Since mid-2001 there has been talk in Mexico and abroad about a new upstream philosophy in Mexico. One reason: natural gas imports in particular have grown dramatically in the last year. In June alone, gas imports were 138% ahead of June 2001. This gives more impetus to the growing perception that something must change in Mexican energy policy toward foreign oil companies' involvement. Pemex leader Raúl Muñoz expects to issue tenders later this year for multiple service contracts to increase Mexican gas output by 1 billion cubic feet per day within two years. At a special breakfast briefing in Mexico City in December, there was a preliminary unveiling of the new ideas for multiple service contracts to an audience of some 600 representatives of industry, academia, Congress and media. Some 400 industry representatives attended a second conference in June. What is new and what is old in these ideas? First, some background. In 1917, the Mexican Constitutional Convention declared in Article 27 of the new constitution that subsoil resources belong to the state--at a time when Mexico was the world's second-largest oil exporter after the U.S. In response, U.S. and British oil companies operating in Mexico made a huge miscalculation: they reasoned that, because they had bought their oil rights as a function of surface titles, they could safely reject an offer by Mexican authorities to exchange those titles for 50-year concessions. They feared that if Mexico were to entertain such an idea, then all oil-exporting countries would do so. No one foresaw that, in the next 40 years, all oil countries would take essentially the same view of national resources as Mexico. No one foresaw that oil companies could carry on their business independent of who had legal title to the hydrocarbon resources. In 1938 Mexico nationalized the oil industry-a subject of libraries of political and historical analyses. In the aftermath of World War II, the U.S. government, focused on European reconstruction, wanted the Americas to be self-sufficient in oil production. Negotiations with Mexico were held to increase Mexican output through special contracts signed in 1949-50 with about a dozen American oil companies. The companies would be granted a type of concession, reimbursed for their expenses and have limited participation in new production under a very favorable tax treatment. In 1958 Mexico's Congress-alarmed that government oil policy was reversing course-passed an act that was to implement the terms of Article 27 of the Constitution. The new law was to limit the ability of Pemex to contract with international oil companies. Article 6 authorized Pemex to contract with whomever it pleased toward the betterment of its operations, provided that payment would not include transfer of title to resources, payment in kind or payment as a function of production. The padlocks, as the terms of Article 6 would be thought of later, were meant to take Mexico off the map of countries in which the standard business model of the upstream oil industry could be meaningfully applied. From 1970, when the last of the contracts from 1950 were bought out, to 2001, the padlocks of the Petroleum Act of 1958 worked perfectly. Not even during the period of great expectations of the early 1990s, when Nafta (the North American Free Trade Agreement) was being negotiated, did Mexican policy change course--or so it seemed at the time. The 1990s In 1992 Mexico's Congress approved a change to the Constitution that authorized the private generation of electric power: independent power producers (IPPs) would be able to build generation plants whose output over 20 or 30 years would be sold to the state-owned power utility (CFE) at a fixed price awarded as a result of an international tender. The IPPs would not, however, have the ability to sell power directly to end-users. In the first decade of the IPP program, some 5,000 megawatts of capacity were installed, with more tenders scheduled. In the summer of 1993 a draft policy document was leaked to the Mexican press that clearly showed the government's intention to allow private investment in gas pipelines. In November 1995 the energy ministry hosted a briefing of some 400 representatives of industry and banking, outlining its new policy of allowing private investments in gas distribution and transportation. Simultaneously, the government created a federal energy regulatory commission (CRE) with the mission of overseeing permits and tenders in downstream and midstream gas. Unfortunately, Pemex was not fully consulted in the gas-policy change, and as a result, implementation of the new competitive gas market was limited to licensing franchises for local gas distribution in some 20 cities. During 1993-95 a consortium of international oil companies created a proposal to develop the Burgos Basin. The consortium would prepare a master development plan, use its own resources to implement it and wait for reimbursement of costs (plus interest) and profits from successful production. This idea was received well at the energy ministry, but was opposed by traditionalists. What could be foreseen in 1996 was that Mexican energy policy was moving toward finding spaces for private contractors and investors in exploration and production. Service contracts or alliances with companies such as Schlumberger and Precision Drilling are already in force. Such service companies have drilled hundreds of wells so far in the Burgos Basin in an alliance project. (They are also the ones that may expect to receive the bulk of subcontracting work from winners of multiple service contracts.) Fox's upstream thinking The new ideas for upstream contracting draw on the Mexican government's prior experience with IPPs, plus the vision put forward by the Canadian-U.S. consortium for the Burgos Basin. The new idea was to turn Article 6 of the Petroleum Act of 1958 on its head: find a way to motivate contractors, principally oil companies, to invest in gas production infrastructure and make payment contingent on successful production, without making compensation itself a direct function of new volumes or revenues. There is an imperfect analogy with the IPPs: the IPP developer invests his resources in a power plant, but is paid over 20 years as a function of the units of power delivered to the CFE at a fixed price. Payment is guaranteed by public debt (albeit in an off-balance-sheet format). In the approach advocated by the Fox administration, the upstream contractor invests his resources in an approved development plan for a tendered block (i.e. work area) in the Burgos Basin and is subsequently reimbursed for his direct costs, indirect costs and associated cost of capital. In addition, he is paid a percentage of the sum of his costs, representing profit. In the Fox approach there would be no public debt, as all invoices by contractors would be liquidated on a monthly basis, provided that revenues from the sale of the contractor's incremental production were sufficient to cover costs and the negotiated profit margin. Criticism is centered in the Mexican Senate, which is worried about the consequences of the new approach to oilfield contracting. Specific criticism concerns three principal points: Producer claim on gas revenues. Banks that lend money to Pemex for offshore projects have a type of lien on oil-export revenues, in the sense that a portion of the revenues are required to be set aside for repayment of principal and interest. In the present case, the upstream contractor would have a claim on a portion of production revenues corresponding to his reimbursable expenses, plus profit. The difference between the banker and the contractor is that the latter is the producer as well as the supplier-lender. Some critics argue that this difference makes the contractor a direct beneficiary of hydrocarbon production, a principle disallowed by the Constitution. State exclusivity. Articles 25 and 28 say that the state exclusively has responsibility for the planning, execution and management of strategic areas, including oil and gas. One of the benefits Pemex would receive from the Fox approach is that the administration of hundreds of second-level contracts would be consolidated under a single general contractor, but it is just this benefit that some critics say violates the exclusivity requirement of the law. Concession. In August 2001, Pemex's Alfredo Guzmán spoke in Houston about eight to 10 blocks that would be tendered in the Burgos Basin. Later, the concept of block was changed to "work area." Critics point to Article 27 that forbids concessions. Additionally, Article 15 of the Regulations of 1959 of the Oil Law of 1958 says Pemex may not cede or transfer its rights to lots or land in which it has received permits to explore and develop hydrocarbons. Critics ask how Pemex will legally award a contract associated with the exploration and production of gas in a specific geographical area without violating legal and constitutional precepts. Concerns by prospective contractors (oil companies) are focused in several areas: • Legal rights in work area. Will Pemex be able to assure the contractor the exclusive right to develop commercial gas discoveries in its awarded work area? • Form of payment. Except for companies such as TotalFinaElf, which have operations where analogous production contracts are in force (e.g. Iran and Venezuela), few companies have any experience with contracts in which compensation is not linked to production. • Gas-price risk. Companies are concerned that they, not Pemex, are taking the gas-price risk. Should prices fall below a certain level, contractor invoices would go unpaid until sufficient production and revenues were generated (unpaid amounts also earn interest). On the other hand, should prices rise, there is no upside for the contractor. • Country risk. The very existence of a debate about the legality of the new contractual framework is itself a risk factor. No contractor will want to invest time and money under a contract that subsequently might be declared invalid. Since 1992 the policy of the Mexican government has been to find new spaces in law and policy for private investment in energy-sector infrastructure. The new proposals from Pemex about private investment in gas infrastructure are consistent with this vision. The Mexican Constitution requires that the state be exclusively responsible for the development of Mexico's hydrocarbon resources. The Fox administration is proposing a method by which Pemex is the exclusive beneficiary of both the volumes and the revenue of the additional gas production generated by contractors. If the program is successful, the concept may be applied in the future not only to oil fields but other activities such as oil refining. Nevertheless, the long tradition of excluding oil companies from operating in Mexican fields will itself generate extra-legal and extra-constitutional objections to the new approach. The ultimate interest of international companies in participating in the new upstream contracts will be a function of the country strategy, the final contract terms, the unit price for reimbursable activities, and country-risk perception, which will largely be determined by the success of the Fox administration in negotiating with political and policy adversaries.