KBR: Foreign Investors May Balk at Pemex's Sovereign Status

KBR: Foreign Investors May Balk at Pemex's Sovereign Status

During the past decade, Petroleos Mexicanos (Pemex) has grappled with steady declines in its oil and gas proved reserves as well as production rates of these hydrocarbons. Moreover, Pemex's refining capacity has remained flat since 2007 and the national oil company has had to increasingly import fuels to satisfy local demand.

Pemex lacks the capital and technical expertise to reverse such trends, in part because the Mexican constitution bars foreign investors from owning the country's hydrocarbon resources, according to a U.S. Department of Energy Energy Information Administration analysis of Mexico's energy sector. Recognizing that outside money, skills and technology would help to reinvigorate Pemex, Mexican government officials are weighing various energy reform proposals that could allow foreign investment in the country's oil and gas sector.

To be sure, non-Mexican companies currently provide technology and services to Pemex. However, the state-owned firm retains all ownership of natural resources and physical facilities. Although the scale and scope of Mexico's energy reform effort remain uncertain at this writing, allowing foreign ownership would give investors from the United States, Canada and elsewhere the opportunity to buy into a market that has been off-limits for three-quarters of a century.

Gaining an ownership stake in the Mexican oil and gas sector could be a rewarding growth opportunity for foreign firms. Under a more receptive energy policy, outside investors could provide the money and expertise necessary to exploit deepwater fields and onshore shale plays as well as modernize refining and pipeline infrastructure. When contemplating a possible move into Mexico, however, foreign companies should familiarize themselves with a little-known provision in Mexican law that could wreak havoc on their risk tolerance, according to a top attorney with Houston-based service company KBR, which has done work for Pemex for several decades.

Pemex is treated as a "sovereign" under Mexican law, meaning that it enjoys rights that are unheard of for most companies – such as having the right to set aside contractual obligations, explained Mark Lowes, KBR's vice president of litigation. In fact, even Pemex – the source of roughly one-third of the Mexican government’s total revenues – was only granted this privileged legal status within the past decade. 

Prospective foreign investors "need to be aware of this law," said Lowes. "It is a risk that I don't think most people are aware of, it's outside the norm, and I think you need to go in with your eyes open, making certain that you're aware of this potential problem."

The national oil company’s (NOC) sovereign status has resulted in a drawn-out legal battle between KBR and Pemex subsidiary Pemex Exploration and Production (PEP). The lawsuit hinges on KBR's attempts to collect unpaid engineering service fees under a contract for an offshore facility project that PEP awarded KBR's Mexican subsidiary COMMISA in 1997.

COMMISA filed suit against PEP in March 2004 after the client took possession of the still-uncompleted project but did not pay for the services rendered, according to KBR. Both parties accused each other of breach of contract, and PEP informed COMMISA that it would simply rescind the contract. Efforts to amicably resolve the matter ultimately failed in December of that year. KBR would eventually win a judgment against PEP in arbitration, but the Mexican court system upheld PEP's assertions that the International Chamber of Commerce (ICC) arbitration panel lacked jurisdiction and that COMMISA waived its right to arbitration by seeking to resolve the dispute in the courts. In 2009, ICC arbitrators found that PEP owed COMMISA approximately $323 million in damages; the Mexican courts subsequently nullified the judgment. KBR scored another legal victory in August of this year when a U.S. federal judge in New York ruled in the service company's favor; the following month, the court ordered PEP to pay COMMISA slightly more than $465 million, which includes damages plus interest. (For more background on the legal dispute, read Note 6 to KBR's June 30 Form 10-Q filing with the U.S. Securities and Exchange Commission.)

Because international companies doing business with Pemex could find contracts and agreements to arbitrate potentially unenforceable, the NOC's sovereign legal status could impact Mexico's plan to seek foreign investment in its oil and gas industry, Lowes said.

In a recent interview with Rigzone, Lowes elaborated on the sovereignty issue and its implications for Mexican energy reform. A transcript of the conversation follows.

Rigzone: In terms of enforcing contracts, how is doing business in Mexico different from, say, the United States, Canada or Europe?

Lowes: I think it depends on the timing. Up until issues that we've encountered in last 4-5 years, our treaties in Mexico and Mexican law recognized arbitration, they enforced arbitration awards. Since then – beginning in 2008 or 2009 – there's been a change in the law and a change in attitude.

In 2003 or 2004, at the basis of our current dispute, I think most would've told you that Mexican courts recognized arbitration. Now, Pemex is treated as "sovereign." What it means is it's different from a regular company. Sovereigns have rights that the rest of us don't.

What's basically happened, in the simplest terms, is they've allowed Pemex to say, "COMMISA, we've rescinded your contracts and all your contractual rights are gone and under the new law." If they do that, you have 45 days to file a claim for what you think you're owed in a very limited jurisdiction  court. The reality is, on a complex deal, you couldn't get the paperwork together to file a claim in 45 days if you wanted to. So it really creates a risk that I think most corporations thinking about doing business in Mexico are not aware of.

Rigzone: What are some examples of the preferential rights for a sovereign such as Pemex?

Lowes: You can't sue the United States Government unless they waive what's known as sovereign immunity. So if I enter into a commercial contract with the government they in essence are waiving their sovereign immunity and I can file a claim – there's a fairly complicated process but the system works.

Look at the tort side of things. If I want to sue the federal government for whatever reason – their driver runs me down, or I'm libeled or slandered, or whatever it is – there's a statute called the Federal Tort Claims Act. There is a process under which you can file and pursue a claim against the government.

What normally happens in commercial transactions, particularly if you're outside the United States, is you negotiate to have whatever disputes you have resolved in international arbitration. The reason you do that is, you don't want to be "hometowned." You want to have an independent body deciding the questions of law and fact so that your dispute can be resolved. 

What happened to us in Mexico, and so far we've been successful in getting the court in New York to agree with us that it was improper and unjust, was they took those rights away from us after 6 years of arbitration and 4 weeks of hearings and Pemex and PEP wanted to say, "no, we want to set this aside, we don't want to be bound by the award." That is a risk adjustment that most companies don't take into account and, frankly, I don't know how you would prepare for that.

I think KBR is like most companies. When you enter into a deal, you have different buckets of risk. For example, one can be a currency risk – how do I hedge the currency so that I'm not impacted? In our business, one of the risks is how do I make certain I have the raw materials, the steel, the engineers, whatever is needed to build it, and we have processes in place to identify that risk and to mitigate it. One of the risks in these buckets is a political risk and one of the ways you try to mitigate that is by agreeing to international arbitration. When Mexico declares that they can cancel this at their own behest without any consequence and with no remedy, that pretty much upsets your risk analysis.

Rigzone: Mexico is weighing various energy reform measures that could allow foreign direct investment into the country's oil and gas industry. From your perspective, what should that reform include to provide a more level playing field for outside companies?

Lowes: First, I think it is absolutely in the U.S. interest, in U.S. corporations' interest, to have a stable and prosperous Mexican government and economy. We are joined in so many ways. Their success will be to our benefit. I think that anyone who's done business with Mexico will tell you the same thing.

In order for businesses to want to invest in Mexico, people need to have predictable results that they can fit into their risk equation. Otherwise, how do you justify making an investment if you don't know if you're going to get the return based on your reasonable expectations? One of the things I think the United States does well, and one of the reasons people are comfortable investing in the United States is our legal system is pretty consistent – not always accurate – in enforcing and recognizing your rights, whether you're a U.S. company or Mexican or Swedish or English, and that sense that you're treated fairly and equitably makes it easier to do business.

A fundamental change that has to happen is the rule of law needs to apply whether you're the sovereign or not. In the United States, what would happen is – and we do work for the U.S. government as well – if the U.S. government wanted to terminate a contract, for whatever reason, they – like the Mexican government – would have a right to rescind it. [But] our rights and processes that had been negotiated to determine damages would not be rescinded as well.

What the law in Mexico has done is go a step further and say not only are we terminating your contract, but we're terminating all the contractual rights as to how damages and the right to compensation are going to be determined. So … in Mexico, if I were advising another client, you need to go back to the system where your rights that you've negotiated for the contract for dispute resolution will be recognized and enforced.

Frankly, up until this recent history, Mexico had been very consistent in recognizing and enforcing these rights and I don't know what accounts for the change.

Rigzone: Are there any other major considerations for foreign companies considering entering the Mexican market that they should keep in mind?

Lowes: I think there are considerations that would apply not just to Mexico, but you always have import and export concerns with technology. I don't think most individuals appreciate how complicated that area can be. You're seeing increased [U.S.] Department of Justice enforcement on Foreign Corrupt Practices Act investigations. All of those areas where, if you're going to do business in any foreign country, you need to have the policies and procedures in place to mitigate risk and exposure for your client.

(EDITOR'S NOTE: Pemex did not respond to Rigzone's request for a response to this article.)



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