Institute of The Americas | Report:
Mexico's big moment: the deepwater oil auction
On December 5, Mexico's energy reform will face its biggest test.
Mexico, the world's 12th-largest oil producer, has long been a tantalizing but inaccessible market for international oil companies (IOCs). After President Lázaro Cárdenas nationalized Mexico's oil sector in 1938, all exploration and production activities in the country were reserved for national oil company Petróleos Mexicanos (Pemex).
The problem today for Mexico is that Pemex is no longer meeting the needs of the nation's population. For decades, the firm was reasonably successful at tapping Mexico's vast shallow-water Gulf of Mexico oil fields. However, most of that easy oil is now gone – the Cantarell superfield, long Pemex's largest producer, saw production fall from over 2 million barrels per day (b/d) just over a decade ago to less than 170,000 b/d now. Largely as a result, Pemex's total crude production has plunged from a peak of almost 3.4 million b/d in 2004 to just 2.1 million b/d. The fall in production has meant Mexico must rely increasingly on gasoline imports from the US to supply domestic fuel demand. Currently, such imports account for more than half the gasoline sold in Mexico.
Furthermore, Pemex has been singularly unable to develop new sources of production to counteract its long decline. In a recent interview the firm's CEO, José Antonio González Anaya, acknowledged as much and noted that recovering production to the order of 3 million b/d is not feasible.
Mexico does have lots of untapped oil resources – but they are largely in the deepwater Gulf, where exploration and production are far more complicated and expensive than in the shallow areas where Pemex is used to operating. During Cantarell's heyday, Pemex had little reason to develop its technological capacities to meet the deepwater challenge. And, even if the firm had wanted to, it lacked the cash to make such investments, due to a heavy tax and royalty burden imposed by the federal government.
A Historic Energy Reform
It has long been clear that Pemex's situation was becoming increasingly unsustainable both for the company and for the government – which historically relied on oil taxes to fund over one-third of the federal budget. Indeed, as far back as 2008, then-President Felipe Calderón pushed through Congress a legislative reform that allowed private companies to work alongside Pemex in upstream projects, although only as junior partners under a fee-for-service model. The results of that reform were largely invisible, as IOCs saw little upside from working in Mexico under such terms.
It was becoming increasingly obvious to many in the oil sector that Mexico needed to revisit the Pemex monopoly, but fear of unleashing the ire of Mexico's nationalist left made that a risky proposition. It was only when Enrique Peña Nieto won Mexico's presidency in 2012 that the political winds seemed to shift. Peña Nieto, of the centrist PRI party, had campaigned on a promise to reform the constitution and made a major energy overhaul the cornerstone of his economic plan. Shortly after taking office that December, the new president got Mexico's two other main political parties, the center-right PAN and leftist PRD, to agree to the so-called Pact for Mexico. The pact, a far-reaching blueprint for economic and social reform, included a groundbreaking call to permit competition in the Mexican oil sector.
The Peña Nieto administration's energy reform, passed in Dec. 2013 via a constitutional amendment, went farther than many longtime industry watchers ever thought possible. Critically, it eliminated Pemex's monopoly, permitting private investment in all stages of the hydrocarbon production chain – thus dismantling what many had long viewed as the third rail of Mexican politics. After the reform's passage, Peña Nieto's team at the energy ministry – known as Sener – embarked upon an aggressive plan to hold regular auctions of oil and gas acreage. The government is pinning its hopes on the arrival of billions of dollars in new investment by private oil companies, which the thinking goes will lead to a rebound in domestic oil and gas output within the next few years
Mexico's Deepwater: The Nation's Crown Jewels
On December 5, Mexico's energy reform will face its biggest test. The CNH, the country's upstream regulator, will auction off 10 sizable exploration blocks in the deepwater Gulf of Mexico via a public auction. IOCs consider that deepwater acreage to be one of the most attractive exploration prospects currently available anywhere in the world, as it shows strong geological potential but saw just a dozen exploration wells drilled during the years of Pemex's monopoly. On the same day, the CNH will also offer up a 60% “farm-out” stake in the Trión deepwater field, located in the Perdido Fold Belt just south of the maritime border with the United States. Pemex discovered oil and gas at that field in 2012 but has lacked the financial and technical resources to develop the find on its own.
The auction is the fourth and final stage in “Round 1,” a multi-phase bid round that the Mexican government formally launched in 2014, after the passage of secondary legislation needed to put the constitutional energy reform into practice. The first three auctions, all held last year, featured small blocks with relatively limited potential for new production. Those auctions were widely seen as a trial run for the deepwater offering. The thinking went that Mexican officials would learn from the initial efforts and correct any problems that emerged in order to ensure the success of the much more important deepwater auction.
Mexico's government estimates that the 10 exploration blocks on offer contain almost 11 billion barrels of oil equivalent in mean prospective resources. Four of the blocks are located in the Perdido area (see map). Pemex's existing discoveries, and the fact that Royal Dutch Shell and other firms are currently producing oil in the portion of Perdido in US waters, mean IOCs are particularly interested in this area. The geology on both sides of the boundary is seen as broadly similar, and indeed the success rate of Pemex's 12 exploratory wells stands at 42% - in line with that seen on the US side. Mexican officials also suggest that some early production from new discoveries in the Perdido blocks could be shipped north to refineries in Texas via underutilized pipelines currently in place just across the maritime line.
The auction also includes six blocks in the Salina Basin, located in the southern Gulf close to the coast of Tabasco state. While Pemex has made no discoveries in the area, the government claims the area holds the largest undiscovered hydrocarbon potential in all of North America. The Salina Basin has been heavily mapped by seismic surveys; the CNH says there is three-dimensional seismic data covering 100% of five of the blocks on offer, while the last block has about two-thirds coverage.
For all the deepwater blocks, the CNH is offering so-called “license” contracts, which are largely equivalent to standard international oil and gas concessions. Bids for the exploration areas will be ranked according to a formula that puts the greatest weight on the amount of additional royalties that a bidder offers to the state, with a smaller weight given to promises of additional work commitment above the minimum requirements. For Trión, the sole variable will be additional royalties. In both cases, in the event of a tie the block will go to the bidder that presents the highest upfront cash payment.
The contracts will have a base exploration period of four years, with two possible three-year extensions. In the event of a discovery, companies have an evaluation phase lasting up to three years. If the project moves into development, the contract envisions a base development period of around 22 years, which companies can extend by as much as 15 years as long as the area remains in regular commercial production. The maximum life of the contract is set at 50 years, upon which the block reverts to state control.
The response from IOCs to Mexico's deepwater offering has been largely positive. A full 26 companies, including some of the world's largest oil producers, prequalified to participate in the auction for the 10 exploration blocks; for Trión, 10 firms prequalified. While some of those companies decided not to proceed to the bidding stage, the final list of bidders announced by the CNH on November 28 included a notable list of 17 names, including some of the world's largest oil producers (see table). However, it was not clear how many of the listed companies had registered to bid on the exploration acreage and how many for Trión, as the CNH said it would keep that information secret to ensure a competitive auction.
Most industry sources expect a positive auction result, with many – perhaps a majority – of the blocks receiving bids. Companies note that the minimum bidding parameters are relatively moderate, with the finance ministry setting the minimum additional royalty requirement at no more than 3.1% for the exploration blocks. For Trión, the additional royalty is pegged in a range between 3%-4%. Similarly, the government has established low local-content requirements, with companies required to source just 3% of their goods and services from local suppliers at the start of the exploration phase, with the figure rising to 10% once production begins. Those levels compare quite favorably to those in, say, Brazil – where rates of up to 85% in some categories have been blamed for pushing up supply costs in the local market and seriously impacting IOC interest in new upstream investment.
Another factor giving companies cautious optimism is the fact that Mexico's government has already carried out three upstream auctions since the energy reform, and officials have worked assiduously to engage oil companies in the process. Furthermore, the government has shown a clear willingness to learn from its mistakes and adapt its policies to achieve the desired outcome. After a semi disastrous result in the first auction, held in July 2015, when just two out of 14 shallow-water exploration blocks were awarded, the government took several steps that helped improve the tally in the following two rounds. In the first place, the finance ministry started making its requirements public before the auction date. The ministry had kept those parameters secret in the first auction until after bids were received, leading to a situation in which some blocks were left on the table because bids came in just below the required minimum. The results of the more successful second auction are already on display as the first non-Pemex operated well was spudded in November by Pan American Energy.
The government has also worked to bring its contract terms more in line with standard international practices. That isn't to say that It's succeeded entirely; in fact, companies continue to grumble about Mexico's tendency to regulate with a heavy hand, and about reporting requirements they see as onerous. One particular worry for corporate lawyers is that Mexican law gives the government unusually broad scope to rescind contracts without compensation in the event of a violation or an accident. Sener has gone out of its way to reassure potential investors that it has no intention of using that legal tool in an abusive fashion, and companies seem willing to take the government at its word. Still, quirks like that may yet persuade some companies to take a wait-and-see approach to investing in Mexico.
Trión: An Awkward Marriage?
The biggest question mark about the upcoming auction surrounds the Trión farm-out. It was added to the December 5 lineup only in July – seven months after the exploration auction was formally launched – and apparently only after Peña Nieto and Sener arm-twisted a reluctant Pemex into acquiescence. Geologically, Trión looks solid; Pemex's discovery means exploration risk is relatively low, and the government estimates the field could hold over 485 million boe of technically recoverable oil and gas reserves. However, under the terms being offered Pemex will retain a non-operating 40% interest in the field, and concerns that the heretofore dominant state giant will not adapt well to a junior role remain prevalent.
Company doubts about how much control they would really have in the relationship with Pemex at Trión were exacerbated by the first draft of the joint-operating agreement (JOA) issued by the CNH. Weirdly, the draft gave Pemex the de facto ability to unilaterally remove the operator; after companies expressed their concern, the government removed that provision from the final version.
Indeed, the final farm-out terms are far less favorable to Pemex – the firm's stake in the project was reduced from 45% to 40%, and the number of workers it is allowed to appoint in the joint venture has been halved, to 10%. Furthermore, in the final JOA the operator is explicitly given the deciding vote in the event of a disagreement over the minimum work program.
Despite those modifications, sources at oil companies say the final JOA remains a bit idiosyncratic, and there are worries that Pemex may in practice be reluctant to cede control of the project. The very structure of the Mexican farm-out process also enhances the awkwardness. More typically in the oil industry, farm-outs are conducted by way of direct negotiations between the company controlling the project and a partner or partners of its choice. However, the Mexican energy reform stipulated that Pemex's farm-outs would be conducted through a public auction by the CNH. While Pemex is reported to have strong opinions on the firms it would like to work with, it may yet end up finding itself in an arranged marriage with a partner not to its liking.
While the potential for hiccups remains, the most likely outcome is that the CNH awards several deepwater blocks on December 5. But the simple metric of blocks awarded does not in of itself correlate directly with success, given the complexity and long fuses the projects entail. More importantly, the deepwater auction will not by any means put an immediate end to the woes afflicting Mexico's oil sector. Even if the winning bidders make large oil discoveries, it will likely take at least five years or so to put those fields into commercial production, although first oil from Trión could come a couple of years earlier. And, while most analysts say Mexican deepwater production should be profitable at oil prices of around $50 per barrel, another price plunge could wreak havoc on the economics of future projects. With Pemex's output continuing to fall – the firm predicts next year's production will average below 2 million b/d – Mexico will continue its decline as an oil producer for the foreseeable future.
That said, a strong showing in December would serve as an impressive signal – both to the global oil industry and to Mexico's still-skeptical population – that the energy reform is delivering results. For Mexico, the arrival of international oil majors would serve to ratify the country's transformation from an isolated backwater in the global oil business into an emerging new investment destination.
No matter the final results on December 5, the Mexican government continues at a blistering pace in its efforts to conduct upstream auctions and encourage private investment. Private players from across the globe will again have an opportunity to take a stake in Mexico's oil sector come next year. So far, the CNH has announced plans for three auctions in what it calls Round 2, the next in what is supposed to be a series of annual upstream bid rounds. The first tender, for 15 shallow-water blocks, will be held on March 22. Two other auctions, comprising 26 onshore blocks, will take place on July 12. Meanwhile, new Pemex farm-outs are likely. Among the possible candidates, say Mexican officials, are the onshore Ogarrio, Cárdenas, and Mora fields, as well as the shallow-water Ayin and Batsil fields.
The Institute of the Americas, an impartial and independent non-profit organization, the Institute of the Americas benefits by having its complex in La Jolla, California, on the campus of the University of California, San Diego. The Institute of the Americas recognizes and greatly appreciates the contributions by Jason Fargo at Energy Inteligence in preparing this report. Petroleumworld does not necessarily share these views.
Editor's Note: This commentary was originally published by The Institute of the Americas on December 02, 2016. Petroleumworld reprint this article in the interest of our readers. Link to original article .
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