Investing in Upstream Oil and Gas in Mexico

Investing in Upstream Oil and Gas in Mexico

We Know Energy®

Liberalisation of the Mexican Energy Sector Although oil and gas exploration and production in Mexico has over 75 years of history, for most of that period the Mexican market was closed to private investment. In late 2013, Mexico de-nationalised its oil, gas and power industry and invited international companies to participate for the first time in the country’s history following the enactment of comprehensive legal reforms. Prior to the 2013 constitutional reforms, the sole market producer was Mexico’s state-owned oil and gas company, Pemex Exploración y Producción (“Pemex”). Since the reforms, international investment in Mexico has gained momentum and the oil and gas industry has quickly become competitive as international companies seek to take part in developing the country’s considerable hydrocarbon reserves. Demand has been high, with companies that meet pre-qualification criteria able to bid for blocks awarded directly by the Mexican State, or to participate through contractual arrangements with Pemex. There are a wide range of possible investments for international oil and gas companies in Mexico. Opportunities exist for producing both conventional and unconventional resources, and are onshore and offshore in both shallow and deep water. Development is potentially aided by an existing infrastructure network for transportation and processing. Multiple auction rounds have been successfully held. Oil and gas resources are identified by Mexico’s Ministry of Energy (Secretaría de Energía) (“SENER”) before they are presented for open bidding by Mexico’s Comisión Nacional de Hidrocarburos (“CNH”). SENER establishes the type of exploration and production contract to be awarded in the bid process. At the conclusion of the bid process, contracts are entered into between the winning company or consortium and CNH, on behalf of the Mexican State, and CNH continues to manage and supervise contracts after they have been awarded.

Opportunities for Investors

How to participate There are three primary routes under which a company can participate in the Mexican upstream oil and gas sector: • Contract auctions . The Mexican State auctions specific oil and gas blocks in bid rounds conducted by CNH to companies bidding individually or as consortia. The type of contract that will be awarded in a given auction (a production sharing contract, profit sharing contract, licence or service agreement) is established by SENER. Mexican law requires foreign companies to incorporate a Mexican entity in order to execute a contract with CNH. Up to February 2018, eight international public tenders had concluded and two additional rounds remained ongoing. In March 2018, CNH announced a further planned bid round for onshore blocks. • Partnering with Pemex . “Assignments” are transfers of oil and gas exploration and production rights to Pemex. Assignments are subject to different laws than the contracts that are issued by the Mexican State. During the first round of bidding (known as “Round Zero”), before the regulations of the 2014 laws became effective, SENER granted Pemex assignments of 83% of Mexico’s proved and probable reserves and 21% of prospective reserves. Pemex may migrate its assignments to contracts and partner with domestic or international oil and gas companies through a bidding process conducted by CNH. • M&A . As the international focus on Mexico continues, M&A activity will follow. International oil and gas companies may seek to partner with companies which were previously awarded contracts. Special consideration should be given to the consent requirements under the Hydrocarbons Law and the terms of the relevant contract. How to pre-qualify “Pre-qualification” with the Mexican State is required for a company to participate in any manner, whether by contract auction or association with Pemex, and, when deciding whether to grant consent to an assignment in connection with an M&A transaction, CNH will also reference the pre-qualification criteria established during initial bidding. The Mexican State establishes pre-qualification requirements for each bidding round based on the nature of the underlying resources. The pre-qualification process is subject to a strict schedule and generally requires a bidder to demonstrate its technical capability (through experience in exploration and production projects and in industrial health and safety) and financial capacity (typically requiring a minimum net worth, and, if the bidder is also to be the operator, further demonstrating minimum total assets and minimum investment grade qualification). Bidders that pre-qualified in certain earlier rounds automatically pre-qualify for specified later rounds based on the nature of the underlying resources and the contractual arrangement.

Mexico’s Five Year Plan SENER established a “Five Year Plan” that contemplates four rounds of bidding for exploration and production contracts from 2015 to 2019. SENER’s Five Year Plan includes 237 blocks, 29 of which represent conventional resources in deep waters. The following map shows the location of the blocks based on SENER’s evaluation as of 2017.

2017 Evaluation. Source: www.gob.mx

Existing Awards

Offshore Contract Awards

Round 1.1 PSC, Shallow Water

Round 2.4 Licence, Deep Water

Block 2 – Talos, Sierra and Premier Block 7 – Talos, Sierra and Premier

Block 2 – Shell and Pemex Block 3 – Shell and Qatar Petroleum Block 4 – Shell and Qatar Petroleum Block 5 – Pemex Block 6 – Shell and Qatar Petroleum Block 7 – Shell and Qatar Petroleum Block 10 – Repsol, PC Carigali and Ophir Block 12 – PC Carigali, Ophir and PTTEP Block 14 – Repsol and PC Carigali Block 18 – Pemex Block 20 – Shell Block 21 – Shell Block 22 – Chevron, Pemex and Inpex Block 23 – Shell Block 24 – Eni and Qatar Petroleum Block 25 – PC Carigali Block 26 – PC Carigali Block 28 – Shell Block 29 – Repsol, PC Carigali, Sierra and PTTEP

Round 1.2 PSC, Shallow Water

Block 1 – Eni Block 2 – E&P and Hokchi Block 4 – Fieldwood and Petrobal

Round 1.4 Licence, Deep Water

Cinturón Plegado Perdido Block 1 – CNOCC Block 2 – Total and ExonMobil Block 3 – Chevron, Pemex and Inpex Block 4 – CNOCC

Round 3.1 PSC, Shallow Water

Block 5 – Repsol Block 11 – Premier Block 12 – Repsol Block 13 – Premier Block 15 – Capricorn and Citla Block 16 – Pemex, Deutsche and Compañia Española Block 17 – Pemex, Deutsche and Compañia Española Block 18 – Pemex and Compañia Española Block 28 – Eni and Lukoil Block 29 – Pemex Block 30 – Deutsche, Premier and Sapura Block 31 – Pan American Block 32 – Total and Pemex Block 33 – Total and Pemex Block 34 – Total, BP and Pan American Block 35 – Shell and Pemex

Cuenca Salina Block 1 – Statoil, BP and Total Block 3 – Statoil, BP and Total Block 4 – PC Carigali and Sierra Block 5 – Murphy, Ophir, PC Carigali and Sierra

Round 2.1 PSC, Shallow Water

Block 2 – DEA and Pemex Block 6 – PC Carigali and Ecopetrol Block 7 – Eni, Citla and Capricorn Block 8 – Pemex and Ecopetrol Block 9 – Capricorn and Citla Block 10 – Eni Block 11 – Repsol and Sierra Block 12 – Lukoil

Block 14 – Eni and Citla Block 15 – Total and Shell

Onshore Contract Awards

Round 1.3 Licence, Onshore

Round 2.3 Licence, Onshore Block 1 – Iberoamerican and PJP4 Block 2 – Newpek and Verdad Block 3 – Newpek and Verdad Block 4 – Iberoamerican and PJP4 Block 5 – Jaguar Block 6 – Shandong, Sicoval and Nuevas Soluciones Block 7 – Jaguar Block 8 – Jaguar Block 9 – Jaguar Block 10 – Shandong, Sicoval and Nuevas Soluciones Block 11 – Shandong, Sicoval and Nuevas Soluciones

Block 1 – Diavaz Block 2 – Marusa, Nuvoil and SIC Block 3 – CMM Block 4 – Calicanto

Block 5 – Strata Block 6 – Diavaz Block 7 – Lifting Block 8 – Dunas Block 9 – Perseus Block 10 – Oleum, Conequipos, Industrial Consulting, Marat and Tzaulan Block 11 – Renaissance Block 12 – Grupo Mareógrafo Block 13 – Mayacaste Block 14 – American Oil, Canamex and Perfolat Block 15 – Renaissance Block 16 – Roma, Tubular and Geoscience

Block 12 – Carso Block 13 – Carso Block 14 – Jaguar

Block 17 – Lifting Block 18 – Strata Block 19 – Renaissance Block 20 – GS, Arenas Silicas, DTSI, Hostotipaquillo and Steel Block 21 – Strata Block 22 – Secadero and Grupo R

Round 3.2 Licence, Onshore

Block 23 – Perseus Block 24 – Tonalli Block 25 – Renaissance

Bidding process is ongoing for 37 contract areas divided into three sectors: Burgos, Tampico- Misantla-Veracruz and Cuencas del Sureste

Round 2.2 Licence, Onshore Block 1 – Iberoamerican and PJP4 Block 4 – Sun God and Jaguar Block 5 – Sun God and Jaguar Block 7 – Sun God and Jaguar Block 8 – Sun God and Jaguar Block 9 – Sun God and Jaguar Block 10 – Sun God and Jaguar

Round 3.3 Licence, Onshore Bidding guidelines published March 2018 for 9 contract areas

Types of Contract Awards SENER establishes the type of contract to be awarded in a bid process. There are four types of contracts: Production Sharing Contracts (PSCs) , Profit Sharing Contracts , Licences and Service Contracts .

Profit Sharing Contract

PSC

Licence

Service Contract

Description

As is common for PSCs, after payment of a royalty, the “contractor” parties retain a share of production to cover their accumulated costs The remaining production is shared between the contractor parties and the State in accordance with the PSC Contractor parties can market their shares of hydrocarbon production independently The State’s share of production is marketed by an agent appointed by CNH, and Mexico’s petroleum fund receives the proceeds from the sale of such production A monthly “quota” (rental payment) during the exploration period Royalties on production once production begins (which increases with oil price) Variable percentage share of production in cash or kind, based on “operating profit” (value of hydrocarbons less contractor parties’ cost recovery less royalties paid) Share of hydrocarbons as cost recovery pursuant to the Ministry of Finance rules Variable percentage share of production based on “operating profit” (value of hydrocarbons less contractor parties’ cost recovery less royalties paid)

The contractor parties deliver all production to CNH’s marketing agent, which will deliver the revenues to Mexico’s petroleum fund The fund will distribute the profits to the contractor parties in cash on a monthly basis

The contractor parties own the hydrocarbons once extracted

The contractor parties will deliver all production to the State, which shall pay the contractor parties in cash an amount established by the terms of the contract

Payments to the State

A monthly “quota” (rental payment) during the exploration period Royalties on production once production begins Compensation determined as a percentage of operating profit

An upfront signing bonus determined by the Ministry of Finance A monthly “quota” (rental payment) during the exploration period Royalties on production once production begins Compensation based on either operating profit or the value of the hydrocarbons produced

All hydrocarbons will be delivered to the State No other fees or royalties will be included in service contracts

Payments to the Contractor Parties

Share of hydrocarbons as cost recovery pursuant to the Ministry of Finance rules Distribution of profits to contractor on a monthly basis from Mexico’s petroleum fund, based on revenue generated by the CNH marketer from the hydrocarbons delivered to it

The contractor parties may take all the hydrocarbons in-kind at the wellhead

Cash payments to be provided in each contract

The term of the contract varies from one bid to another, but is generally from 25 years to 35 years with some extension options. Contracts granted by the State continue to be subject to supervision by CNH and are subject to rescission under certain circumstances. The Hydrocarbons Law also provides that companies holding contracts should use a minimum percentage of local content in their operations. “Local content” generally describes Mexican good and services, labour, training, investment in infrastructure and investment in local technology. A minimum local content threshold of 25% was established for 2015, which will gradually increase to at least 35% by 2025.

M&A Considerations Nature of the interest being transferred affects the transfer process. The range of different title documents (PSCs, profit sharing contracts, licences and service contracts) used in Mexico means that the transfer and consent process can vary dependent on the type of interest being transferred. It is important to ensure that attention is paid to the terms of the relevant document, as well as the bidding guidelines that awarded the contract and the Hydrocarbons Law. Engagement with CNH is also advisable to establish a workable process (on a “no names” basis when appropriate), given that the M&A market and accompanying regulatory processes are not yet well established. Consents required. Mexican law has a distinct transfer process for assignments which involve a change of operatorship or of “administrative or corporate control” (being, in effect, the majority of voting rights in the decision making body), and those which do not. When there is such a change, prior written consent of CNH is required and detailed procedures must be followed. Where there is no such change, the law requires that any such assignment must simply be notified to CNH following completion. However, CNH consent will likely be required in any case in accordance with the terms of the underlying PSC (or other relevant title document). Where there is no change of operatorship or of administrative or corporate control, there is no other regulatory framework or established practice which would otherwise apply to CNH in granting consent pursuant to the PSC and effecting the transfer. “Multiple contractor” issues. Contracts are awarded in a sole contractor or multiple contractor form, dependent on their initial contractor participation. Assignments that cause a transition from one contractor member to multiple membership will require amendments to the PSC (or other contract forms) to provide for such ownership. This can introduce procedural complexity to the transfer process. PSCs provide for joint and several liability on the part of contractor members to CNH, which may need to be regulated as between contractor members as part of any assignment process. Steps required to transfer legal title. The transfer of legal title to the PSC or other contract is not a single- step process and the transaction documents should reflect the timetable and process set out in the PSC (or other contract), the relevant bidding guidelines and Mexican law. Relevant issues to note include: • CNH is obliged to respond to an application for consent with a time period specified under Mexican law and the underlying PSC (or other contract). • CNH consent does not itself effect the transfer of legal title of the relevant interest in the PSC, and does not oblige the parties to complete the transfer. • Following receipt of CNH consent to a transfer, the parties to the transaction must execute a standalone deed of assignment effecting the transfer and notify the CNH by way of notary public. Various other supporting documents, including a parent company guarantee and letter of credit may also be required. Failure to meet this timeframe causes the consent granted by CNH to lapse and a new application for consent must be obtained. • In the case of a PSC, CNH will prepare and issue to the parties an amendment to the PSC reflecting the new contractor party (and any shift from a sole contractor form of PSC to a multiple contractor member form), which must be executed by the parties and CNH within a specified time period following the date of notification of the deed of assignment to CNH. Failure to meet this timeframe causes the consent granted by CNH to lapse and a new application for consent must be obtained. • Execution of the PSC amendment (within the specified timeframe) is the final step to complete the legal transfer of title.

Financing Considerations Reserve based lending financing structures have not, as yet, been used with Mexican licences or PSCs (or other contract forms), which is not surprising given the short history of liberalisation. That does not mean that they are not financeable in this way and the upstream concession terms in Mexico share many similarities with other jurisdictions where international (non-US) RBL financing is used. However, there are certain key issues raised under the terms of the PSCs (or other contracts) that lenders and borrowers will need to digest. On the plus side, Mexico has a well-developed legal system and a range of different collateral instruments available to lenders which have be used in other sectors in Mexico where lenders take security. So there is nothing deficient in the suite of security available to a lender in Mexico. The principal issues that arise in the upstream lending context in Mexico are:

• what consents are needed to create the security in the context of an upstream financing in Mexico?

• what is the way in which security can be enforced by lenders if there is a default?

• what are the principal risks for lenders arising from the PSC (or other contract) terms?

All three of these are issues that require consideration in any emerging market financing and many of the solutions that are typically used elsewhere are relevant in the Mexican context. So, for instance, having regard to the desire of international lenders to have an enforcement option that avoids local courts where possible, we would expect any security package to contain a number of offshore components (in particular, security at some point up the corporate chain over shares in a non-Mexican corporate entity). However there remain important local issues to consider on enforcement, including CNH consent to change of control. There are also a range of issues that arise under the PSC (or other contract) terms themselves to be understood and, where appropriate, structured around. The set of issues here are very different to those that typically arise in a US RBL where the lenders are lending against real property interests (rather than concession rights which are capable of termination in certain circumstances, including a financial failure of the concession holder). However, these issues are familiar to lenders to the upstream sector active in other emerging markets, although every transaction needs its own bespoke analysis. So is Mexican upstream suitable for debt financing? The proof of the pudding is in the eating and we are pleased to have acted for the borrower on the first upstream debt financing in Mexico to close since the denationalisation of Mexico’s oil and gas sector.

We Know Energy® Bracewell LLP is a leading law and government relations firm and oil and gas transactions, financings and projects are at the heart of what we do. This means that we can readily integrate with your team to deliver greater efficiency as we already “speak the language,” so there is no time wasted in getting up the industry curve. Our Mexico team is comprised of leading energy lawyers in Houston and London and we are one of the few law firms that have been involved in all aspects of the liberalisation process. Our recent representations include:

• assisting clients with pre-qualification and bid auction processes;

• advising clients on proposed M&A transactions, including “swap” transactions involving multiple PSCs;

• advising on the procurement process for the tender and subsequent negotiation of several contract packages, including drilling rig, drilling services, transport and installation and logistics;

• assisting clients with project development activities; and

• advising the borrower on the first upstream debt financing in Mexico to close since Mexico passed its constitutional reforms. Our breadth and depth of oil and gas experience means we can not only offer the right advice, but that we can do so through an appropriately tailored team – we provide the right people with the right skillsets.

Philip J. Bezanson Managing Partner, Seattle T +1.206.204.6206 F +1.800.404.3970 philip.bezanson@bracewell.com

Adam Blythe Partner

Kate H. Day Partner

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Jason Fox Managing Partner, London T +44.(0).207.448.4206 F +44.(0).207.657.3124 jason.fox@bracewell.com

Tracy London Partner

Fernando Rodriguez Marin Partner T: +1.212.508.6139 F: +1.212.508.6101 fernando.rodriguez@bracewell.com

T +44.(0).207.448.4211 F +44.(0).207.657.3124 tracy.london@bracewell.com

Nicolai Sarad Partner

Darren Spalding Partner

Martin Stewart-Smith Partner

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T +44.(0).207.448.4209 F +44.(0).207.657.3124 darren.spalding@bracewell.com

T +44.(0).207.448.4210 F +44.(0).207.657.3124 martin.stewart-smith@bracewell.com

Jeffery B. Vaden Partner, Houston T +1.713.221.1501 F +1.800.404.3970 jeff.vaden@bracewell.com

Manuel Vera Partner, Foreign Legal Consultant

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