THE MEXICAN NEWOIL LEGAL REGIMEA change of paradigm towards private venture

2008 PEMEX DIAGNOSTIC

The 2008 PEMEX Diagnostic was presented by Calderon’s Energy Minister and PEMEX’s General Director. The scope of the report covers the following aspects:

1. PEMEX productiveness2. Operational, environmental and industry security challenges3. Execution capacity4. Regulatory restrictions5. Corporate governance

OIl fIElDS CurrENT SITuATION The report affirmed that the lack of investment in exploration and refineries has left Mexico in dire straits. Oil production has been falling since 2005. At the same time, PEMEX has begun to exhaust Mexico’s giant offshore Cantarell field, followed by Ku-Maloob-Zaap, Samarina Luna, Marina Suroeste and Bellota Luna reservoirs –which constituted Mexico’s 92 percent overall oil production in 2008–. Last year alone, it dropped 5.3 percent to about 3.1 million barrels per day.

Main actives oil estimated productionThousand barrels per day 2008-2021

1

3,000

2,500

2,000

1,500

1,000

500

0

777 Mbd

1,533 Mbd

1,797 Mbd

2006 2010 2012 2014 2016 2018 2020

Marina Suroeste

Samaria Luna

Bellota-Lujo

Ku-Maloob-Zaap

Cantarell

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EXPlOrATION AND PrODuCTION Hydrocarbons reserves have diminished since the mid 80’s; this topic represents a major challenge for the Mexican government, as it compromises national energy security.During 2002 proven reserves total amount was 20.1 billion oil barrels, the equivalent to 13 years’ production. Conversely, in 2007 proven reserves total amount was 14.7 billion oil barrels. This is consistent with Mexican oil reservoirs situation. On the one hand main gigantic oil fields have entered a stage of decline. On the ot r, new reservoirs do not possess the same production capacity. The strategies proposed in the report to maintain production levels in the short and long terms to improve proven reserves average are the following:

• Discoveryofnewfields• Shorttermnewfieldsproduction• Developmentofprovenandprobablereserveoilfields• Enhancementofproduction,discoveryanddevelopmentcosts

Nowadays, Mexico’s reservoirs are calculated to be 44.48 billion oil barrels. Ninety three per cent of those reserves are located in the following areas: 41 per cent in the depleting fields, 10 per cent in declining fields and 42 per cent in developing fields. There exist four core exploration areas considered by PEMEX:

• South-eastwatershedsprospectiveresourcesexplorationandproduction• Abandonedfieldsexploitation• Chicontepecdevelopment• GulfofMexicodeepwatersdevelopmentandexploitation

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DEEP wATErS PrODuCTION Deep waters production is the report’s main concern. PEMEX has to promptly initiate deep waters development in order to guarantee production for following years. In accordance with 2002-2008 relevant data, there are more than 200 potential exploration sites. In that period, PEMEX had the chance to exploit only 6 new wells (approximately one per year). The report indicated that PEMEX neither possesses the expertise nor the funds to explore risky, deep water oil fields; plus it must enter into partnership with foreign firms, something the Constitution prohibits. The report stresses the current need for PEMEX to enter into join ventures with other companies to increase its production.Deep waters characteristics:

• Depthofover500meters• Geologicallycomplexvarietyofstructures• Lackofexpertiseinriskyinvestmentareas• Highcostofdiscoveryanddevelopmentforexploitation.

In order to maintain current production of 1.3 million oil barrels per day, it is necessary to harmonize deep waters production and current fields’ production. In 2021, deep waters production should provide, at least, 500 thousand oil barrels per day.

Deep waters oil requirements(Thousand barrels per day)

TrANSbOuNDAry OIl AND GAS rESErvOIrSMexico’s transboundary oil and gas reservoirs mainly lay across its maritime borders with the United States and Cuba.Cuba has identified potential resources for more than 13.5 billion oil barrels, situated in the Mexican frontier area. In the northern area, PEMEX has located prospective resources in the border area with the United States.

600

400

200

02013 2014 2015 2016 2017 2018 2019 2020 2021

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Gulf of Mexico

Darkmarksreflecthydrocarbonsnaturalemanations

INfrASTruCTurEThe report highlighted Mexican infrastructure following requirements:Pipe lines: Mexican pipe lines do not possess technological advantage. Their average age is 24. High energy consumption and clandestine leaks constitute Mexican pipe lines major challenges. Tankers: PEMEX’s tankers do not comply with international standards. 12 of them are no longer in operation. Mexican production requires approximately 20 of those vessels.Land Transportation: There is low efficiency concerning loading and discharging operations. There is no adequate infrastructure and multi-purpose capacity. Long term contracts on new routes are required.

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PArTIES PrOPOSAlS

All of the reform initiatives presented either by the Federal Executive branch or the political parties were greatly enriched in Energy Reform debate forums organized by the Senate. The opinions and participations of specialists in the area helped the different Senate commissions harmonize the various details in order to form projects more complete and viable than the original separate initiatives.

PrI(Institutional revolutionary Party)

The PRI party defends the constitutional principle of Nation property. It is necessary for a long term integral State policy which contains a sectorial policy that preserves the energy sovereign for the State. PEMEX should have administrative and financial autonomy with operative flexibility.

PAN(NationalAction Party)

The PAN party is absolutely supportive of the Federal Government proposal related to the oil’s industry modernization.

fAP (Progressive Ample front)

The FAP is a coalition of the left side Mexican parties, conformed by the PRD (Democratic Revolution Party), PT (Work Party) and the PC (Convergence Party). They do not want changes to the nature of PEMEX.

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INSTITuTIONAl STruCTurE

ADMINISTrATION bOArDThe PEMEX Board of Directors will determine the organizational and operational structure for the realization of the organism´s activities and purpose within the technical, commercial and industrial aspects.It will be granted greater administrative and management facilities for the improved management by PEMEX of its debt. A new law for PEMEX which favors the structure’s increased operational efficiency in accordance with today´s activity related challenges present at an international level, which are particularly more uncertain for Mexico; one which especially strengthened the Board of Directors as the superior government organism and which increased the transparency present in PEMEX’s activities and operations, would be convenient.At its organic structure, the Board of Directors will be composed by four Professional Counselors.Within its main functions are the general conduction and strategic management of PEMEX along with its subsidiary organisms; the establishment of general policies for production, commercialization, technological development, general management; the issuance of operational guidance norms; the supervision and evaluation of PEMEX’s and its subsidiaries’ performance; the approval of the budget projects; the approval of the terms and conditions for contracting among others.buDGETAry frEEDOMThe creation of a modern legal framework which grants PEMEX greater operative and budgetary freedom by awarding it autonomy was considered.In its first stages, PEMEX will be able to employ up to 35% of its excess revenues or given the case, a quantity of up to MXN 11 billion, whichever is greater, in order to increase its investment, maintenance and operation costs. Said quantities can increase up to 87.5% in the case of excess revenues, or up to an amount MXN 15 billion, during the next 5 years after the adoption of the new energy regime.PEMEX will be able to exercise , without prior authorization of the Minister of Tax and Public Credit, the budgetary allocations which it considers necessary, as well as employ up to 50% of its excess revenues or up to MXN 12,500 billion, whichever is greater, in order to increase its investment, maintenance and operation costs.

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HyDrOCArbONS NATIONAl COMMISSIONIt is an organism with the technical capacity and necessary knowledge to analyze PEMEX’s activities in depth, in such a manner that it can better manage the exploitation plans and participate in the selection of the most adequate technology.The new technical organism was named as the “Hydrocarbons National Commission” because that name emphasizes the nature of its object, being a highly technical and specialized organism for hydrocarbons extraction in its natural form.The Commission will be constituted as a independent entity of the Energy Secretariat.Its fundamental objective is to regulate and to supervise hydrocarbons exploration and exploitation, in oil pools or fields. Refinery, storage, transport, distribution, direct sales of the products obtained from the refinement, natural gas or raw materials are excluded from this regulation.The Commission shall establish the technical dispositions applicable to hydrocarbons exploration and exploitation; establish the technical guidelines for the design and execution of the hydrocarbon exploitation and extraction projects; lay down the evaluation mechanisms of operative efficiency; supervise, verify and, in its case, certify the fulfillment of regulations. It can issue opinions about assignation or cancellation of the assignation areas for oil exploration and exploitation, and about the licenses for the recognition and the superficial exploration in order to investigate its oil field possibilities.In addition, it has faculties to handle and resolve administrative proceedings of any kind.

rEGulATOry ENErGy COMMISSIONArose from the discussion in regards to the need to count with a regulating body possessing greater attributions for the purpose of increasing its capacity as well as the efficiency of the energy sector.With respect to Mexico, the regulation of its energy sector is the responsibility of different authorities. The Energy Regulatory Commission is responsible for the economic regulation linked to the electricity and gas sectors, notwithstanding, the Ministry of Energy, the Ministry of Tax and Public Credit, the Ministry of the Environment and Natural Resources, the Federal Competition Commission and the Federal Consumer Attorney, also perform regulatory activities related to the matter.The Energy Regulatory Commission’s purpose was expanded, given that regulation is a form of State intervention, appropriate for the nation’s economic development.Its attributions were modified in order to award it more active regulation powers than it has had in the last 13 years.

lEGAl DISPOSITIONSThe new energy regulation is based on the following reforms, additions of suppressions to various legal dispositions:The PEMEX Organic Law and Subsidiary Entities was suppressed, and in its place, the PEMEX Law was enacted; second, the Hydrocarbons National Commission Law was enacted; third, many articles of the Regulatory Energy Commission were reformed or added; fourth, some articles of the Statutory Law of the 27th Constitutional article were reformed or added; fifth, there were modifications to the Organic Law of the Public Federal Administration; sixth, the Usage of the Renewable Energy and the Financing Transition Law was enacted; and seventh, the Sustainable Energy Enjoyment Law was enacted.

TrENDS IN CONTrACTING wITH PEP

TrADITIONAl CONTrACTING MODElThe model for developing major projects used by PEP has been the usage of numerous contracts regarding a wide range of specific services ranging from logistics, transportation to procurement and installation, among many others. Having a high number of contractors has caused a number of difficulties to PEP, such as the increase in operative costs, the lack of effective supervision, cases of accidents and sometimes even corruption. It all sums up into a global lack of efficiency.

frOM THE MulTIPlE SErvICES CONTrACTS TO NEw EXECuTION MODElS (NEM)Multiple Services Contracts (CSMs) have been tested for the first time in natural gas in the Burgos Bassin. They contemplate a wide range of services to be provided by a sole or a limited number of contractors.There was some political reaction to the CSMs, and unsuccessful annulment claims were filed. Consequently, the Federal Superior Comptroller issued a recommendation in 2003 differentiating between “strategic” and “none strategic” activities, the first ones being reserved to PEMEX. This recommendation resulted in the drafting of a new CSM: the New Execution Models (NEMs).The NEMs, like the CSMs, comply with the Public Works Law and are modeled according to unit prices and predetermined duration. They are normally divided in three stages: development, reactivation and maximum recovery.

A ClOSEr lOOK AT NEMSThe creation of NEMs proved to be very promising for the development of the Mexican oil industry. Among their most important characteristics and figures are the following:

•The flexibility of the new contractual regime is mainly devoted to upstream (exploration and production) as opposed to most downstream activities. The contractual regime will be more integrated to the international best contractual practices of the oil industry. • The legal reform of the oil sector exclusively contemplates service contracts (as opposed to production sharing, concessions or any other equivalent feature). • Although the public tender will continue to be the general rule, the Board of Directors will decide on the application of closed invitations (3 companies) or direct awarding. Special modalities of service contracts in which additional compensations are granted are also incorporated. • Whilst ordinary cases of direct awarding will be oil spills or equipment maintenance by the company that originally installed the said equipments; closed invitations will be related to technological innovation or research. The main features of the special modalities are described herein below.

• A Master NEM: One large contractor and subsequent private contractors• A set of NEMs divided according to functions and regions. Various large contractors for specific blocks or groups of services.• The Credit rating: The bidder is required to submit a document issued by a certified rating agency registed before the National Banking and Values Commission, containing and approved rating (ie C+: Fitch, Caa1: Moody’s, etc)• Environmental Considerations: Environment reports are required to be submitted annually, as well as an initial and final environment diagnostic report;• Consortium leader: Proposals can be submitted on behalf o fan entire consortium, which in

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turn will designate a leader. This leader will be responsible for the communication sustained with PEP and the joint obligations entered into by other Consortium members;• PAT (Annual Work Program): Refers to the work schedule/program and its related budget which must be made annually by the Bidder. Together, several PATs compose the Master Execution Program, which contains at a basic level the execution schedule of the different PATs;• Management Group: This group is composed by 3 PEP members and 3 Contractor members and is responsible for proposing, discussing and evaluating all those Technical Assistance activities for PEP, scheduling of works, coordinating PEP and Bidders, applying ICD and other related matters; • Directive Group: Integrated by three PEP members and 2 Bidder members. The group meets to resolve any topic related to the contract or any difference deriving from the Management Group. In order to so it may require the assistance of independent experts; • Performance Indicators (ICD): They are specific to each phase and allow for the evaluation of the safety, environment and health conditions as well as the Reliability of the Administration’s Performance; • Guarantees: Several guarantees must be issued such as the Corporate Guarantee, Hidden and Latent Defect Guarantee, and Fulfillment Guarantee depending on which requirements each company meets.• Non-subcontractable items: job planning, onsite job direction and performance evaluation in meetings with PEMEX.

COrPOrATE INTEGrATION wHEN CONTrACTING wITH PEPThree different schemes may be planned, each one triggering different contractual and corporate responsibility.

Corporate Integration

IntermediateLevel

HighLevel

BasicLevel

(Joint Bid)(Joint

Venture)

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CONTrACTuAl rEGIME

Among other categories, there are the following types of legal vehicles in the international oil industry: (i) services regime; (ii) concessions regime; and the (iii) shared production regime.Mexico belongs to the group countries whose oil industry operates within the services regime, although it is the only country which has not yet adequated its needs to the international oil industry. In services and public works contracts above all, there are problems with bureaucracy and a complex administrative regulation.On other hand, the contracting scheme of PIDIREGAS does not respond anymore to the contractual needs of the institution because it lacks flexibility and requires public debt for financing.The Federal Government’s project to reform PEMEX aims to adequate the services contract regime at par with the international outlook.

A NEw CONTrACTuAl ENvIrONMENT The utilization of NEM contracts has proved to be successful and therefore, it is highly likely that their main elements will be continued to be used.However, one of the major changes achieved with this reform that is worth pointing out is in respect to the Board of Directors. This board will operate through various committees such as: (i) Performance Audit and Evaluation Committee; (ii) Strategy and Investment Committee; (iii) Remunerations Committee; (iv) Acquisitions, Leasing, Public Works and Services Committee; (v) Environment and Sustainable Development Committee; (vi) Disclosure and Accountability of Information Committee; and the (vii) Technologic Development and Investigation Committee.In addition, oil industry related contracts will now not be regulated by the Law of Public Works and Related Services. Instead, the law will grant the Board of Directors broad attributions for the regulation of these contracts.Among the most important features of the reform are the following:

• Hydrocarbons and oil reserves will remain being property of the Nation. • No rights of preference for the purchase of oil and its derivatives will be awarded• Payments shall be made in cash and in case can a payment be accorded in the form of

percentage of production or of sales revenue of oil and its derivatives.• Shared participation contracts nor association can be subscribed in the exclusive and

strategic areas of the Nation.• The Contracts can contemplate clauses allowing for technological, price and information

modifications.• Payments must be contained in the contract• Compensations can be awarded when the Contractee obtains economies for execution of

the jobs in less time• When the Contractee obtains benefits from new technologies provided by the Contractor• Whenever other circumstances are given which result in increased profits for PEMEX

and in a improved result in the services job, making sure sales revenues and hydrocarbon production are not compromised

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• A phase in which prices will be subject to negotiation, as per general rules approved by the Board of Directors is also included.

• With respect to international transactions, PEMEX will be authorized to agree on non-Mexican law and forum.

Up until this day, the applicable contract scheme is a “pure services” one. This equates into the productivity of the works constructed not having any repercussion over compensation.The new regime will allow for a basic payment to be made first, regardless of whether the oil platforms are productive or not. Following, compensation linked to level of productivity will be able to be awarded. In the contract models and rules deriving from these laws, the National Hydrocarbon Commission will be responsible for establishing the corresponding ranges within which the compensation will occur.It is probable that with both this new contractual regime and the autonomy of the Board of Directors, clusters of oil contracts will be awarded to international oil company consortiums. These consortiums in turn, will be able to subcontract related services with other private companies.

With 75 years of solid experience and permanent innovation, our firm is duly prepared to assist its clients interested in the oil sector. The firm’s maritime and

offshore energy practice is focused on providing comprehensive assistance to PEMEX’s marine contractors, concerning public bids, corporate structuring, ship

finance, permits and transnational commercial arrangements, among other services related to vessels, naval artifacts and oil rigs that are used in upstream operations.

Goodrich, Riquelme y Asociados is one of the most prestigious, widely respected and innovative law firms in Mexico City. The majority of its clients are medium and large companies, many of which are in the “Fortune 500” category. As creative problems solvers, we help our clients address their changing needs so they can prosper in the Mexican business environment, which itself is continually changing.Aside from providing our corporate clients with complete legal services, we also help them achieve their business objectives in today’s growing globalized business world and within the parameters of the various new multilateral and bilateral trade and investment agreements such as NAFTA, WTO, MEUFTA, MERCOSUR and others. Today the firm has a professional and administrative staff of over 200.

Please note that this newsletter has been produced for informational purposes only. It may not be relied upon as legal advice. For further information about the issues discussed in this newsletter, please contact:

DavidEnríquez(Partner)e-mail: denriquez@goodrichriquelme.comTel:(+52)5552250369

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