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Industry wants clarity on reserves, says SEC reserve rules out of date Agency asked Gulf of Mexico operators in 2002 if they were using 1978-prescribed formation testing, historically interpreted as flow testing, to gauge deepwater reserves, a process that could take two years, cost upward of $35M Ray Tyson Petroleum News Houston Correspondent
In the year and half since the U.S. Securities and Exchange Commission put companies on notice concerning their methods of accounting for oil and gas reserves, industry’s world has been turned upside down with a flurry of high-profile reserve write-downs that has both shaken investor confidence in reserve reporting and left industry second guessing the SEC’s next move.
“We want clarity. That’s all we really want,” said Ronald Harrell, chief executive officer of petroleum consulting firm Ryder Scott.
“We want a level playing field, too,” added Dan Olds, a petroleum engineer for Ryder Scott. “We don’t care what the rules are. We just want to know what the rules are so we can tell our clients.”
Industry is essentially at the mercy of two SEC engineers charged with reviewing the oil and gas reserves of all energy companies publicly traded in the United States. Critics believe the SEC is operating under archaic rules that do not address industry changes over past quarter century, particularly in the arena of technology.
More than 80 percent of those polled at last October’s Society of Petroleum Engineers Evaluation Forum in Houston, Texas, said they did not feel the SEC adequately incorporated today’s technology.
That concern turned into a mild panic a year earlier when the SEC sent a letter to companies operating in the Gulf of Mexico with questions centered on whether they were using “formation” testing, historically interpreted to be an actual flow test of wells, to gauge deepwater reserves, a technical requirement under SEC rules adopted back in 1978.
In fact, explorers rarely, if ever, resort to flow testing to determine whether a deepwater discovery is productive, largely because of expense and time constraints. Such a test can take two years to prepare and cost upward of $35 million. Moreover, industry argues that flow testing is unnecessary with today’s sophisticated seismic technology and downhole tools that can provide accurate readings on fluids, pressures and other reservoir characteristics. SEC still evaluating responses A year and a half after dropping the deepwater bomb on industry, the SEC continues to operate under the old rules with no apparent intent of altering them anytime soon. Interestingly, the agency apparently has yet to penalize industry for not testing deepwater reserves the SEC way.
“We are still processing the results of those letters,” SEC Assistant Director Roger Schwall said. “We have done nothing specifically with the idea of changing rules or making specific revisions.”
It wasn’t only deepwater companies that received a letter from the SEC. Virtually all publicly traded companies that have offshore and onshore oil and gas reserves in North America and abroad received one, sources said.
As far as the SEC is concerned, only proved reserves that can be economically produced count. That has been the case for some time, but the definition has taken on a whole new dimension since the Enron scandal.
“In light of Enron and other disasters in the stock market, the SEC is taking a more conservative approach in what they want industry to do,” Ryder Scott’s Olds said. “Enron didn’t have anything to do with oil and gas reserves in the ground. Nevertheless, we’re being painted with the same brush.”
Even the SEC concedes its conservative bent when it comes to assessing oil and gas reserves. “We feel the conservative approach is most appropriate,” Schwall said. SEC feels some companies ‘overly optimistic’ “We certainly do see companies we feel are being overly optimistic in their (reserve) reporting,” added Ron Winfrey, one of the SEC’s two petroleum engineers.
Analysts speculate that SEC scrutiny may have influenced Shell’s stunning decision in January to reclassify 20 percent of its proved reserves, or a hefty 3.9 billion barrels of oil equivalent. The revision also led to the resignation of its chairman and the chief of its exploration and production business.
Houston’s El Paso reduced its estimated proven oil and gas reserves by 41 percent in February, followed in March by BP’s 2.5 percent downward revision of proven reserves. Among U.S.-based independents, Denver’s Forest Oil cut its proven reserves because of the company’s ill-performing Redoubt Shoal oil field in Alaska.
Exploration and production companies have devoted considerable time in quarterly conference calls attempting to justify their reserves to analysts. That’s because reserves reflect on a company’s future profit potential and therefore a company’s value and stock price. Also, in an effort to bolster credibility, an increasing number of companies are said to be turning to independent consultants to verify their reserve estimates. SEC taking a conservative approach The SEC’s conservative approach to reserve reporting appears to be at odds with that of the E&P sector, which generally claims every barrel it believes it’s entitled to. The SEC says while it “recognizes” probable and possible reserves, it still wants “reasonable certainty” based on proved reserves only.
“We recognize those volumes are part of the business,” Winfrey said. “But our current rules don’t allow for disclosure in general of unproved reserves. We believe that proved reserves by their nature are conservative … and that proved reserves should have a much greater chance to increase in performance than decrease.”
If industry wants to change the rules, Winfrey added, “they need to mount an effort. We interpret what we think those rules are. But I think it is important for them to understand what the rules are and what is expected of them in their disclosure to the public.”
There is little doubt the agency is suspicious of industry. SEC engineer Jim Murphy, in last October’s address to the Society of Petroleum Engineers Evaluation Forum, which was closed to the press, said that undue reliance on so-called “can’t-miss” technology had been the cause of several reserve write-downs and impairments over the preceding two years.
“We feel in these cases and others there was an attempt to maximize the initial reserve estimates over and above which was realistically supported by the data at hand,” he said at the forum. “The underlying theme of this conference … appears to be ‘what are the shortcuts that we can take to allow us to book more reserves sooner.’ We would hope in the future your focus will be on getting the estimates correct …” Engineers joined SEC in 1999 One participant in the SPE evaluation forum said there were no SEC engineers on staff for most of the 1990s and that Murphy and Winfrey joined the agency in 1999, before the Enron scandal broke.
“As far as I know there were no major events that triggered their coming,” he added. “They’ve been learning their jobs, digging deeper and deeper each year into companies’ reserves.”
In addition to technology, SEC critics believe agency rules fail to recognize critical market changes over the 25 years. For example, natural gas reserves are still valued on the spot price of gas at year-end rather than on the average spot price throughout the year. In the past, year-end pricing worked because most gas was sold on long-term contracts with fixed prices. That is no longer the case because most gas today is sold on the spot market and because prices tend to be volatile.
“So the company that is fortunate to have high prices at year-end makes their reserves look very good,” according to one market observer. “But if they are unfortunate enough to have a year-end when prices are lower than the average then that is the price they are stuck with. So you have accounting implications. If the reserves are less than book value, companies are forced to take write-downs.”
He also noted that involvement of U.S. companies in overseas projects and their complicated production sharing arrangements and contracts was far less pre-1978 than today. “So the two engineers are somewhat forced into having to adapt to this changing environment with these old definitions,” he added.
Industry experts do concede that reserve estimating, even with the benefit of new technologies, is not an exact science and mistakes are made.
“We really don’t know how much a reservoir is going to produce until after it’s done producing,” Ryder Scott’s Olds said. “Some of the new technologies allow us to get data in a real-time fashion in some instances, and we can do some pretty good things with that data. But we do predict the future and occasionally we do predict wrong.”
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