Repsol Cuts Back at Mexico Gas Field, Contracts Disappoint

MEXICO CITY Oct. 9, 2007 (Dow Jones Newswires)

In 2003, Repsol YPF (REP) began tapping Mexican natural gas under a contract many viewed as a launching pad for future oil and gas plays in Mexico's tightly held energy industry.

But after four years of rising costs, difficult politics, and lousy contract terms, Repsol is cutting back at the Reynosa-Monterrey block, say industry insiders.

Repsol's woes underscore how Mexico's efforts to farm out natural gas production have fallen short of expectations. The contract problems also come amid a growing natural gas import bill.

By 2015, the Energy Ministry expects imports to reach 2.5 billion cubic feet a day, up from an estimated 1 billion cubic feet a day this year. The rise comes as U.S. natural gas output is expected to stabilize or decline, putting additional pressure on prices in the North American gas market.

This means cash-strapped state company Petroleos Mexicanos must continue ramping up its own output to meet growing domestic electricity demand, or import more gas.

It appears Pemex, as the company is known, will have to do both. Total gas demand is expected to increase 4% annually over the next 10 years, while domestic supply is forecast to rise just 3% a year in the period.

Mexican gas output has risen 39% since 2003 to a record of 6.2 billion cubic feet in July, but is expected to peak at around 7 billion in 2011.

The so-called multiple-service contracts like Repsol's have only accounted for a fraction of the increase in recent years.

One oil service executive said Repsol has cut its drilling fleet at Reynosa to one rig, down from four as recently as two months ago. Another executive at a foreign oil services firm said Repsol's drilling operations haven't produced expected returns, and the company is simply producing from existing wells to reduce costs.

"Most companies are doing that anyway, it is inherent to the way those contracts are set up," said John Padilla, an analyst at energy consultancy IPD.

A Repsol official in Mexico City said the company wouldn't comment on its operations.

A strong tradition of resource nationalism prevents Mexico from opening its oil and gas industry to outside capital. The country's constitution bans oil and gas concessions, and only state-run Pemex can book Mexico's reserves.

Given these restrictions, Pemex in 2003 set up natural gas multiple service contracts by which Pemex pays companies like Repsol fixed fees to find and produce gas, but doesn't share profits.

Regardless, the 15-year to 20-year contracts have come under a series of lawsuits as unconstitutional.

The multiple service contracts put international oil firms, which are accustomed to risk-reward contracts through which they buy exploration tracts and keep most of the profits, in the role of oil service companies. Unlike oil companies, oil service firms provide technology and expertise but don't buy reserves or sell oil.

The service contracts also penalize operators for drilling dry wells.

"You have reserve risk with a service contract," said Occidental Petroleum (OXY) Senior Vice-President Stephen Weiman. He said Occidental looked at the contracts back in 2003, but decided not to participate.

Large and mid-sized firms including Brazil's Petrobras (PBR), Japan's Teikoku and Argentina's Tecpetrol bought multiple service contracts in 2003, hoping to gain a foothold if the industry opened up to private capital.

This hasn't happened. Efforts by the previous Vicente Fox administration to allow broader private involvement in the sector went nowhere in Congress. President Felipe Calderon has no current plans to open the industry.

Meantime, the natural gas contracts have become even less profitable.

The contracts peg cost increases to U.S. inflation, which fails to take into account faster inflation in the oil industry. Steel prices, rig rental rates, and other oil services costs have posted double-digit gains in recent years.

Furthermore, analysts say the areas have less gas than expected.

"Bad contracts with bad blocks. That's not a good combination," said Roger Tissot, an analyst with PFC Energy, an energy consultancy. "This is not how they are going to solve their gas problem."

The impact of the unfavorable terms emerged in 2004, when industry leaders like Repsol and Petrobras passed over the second round of contracts. That year, only two new blocks were awarded to consortiums of small Mexican and other Latin American companies.

A similar offer this March only attracted niche players, including Spain's Cobra and Mexico's Monclova Pirineos Gas.

These private contracts only account for a fraction of Mexican gas output.

In March, Pemex said production from the first seven multiple service contracts was around 160 million cubic feet a day. The seven contracts only produce 12% of the total output in the Burgos basin where they are located.

Pemex expects these contracts to have an average output of 600 million cubic feet a day from 2008 through 2014, according to a company presentation. If production continues to fall short of expectations it will put pressure on Mexico to import more gas in what is becoming a seller's market.

Pemex already imports 40% of its gasoline supplies due to a limited domestic refining network. The increased natural gas imports will add an additional financial burden on the state-run firm. Pemex currently imports around a third of Mexico's total gas imports.

IPD's Padilla doesn't see Mexico attracting any more large firms unless the country alters the contract terms to a risk-reward structure, where operators take part in profits and book gas reserves.

Mexicans still view the 1938 oil nationalization as one of the country's main successes in confronting U.S. and European interests, making it difficult to unwind the state's monopoly on resource ownership.

"You'll likely only see more local companies looking to participate in order to gain experience in the sector," Padilla said.

Copyright (c) 2007 Dow Jones & Company, Inc.