Economic balance protection in oil contracts

Mexican new government has emphasized its concerns regarding the government take in the awarded oil  contracts. It is not clear if these worries will lead to an audit or some type of “adjustment” for the govern-  ment take via legislation. In these times, understanding the risks and protection mechanisms available is  of paramount importance to oil companies.


1.- FISCAL CONTRIBUTIONS AND THEIR STABILITY

The following graphs show the government take distribution by contribution type.



The fiscal elements in the blue areas (Royalty, Additional Royalty and Contractual fee for the exploratory  phase) are frozen in Exhibit 3 of each LC and PSC. These terms, which reflect the Hydrocarbons Revenue  Law in force at the time of contract awarding, cannot be changed unilaterally.

In contrast, the fiscal elements in the gray areas (corporate income tax and the exploration and extraction  activity tax) are defined only in the Hydrocarbons Revenue Law. These two elements are unstable  because they are subject to a change of legislation. Additionally, another source of fiscal instability is that  Government could enact new contributions specific for the Hydrocarbons Industry.



2.- RESTORING THE ECONOMIC BALANCE

Despite the unstable fiscal elements, contracts contain stabilization clauses that allow to restore the  original project economic balance (revenues – costs) at the time of awarding, in case government  increases or creates new contributions specific to the exploration and extraction activities. For PSC,  the adjustment shall be made through cost recovery mechanisms whereas for LC it is contemplated an  adjustment via the additional royalty rate.

Contracts establish that the Ministry of Finance (“SHCP”) shall apply these compensatory mecha-  nisms, but there is no definition about the applicable methodology, nor the resources to  request for its application. This lack of definition reinforces the contracts’ instability of the fiscal  regime leaving contractors exposed to higher risks. Even further, there is no certainty about the willing-  ness of the SHCP to establish said mechanisms. In case of SHCP’s reluctancy or establishing of an  inadequate mechanism, contractors will have to go through an arbitration process.




Economic balance example

1 A project obtains a net profit of 1.4 dollars per  barrel of oil equivalent (usd/boe) with the tax  regime in force.


2 Due to an increase in taxes, the same project  is affected resulting in net profits of -1.2  usd/boe.


3 SHCP should apply adjustments equivalent  to 2.6 usd/boe to restore the original  economic balance (net profits of 1.4 usd/boe)  via adjustments to the additional royalty or  cost recovery.




In Talanza we provide services of  advance modelling for financial  evaluation in the Mexican fiscal  regime, developed by former officials  in charge of the definition and  evaluation of contracts’ fiscal  behavior. This has benefitted our  clients’ cashflow-related decision  making processes.