The Changing Role of O&G on Public Finances

The Fiscal Reform implemented by the Peña Nieto administration, including the mechanisms set in place to manage the income generated by the hydrocarbons industry, provide the Mexican government with flexibility to deal with any oil-price surprises that might arise, Salvador Ugalde, Director of the Income Unit of Hydrocarbons at the Ministry of Finance, told the 2017 Mexico Oil & Gas Summit on Tuesday at the Mexico City Hotel Sheraton María Isabel.

“From a governmental perspective, one of the most important advantages of the system is the flexibility of its mechanisms. This means the state can obtain a larger income from the generated hydrocarbons production when market prices increase,” said Ugalde in his keynote speech on the changing role of the oil and gas industry on public finances.

The referenced flexibility is provided by the model of incremental royalties imbedded in contracts. “Although it might seem very harsh to set an incremental model, it shields both the government and the companies from having to renegotiate the contracts in light of new discoveries or an increase in international prices,” said Ugalde. The renegotiation of contracts is a fairly common practice in countries such as Brazil, Africa or the Middle East. Ugalde told the summit that Mexico’s government wanted to avoid the practice by imposing the ex-ante conditions.

“In economic terms, flexibility is provided by the tax rate, which is the result of a competitive process, wherein free competition allows the government to award contracts to companies that offer the biggest contribution to the Mexican state in terms of income and investment commitment,” said Ugalde. “Free competition has led us to contractual fiscal mechanisms that allow the government to access over 75 percent of the hydrocarbons generated by the projects.” However, for this mechanism to function, Ugalde noted that contracts must offer an appropriate balance between risk and return. “We have to find ways to continue capturing resources in a manner that does not discourage private investment,” he said.

Ugalde suggested that the most important success of the 2013 Fiscal Reform is that it allowed the Mexican government to amortize the drop in oil prices. “In 2008, oil income represented around 6 percent of Mexican GDP. Today, it only represents around 2 percent.”

According to Ugalde, the participation of third parties will allow the country to reverse its downward production trend while diversifying investment risks and allowing for a better management of hydrocarbon-generated income. “Back in the 1970s, the country did not have any rules for managing oil-generated income. The creation of the Mexican Petroleum Fund now provides a framework on how to manage those resources.”

The Mexican Petroleum Fund was established in 2014 to manage Mexico’s hydrocarbons income. “If hydrocarbons income is above 4.7 percent of GDP, it will be stored and invested in sectorial improvement proportional to the amount,” Ugalde said. “Once the fund generates savings above 3 percent of the country’s GDP, the resources will be used to generate more human capital, infrastructure, pension funds or scholarships. Savings above 10 percent of the country’s GDP can be transferred directly to the Federation Expenditure Budget.”

In addition to the advantages, Ugalde said that one of the most important aspects of this new system is its transparency. “The Mexican Petroleum Fund has the responsibility of making all its investments public. This, combined with transparency of the bidding processes, will allow Mexico to take part in the global dynamic of accountability,” he said.