Investments Versus Royalties in Round 1.4

Deepwater Round 1.4 attracted the attention of global Majors and the government felt the glare of the spotlight. Many praised the round for its transparency but one criticism was the focus on royalty rates over additional investment.

The Mexican oil and gas industry breathed a sigh of relief in December 2016 when CNH’s long-awaited deepwater round finally materialized and was hailed as a resounding success. A range of consortiums, including international and national operators, won the eight blocks out of nine that were awarded. But despite the success of the round, there are concerns regarding the prioritization of the government’s eventual take from the projects (in the form of royalty taxes) over the workplan investment offered by bidders.

With the industry’s downturn still hindering the number of projects available throughout the supply chain, questions abound over whether CNH should have ranked bidders’ promises to drill wells higher than royalties to push the industry into action sooner. Ernesto Marcos, President of AMESPAC and Founding Partner of Marcos y Asociados, praises the authorities’ openness to private sector input but says that “the only theme to be debated is the unbalance between the central elements of the bidding rounds, namely the government’s take and the investment amount promised by each bidder.”

CONTROVERSIAL CALCULATION

In Round 1.4, the economic proposal submitted by each bidder consisted of two components: minimum workload investment factor and additional royalty rate. The royalty rate was submitted as a percentage representing the eventual government take from the block’s revenue, while the investment factor could be one of three amounts: 1.5, 1 or 0 and was based on the number of wells the bidder promised to drill during the exploratory phase of the block

An investment factor bid of 1.5 indicated the promise of two wells during the exploratory period, 1 represented the equivalent of one well and 0 meant the bidder had not committed to investment for any exploratory wells. The 

two variables offered by the bidding participants were then calculated by CNH using a set equation to generate a number termed “weighted value of the economic proposal.” This final calculation was the deciding factor determining the winners of each block.

Nicolas Melissas, Director General of Athena Consulting and expert in the academic study of bidding terms in licensing rounds, believes the calculation was too complex and that a simpler method would be advantageous. “It would be better to fix the amount each firm must invest in a given block in advance and let the bidders compete on only one variable. This intensifies competition and benefits the Mexican state.”

However, criticism of the bidding terms centered on the weighting of the calculation rather than on its complexity. Due to the weighting of the variables in the equation used by CNH to calculate this decisive number, the royalty rates offered took precedence over the additional investment factor. The result was that in some cases a bidder beat another to win a block despite promising zero wells during the exploratory phase (a 0 workplan investment), simply because they bid a higher royalty rate.

ROYALTY RATE BEATS PROMISED WELLS

An example of this occurred in the auction of Contractual Area Four, which Petronas’s subsidiary PC Carigali and new Mexican operator Sierra won after beating a consortium formed of three oil Majors, Statoil, BP and Total. Despite not committing to any additional investments on the block, PC Carigali and Sierra’s proposed royalty rate was higher, leading them to beat competitors that had promised investment to drill two wells in the exploratory phase of the block. This is a clear example of how the  government take eclipsed promises of investment and activity on the block during Round 1.4.

SUPPLY CHAIN IN NEED

As Mexico’s oil and gas regulator and the counterpart to all the contracts involved in the licensing rounds, CNH is tasked with maintaining a fine balance between creating revenue for the federal government while simultaneously encouraging an open and competitive market. As PEMEX slashes its budget and subsequently reduces its activity, Ricardo Arce, CEO of Perforadora México, part of mining giant Grupo México, says that the government should favor investment commitment. “The role of the government is not necessarily to attract more money but to promote the development of a higher oil production environment,” he says.

CNH SHOWS TRUST

Although an increased emphasis on investment commitment would have given the supply chain more certainty that there is light at the end of the tunnel for the lack of projects many are facing, KPMG’s Advisory Partner and Head of Energy and Natural Resources Ruben Cruz highlights the government’s trust in Round 1.4’s companies. “The winning companies that have committed themselves to work in Mexico after Round 1.4 have good reputations and are not coming to Mexico to waste time but to seize real opportunities. CNH knows this,” he says. With the participation of some of the world’s oil heavyweights and projected investment totaling an eyewatering US$34.4 billion over the next 35 years, the stakes are high for companies to commence drilling and bring a return on investment quickly.

NATURE OF THE BLOCK

The balancing of royalty rates with investment quantity is a complex procedure with various factors to take into account and Carlos Morales, Director General of PetroBAL, points out that companies will bid differently depending on whether a round involves exploration or production only. Morales warns that companies participating in production rounds could be tempted to keep operations at their current levels rather than drilling additional wells, so rounds of this nature would need more focus on initial investment offerings. “The winners of production Round 1.3, for example, may be disinclined to drill exploratory wells if production on the blocks is already adequate, especially given the high royalty rates involved,” he says. Round 1.4, which offered blocks for both exploration and extraction, is less affected by this potential issue but the fact remains that the government should treat royalty rates and investment amounts on a case by case basis, studying the nature of the blocks themselves and basing calculations on that, Morales adds.