Mexico: "Gathering": The Missing Piece In The Mexican Oil & Gas Regulation

On December 20, 2014, the Mexican Constitution was modified to allow private investment in the hydrocarbons sector. Parts of the constitutional text that were thought for decades to be set in stone were thus chiseled to set the foundation for a new era in Mexico's energy sector. Eight months later, the Hydrocarbons Law (Ley de Hidrocarburos, "LH") was enacted, setting up the legal structure for the future development of all the activities of the value chain, from the exploration and production of oil and gas, to the retail of refined products; almost 3 years later, the Energy Reform is well under way.

Upstream, the National Hydrocarbons Commission (Comisión Nacional de Hidrocarburos, "CNH") has issued a total of 10 tenders, 5 of which have concluded in successfully awarding 32 blocks, as well as selecting a partner for Pemex to further develop the Trion deep-water block. Round 1 has concluded and Round 2 is currently under way, which will result in even more blocks being awarded both onshore and offshore, including non-conventional resource blocks, which will allow operators to prove that the Burgos Basin -the continuation of the Eagle Ford Shale on the Mexican side of the border- can be exploited with commercial success. This is just the dawn of a new era of the Mexican E&P sector that will hopefully result in a reversal of the steady decline in production the country has faced for the past 10 years and should translate into greater government revenues and benefits for the Mexican population.

In the Midstream side of the chain, new storage terminals and pipelines are being built under the new open access regime, and there is a tremendous amount of interest in forming alliances with Pemex to revamp and remodel its refineries to empower Mexico's diminished refining potential and reduce its dependence on imported fuels. As for the downstream side, since April 2016 anyone on the private sector may obtain permits from the Ministry of Energy (Secretaría de Energía, "SENER") to import gasoline and diesel, opening these products to competition; competition that will freely determine the price of these fuels by 2018.

There is no question that progress is being made, but going forward, it is not a bad idea to evaluate if there is anything missing from the legal framework of the new Mexican hydrocarbons industry. The LH and the relevant authorities in charge of permitting and overseeing the regulated activities are to be analyzed in order to make such an evaluation. Mexican regulation allows private parties to carry out Surface Exploration and Recognition of Hydrocarbons and develop E&P activities through an authorization or an Exploration and Extraction Contract granted by the CNH; Treatment and Refining of Oil and Natural Gas Processing as well as the Import/Export of Hydrocarbons and Refined Products requires a permit granted by the SENER. Finally, Storage, Transport, Distribution, Natural Gas Compression, Decompression, Liquefaction and Regasification, along with Marketing and Retail of Hydrocarbons, Refined Products and Petrochemicals requires a permit granted by the Energy Regulatory Commission (Comisión Reguladora de Energía, "CRE")[1].

The above list seems comprehensive enough, and it apparently covers the whole value chain of the industry; however, one must never forget that the operation ordinarily precedes the regulation, and therefore the law may not always correspond exactly to the reality it is trying to regulate, which may not be as clear cut as the authorities may assume. This complex nature of the industry may lead to certain regulatory vacuums, as is the case of a particular intermediate activity that lies between the E&P and the Transport links of the value chain, which has been noticed by operators with expertise in other jurisdictions: "gathering".

In this regard, Brandon Seale, President of Howard Energy Mexico, published an article[2] in which he, depicts the "gathering and processing" ("G&P") component of the international oil industry value chain and describes the ways in which these activities add value to the sector. According to Seale, these activities vary depending on the type of resource: "For oil, G&P activities include all transportation, separation, settling, processing, treating, stabilization, and sweetening (among others) upstream of the refinery. For gas, G&P activities include all transportation, separation, processing, treating, sweetening, and dehydration (among others) upstream of final delivery into a regulated transmission line."[3]

The abovementioned article explains that the performance of G&P by third parties different from E&P operators is common practices in other jurisdictions, and that this segregation generates value by fomenting specialization and economies of scale in the different activities, as well as deterring anti-competitive or discriminatory practices that may arise in a producer-owned pipeline[4]. Furthermore, it illustrates that third party G&P allows for an efficient commingling of production among different operators in a same area, and sets up the possibility of entering into a Quality Bank agreement, to redistribute the proceeds among the different producers according to variations in product quality and quantity[5].

These observations are worth taking into account as the Mexican hydrocarbons industry continues to grow. In his article, Seale makes valuable, specific comments to the text of the model production-sharing contract issued by the CNH and make suggestions of what the G&P segment regulation should contain; however, before accepting them wholly, it is worth looking at the text of the LH and the existing regulations to understand if there is already any framework applicable to G&P in Mexico, by analyzing certain definitions contained in the LH and the Regulations of the activities of Chapter III of the Hydrocarbons Law (Reglamento de las actividades a que se refiere el Título Tercero de la Ley de Hidrocarburos, "RT3"):

Treatment (of Oil)[6]: comprises all the industrial processes prior to refining to which oil is subjected to separate water, sediment or other compounds mixed within.

Processing (of Natural Gas)[7]: comprises the physical and chemical processes to which [natural gas] is subjected, as well as its associated condensates to obtain refined products and petrochemicals (...).

Gathering[8]: collection of hydrocarbons from each well once they have been extracted from the soil by means of a discharge line system that goes from the wellhead to the first separation batteries or, if applicable, to the transmission systems.

A couple of observations arise when comparing Brandon Seale's the definition of G&P to the above terms contained in the Mexican legal framework. It appears that a component of G&P for oil is similar to "Treatment" under Mexican Law, while G&P for gas coincides with "Processing". In this sense, it is possible to say that at least the "Processing" component of G&P is regulated under Mexican Law (as Oil Treatment and Natural Gas Processing) and it requires a permit granted by the SENER, as stated above.

Another thing worth noticing is that "Gathering" is included under the definition of "Extraction", which includes "all activities destined to the production of hydrocarbons" [9]. Mexican Law therefore recognizes the importance of "Gathering" as a specific activity, but generally comprises it under another regulated activity: "extraction".

Finally, close attention should be paid to subsection d), section I, of Article 43 of the LH, as it explicitly states that the CNH has the power to issue regulation regarding the Gathering of Hydrocarbons. Now, to this date, the CNH has not issued any regulations regarding "Gathering", and no draft of any such regulation is currently available for public consultation. This piece of regulation is the part that is currently missing from the regulatory framework of the Mexican hydrocarbons industry.

Notwithstanding the above, it is important to note that Annex 13 of the hydrocarbons exploration and extraction agreements currently in force, sets forth a contractual "open access" regime with regards to gathering lines and other facilities. Pursuant to the terms of this annex, contractors are allowed to use third party gathering facilities and likewise, have to allow third party contractors to use their facilities (whether preexisting or newly developed) in exchange for the payment of a "tariff" that shall not exceed a maximum one determined by a methodology contained in such Annex.

These provisions at a contractual level represent the closest thing there is to Gathering regulation in Mexico right now, but at this moment there is no regulation specifically for this particular activity of the oil and gas value chain.

This regulatory vacuum however, presents an opportunity to assess the current situation of the sector and suggest, as Seale does in his article, certain guidelines or recommendations that the authority may take into consideration when drafting this missing piece of the oil and gas regulation. For such purposes, it is worth taking into account that the current price of oil is forcing all of the agents in the industry to optimize their costs. In this regard, new players that enter into the playing field will be looking for any way to keep their costs at a minimum, especially if they enter into license agreements where the main tax instrument is an additionally royalty[10], as has been the case for most of the agreements executed by the CNH. This becomes even more relevant in the case of marginal production blocks instead of exploration blocks, like the ones that were tendered in Round 1.3, where the contractor's success and profits depend on its ability to enhance production with a mixture of innovation and taking advantage of preexisting infrastructure.

Furthermore, these marginal blocks have an additional factor to take into consideration: they were awarded to the winners along with Pemex's preexistent Gathering infrastructure; however, from the terms of the license agreements, it is not clear who is the owner of these facilities, nor under which title they were transmitted to the winning bidders. The key issue here is defining liability for any event that occurs in relation to these preexisting gathering lines. If the contractors are the new owners of these lines and/or are liable for these types of events, then they will have to spend resources doing a proper assessment and due diligence of the infrastructure as well as maintaining them going forward, or they have to abandon these facilities and build new gathering lines for themselves. Either way, this represents additional production costs to the contractors, and may detract investment in the sector.

In view of the current situation of the Mexican hydrocarbons industry, it would be ideal for the CNH to take into account the following suggestions when drafting the Gathering regulations:

  1. Third parties different from E&P producers should be allowed to carry out Gathering activities with a permit granted by the CNH. As Seale suggested, the permits could be granted for a period of 30 years, with the possibility of renewal, as is the case of most of the other regulated activities.
  2. Third party gathering companies should be allowed to acquire existing gathering infrastructure from PEP or other third parties, including the gathering lines transferred to the winners of Round 1.3 after proper due diligence to determine the market value of such infrastructure.
  3. The liability of any incident in gathering lines should be of the owner of the assets, which will be either the contractor under a hydrocarbons exploration and extraction agreement or a third-party gathering company.
  4. The performance of Gathering along with Oil Treatment and/or Natural Gas Processing by the same entity should be allowed, avoiding the strict legal separation requirement applicable to other activities of the hydrocarbons sector.
  5. Quality Bank agreements should be allowed to be entered into between different producers of Oil and Natural Gas liquids, and the third-party Gathering entities, with independent administration thereof by a third party, as suggested by Seale.
  6. The measurement of hydrocarbons by the third party gathering entities should be allowed, which may aid in reducing the conflict of interest in the determination of the hydrocarbons taxation instruments to be paid by the contractors to the government.
  7. The CNH should analyze if economic regulation of this activity is necessary and what benefits it would bring to the industry. This is especially relevant from a legal point of view, because unlike the CRE, the CNH is not explicitly granted authority to economically regulate activities under the LH, and an attempt to issue such regulation could derive in litigation for the regulators. 
  8. Open access, non-discriminatory principles should apply to the Gathering activity, and expansion plans of Gathering infrastructure should take into account future demand of this service in nearby areas. For these purposes, the CNH may require the Gathering companies to carry out open season procedures, and they may reserve the right to suggest adjustments to expansion plans based on the information available to this regulator and the public policy of the government.

[1] LH, Article 48.

[2] Seale, Brandon. The Future of Gathering and Processing in Mexico. June 15th, 2017. < https://www.linkedin.com/pulse/future-gathering-processing-mexico-brandon-seale>

[3] Idem

[4] Idem

[5] Idem

[6] RT3, Article 15, Section I.

[7] Ibidem, Article 16.

[8] LH, Article 4, Section XXXI.

[9] LH, Article 4, Section XV.

[10] Since the royalty is taken from gross revenues instead of the operating income, it is a contractual arrangement that does not share the risk between the government and the contractor.

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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