associated with exploring and extracting oil and gas from depths greater than 500 meters below sea level, it may not only be useful, but even necessary in some cases for companies of this size to participate jointly.

Removing this prohibition from deep waters activities would not be the first time the legal and regulatory framework is adapted to meet the special nature of this type of enterprise. Due to the intensive capital expenditure that they entail, pursuant to the last paragraph of article 32 of the Hydrocarbons Revenue Law, tax losses may be regained during a period of 15 years for deep waters activities as opposed to the ordinary 10 years that apply to the rest of the industries.

Finally, the SHCP needs to take into account the effect that the low price of oil in international markets has on the industry, as well as the considerable risk that operations in a new country present for investors. It should definitely consider lowering the minimum values for the economic proposals in the future.

This is especially interesting if one takes into account that if the requirements were lower, 6 instead of 14 blocks would have been awarded, and the tone of the conversation regarding Mexico's upstream industry would be entirely different. Furthermore, it should be noted that in 3 of the 4 blocks which were not awarded due to not meeting the minimum economic requirements, the spread between the bids and the minimum economic requirements was 5%. A bit of compromise by the SHCP could have made a tremendous difference in the results of the historical event that took place on July 15, 2015.

Mexico can and should recover from the disappointing results of the First Call for Bids of Round 1. In time, the private sector will grow more comfortable with Mexico's newly opened upstream sector, and the regulators will gain experience and take the appropriate actions, some of which have been outlined herein. For now, we should wait for the results of the Second Call for Bids in September 30th, and the Third Call for Bids in December 15th.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.

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