Accounting of the reserves exploration and extraction contracts

Accounting of the reserves exploration and extraction contracts

Accounting of the reserves exploration and extraction contracts In December 2013, the Mexican government amended its Constitution, effectively opening the oil and gas energy market (other than gas transmission and nuclear power) to private foreign and local investors for the first time since 1938. Secondary laws were recently presented to Congress, which may amend the initiatives on those secondary laws. The analysis, discussion, and approval process is expected to finalize by June. While subsoil hydrocarbons will remain property of the Mexican State, the initiatives confirm the possibility of private companies participating in exploration and extraction (as such activities are defined therein) by means of four mechanisms: Licenses, Profit Sharing Agreements, Production Sharing Agreements and Service Contracts. Further, the proposed laws indicate that private companies will be able to report the contracts, for financial and accounting purposes, as well as their expected benefits. The purpose of this document is to discuss the potential accounting impacts on these particular aspects of the proposals. Remuneration of contractor Licenses Profit Sharing Production Sharing Sales Price of hydrocarbons once extracted from the subsoil In cash: i. Recovery of costs, expenses and investments. ii. Operational profit after remuneration of government In kind: i. Recovery of costs, expenses and investments ii. Operational profit after remuneration of government Service In cash for production delivered Marketing of hydrocarbons Remuneration of government Contractor markets the hydrocarbons Contractor delivers all the hydrocarbons to the State s designated marketing Contractor markets its share of the hydrocarbons; the remainder is delivered to the State s designated marketing Licenses entity Profit Sharing Production entity. Sharing Service All of contractual production Signing bonus Exploratory phase fee Royalties Additional compensation The amount is defined prior to the bidding process and will be paid in cash by the contractor. The amount is not expected to be significant and is meant to promote the formality of the bids. Serves as an incentive to the contractor to expedite exploration of the area. Amounts to MXP $2,650 during the first 60 months and to MXP $4,250, thereafter, per square kilometer Payment equivalent to a percentage of the net value of the production. Royalty rate on Oil: [(0.125 x AUSP) 2.5]% with a 5% floor. Associated Natural Gas: 1% Natural gas: Between 0% to 1% depending on market price per BTU Percentage of: i. Operating profit (see below), or ii. Contractual value of hydrocarbons Percentage of operating profit (see below) Percentage of operating profit (see below) 2

Determination of operating profit Licenses Profit Sharing Production Sharing Service Contractual value of hydrocarbons (the mechanisms for determination are to be included in each contract and is meant to be by reference to market prices) Less: Royalties Costs and expenses Depreciation of investments as established by the Income Tax Law authorities Royalties Costs, expenses and depreciation of investments as will be established by the taxing authorities Royalties Costs, expenses and depreciation of investments as will be established by the taxing authorities Depreciation rates: Exploration 100% Development 25% Infrastructure 10% Non deductible items are noted 10 year period for loss carryfowards Mechanics for adjustments for extraordinary gains might be included in each contract Recovery of costs is capped with carryforwards of excess amounts Non deductible items are noted Mechanics for adjustments for extraordinary gains to be included in each contract Recovery of costs is capped with carryforwards of excess amounts Non deductible items are noted Mechanics for adjustments for extraordinary gains to be included in each contract 3

Accounting for contracts under IFRS or MFRS Licenses, Profit and Production Sharing Agreements It is worth noting that analyses will have to be based on finalized laws. Also, the economics of each particular contract as well as other technical aspects will be established on a contract by contract basis. Therefore, we present a general framework of analysis but each contract has to be assessed based on the specific facts and circumstances. Also, lack of specific guidance could result in diversity in practice. Entities will first have to determine whether a contract falls within any existing IFRS or MFRS. In particular, entities will need to determine whether the contract meets the definition of a joint arrangement. Other IFRS or MFRS should be analyzed, although we believe it is unlikely that a contract will fall within their scope, for instance, standards addressing whether a contract conveys the right to use assets in return for a (series of) payment(s) or whether it is a concession arrangement for the supply of public services. If no specific IFRS or MFRS applies entities will be required use their judgment to develop an accounting policy based on the substance of the transaction. With respect to exploration and evaluation expenditures, a contractor should develop an accounting policy which specifies the types of expenditures that it recognizes as exploration and evaluation assets. The policy should be applied consistently, but additional flexibility around the rules to establish an accounting policy is provided for this matter. The determination as to what qualifies as eligible expenditure should be based on an assessment of how closely associated the expenditure is with finding specific mineral resources. In practice, the successful efforts or full cost

methods might be applied with certain limitations. For License-type contracts, the contractor will generally recognize the proceeds from the sale of the hydrocarbons as revenue. The additional payments based on operating profit will have to be assessed to determine whether they are considered to be income taxes from an accounting stand point; in which case, they would be presented as part of the tax expense or income line items and deferred taxes would be calculated. For production or profit sharing arrangements, proceeds from the sale of oil for recovery of costs, expenses and investments to the contractor, cost oil are likely to be recorded as oil revenue and once costs are recovered, profit oil would be recognized as revenue for the share of production corresponding to the contractor. Reserves are not recorded as an asset in the statement of financial position (with some exceptions, for example, when they are acquired in a business combination). IFRS or MFRS do not specifically require the disclosure of reserves. However, a fair presentation of financial statements requires additional disclosures to those specifically addressed by the standards when they are necessary to understand the impact of particular transactions, as well as other events and conditions on the entity's financial position and financial performance. Accordingly, disclosure of reserves will generally be included in financial statements to comply with such fair presentation. Additionally, reserves might have other impacts in financial information, for instance, capitalized cost of properties with proved reserves are commonly amortized using the units of production method with reference to the reserves. It is likely that under most of the types of contracts proposed, the contractors will bear significant risks of exploration and evaluation and will disclose the reserves on their financial statements even though they are the property of the Mexican State. It is relevant that the proposed laws do not include legal restrictions to the disclosure of such reserves as is the case of certain other countries. This factor promotes investment as more transparent information is provided to the users of the financial information.

Service contracts As far as particular contracts are bid as pure services where the contractor does not bear significant risks of exploration and evaluation, it will not be deemed to be performing exploration and evaluation of mineral resources. Revenue is recognized by the contractor by reference to the stage of completion, when the outcome of a transaction involved the rendering of services can be estimated reliably. 6

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John England Vicepresidente Líder de Petróleo y Gas Deloitte LLP +1 713 982 2556 jengland@deloitte.com Arturo García Bello Socio Co Líder de la Industria de Energía y Recursos Naturales Deloitte México +52 (55) 50806000 argarciabello@deloittemx.com Jorge Castilla Socio Co Líder de la Industria de Energía y Recursos Naturales Deloitte México +52 (55) 50806000 jocastilla@deloittemx.com www.deloitte.com/mx Deloitte refers to one or more of Deloitte Touche Tohmatsu Limited, a UK private company limited by guarantee, and its network of member firms, each of which is a legally separate and independent entity. Please see www.deloitte.com/mx/aboutus for a detailed description of the legal structure of Deloitte Touche Tohmatsu Limited and its member firms. Deloitte provides audit, tax, consulting, and financial advisory services to public and private clients spanning multiple industries. With a globally connected network of member firms in more than 150 countries, Deloitte brings world-class capabilities and high-quality service to clients, delivering the insights they need to address their most complex business challenges. Deloitte has in the region of 200,000 professionals, all committed to becoming the standard of excellence. As used in this document, "Deloitte" means Galaz, Yamazaki, Ruiz Urquiza, S.C., which has the exclusive legal right to engage in, and limit its business to, providing auditing, tax consultancy, financial advisory, and other professional services in Mexico, under the name "Deloitte". This publication contains general information only, and none of Deloitte Touche Tohmatsu Limited, its member firms, or their related entities (collectively the Deloitte Network ) is, by means of this publication, rendering professional advice or services. Before making any decision or taking any action that may affect your finances or your business, you should consult a qualified professional adviser. No entity in the Deloitte Network shall be responsible for any loss whatsoever sustained by any person or entity who relies on this publication. 2014 Galaz, Yamazaki, Ruiz Urquiza, S.C.