July 23, 2015
On July 15, 2015, Mexico announced the results of the first phase of “Round One,” or a series of auctions providing foreign companies access to oil and gas acreage after over seventy-five years of state control of upstream exploration and production. Only two of the fourteen shallow water blocks on offer were awarded—far below the government’s publicly stated expectation that at least five blocks would be awarded. But for those two blocks, the share of the project the winning bidder offered the Mexican state far exceeded the government-stipulated minimum share. So was the round a success or failure?

We think there are seven lessons from the inaugural round that—if learned—could lead to highly successful auctions for the existing producing, heavy oil, and especially critical deepwater rounds to follow.

Lesson 1: Good Geology Trumps the Low Oil Price Cycle. While many analysts (and some Mexican officials) blamed low oil prices for the low subscription rate, the reality was that the two blocks perceived as having superior prospects attracted heavy competition as there were competing bids offering the government shares well in excess of the government’s minimum.  Companies must replace reserves to stay in business and, if the fiscal terms are reasonable, will pay top dollar for quality prospects—even in a low oil price cycle. The lack of interest in some blocks should not have been a surprise to the government as PEMEX, Mexico’s state-owned petroleum company, chose not to retain these blocks in “round zero” where they had first pick, indicating PEMEX’s low enthusiasm for the overall prospectivity of these blocks. For the next rounds the acreage needs to be top flight and, especially, if middling prospects are instead on offer, the price and the terms of investment need to be right (See Lesson 3).

Lesson 2: Size Matters. The largest international oil companies (IOCs) did not bid because the blocks were too small to be material for them. CNH, Mexico’s national hydrocarbons commission, divided some of the blocks offered early in the process and was warned that they would not be material enough. Either CNH wanted to prioritize small bidders or they did not believe what they were told.  The heavy oil and deepwater blocks will be subscribed at a much higher rate if they include blocks sized to be material to IOCs.

Lesson 3: Let the Market Set the Price. Auctions are an efficient mechanism for price discovery because sellers can greatly under- or overestimate the value of an asset to the buyer. Mexico’s finance ministry, known as Hacienda, just re-learned this lesson the hard way. Hacienda set the minimum profit share for the government at 40 percent for nine of the fourteen blocks on offer (the minimum profit share for the remaining five blocks was 25 percent). This was too high relative to the limited resource potential of these blocks. On the other hand, Blocks 2 and 7 went for far higher than the minimum. The government guessed wrong across the board. This fundamental mistrust in the market kneecapped the bid round. If the minimum had been set as little as 5 percent lower in some cases, the blocks would have been sold and the government would have met its target of selling at least 40 percent of the blocks. If the government had taken the bids on offer for Blocks 3 and 4, the government’s total take could have been at least 50 percent for each block—way better than the zero percent take they ended up with. The lessons here are 1) set minima lower and trust the market to set the price, and 2) let geologists take the lead on valuing the blocks (that most of the blocks had a 40 percent minimum share tells us the geologists were not at the table when these were set).

Lesson 4: The Process Worked Beautifully. The process the Mexican government employed to carry out the auction exceeded international best practices with respect to transparency, reflecting its efforts to craft one of the most transparent oil and gas sectors in the world. The auction results were broadcast on Mexican television and online, with each bid read out loud and displayed on screen. This efficiency, plus the energy ministry’s (SENER) active consultative style, has built confidence in the auction system.

Lesson 5: Risk and Reward are Still Out of Balance. The shadow of a state-dominated service contract mentality still hangs over the government’s production sharing and license agreements. Neither is yet at international standards and both need to change as the size of investments grows in the next rounds.

The major risks are much too elastic provisions under which the government could rescind the contract (administrative and contractual rescission) and a surfeit of reporting requirements that carry serious and disproportionate penalties if not proffered to the government’s satisfaction.  In addition, the state’s apparent predilection to interfere with how companies jointly agree to operate, customarily disclosed to but not agreed with the government, speaks of a cultural resistance to accept the market nature of the reforms.  While the government is overtaxed, with dedicated officials working long hours already, these contract forms direly need to be rewritten to reflect international standards. Otherwise, the inherent risks will lead to weakened participation or heavy discounting of the value of the asset. The issue of administrative rescission (the ability of the government to rescind the contract entirely for a breach) must be addressed. Either some reassuring formal interpretive guidance should be issued, or some assurance that the investor protection offered in the energy sector will be at least as good as the international standards offered to investors in other areas (i.e. under NAFTA). For deep water the rescission risk can be a deal breaker for many investors.

The reward side of the equation also needs adjustment. Investors will be asked to spend money over the near term, and at high levels for deep water and extra heavy oil.  If they can profit over the life of the investment, they can take a long view and justify the investment. But today the “adjustment mechanism” in the fiscal terms caps what investors can earn at the back end of the contract.  Those terms do not fit this market and will have to be adjusted for future rounds to be well subscribed.

Lesson 6: Provide Better Data. Bidders complained that there were holes in the data offered, a lack of access to geologists who understood the data provided, and no access to relevant, comprehensive, and regional geologic data that would inform the interpretation of the data provided. The government should promise to fix this swiftly for the next round; the better educated the bidder, the better the bid will be.

Lesson 7: Consider Moving to License Agreements for Subsequent Rounds. Mexico should consider transitioning from the use of production sharing agreements (PSAs) to licenses, which are less complex to administer. Both the current PSA and license used by Mexico appear to be poorly altered versions of the country’s old service contracts and do not reflect international standards. To the extent PSAs continue, the Mexican state should maximize exploration and the likelihood of development with a much greater emphasis (weight) on work programs in the bid evaluation criteria.

Mexico’s government has made rapid and dramatic progress in fundamentally reshaping Mexico’s energy sector for the benefit of the state and the citizenry. It has adapted to dramatic change in the market, but not enough for the rounds ahead. The fiscal terms, the contracts themselves, and the data on the geology on offer must all be seriously adjusted. It would be better to postpone the next rounds than to get them wrong. But success is within Mexico’s reach: with some lessons learned from the first round there is every reason for optimism that further success is achievable and likely.              

David Goldwyn is Chairman of the Atlantic Council’s Energy Advisory Group and Senior Nonresident Energy Fellow at its Adrienne Arsht Latin America Center. Cory Gill is his associate at Goldwyn Global Strategies, LLC.