PEMEX’s Draft Multiple Services Contract - Exploring New Ground?

07/16/2002

Introduction

In mid-June Pemex Exploracion y Produccion (“PEP”) released a draft version of its much awaited 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 double Mexico’s natural gas production in a relatively short period of time.  The full text of the MSC is 106 pages long and is currently available only in Spanish.

The MSC has been the subject of significant controversy in Mexico for a number of reasons.  In particular, the political sensitivity of the subject, coupled with the congressional deadlock among Mexico’s leading political parties has meant that President Fox has been forced to move very slowly in this mission critical area of the economy.  Nevertheless, the current draft of the MSC has been attacked by the political opposition which claims that it implicitly transfers ownership of the natural gas to a private party, which ownership, in accordance with the Mexican constitution, corresponds exclusively to the Mexican state.  In addition, Fox’s political opposition claims that the MSC is a form of a joint risk contract and that its cost is not budgeted for, both of which are expressly forbidden by Ley Reglamentaria del Articulo 27 Constitucional en el Ramo del Petroleo.

Notwithstanding the political opposition’s assertions to the contrary, PEP takes the position that the MSC is not a risk contract because the MSC expressly provides that the parties recognize the constitutional authority of the Mexican government with respect to the exploration, exploitation, production, and first sale of natural gas and the exclusive property right of PEP over all hydrocarbons produced from the Contract Area.

In observance of the foregoing, under the terms of the MSC, a private sector contractor (the “Contractor”) is paid solely in cash and is not entitled to receive a percentage of the hydrocarbons produced from the particular area of the Burgos Basin for which the Contractor is responsible under the MSC (the “Contract Area”), or any right to acquire such hydrocarbons arising from its performance under the MSC.  In addition, the Contractor is not entitled to participate in the benefits of the exploitation of the natural gas reservoirs and does not have title to the “key assets” (such as the hydrocarbon reservoirs and produced hydrocarbons, gathering lines, and other installations and equipment not considered by PEP to be “complementary equipment”).  The MSC goes even further in expressly providing that it is not to be construed as creating an entity or association between PEP and the Contractor  or creating a concession, joint-risk contract, production sharing agreement, share earnings contract, association contract, or any other type of contract which gives the Contractor any rights to the hydrocarbons produced under the MSC.

Set forth below is a summary of the most pertinent provisions.

Summary of the MSC’s Provisions

1. Purpose of the Contract

A. The Contractor is to perform and manage three types of work as follows:

(i) Development Work, which includes geological and geophysical services, engineering services, development services, and abandonment of any non-profitable wells and operations.

(ii) Infrastructure Work, which includes construction and repair of access roads, installation of separators, dehydrators, compressors, and meters, and supply of all necessary material.

(iii) Maintenance Work, which includes maintenance and operation of the wells, gathering lines, field, and other related equipment.

All equipment, tools, materials, and labor required under the MSC are to be provided by the Contractor.

B. In its performance of the MSC, the Contractor is not permitted to subcontract any of the following items:

(i) Administration and management of the work;
(ii) Interpretation of geophysical data;
(iii) Development of the geological models;
(iv) Reservoir or production engineering;
(v) Geological control of drilling operations; or
(vi) Control of drilling operations.

The Contractor is to be principally responsible for all work it is allowed to subcontract.

C. 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 required only to use reasonable efforts (most probably not involving any expense to PEP) to assist the Contractor in obtaining the permits and licenses.

2. MSC Phases and Payment

A. Phases.

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.

The Development Phase lasts a minimum of three years and maximum of eight years, and is divided into three stages, each respectively of three, two, and three years.  The Contractor must, during the first stage of the Development Phase, complete the non-reimbursable work which it offered to perform in its bid.

The Reactivation Phase lasts from zero to five years; and the Maximum Recovery Phase lasts seven years.

B. Pricing.

The prices for each of the items performed by the Contractor and accepted by PEP for Development Work, Infrastructure Work, and Maintenance Work will be based on a schedule of “Original Unit Price” to be set forth in the MSC (the “Unit Prices”).  The Unit Prices are to include the following components:

(i) Direct Cost of each item.
(ii) Indirect Cost of each item (a specific percentage of the direct cost).
(iii) Financing Cost related to the item (a specified percentage of the direct and indirect cost).
(iv) Earnings (a specific percentage of the direct, indirect and financing costs).
(v) Additional charges (i.e. import taxes and duties on materials and equipment required to perform during the Construction Phase).

All of the Contractor’s costs, except for indirect costs and earnings, 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.

C. Payment.

PEP is to make payments monthly for all work accepted by PEP and performed or completed during the previous month, relating to the following three basic categories:

a. Maintenance Work attributable to existing wells and facilities;

b. Maintenance Work attributable to Development Work and Infrastructure Work; and

c. Development Work and Infrastructure Work.

Monthly payments are subject to a basic limitation of “Available Revenue,” with a couple of exceptions noted below.  PEP is required to sell the Contract Area production to an affiliate, Pemex Gas y Petroquímica Básica (“PGPB”), pursuant to a contract between those entities (the “PGPB Contract”).  Under the MSC, Available Revenue is a percentage of the PEP’s sales revenue under the PGPB Contract for Contract Area incremental production.  The incremental production is the total Contract Area production minus the “existing” production (in accordance with a pre-determined decline curve).  If payments due to the Contractor in any given month exceed Available Revenue, the excess is carried forward to the next succeeding month.  Any excess carry-forward remaining at the end of the term of the MSC is absorbed by the Contractor.

In addition to the limitation of Available Revenue, the amount due to the Contractor for each item of Development Work and Infrastructure Work is to be spread out over a forty eight month period (per a schedule contained in the MSC), beginning in the month following PEP’s acceptance of the item.  Although Available Revenues in a given month may exceed the amount due to the Contractor that month (as a result of, singly or in combination, successful operations, market conditions, or the payout provision mentioned above), the MSC expressly provides that such surplus of Available Revenue cannot be used to make up a payment deficit in a subsequent month.  One possible consequence of this provision is that, at the end of the term, there may be an unrecoverable payment deficit even though throughout the life of the project there was an Available Revenue surplus.

There are two basic exceptions to the Available Revenue limitation.  The first applies to payments for Maintenance Work for existing wells and infrastructure.  In such event, payments to the Contractor are based on both the value of existing production and PEP’s own resources.  The second applies to payments for Maintenance Work attributable to Development Work and Infrastructure Work.  After the first stage of the Development Phase (i.e., the first three-year period), PEP is obligated to pay the fees for this Maintenance Work even if it exceeds Available Revenues.  The problems is that should the Contractor require PEP to do so, PEP may terminate the contract for convenience.  To avoid this obviously Draconian result, the MSC generously grants to the Contractor the option to subject PEP’s payment obligation to the Available Revenue limitation.

Deliveries of natural gas by the Contractor are to be in accordance with monthly projections and at the points specified in the MSC by PEP.  The gas is to meet certain specifications to be described in the MSC and the PGPB Contract.  The Contractor is required to install and maintain the necessary metering devices at the delivery point; and is required routinely to test the gas to ensure compliance with the required specifications.

Note that the price for natural gas payable to PEP under the PGPB Contract is pegged to the price of natural gas in the United States market and is therefore not subject to arbitrary modification.  Should the price for natural gas drop below $1.50 per MMBTU for a period in excess of nine consecutive months, the Contractor will have the right to suspend performance of any new development work and new infrastructure relating to production in excess of available processing and transportation capacity.  However, the Contractor will be required to continue production of natural gas so long as processing and transportation capacity remain unaffected.

3. 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 on the project.  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 to the Contract Area.  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 patent.

4. Rescission, Termination and Penalties

If the Contractor either (i) fails to fulfill its obligations under the MSC; or (ii) contravenes any of the laws, regulations or procedures applicable to the Contractor, PEP will have an extrajudicial right of immediate termination of the MSC.  Upon termination, PEP will have the right to (i) execute on the bonds provided by the Contractor, (ii) stop any payments to the Contractor, and (iii)  impose the penalties set forth in the MSC.

PEP may also terminate the MSC as follows:

(i) At any time during the term of the MSC, for reasons of public policy and national interest.

(ii) 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).

5. National Content

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.

6. Assignment and Change of Control

PEP may assign the contract to PEMEX, the Mexican government or to any other subsidiary of PEMEX, provided that the assignee is able to comply with PEP's obligations under the MSC.

The Contractor, on the other hand, may not assign any of its rights or obligations under the MSC to a third party with the exception of its right to receive payments from PEP, and then only with the prior consent of PEP.

To ensure that the technical and financial standards which PEP requires of the Contractor remain unaltered during the term of the MSC, any change of control in the Contractor (defined as the sale of a yet to be determined percentage of the Contractor’s shares) requires the prior consent of PEP, which consent will be entirely within PEP’s sole discretion.

7. 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 to be liable for environmental matters relating to the period of time during which such party controls the Working Area, and is to be responsible for indemnifying the other party in such regard.

8. Applicable Law and Dispute Resolution

All disputes arising from its operation are to be resolved in accordance with Mexican law.  In addition, the following mechanisms are provided to resolve the different types of disputes that might arise under the MSC:

(i) Independent Expert.  An independent expert may be designated by the parties from a list of independent experts, to resolve any technical, operational or similar disputes.  In the event that the expert commits an apparent error (as of yet, undefined by the MSC) the party who disagrees with the expert’s findings may request that the matter be referred to arbitration.

(ii) Consulting Group.  The parties are to designate a consulting group.  The consulting group will be comprised of four persons, two of which will be appointed by each of PEP and the Contractor.  The group will meet at the request of either party to resolve the dispute in question.

(iii) Arbitration.  All disputes derived from the interpretation, execution and/or fulfillment of the MSC, not otherwise resolved in accordance with the above mechanisms, may be submitted to arbitration pursuant to the Rules of the International Chamber of Commerce.

Conclusion

The MSC represents Mexico’s attempt at a compromise between Pemex’s typical services contract of old and the modern vehicles (concessions, production sharing contracts, risk service agreements, and the like) employed by other nations.  It has resulted from Mexico’s desire to attract badly needed private investment in its energy sector at a time when the state finds itself incapable of sustaining the levels of investment required to maintain existing levels of hydrocarbon production, let alone, the investment required to develop additional hydrocarbon deposits.

Notwithstanding Pemex’s attempts at working within Mexico’s current legal and constitutional framework to create a novel framework to attract foreign investment, an important question still to be resolved is whether the MSC, in its current form, is an attractive business proposition from a private contractor’s point of view.

One thing is certain: the MSC is not as novel as it has been touted to be.  This MSC resembles less of a novel, risk sharing arrangement and more of a mechanism under which services previously obtained by Pemex on a piecemeal basis are to be purchased in bulk.  To its further detriment, the MSC adds an element of risk for the contractor (i.e. payment only from the proceeds of gas produced by the Contractor), not found in the previous form of services contracts, without adding an adequate reward for undertaking such risk.

Notwithstanding the foregoing, some foreign investors may be willing to live with these risk factors so long as they are offered some form of “upside” in exchange for the risk they are assuming (i.e. incremental fees for meeting production targets).  Other investors appear to be attracted by the possibility that, by virtue of entering Mexico’s energy sector, even if under less attractive conditions, they will be best positioned to take advantage of an eventual liberalization in the sector’s current ownership restrictions.

Mexico’s need to boost its domestic natural gas production in order to meet increasing demand from power plants and other industrial users, will be directly affected by the market’s reaction to the MSC.  In this regard, potential investors are certain to watch closely to see if the final version, expected to be issued by PEP later this year, will be revised to address the “upside” issue to the satisfaction of foreign investors.

For additional information, please contact:

Hunt Buckley or Marcelo Paramo at our Mexico City Office at 011.52.55.55.40.5558 or Lee Harwood or Alejandro Pucheu at our Houston Office at 713.547.2000.

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