Mexico: On Reporting Oil & Gas Reserves: A Turning Point In The Upstream Sector

"Eminent Domain" and the Constitution

In keeping with Post-classical Roman law, all Mexican constitutions —from the Constitution of Cadiz and the Constitution of Apatzingán— have based their system of land ownership on the principle of Eminent Domain. According to this principle, private owners own the surface of their property, while everything above and below it is property of the State.

Historically, the industry has not suffered serious complications from such a limitation: the air above someone's property is normally a pure public good ("non-rivalrous", as economists would say): a good that is available to all and whose use, even intensive use, by one individual does not challenge its use by others, which discourages any motivation to profit from oxygen.[1] And with regard to the subsoil, the principle of Eminent Domain does not prohibit developers from burying the foundations of their buildings as deep as necessary. This explains why land ownership as a two-dimensional real right, of area, not volume, has not meant greater disarray for the industry in general.

Except when it involves mining and hydrocarbons.

And except in the terrible days of the Mexican Oil Expropriation of 1938, when Article 27 of the Constitution pointed out that "[i]n the Nation is vested the direct ownership of substances, which in veins, layers, masses or ore pockets, form deposits [...] such as [...] petroleum and all solid, liquid, and gaseous hydrocarbons [...]"; and that "[i]n the case of petroleum, and solid, liquid, or gaseous hydrocarbons, underground, ownership by the Nation is inalienable and imprescriptible [...]."

Opening up of the sector: Cárdenas revisited

Thus, after more than sixty years of a state energy monopoly and a slow process of deregulation (thirty years), a path was opened to energy reform (the "Reform").

The old Cardenist energy model was no longer compatible with the prevailing reality. Private oil companies existed alongside national oil companies (the NOCs) in a state of mutual benefit. These had endeavored for years to adopt best practices to maximize oil revenue, while Pemex patiently awaited a corporate update.

It was as imperative to modernize Pemex as it was to open up the sector.

And Pemex did modernize. It metamorphosed, at least on paper, into a "Productive Company of the State", keeping pace with best corporate practices, but without ceasing to be 100% Mexican and public.

All that was left was to open up the sector: increase private investment and jobs, putting Mexico back on the map of oil-producing countries, not only in terms of reserves, but also production.

For this reason the Reform eliminated from Article 27 of the Constitution, the (historical and evocative) restriction against agreements for the exploration and extraction of hydrocarbons ("Upstream"), moving its regulation to secondary legislation and emphasizing almost paranoiacally the irreducibility of the Nation's ownership (Eminent Domain) of hydrocarbons that lie in the subsoil.

The secondary regulation, the Hydrocarbons Law ("HL"), provides a contractual numerus clausus comprising shared Services, Revenue and Production agreements, as well as the ill-named "License", which in Mexican Law is a unilateral act of authorization to do something (the "Agreements").

But it is less concerning that the Agreements are binding (whether they compel adherence or not, either to their form or clauses, leaving little room for negotiation) than that they should stipulate the feared Administrative Termination ("AT"), the stuff of nightmares of even the bravest of investors.

Investments and risk

The risks inherent to the obligations of an Agreement can be overwhelming. Actuaries and analysts pore over matrices that could leave even the most enthusiastic of entrepreneurs faint-hearted.

In addition, there is the contractual "exit door", whose key is held by the government counterparty: the AT, which the HL requires to stipulate as grounds for termination.

Grosso modo, an AT entitles the State to terminate an Agreement early for causes other than a breach by the counterparty (according to the requirements of Pactum Commissorium, tacit in all agreements that contain reciprocal obligations, such as Upstream agreements), but for the sake of the public good, which often does not coincide with the good of the terminated individual.

Over the potentially ruinous contingency of an AT loom other hardships, also contained in the HL and its regulations: the terminated contractor must transfer to the State, at no cost, the area and volume, as well as where such performed or attempted to perform the Upstream, settle all other obligations, and compensate for any damages or losses in the terms of applicable legal provisions.

Operational risks, the threat of an AT, geopolitical factors and external economic factors... All contribute to the difficulty in securing the financing needed for large-scale projects, such as those the opening up of the sector requires.

Fictio Legis—another Roman solution

Legal fiction is the legal technique of Roman origin, through which something that is untrue is assumed to be true to substantiate a law that conforms to a legal reality.

Legal entities and the rights of the unborn are legal fictions, as are currency and credit cards.

To bank an Agreement, investors must secure the necessary financing. And for that, ownership of the hydrocarbons effectively extracted is instrumental.

But on the other hand, the Constitution stresses that the hydrocarbons that lie in the subsoil belong to the Nation.  Contractors only make them theirs "at the wellhead": as soon as they are taken out.

The necessary legal fiction would consist of considering the reserves, that is, the volume of hydrocarbons that remain trapped in the oilfields of the contractual area, as already appropriated by the contractor, and report them as an asset with which to guarantee a loan, bank an Agreement, as well as make its financial information transparent and more attractive for possible co-investment.

And so the Law provides, having heard the voices of the sector that expressed the impossibility of launching an Upstream venture without the necessary financial leverage.

Accounting entries for reserves

Fortunately, echoing the outcry by potential investors, Article 45 of the HL provides that contractors shall be entitled to report the Agreement, as well as its expected returns, for accounting and financial purposes, provided that the Agreement affirms that the hydrocarbons in the subsoil are property of the State.

Separately, Article Two, section X, of the Hydrocarbons Revenue Law (Ley de Ingresos sobre Hidrocarburos) states that for reporting purposes, the National Banking and Securities Commission (Comisión Nacional Bancaria y de Valores, CNBV) will eventually make the appropriate adjustments to the applicable legislation, undoubtedly referring to the pre-existing legislation regarding the sample agreements issued by the National Hydrocarbons Commission (Comisión Nacional de Hidrocarburos).

But what is recommended at this time is to report expected returns in accordance with: (i)the U.S. Securities Exchange Commission's Oil and Gas Rules in Regulation S-X and Regulation S-K under the Securities Act of 1933 and the Securities Exchange Act of 1934, as well as the (ii) U.S. Securities Exchange Commission's Industry Guide 2, and according to the terms of the (iii) International Financial Reporting Standards.

In this way, one can be sure to comply with the requirements that the CNBV will eventually put into place, and it will be possible to obtain cross-border financing.

[1] More seasoned readers will recognize that there is also air space over a land area, and especially the valuable radio spectrum, whose scarcity is determined by technological advancement that expands Hertzian limits engaged by telecommunications. However, air space and the radio spectrum are two topics that fall out of the scope of this study which focuses on tangible real estate property.

The views and opinions expressed in this article are those of the author and do not necessarily reflect the official opinion or position or institutional view of Rodríguez Dávalos Abogados.

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