Countries where, by law, oil belongs to the state have basically three options for producing it: a) let someone else do it, b) let someone else help you do it, and c) do it all yourself. All three work in practice, but nationalism is a strong feeling which fuels the aspiration to move from a) then b) through to c).
Mexico started with a) but then jumped to c) in 1938 when it nationalized the oil industry and formed Pemex to take over the private companies. Mexicans are among the most nationalistic people in the world and are proud they have run their oil industry by themselves. However, oil production has been steadily declining, particularly from the giant Cantarell oil field, and the government needs to increase production. Oil has been found offshore in the Gulf of Mexico but it is in deep waters, needs huge investment and is costly to produce. The country now has the dilemma of whether to continue to go it alone, and increase production slowly, or invite private companies to assist and increase production quickly. It is a question of nationalism versus pragmatism and it is uncertain which will prevail. However, Mexico can learn something from studying how oil production has developed in other countries.
1) Venezuela . Up to the end of 1975, the country mainly depended on a). The major oil companies, which produced and sold the oil, obtained their share of the proceeds through net income and Venezuela claimed its share via royalties and income tax. Upon nationalization in 1976, the country moved briefly to c) but then recognized it had insufficient capital to increase production at the pace it wanted, so it established service contracts with private companies to produce oil from marginal fields, and then followed this with joint ventures to develop the Orinoco Oil Belt. The latest step has been to form ”mixed companies” where foreign oil companies hold a minority interest. But because of the large investment required, Venezuela has recently asked foreign companies to bid for the Carabobo blocks in the Orinoco Oil Belt. This means the country will be in phase b) for some time to come.
2) United Kingdom . By adjusting royalties and taxation as necessary, a country can obtain a fair share of the oil revenues. The United Kingdom plumped for a) right from the start. The British National Oil Corporation existed briefly from 1975 to 1982, when it was privatized, but basically the North Sea was, and still is being, developed by private oil companies. Royalty payment was abolished in 2003 and state revenue is now all derived from taxation. A windfall tax, called a supplementary tax, is applied when the government considers the oil companies are making too much money from high oil prices. The system works well: the government only receives money and does not have to pay it out financing its share of any direct investment in the oil operations. The private companies complain of high taxes and would like to make more money, but who wouldn’t?
3) Petrobras. Founded in 1953, the company started with b) and looks like continuing that way. It has the technical expertise, particularly in deep water production, to go it alone, but not the financial capacity since its plans call for a huge investment of $174 billions for the period 2009 to 2013. It is an international company that operates in 27 countries which is perhaps why Brazil has a reputation for being investor-friendly. Both Brazil and Mexico have the same problem: huge investment is required for drilling in deep water. It is estimated the production cost offshore Brazil in the pre-salt layer could be as high as $30 a barrel. In the Gulf of Mexico it may be somewhat lower, but the structures must be stronger to withstand hurricanes and production is sporadically closed in during the hurricane season.
Let us look at the economic conditions. Venezuela has a high government take with income tax of 50% and a minimum royalty of 33.3%. The latter can be reduced to 23.3% if it can be shown production is not economically viable at the higher rate. A windfall charge kicks in when oil prices exceed $70 a barrel. PDVSA, by law, must have a minimum of 60% of the equity in the mixed companies. The foreign participants are simply minority shareholders and not partners in a joint venture. PDVSA is also the operator of the mixed companies. It is possible income tax will be reduced to 34% and royalty to 16.67% to attract new investment in the Orinoco Oil Belt.
Brazil has adopted an innovative and more flexible system for its government take: it charges different rates according to the profitability of the reservoirs. Private oil companies pay a royalty of 5% to 10% on hydrocarbons sold, and they are charged income tax on a sliding scale between 10% and 40% depending on the age, depth, size and location of the field and the volume of oil produced. Though oil companies complain the system is unnecessarily complicated, the concept of different treatment for different profitability levels is sound.
Tupi or not Tupi, that is the question investors are mulling over because Brazil now proposes to change the ground rules and move to a production-sharing framework. Petrobras will hold at least 30% of the shares and also be the operator of each joint venture which will be run by an Operational Committee.
These new rules will not affect the 28% of the pre-salt fields already allocated, but will cover the 72% that remains to be allotted. The government says more demanding conditions will apply to new contracts because the oil is known to be there and no exploration risk exists. This is doubtless true, but so is the fact the production cost could be as high as $30 a barrel. Investors will look for less costly alternatives elsewhere if Brazil makes the conditions unattractive.
What should Mexico learn from the above? I suggest that, if the country does decide to invite foreign companies to take an equity stake in the production process, it should avoid Venezuela ’s prescriptive approach that has made the legislation inflexible. The latter is already having problems finding the capital to fund its minimum 60% shareholding, and in attracting foreign investors in the Orinoco Oil Belt because of the high government take. A better approach would be for Mexico to set minimum conditions, e.g. minimum Pemex shareholding in each company of 30%, minimum royalty of 16.67% and minimum income tax of 20%.
This would allow Mexico to adopt Brazil ’s flexible system. As an illustration, production on land which costs, say, $10 per barrel would be charged tax at 40%, production close to shore in the Gulf of Mexico which costs $20 a barrel would be charged 30%, and production far out to sea which costs $30 a barrel would be charged 20%. Mexico could copy Brazil and require Pemex to hold a minimum of 30% in the new associations rather than follow Venezuela which insists on majority control with a minimum of 60% of the shares. It may decide foreign companies can be the operator as Brazil allows at present--though this may change in future. There is no doubt foreign companies will be more attracted by being partners in joint ventures, as Brazil proposes in its new framework. This is certainly more common in the oil industry than being minority shareholders in mixed companies which is what Venezuela has implemented.
In brief, Mexico may well decide to go it alone and that is a decision for the Mexicans. However, if it does invite foreign oil companies to be partners in developing deepwater production in the Gulf of Mexico , then Brazil is a good example to follow. The legislation should not be too prescriptive but allow flexibility for setting different economic conditions depending on the costs of exploiting different reservoirs--though minimum conditions can be set which satisfy the Mexican Congress. The secret is to establish economic conditions which are tough but, at the same time, deemed fair so as to attract foreign investors.
Development of the Gulf of Mexico , like pre-salt offshore Brazil , requires huge investment and, if foreign companies can provide a substantial share, this will free up funds for social development. It is interesting that, from income derived from its pre-salt reservoirs, Brazil intends to set up a new social fund to finance education, infrastructure and the reduction of poverty. My wife did a post graduate course in Mexico City , and I have a soft spot for Mexico , so I wish the country every success whatever it decides.