This content is from: Local Insights

Risks in financing the new Pemex contracts

One of the important purposes of the Pemex law enacted in 2008 was to allow Petróleos Mexicanos (known as Pemex) to implement new contractual schemes for petroleum production which would no longer be subject to the restrictions of the Public Works Law. It took some time from the effectiveness of the reform in November 2008 to the publication in November 2010 of the of the new model contract, known as the Generic Service Contract Specimen for Evaluation, Development and Production of Hidrocarbons.

The regulations of the new Pemex law had first to be published and the board of Pemex had to issue general guidelines for contracting. Importantly, in the meantime constitutional litigation before the Supreme Court was resolved in favour of the government regarding certain issues under the new regulations in connection with the new contracting process.

On March 1 2011 an international tender for the award of service contracts for the Magallanes, Carrizo and Santuario areas in the South Region was published by Pemex-Exploración y Producción (PEP), the exploration and production entity of Pemex, using the model contract. More than 25 companies have bought the bidding guidelines, including affiliates of some international oil companies.

The prequalification process of bidders will be completed by the end of July 2011, bids are due on August 11 and the contracts signed before October 11.

The new Pemex law does not allow contractors to book reserves. Since it is of great importance to international oil companies to book reserves, it will be very interesting to see if any will present a bid notwithstanding this prohibition.

Relevant provisions

The following is not intended to be a complete description of the model contract, which is a rather complex and lengthy document.

The total term of the model contract is up to 25 years, which term is divided in an evaluation period (up to 24 months) and a development period (the remainder).

There is a minimum amount of expenditures to be made by the contractor during the evaluation period ($112 million) but no minimum amount for the development period. The development period starts only if the contractor declares that the development of the area (or a portion thereof) is viable and supports that statement by a development plan which has to be approved by PEP. PEP may deny approval if certain technical and economical criteria are not met. In such case the contract may be terminated by PEP.

The contractor is required to submit yearly work programmes, including budgets of eligible expenditures (six months before the fiscal year); such programmes and budgets require the approval by PEP.

It is important to note that payments by PEP to the contractor start only after crude oil is produced by the contractor.

The monthly payment by PEP is the lesser of:

(i) the fee (see below) plus 75% of the expenditures incurred; and

(ii) the actual cash flow estimated by PEP as result of the production for the month.

The fee is the result of the tariff per barrel offered by the contractor in its bid submitted to PEP times the barrels produced, provided that PEP pays in respect of the barrels specified in the contract as estimated production based upon the historical decline of the field only 21% of the tariff per barrel and in respect of the barrels produced outside the contractual area only 10% of the tariff.

The fee is subject to adjustment for inflation in January and July of each year based upon a basket of industry-related indexes, and for an R-factor which reduces the fee on a linear basis from 100% down to a floor of 60% if the total compensation as per (a) above is between 150% and 250% of the total expenditures of the contractor.

The actual cash flow is calculated as the result of the monthly production and a West Texas Sour price average adjusted for the quality of the crude oil produced and a certain formula. Furthermore, actual cash flow is adjusted for the adjustment to the gross income estimated by the tax base production. If production is higher or lower than the volumes shown in a table, further adjustments are made.

If in any given month the amount in (a) above is greater than the adjusted actual cash flow, the difference can be paid in the following months (without interest) and excess amounts of (b) over (a) can be carried forward. Upon termination of the contract, unpaid balances are extinguished.

Potential financing risks

Based on the foregoing, in addition to the risk of non-performance by the contractor, the following risks for a financing based upon the cash flows of a contract can be identified:

(i) The Contract may be terminated if the development of the area is found not to be viable.

(ii) The actual cash flow may be lower than projected by the lender due to lower volumes or oil prices or the tax adjustment component and, as a result, cash available for debt service is reduced. (It should be mentioned that in mature fields, such as Magallanes, Carrizo and Santuario, the risk of a lack of viability of development and production should be considered as rather remote.)

(iii) In addition, the contractor has to obtain rights of way and permits required for the performance of the services for development and production. Since obtaining such permits and rights depend to a great extent on factors outside the control of the contractor, future results may be negatively affected by its failure to obtain them.

(iv) Furthermore, the contractor is responsible for all environmental damages and claims in connection with the performance of the works and has to indemnify PEP for any related liability. The model contract provides that any contamination by hydrocarbons, explosives, repair and cleaning costs as well as environmental damage and damage to third parties in the contract area shall be the direct and immediate consequence of the rendering of the services by the contractor.

That is a very far reaching liability for the contractor, which may even include environmental damages not caused by the contractor. In principle, such an environmental liability should be insured. Interestingly, the model contract does not establish specific insurance requirements but only the general obligation of the contractor to obtain insurance coverage as required or recommended by prudent experience and practices in the industry and applicable law.

(v) It is important to mention that PEP requires a corporate guarantee from the parent company of the contractor and a stand by letter of credit for the minimum amount of expenditures during each year of the evaluation period. If the Contract is guaranteed by the parent company, most likely the financing of such contract would also be guaranteed by the parent.

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