Oil field bids in Mexico: Round 1.3. “Onshore

Fields”. Commerciality evaluation under High

Royalties offer.

Keywords: Round One, License Contract, profitability, royalty, government revenues,

For further details or full report please contact:

Juan Diego Suarez Fromm

Senior Reservoir Engineering Advisor

jdsfromm@hotmail.com

Mexico

“Mexico urgently needs a series of structural reforms

that will detonate its true economic potential for once

and generate more public welfare”, Enrique Peña Nieto.

1

0. Summary

The third phase of Round One bids (“R1L3”) has recently finished in past December,

where 25 onshore blocks were awarded to 14 companies, mainly from Mexican oil field

service. In the short term it is expected to bring private investment, and thus it will

contribute to government revenues and E&P Mexican industry recovery.

The Energy reform for petroleum industry was very welcomed but unfortunately

launched in the oil crisis. In spite of low oil prices and less expectations respect to

2014, the winning offers displayed high royalties. For gas fields, royalties range

between 10% and 50%; but for oil fields, they range between 36% and 86%, much

greater than threshold values (1%-10%).

So, the next question should be: How high royalties will affect contract development

under low oil prices?

To this respect, the aim of this study is to evaluate oil field development profitability

for different oil prices and costs for an onshore type block from “R1L3” bids.

An economical model for oil field development was built for onshore License Contracts,

taking into account average well productivity, decline and units costs. In these

contracts the operator pays a basic royalty plus additional one which is offered in an

international public tender process and is the main factor in bid result. The income tax

is also included in the model, ruled by the new “Hydrocarbon Revenue Law”.

Some important conclusions for awarded fields are obtained: some would be

uncommercial and others would have critical performance due to very high offers in

royalties.

On the other hand, the Government Revenue model promotes investments in a License

Contract in oil price range between 30 and 100 usd/bbl; aiding the high royalties cases

to achieve profitability under favourable costs conditions.

During next years, the success of onshore bids will be defined, depending on

commerciality assessment for the blocks during the evaluation period. The

complete success of the process will be to achieve the continuing of operation

of these contracts after this period.

2

1. Introduction

The Mexican Energy reform for petroleum industry was very welcomed but

unfortunately was launched in the oil crisis, generating uncertainty in potential

investors (Chart 1).

Chart 1. Historical Oil price and Calendar of Round One bids in Mexico.

First two calls had attention but without much interest as the third one (Chart 2). The

first bid of Shallow Water blocks was unsuccessful because only few blocks were

awarded (14%) and many with no offer; while the second call had a moderate

outcome (60%) [1].

In consequence the Mexican Energy Agency (SENER) adjusts properly the contract

conditions and tender process, leading to greater interests from investors. These terms

and particular nature of third call allow much better results. In onshore bids, all blocks

were awarded, but with high royalty rate (Chart 3).

*Wall Street Journal

R1L3: Onshore

Historical Oil price and Calendar of Round One bids in Mexico

R1L1: Shallow Water EXP

R1L2: Shallow Water PRD

3

Chart 2. Round One – Onshore. Blocks distribution [1].

Chart 3. Royalties comparison for Round One: First, Second, and Third calls; between awarded

and minimum values. *PSC: Production Sharing Contract, LC: License Contract.

Round One – Onshore. Blocks distribution.

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MIN additional Royalties

Royalties comparasion for Round One L1, L2, L3*

R1L1 PSC

R1L2 PSC

R1L3 LC (oil)

4

Blocks from third bid have some differences from first and second one:

Mature onshore fields.

Security and local community issues.

Large number of blocks with small area.

Geological Plays with low technical and financial risk.

Expenditures are lesser, and are more intensive due to greater amount of well

intervention, adding more value to the supply chain and local communities from an

economic and social point of view.

The third bid comprises 25 blocks, awarded to 14 companies and joint ventures;

mainly from Mexican oil field service. A learning curve will be needed due to lack of

experience in field development.

Despite of bids results, it is required the development of the evaluation period. The

complete success of the process will be to achieve the continuing of operation of these

contracts after the evaluation period.

5

2. Economical model

In spite of low oil prices and less expectations respect to 2014, the winning offers

displayed high royalties.

For gas fields, royalties range between 10% and 50%, averaging 36%; but for oil

fields, they range between 36% and 86%; averaging 64%; much greater than

threshold values set and published before bid openings.

The aim of this study is to evaluate oil field development profitability for different oil

prices, costs and royalties.

An economical model for oil field development was built for onshore License Contracts,

taking into account average well productivity, decline and units costs. In these

contracts the operator pays a basic royalty plus additional one which is offered in an

international public tender process and is the main factor in bid result. The income tax

is also included in the model, ruled by the new “Hydrocarbon Revenue Law” [1].

In order to evaluate oil price sensibility, it is needed a forecast base. For this purpose it

is used a report from the U.S. Energy Information Administration (EIA) [2] (Chart 4).

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EIA Short-term Energy Outlook - Oil price

Historical spot price (dollars per barrel) STEO price forecast (dollars per barrel)

NYMEX futures price (dollars per barrel)

6

Chart 4. Short term oil price projections. Source: “EIA Short-term Energy Outlook Feb

2016”.

For oil fields, 3P Reserves by state energy agency SENER have an upper limit value of

14 MMbls, and 80% of blocks do not exceed 3 MMbls (Chart 5).

Chart 5. Onshore oil fields. Reserves distribution. Source: State Energy Agency from Mexico

(SENER).

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Reserves 3P [MMbls]

Onshore oil fields. Reserves distribution.

Frecuency cumulative

7

2.1. Base Case assumptions

The following assumptions were made:

Field (Table 1).

Contract (Table 2)

Price and Costs (Table 3)

Capital Expenditure composition (Table 4)

Table 1. Field assumptions.

Table 2. Contract assumptions.

The royalty for Base Case is fixed as the lowest winner offer for oil blocks.

Table 3. Price and Costs assumptions.

Field assumptions

Field type Mature oil field under primarydepletion.

Original Oil In Place Type II (> 200 MMbls)

Recovery Factor. Present-Final 35% - 38%

Base curve 500 bpd – Anual decline rate 9%

Production peak 4.000 bpd

Oil reserves 14 MMbls

Gas reserves (associated) - (100% self consumption)

Contract assumptions

Type License

Period 30 years

Additional royalty 36%

Oil price & costs assumptions Base Case

Oil price 40 usd/bbl - uniform

Development Cost (average) 4 usd/bbl

Operation cost (average) 12 usd/bbl

8

Oil price for Base Case is fixed as average NYMEX between Sep-16 and Sep-17;

considering that field operations will start second semester of 2016 (Chart 4).

Table 4. Capital expenditures composition assumptions (Income Tax deduction).

Oil reserves, capital and operation expenditures profiles are calculated with the model.

An economic limit of 8 barrels of oil per day is obtained (Chart 6 y Chart 7).

Chart 6. Oil production profile for Base Case. The economic limit is 8 bopd.

Expenditurescomposition

Income Tax deductions

Enhance & Secondary Recovery / Exploration

0% 100%

Development 73% 25%

Facilities & flow lines 27% 10%

0,000,501,001,502,002,503,003,504,004,50

0 2 4 6 8 10 12 14 16 18 20 22 24 26 28 30 32 34 36 38 40 42

[Mb

/d]

year

Oil production profile for Base Case

O Inc Mbls/d O Base Mbls/d

9

Chart 7. Capital and Operation Expenditure’s for Base Case. The economic limit is 8 bopd.

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[MM

usd

/ye

ar]

Year

Capital & Operation Expenditure's for Base Case

CAPEX [Mmusd/year] OPEX [Mmusd/year]

10

2.2. Base Case economic results

The base Case economic results are as follow (Table 5).

Table 5. Economic results for Base Case.

2.3. Base Case economic sensibilities

Price, royalty and costs are varied within the following ranges (Table 6).

Table 6. Price, royalty and costs for sensibility analysis.

Economic Indexes

Sales (S) 575 MMusd

CAPEX & OPEX (C ) 224 MMusd

Royalties (R ) 250 MMusd

NPV (8%) operative (S-C-R) 62 MMusd

Taxes (T) 49 MMusd

Government revenue (R+T) 52 % sales

NPV (8%) ATAX 31 MMusd

IRR ATAX (Internal Rate of Return) 28 %

Pay out ATAX 4 years

Base Case

Sensibilities Base Case reference

Development Cost (-30%, +30%)

Operation Cost (-30%, +30%)

Additional royalty (5%,65%)

Oil price (usd/bbl) (35,65)

11

The sensibility results are evaluated using the following indexes (Table 7).

Table 7. Economic indexes for sensibility results evaluation.

Government revenues are defined as royalties and income tax revenue as sales

percentage.

Royalties has two components: Basic royalty (Rb) and Additional royalty (Rad). Both

are a percentage factor of hydrocarbons sales [1].

The percentage factor for “Rb” depends on hydrocarbon type: oil, condensate,

associated gas, and non-associated gas. The percentage factor for “Rad” is a fix

percentage (offered in bids).

For oil, basic royalties factor is 7,5% under 48 usd/bbl, and increases linearly with oil

price with rate 0,125, becoming 14% at 100 usd/bbl.

The Income Tax [1] is defined as 30% of Net sales, discounting Operation Expenditures,

Royalties, and percentage of Capital Expenditures (deductions for Income Tax, Table

4).

Two types of charts are presented, cartesian (Chart 8) and tornado types (Chart 9).

Percentages represent variations respect to Base Case.

Economic Indexes

Government revenue / Sales

Pay Out ATAX

IRR ATAX (Internal Rate of Return)

12

Chart 8. Sensibility analysis results for oil field development with License Contract. Reference

case is Base case (40 usd/bbl and additional royalty 36%).

Chart 9. Sensibility analysis results for oil field development with License Contract. Percentages

represent variations respect to Base Case. Reference case is Base case (40 usd/bbl and

additional royalty 36%)

13

The Base Case has good profitability considering a IRR ATAX threshold of 30% (Table

5); recalling that in this case oil price is 40 usd/bbl and additional royalty is 36%.

2.3.1. Government take

Sensibility analysis shows that Government Revenue model promotes investments in a

License Contract (Chart 8, Chart 10).

Improvements in oil price and costs leads to profitability increment; while government

take is limited to certain percentage of sales.

Chart 10. Sensibility analysis results for oil field development with License Contract. Reference

case is adjusted to 100 usd/bbl and additional royalty 50%.

14

2.3.2. Additional royalty 36%

With royalty of 36%, field development is still commercial with low price as 30 usd/bbl

(IRR ATAX 4%). On the other hand, at price 65 usd/bbl, profitability become very

attractive (IRR ATAX 85%). Government take rounds 50% of sales.

Cost increases (operation, development) of 30 % decreases project value, but still with

acceptable return (IRR ATAX 16 % - 20%). And cost optimization of 30% increases

profitability to IRR ATAX 36% and 56%.

2.3.3. Additional royalty sensibility

The additional royalty is defined in License contract during bid process. For oil fields

are between 36% and 86%. At oil price 40 usd/bbl, profitability is lost when additional

royalty exceed 50%. In this case Government revenues are about 62% of sales.

This situation is very relevant for awarded contracts because only two have additional

royalty less than 50% among oil blocks (Chart 11).

Chart 11. Additional royalty for awarded onshore blocks for oil fields.

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Additional royalty

Additional royalty for awardedonshore blocks for oil fields

Frecuency % cumulative

15

Consequently, it is primary the estimation of oil prices and cost levels in order to meet

profitability criteria within different additional royalties.

A major hypothesis is applied; it is assumed that Base case represents the upper

reserves recovery for all oil fields. This conceptual simplification is based on technical

grounds, and it allows the calculation of profitability ranges for different oil prices.

Four Groups are defined for representative ranges of additional royalties: Group 1

(36%-37%), Group 2 (60%-65%), Group 3 (66%-68%), Group 4 (79%-

86%). In Group 1 there are 2 contracts, Group 2: 8 contracts, Group 3: 3 contracts,

and Group 4: 3 contracts.

Two profitability degrees are set by IRR ATAX 5% and IRR ATAX 20%. Average

additional royalties are used for calculations for each Group: Group 1: 36%, Group 2:

60%, Group 3: 70% y Group 4: 80% (Table 8).

Table 8. Calculated oil prices for each additional royalties groups for IRR ATAX 5% and IRR

ATAX 20%.

Group Add. RoyaltyMin Oil Price

for IRR 5%

Min Oil Price

for IRR 20%

1 36%-37% 30 usd/b 35 usd/b

2 60%-65% 50 usd/b 65 usd/b

3 66%-68% 90 usd/b N/A

4 79%-86% N/A N/A

16

Group 4: Government revenues rounds 90% of sales. Field development is not

commercial at higher oil prices (100 usb/bbl or more) because the higher the oil price,

the higher is the royalty take. It is needed a 70% of costs reduction in order to make

profits.

Group 3: High oil Price of 90 usd/bbl is needed in order to achieve marginal

profitability. With higher prices IRR ATAX reaches 12%. Government revenues are

about 83% of sales.

Group 2: Marginal profitability is reached with price 50 usd/bbl, requiring 65 usd/bbl

for IRR ATAX 20%. Government revenues are about 72% of sales.

Group 1: Profitability is achieved with low oil prices: 30 usd/bbl and 35 usd/bbl for

IRR ATAX 5% and IRR ATAX 20%. Government revenues are about 50% of sales.

Taking these results, a map of conceptual profitability is made for additional royalty

groups. It is also defined a Risk Index of Profitability regarding profitability degree:

High Risk Index for IRR ATAX less than 5% but positive, Medium Risk Index for

IRR ATAX between 20% and 5%, and Low Risk Index for IRR ATAX greater than

20% (Chart 12). Risk is referred to loss of profitability due to negative variations of oil

price and costs.

The oil price uncertainty is indicated as expectations for Short, Mid, and Long Term,

based on the World Bank forecast [3].

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Chart 12. Profitability conceptual map for onshore oil fields from Round One bids.

1

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4

Med. P. Risk Index

Low P. Risk Index

High P. Risk Index

50%

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90%

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Oil price expectation

Short Term Mid Term Long Term Unknown

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3. Conclusions and Recommendations

An economical model for oil field development was built for onshore License Contracts

in Mexico. The blocks were recently awarded in the Third call of "Round One" bids.

The income tax is also modelled in order to evaluate full Government revenues.

Several Groups are defined regarding additional royalty level. Sensibility analysis is

made over oil Price and costs, allowing the construction of profitability conceptual map.

Some important conclusions for awarded fields are obtained: some would be

uncommercial and others would have critical performance due to very high offers in

royalties.

On the other hand, the Government Revenue model promotes investments in a License

Contract in oil price range between 30 and 100 usd/bbl; aiding the high royalties cases

to achieve profitability under favourable costs conditions.

Finally, each contract can be qualified according to its additional royalty value, Risk

Index of Profitability (Table 11) and oil price expectation between short-term and

mid-term oil prices, by defining an Economical Risk Index.

Long-term oil prices will not impact significantly on cash-flows because main

development would require only one to three years for onshore blocks to start, and

capital expenditures could involve one to four years of investment.

According to previous section, oil prices between 35 usd/bbl and 70 usd/bbl can be

considered as short-term and medium-term values.

1. Contracts with Low Risk of Profitability between 35 usd/bbl and 70 usd/bbl are

defined under Low Economical Risk.

2. Contracts with variable Risk of Profitability (Lower to High) between 35 usd/bbl and

70 usd/bbl are defined under Medium Economical Risk.

3. Contracts with High Risk of Profitability between 35 usd/bbl and 70 usd/bbl but

need less than 100 usd/bbl to lower the Risk are defined under High Economical

Risk.

4. Contracts with no Profitability between 35 usd/bbl and 70 usd/bbl or higher prices

are defined under Risk of Commerciality.

19

Table 11. Economical Risk Index for contracts from “R1L3” bids.

Economical risk Index is referred to loss of profitability due to negative variations of oil

price and costs. For full asset assessment it is also required the geological risk

evaluation, and detail field characterization.

Oil fieldEconomical risk

Index

Additional

royalty

Paraiso Low 36%

Fortuna

NacionalLow 37%

Malva Medium 57%

Mayacaste Medium 60%

Secadero Medium 61%

Cuichapa-

PonienteMedium 61%

Tajon Medium 61%

Ponton Medium 62%

Catedral Medium 64%

Barcodon Medium 65%

La Laja High 66%

Paso de Oro High 68%

Tecolutla High 68%

Topen Uncommercial? 79%

Mundo Nuevo Uncommercial? 81%

Calicanto Uncommercial? 81%

Moloacan Uncommercial? 86%

20

From contract point of view, a first year for initial evaluation period is required, with

additional year extension. At the end of this period, operator will have the option for

the continuing of operations or the end of the contract.

Due to low oil price and slow expected recovery, a general strategy for all contracts

would be to adjust expenditures to Minimal Work Commitment and use the extension

of evaluation period.

On the other hand, expenditures should follow a strategical evaluation plan in order to

reduce critical uncertainties: geoscience, drilling engineering, well stimulation, and

production engineering.

Therefore, a balanced Budget will be required for initial period.

The Evaluation Plan will be central for all contracts, especially for the ones with high

economical risk or with commerciality risk. During next year’s, the success of onshore

bids will be defined, depending on commerciality assessment for the blocks.

21

4. References

1. Official website for “Round One”, from the “National Hydrocarbons Commission”

(CNH), www.ronda1.gob.mx.

2. Hydrocarbon Revenue Law: “Ley de Ingresos sobre Hidrocarburos - México. Released

on August 11th 2014.

3. EIA Short-term Energy Outlook, Feb 2016.

4. World Bank Commodity Forecast Price Data, January 2016