Haynes and Boone's Newsroom

Pemex’s Third Draft of the Multiple Service Contract
01/20/2003
William (Hunt) Buckley

In early January of this year, Pemex Exploración y Producción (“PEP”) released a third draft of its Multiple Services Contract (the “MSC”), for the exploitation of non-associated natural gas deposits from the Burgos Basin in northern Mexico.  PEP hopes that operations under the MSCs will alleviate Mexico’s estimated future demand for natural gas and reduce Mexico’s reliance on imports.  The full text of the MSC is over 200 pages long and is currently available in both Spanish and English.

Although political opposition to the MSC is likely to continue, PEP’s new draft directly addresses both past and anticipated criticisms.  PEP insists the MSC does not violate any constitutional limitations, in that it is not a joint risk contract, does not grant participation in the results of exploitation, and does not trespass on budgetary constraints.

Specifically, PEP notes that the MSC (a) includes an express recognition of the constitutional authority of the Mexican government over the subject matter; (b) expressly negates that the contractor has any property rights to hydrocarbons in place or produced from the contract area; (c) requires Congressional budgetary authorization under Mexico’s PIDIREGAS program (a form of project finance program under which the nation incurs debt in connection with long-term infrastructure development); (d) requires that the contractor’s annual work programs be approved in advance by Pemex, and (e) provides that payments to the contractor be based on the delivery capacity of the contract area rather than on actual gas deliveries and sales.

Set forth below is a summary of the most pertinent provisions of the new version of the MSC:

SUMMARY OF THE MSC’S PROVISIONS

1.  General Description of the Contract.  During the term, the contractor is to carry out all of the work and provide all of the resources, for it to explore for and develop, produce, and operate the non-associated gas reserves within the contract area, in accordance with approved annual work programs and budgets, and in exchange for a fee to be paid monthly in cash.  The fee is based on the per-unit of work charges to be described in the contract.  Those charges are based on the per item direct cost, indirect cost, finance charges, and an agreed-on profit margin, plus interest at LIBOR plus 1.5% for capital items.  The amount payable each month, however, is limited by a formula which is based on the delivery capacity of the contract area, a gas reference price, and a factor (ranging from .88 to .6, depending on the reference gas price).  Because of this limitation, the contractor assumes the risk that payout may not be achieved.

2.  General Work Obligations.

A.  Types of Work Obligations.  The contractor is to perform and manage three broad categories of work, as follows:

  • Development Work, which includes geological and geophysical services, engineering services, well drilling, completion and stimulation, development services, and abandonment of any non-profitable wells and operations.

  • Infrastructure Work, which includes construction and repair of access roads, installation of separators, dehydrators, compressors, processing facilities, and meters, both in the contract area and up to the delivery points of the gas.

  • Maintenance Work, which includes maintenance and operation of the well and field equipment and other infrastructure.

    All equipment, tools, materials, and labor required under the MSC are to be provided by the contractor.  PEP is to construct and operate the facilities to receive the gas at the delivery points described in the MSC.

    B.  Subcontracting.  In a significant concession to industry and change to the earlier versions of the MSC, the contractor, in this version of the MSC, is allowed to subcontract, without PEP’s prior consent, all of the work except administration and direction.  The contractor is to be principally responsible for all work it subcontracts.

    C.  Permits; Access; Environment.  The contractor must obtain all permits and licenses necessary for its performance, such as environmental licenses, easements, rights of way, and governmental licenses and permits.  It must also undertake all required and necessary environmental studies, security measures, and conservation activities.  PEP is only required to use reasonable efforts (most probably not involving any expense to PEP) to assist the contractor in obtaining the permits and licenses.

    D.  Oil Discoveries.  The contractor must turn over to PEP any oil discoveries; but is to be paid for the drilling and related costs under the payment mechanism of the contract.  This clarifies on open issue in prior versions of the agreement.

    3.  Contract Area.  The block covered by a contract will range from as little as 100 square kilometers to as much as 3,500 square kilometers.  The contract area is to consist of “Fields” and an “Expansion Zone.”  The Expansion Zone is periodically reduced during, and finally eliminated at the end of, the so-called “Development Phase.”  At the end of the Development Phase all that remains is the original Fields and additional producing fields drilled and proven up by the contractor.

    4.  MSC Term and Phases.  The term can last between 10 and 20 years, depending on whether there exist commercial drilling opportunities within the contract area.  The MSC provides for three basic phases: the Development Phase, Reactivation Phase, and Maximum Recovery Phase.  It is contemplated that all three broad categories of work (Development, Infrastructure, and Maintenance) will be performed during each of these phases in accordance with yearly work programs approved by PEP, except that no new wells need be drilled or new infrastructure built in the Maximum Recovery Phase.  The Development Phase lasts a minimum of three years and maximum of eight years, and is divided into three sub-phases, each respectively of three, two, and three years.  The contractor must, during the first phase of the Development Phase, complete the non-reimbursable work which it agreed to perform in its bid.  The Reactivation Phase lasts from zero to five years; and the Maximum Recovery Phase lasts seven years.

    The contractor is locked in to the first three-year phase of the Development Phase.  After that, the contractor is locked-in for the balance of the term on a year to year basis, but can opt to shorten the balance of the Development Phase or Reactivation Phase if it demonstrates that there exist no additional locations on which commercial wells can be drilled, or that prices for gas are so low that, as a practical matter, there exist no such further locations.  Subject to certain requirements, the drilling of three consecutive dry holes or six consecutive non-commercial wells satisfies the test.

    5.  Pricing.  The price for each item or unit of work performed by the contractor and accepted by PEP is to be based on a schedule of “Original Unit Prices.”  As to each item or unit, that price includes: (a) direct cost, (b) indirect cost (a specified percentage of the direct cost), (c) financing cost (a specified percentage of the direct and indirect cost), and (d) profit (a specified percentage of the direct, indirect and financing costs).  Value added tax is to be paid separately and is not included in the price.

    The direct costs alone are to be adjusted for inflation on a monthly basis in accordance with formulas provided in the MSC, which are based primarily on the United States CPI.

    6.  Payment.  PEP is to make payments monthly for all work accepted by PEP and performed or completed during the previous month.

    A.  Payment for Capital Items.  The “Original Unit Price” for each item of Development Work and Infrastructure Work is to be paid out over a 48 month period after the item has been completed and accepted by PEP, 40% the first year, 30% the second, 20% the third, and 10% the fourth.  The amount due under this schedule bears interest at LIBOR plus 1.5%.

    B. Monthly Payment Cap.  The monthly payment attributable to interest, Maintenance Work (other than respecting PEP’s existing wells and facilities), Development Work, and Infrastructure Work is subject to a basic monthly payment cap with a couple of exceptions noted below.  Unlike the prior versions of the MSC, the calculation of the monthly payment cap appears to be independent of PEP’s actual takes, sales, or revenue from the contract area, which arguably both shifts away from the contractor potential market risks and also supports PEP’s argument that the MSC complies with Mexico’s constitutional constraints.

    PEP and the contractor are required to determine the daily delivery capacity of the contract area, taking into account both periodic well testing and the capacity of the receiving facilities built by PEP.  The monthly payment cap is based on the daily delivery capacity so determined, minus gas attributable to PEP’s existing production in the contract area, the price of gas published periodically by Mexico’s Energy Regulatory Commission, the costs incurred by PEP to build and operate the receiving facilities and transmission lines from the delivery points to the points of sale, and a factor which ranges from .88 for gas at or below US $5.00 mcf to .6 for gas above US $10.00 mcf.  Further adjustment can occur based on the daily delivery capacity of all contract areas in the first bid round and Pemex’s gas imports.

    C.  Carry Forward.  If payments due to the contractor in any given month exceed the monthly payment cap, the excess is carried forward to the next succeeding month and thereafter.  The amount so deferred does not bear interest.  Any excess carry-forward remaining at the end of the term of the MSC is absorbed by the contractor.

    D.  Look-Back.  One of the issues in the prior versions of the MSC is that the contractor might, at the end of the term, have an unrecovered excess carry-forward although the project, as a whole, was profitable.  The new version of the MSC mitigates this outcome, albeit partially.  It provides that if in (or during) a given contract year the cumulative monthly payment cap exceeds the cumulative amounts due to the contractor that year, the difference can be used to reduce the excess carry-forward.  However, if at the end of the year the cumulative monthly payment cap of that year exceeds the amount due to the contractor that year, such excess is not carried forward to the next contract year.

    E.  Exceptions to Monthly Payment Cap.  There are two basic exceptions to the monthly payment cap: (1) payments for Maintenance Work relating to Pemex’s existing wells and infrastructure; and (2) payments for other Maintenance Work after the first sub-phase of the Development Phase (i.e., the first three-year period).  In the latter case, however, PEP may terminate the contract for convenience.  To avoid this result, the MSC allows the contractor the option to subject PEP’s payment obligation to the monthly payment cap.

    7.  Delivery of Gas.  The contractor is required to build and operate all of the infrastructure up to the delivery points, including the necessary metering devices; and is required routinely to test the gas to ensure compliance with the required specifications.  PEP is to build and operate the receiving facilities at the delivery points, and from the delivery points to the points where the gas is transferred to PEP’s gas affiliate.

    The contractor must deliver the contract area gas to the delivery points in accordance with PEP’s nominations, up to the daily delivery capacity of the contract area (minus a factor called the “Performance Factor”).  The gas is to meet certain specifications described in the MSC.  Short deliveries or deliveries of gas that PEP rejects as sub-standard, create a “Delivery Deficit” for which the contractor is penalized by a reduction in PEP’s payments for Maintenance Work.  Extracted butane and propane are to be dealt with in a separate agreement between PEP and the contractor; and are not considered in the contract area’s delivery capacity.

    8.  Confidentiality and Technology Transfer.  The MSC places an obligation of confidentiality on both parties with respect to information disclosed in relation to the project.  This obligation survives the termination of the MSC for a period of five (5) years.

    One of PEP’s main objectives in entering into the MSC is to cause the application of the newest technology by the contractor.  Therefore, the MSC requires that the contractor provide PEP with all necessary licenses to use such technology.  Likewise, PEP is to provide to the contractor licenses to PEP’s technology necessary for the contractor’s performance under the MSC.

    Upon the expiration of the MSC, the parties are to negotiate a license which will enable PEP to use the technology supplied by the contractor.  If, however, such technology is essential to the continued operation of the wells, the contractor will be obligated to grant to PEP a royalty free license to such technology for the term of the useful life of the item in question.

    9.  Security and Bonds.  In addition to parent company guaranties, the MSC requires that the contractor deliver (1) policies of insurance (US $50 million in liability coverage); (2) a bond to cover defective work (for 10% of each item) or, in lieu, a standby letter of credit (5% of each item); (3) an initial letter of credit, due before signing the contract, of 60% of non-reimbursable items and 25% the work commitment for the first three years; and (4) an annual letter of credit after the first three years for 10% of the approved annual work program’s budget.

    10.  Rescission, Termination and Penalties.  PEP has an extrajudicial right of immediate termination of the MSC in the event of the contractor’s breach.  Upon termination, PEP will have the right to (i) execute on the bonds and letters of credit provided by the contractor, (ii) stop any payments to the contractor, and (iii) impose various of the penalties set forth in the MSC.  PEP may also terminate the MSC (x) at any time during the term of the MSC, for reasons of public policy and national interest, and (y) if the work has been suspended for any reason (i.e. lack of funds, political directive, etc.) and PEP is unable to determine when the suspension will be lifted.

    Upon termination by PEP, the contractor will have the right to receive payment for services performed, as well as for reasonable, duly justified expenses.  However, the contractor will not have the right to receive additional compensation from PEP (i.e. compensation to which the contractor was not otherwise entitled under the MSC).

    The penalties are (1) a daily penalty for delay in the delivery of information (the amount is not yet specified); (2) a penalty for failure to perform each year’s minimum work obligation, in the amount of the work units not performed; (3) in the event of rescission, a penalty of 10% of the work units assigned to the Maximum Recovery Period; and (4) a penalty for a Delivery Deficit, to the deducted from the operating expense payments due by PEP.  The total amount of the penalties is capped to the total amount of the bonds, guaranties, and letters of credit.

    11.  National Content; Training.  The MSC requires that the contractor utilize Mexican goods, services, and employees so long as they are available on a competitive basis.  Notwithstanding this provision’s apparent contravention of NAFTA’s national content and national treatment provisions, note that, under NAFTA, Mexico reserved the “right to adopt or maintain any measure related to services associated with energy and basic petrochemical goods” and is therefore, exempt from such provisions.

    The MSC also requires that the Contractor train both its Mexican employees and other Mexicans in the technology used to perform the work, to be reflected in each annual work program (a minimum of .25% of the annual budget for contractor’s employees and US $500 per sector of the contract area for non-employees).

    12.  Assignment and Change of Control.  No party may assign the contract without the other’s consent.  The contractor, however, may assign its rights to payment, provided PEP consents.  Unlike earlier versions of the MSC, changes of control do not require PEP’s consent.  However, the guaranties of the selling shareholder remain in place unless Pemex agrees otherwise.

    13.  Environmental Responsibilities.  Environmental liabilities are allocated among the parties based on the dates upon which the contractor takes and returns control of the contract area from and to PEP respectively.  An environmental assessment is to be conducted as of each such date to determine the environmental condition of the contract area as of the date of the transfer, and to apportion environmental liabilities accordingly.  In sum, each party is liable for environmental matters relating to the time during which such party controls the contract area, and indemnifies the other party from those liabilities.

    14.  Applicable Law and Dispute Resolution.  The MSC, predictably, is governed by Mexican law.  All disputes arising under the MSC are to be resolved through the following mechanism:

  • Executive Group.  The parties are to designate an Executive Group to effect consultations and address matters specifically mentioned in the MSC.  The consulting group will be comprised of seven persons, four of which will be appointed by PEP and three by the contractor.  Decisions have to be unanimous and are, as a general rule, not binding on the parties.

  • Independent Expert.  An independent expert may be designated by the parties from a list of independent experts, to resolve disputes under the agreement and disagreements over the decisions of the Executive Group.  The party who disagrees with the expert’s findings may request that the matter be referred to arbitration.

  • Arbitration.  Any dispute relating to the MSC may be submitted to binding and final arbitration pursuant to the Rules of the International Chamber of Commerce, in Paris, France.  The parties must have, however, first resorted to the independent expert.  There is no appeal out of the award.  Costs are to be split evenly between the parties (unless the arbitral award provides otherwise).

    CONCLUSION

    The current draft of the MSC contains improvements over the first and second drafts.  It also squarely addresses some of the anticipated political and legal opposition by, among other provisions, truncating the payment obligation from any actual takes or sales of the gas.  Although the new version has been responsive to various industry observations, there is room for additional improvement, especially in the PEP approval mechanisms (which require greater certainty, objectivity, and streamlining), and the definition of daily delivery capacity (on which both PEP’s payment obligation and contractor’s recovery are predicated).  Of concern is that definition’s dependence on the capacity of PEP’s receiving facilities, especially since PEP has no expressed obligation to construct facilities commensurate with the delivery capacity of the contract area.

    For additional information, please contact:
    Hunt Buckley or Marcelo Paramo at our Mexico City Office at 011-52-55-55-40-5558