Energy Reform in Mexico May 2015 A New Market: Legal, Regulatory and Tax Landscape.

Energy Reform in Mexico

May 2015

A New Market: Legal, Regulatory and Tax Landscape

1 Background

Agenda

© 2014 Galaz, Yamazaki, Ruiz Urquiza, S.C. 2

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3 Tax Landscape: O&G Fiscal Regime

2 Legal Landscape


1 Background

Total Crude Oil Production V. Reserves-to-production Ratio* (2003−12)1

Gross Natural Gas Output V. Reserves-to-production Ratio (2003−11)1

Average Retail Electricity Prices - U.S. and Mexico (2003−12)1

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Total oil production is on a downward trend since 2004, while reserve life length remains low compared to previous years.

Mexican electricity prices are on average 25-45% higher compared to prices in the U.S. A lack of natural gas available for power generation is the main driver behind electricity price inflation.

Reserve length has been declining, while output growth started to contract since 2008

• Pemex has also been unable to improve its reserve-to-production ratios for both oil and natural gas, due to limited additions of new proven resources by PEMEX, as most of the potential increase in reserves is located in ultra-deep waters, which requires more capital and technical know how.

• Despite being highly subsidized, the average retail electricity price in Mexico has been higher than that of the US by around 25 percent due to lack of competition in electricity generation and distribution, and non-availability of cheap sources to produce.

*R/P ratios represent the length of time that those remaining reserves would last if production were to continue at the previous year's rate. It is calculated by dividing remaining reserves at the end of the year by the production in that year4

The reform is driven by falling O&G production levels…Domestic production has declined since 2004 for crude oil and since 2008 for natural gas, while the reserve life for both resources continues to fall. The main driver for this is the lack of capital and technological resources of PEMEX, which prevents it to develop abundant resources in technically challenging deep waters and shale formations.

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• Pemex is currently one of the cheapest producers in terms of finding and development costs, as most of its oil production comes from shallow waters (exploration and production in less than 500 feet of water), which is cheaper to extract than from deep-water and shale formations.

Cantarell’s production decline has been putting pressure to Pemex’s ability to meet total production targets in past years

• The implementation of several enhanced oil recovery (EOR) projects (Pemex awarded EOR service contracts to Baker Hughes and Schlumberger years ago) to extract more oil for aging fields, such as Cantarell, has caused production decline rates to accelerate in recent years.

Finding and Development Costs (average of 2010−13)Mexican oil production by resources (1Q08−3Q14)

Note: Pemex’s total cost for natural gas is maintained the same as for crude oil, as 70% of total natural gas produced comes from deposits of oil

…as cheaper sources of oil continue to deplete

Pemex enjoys one of the lowest finding and development costs in the industry, as most of its oil is extracted from shallow water fields (cheaper to extract compared to deep-water fields). However, production decline rates in Cantarell (considered a shallow water field) continue to increase. To compensate for it, Pemex would need to develop more challenging and expensive resources (e.g. deep-water, shale).


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$20.61

$101.90

Profit: $81.30

Series1

$20.61

$16.50Loss: $4.10

• Pemex capital spending is almost entirely focused on maintaining oil output due to favorable economics compared to the ones for natural gas.

• Approximately 70% of Mexico’s natural gas output is produced in association with crude oil (a form of natural gas found in deposits of petroleum).

• As a result, natural gas production has fallen from 6.5 Billion cubic feet per day (Bcf/d) in January 2010 to 5.6 Bcf/d by July 2013. This has increased Mexico’s reliance on imports of natural gas to satisfy demand needs.

6.5 Bcf/d in 2010

5.6 Bcf/d in 2013

-14.5%

Economics of O&G Sectors in Mexico – 2012 Decline in Natural Gas Production – 2010-2013

Note: Pemex’s total cost for natural gas is maintained the same as for crude oil, as 70% of total natural gas produced comes from deposits of oil

Total gas production declines as it is more profitable to produce oilNatural gas production in the country experiences annual contraction rates, as gas production costs are higher than prices (Henry Hub NG prices). This has motivated the country to instead focus investments and efforts on oil production, as it oil output costs are much lower than oil prices (crude oil basket).

Oil Production

Gas Production


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Total Crude Oil Consumption and Production (2003−13*)2

Natural Gas Consumption and Production (2003−13*)2

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ExportsImports

Imports

• Mexico is a net exporter of crude oil, but exports continue to fall due to aging fields and poor resource replacement.

• For natural gas, the Energy International Agency (EIA) puts Mexico’s technically recoverable shale gas resources at 545 Tcf, and ranks the country sixth in the world behind China, Argentina, Algeria, the US, and Canada.

• However, rising energy needs coupled with declining gas production has led to a rise in natural gas imports. Mexico has been relying heavily on U.S. gas imports to meet its requirements.

• Demand for end petroleum products in Mexico has increased by 20 percent in the past 10 years, but production capacity has remained stagnant, leading to higher dependency on imports of petrochemical products.

Imports of natural gas have increased significantly since 2009.

Despite stable domestic oil demand, lower production growth continues to reduce its share of exports

Increasingly dependent on imports of refined products.

Petroleum Products Consumption and Production (2003−13*)2

Note: *2013 implies that the data for 2013 is incomplete and is available till November, Consumption = Production +/- Imports/Exports

There is an increasing reliance on imports of natural gas and refined productsLow production growth along with high energy demand in the country, led to an increase in imports of petroleum products and natural gas. If the decline in oil production continues, assuming stable-to-higher demand in the next few years, Mexico could turn into a net importer of oil during this decade.


New Challenges

As private companies enter

the Mexican market

• The local energy industry has been characterized by bureaucratic processes and a lack of transparency.

• These factors could complicate the permits granting process.

Lack of Transparency

• New departments are being created within the Treasury and Tax Administration with special focus on the control, review and assessment of exploration and production contracts, leading to a highly regulated environment while dealing at the same time with systemic problems.

Tax Policy

• Poor energy infrastructures is an area of concern for upstream players, as Mexico lacks proper pipeline network for natural gas transportation.

Infrastructure Issues

• As IOCs enter the country, they may face talent shortages for various technologies and functions.

• Additionally, Mexico lacks talent for the more technically challenging field operations that several IOCs are interested to develop.

Talent Shortage

Local Sourcing Policies

•The energy reform does not currently mention the requirements regarding local procurement.•A high requirement may complicate IOCs ability to comply, as the Mexican industry may not be able to supply IOCs needs, and may have long lead

times that could slow down companies’ operations.

Increased Control

•Through the energy reform relevant new institutions were created and responsibilities of existing ones were reinforced, which may lead to adjustments on all fronts of the Government and imply a relevant contractual and regulatory management cost for enterprises.

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2 Legal Landscape

Constitutional Mandate

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The past dicember 20th, the Constitution Reform was pubished

Source: Senate

© 2014 Galaz, Yamazaki, Ruiz Urquiza, S.C.

Article

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Article

27

Article

28

Modified

1

8

15

2 3 4 5 6 7

9

16

10

17

11

18

12

19

13

20

14

21

And established

Transitorie ArticlesOutlining the mandate to Congress to bring the necessary legal

framework.

The iniciatives

11© 2014 Galaz, Yamazaki, Ruiz Urquiza, S.C.

In order to accumplish this mandate, the Federal Government propouse to Congress 9 iniciatives:

Hidrocarbons

Electricity Law

Geothermal

National Security Agency Law

Productive State Enterprices

LOAPF Regulators

Tax Decree

Mexican Oil Found Law

Budget Decree Arts.27 Transitories 14 y 21

Arts.28 Transitories 14 y 15

Arts.27 Transitories 4,5,9, 11 y 14

Arts.28 Transitories 10,12 y 13



Arts.25 Transitories 11,17 y 18

Arts.27, 28 Transitories 4 y 11

Arts.27, 28 Transitories 4,5,7,8 y 16

INICIATIVE CONSTITUTION

Source: Senate

Legislative Process

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Even though initiatives were sent to the Senate, 3 of them were turned over to the House of Representatives for being tax laws, budget and state revenue matters.

Source: Senate

© 2014 Galaz, Yamazaki, Ruiz Urquiza, S.C.

Hidrocarbons Law

Electricity Law

Energy Coordinated Regulatory Authorities

Law

Geothermal Energy Law

Income Law on

Hidrocarbons

Mexican Oil Found Law

for Stabilization and

Development

Petróleos Mexicanos

Law

Federal Electricity

Commision Law

Industrial National Security Agency

Law, and Hidrocarbons Environmental

Proteccion

And modyfies12 current laws

Creates 9 new laws

March

April

September

December

April

December

Reform Timeline


Responsible/Topic Natural Days Stablished by Law Dead Line

Round Cero

Secondary Laws Modifications (Congress)

Resolution on the allotments requested by PEMEX

Adjustments to the legal framework on environmental issuesand the regime of transition to clean energy (Congress)

Creation of the National Center for Natural Gas Control and the National Energy Control Center (Executive)

Transition to become productive companies

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485

730

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Miguel Llovera

Actualizar

Hydrocarbons Revenue Law affecting Tax Regime

Typical Tax Issues

• Structuring & Repatriation

• Tax Attributes• Treaty application• Financing –Thin cap

& back to back• New Formalities• Deducibility

Requirements

Energy Reform

• Ring Fencing• Depreciation• Deducibility of new

concepts (signing bonus, contractual fee royalties, etc.)

• Depreciation• NOLs• PTU• VAT• PE• TP

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The Mexican Government will receive income from…

Hydrocarbons’ Revenue Law

• Contractors: PEMEX and productive state enterprises as well as private individuals or both, in association.

• Considerations in favor of the State and the contractor which will be managed by the Mexican oil fund

• Exploratory phase fee will be paid to the state.• Tax on the exploration and extraction for municiples and

states.

• Recipient: PEMEX and productive state enterprises • Three rights in favor of the State, that will be

received by the Mexican oil fund • Contractual fee• The activity of exploration and extraction tax will

apply

• Those activities which are performed by contractors and assignees for their activities are subject to income tax.

Contracts

Income Tax

Assignations

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Production Sharing

ServiceLicenseProfit Sharing

Sale of extracted Hydrocarbons

Signature bonus

Trader

Exploratory phase fee

Royalties

Cash

Additional compensation on operating profit

Contractor’sIncome

Government’sIncome

Contractor/TraderDistributor

Contractor

In cash: Cost recovery + a portion of operating

income

In Kind: Cost recovery + a portion of operating

income


Royalties

Additional compensation on operating profit


Royalties

Additional compensation on value of hydrocarbons

New Contractual Regime

Summary

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Some Examples…

14.4 Contractor take

6.2 Tax

Taxable

25.0 Goverment Share

Profit Oil

45.0 Cost Recovery

Net revenue

Gross Revenue 10.5 Royalty+Fee


4.4 Tax

Taxable


Profit Oil

45.0 Cost Recovery

Net revenue



4.6 Tax

Taxable


Profit Oil

45.0 Cost Recovery

Net revenue


100.7 18

1 -

20.0

40.0

60.0

80.0

100.0

120.0

Royalty+Fee

Cost Recovery

Goverment Share

Tax

Contractor take

1 -

20.0

40.0

60.0

80.0

100.0

120.0

Royalty+Fee

Cost Recovery

Goverment Share

Tax

Contractor take

1 -

10.0

20.0

30.0

40.0

50.0

60.0

70.0

80.0

90.0

100.0

Royalty+Fee

Cost Recovery

Goverment Share

Tax

Contractor take

Licence

Profit sharing

Production sharing

Contractual Regime 15 years

tax losses

VAT

Contractors

Several Contracts

International Issues

New Contractual Regime

Transfer Pricing

• Residents in Mexico• E&E• No optional regime

• Individual• Consortium• AenP

Permanent Establishment

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Tax depreciation

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Energy Reform in Mexico May 2015 A New Market: Legal, Regulatory and Tax Landscape.

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Transcript of Energy Reform in Mexico May 2015 A New Market: Legal, Regulatory and Tax Landscape.