The draft guidelines (Anteproyecto) rightly seek to fill in a missing piece of the regulatory framework of the Energy Reform. There is no urgency in filling in this missing piece, although it would be fitting to have it completed during the present administration. In the U.S. Gulf of Mexico, of 100 leases, only 2-3 ever come to need unitization agreements. 1. The purpose of the Guidelines (as explained by SENER in its response in Section II of the COFEMER Formulario) is to disallow the so-called Rule of Capture in Mexico. This "rule" allows any operator to claim as its own any barrel of oil (or Mcf of natural gas) that is produced from its well, regardless of whether or not the barrel or Mcf may have been extracted from an adjacent well. BACKGROUND 2. A quick look at images of the Spindletop field in Texas in 1901 will illustrate the need for regulations that protect the lease-owner from predators from adjacent blocks by offs-set drillers. 3. It would be soon recognized that the oil company that made a discovery needed legal and regulatory protection from other companies what would drill wells that would drain its reservoir. 4. It would also be recognized that when a reservoir extended into the area of another lease-holder, the latter needed legal and regulatory protection against the risk that its share of production could be "captured" by a neighboring party.  5. Regulations would be issued that would require the "unitization" of the two leases; that is, the areas (acres or square kilometers) of Lease-holder A and Lease-holder B that corresponded to the extension of a reservoir would be established as a single, unified "Production Unit" that would have its own joint operating agreement, operator and division of working interest. 6. These agreements would be submitted to a regulator for approval or adjustment, as necessary. 7. In the case that there were no agreement at all as to unitization, the regulator would serve as a forum in which the party that believed its interests were being harmed by operations on an adjacent lease could petition for relief, asking that the regulator rule on the convenience of a unitized lease. 7. Were the parties unable to agree on an operating agreement or division of working interest, the regular could, in effect, force them to come to an agreement by ordering the suspension of all operations in the area of the reservoir. 8. The regulator might also intervene if there were a risk that the agreements governing operations and working interest were to put in jeopardy its rightful claims to royalty payments. We may consider the situation in which the distribution of hydrocarbons was 20/80 in between Leases A and B. All other things being equal, the distribution of working interest in the reservoir should be 20/80. The situation could occur, however, that the owner of Lease A has a tolerance of risk or available capital for only 10% of the estimated cost of exploration and development. In this situation, the operating agreement might provide for Lease-holder A to have only 10% interest, even though the resources on its side of the lease-line were 20%. This situation would not be an inconvenience for the regulator provided that the royalty rates of the two leases were the same; but, if Lease A's royalty rate were higher than that of Lease B, the regulator might impose compensatory royalty payments on Leaseholder A to make up for the difference between the two rates. 9. In this way, provided that there is a regulator that can offer a forum for parties that believe that their interests are harm by off-set drilling, and provided that the regulator has the authority to order the suspension of operations to incentivize the an agreement, under these two conditions the economics of the Rule of Capture are self-correcting.  THE SENER GUIDELINES 10. The SENER guidelines do not, however, consider this self-correcting dimension. Instead, they presume that the only protection of the interests of the adjacent lease-holder (into whose area the reservoir is presumed to extend) is to order unitization at the earliest possible moment, namely, when there is geological information that indicates the occurrence of a reservoir that either crosses lease lines or extends into an unleased block. 11. This approach to regulation ignores the fundamental question of the commerciality of the two areas. Before a definitive unitization agreement may be negotiated, it must be shown that the hydrocarbon deposits on both sides of the lease lines are independently commercial. (It could happen that, because of a geological fault, the 20% on one side of the lease line might be not commercial, in which case the 80% lease-owner would rightly object to unitization.) 12. These considerations point to the need of the regulator to allow the processes of exploration and commercial negotiation to take their course without prematurely intervening. The regulator should take a hands-off, back-of-the-line attitude toward the efforts of the parties to decide on issues of commerciality and risk. 13. The proposed guidelines of the Energy Ministry, in contrast, require an proactive intervention of the regulator at the first geological indication that there a reservoir might extend beyond the original lease. The proposed guidelines do not consider question of commerciality or of the right of a lease-holder to adjust its working interest in accordance with its tolerance (and budget) for risk. RECOMMENDATIONS 13. Valuable comments have been submitted by CNH, Pemex, AMEXHI, Covar Energy Consulting and others; but none squarely addresses the central issue, namely, that the proposed guidelines serve neither the revenue interests of the Nation nor the commercial interests of the parties. 13. COFEMER should not approve the proposed guidelines for publication in the Diario Oficial de la Federación; instead, they should be returned to the Ministry with the recommendation that the approach to unitization allow for the determination of commerciality and risk by the parties prior to intervention by the regulator prior to intervention by the State. 14. To encourage an agreement between the parties, the regulator should have the authority to order the suspension of operations; but it should not have the authority to set the terms of a unitization agreement. (Were the regulator to impose a working interest on the parties, and were one of the parties to disagree with the allocation, it could characterize the decision as wrongful appropriation or virtual expropriation, and initiate legal actions in Mexico and international venues, such as the arbitration courts provided in NAFTA.) 15. To return to the self-correcting dimension of the Rule of Capture: if the regulations provide a forum where one party may petition for unitization (which should be determined by consideration of commerciality and risk), and if the regular has appropriate authority to motivate the parties to negotiate an agreement (as by the ability to order the suspension of operations), then the very principle of the "rule of capture" allows both parties to capture their rightful, respective interest in the resource and in this way the recovery of hydrocarbon resources is optimized for the benefit of the parties as well as the Nation. George Baker Mexico Energy Intelligence Houston (832) 434-3928