Modernization of Oil and Gas Reporting

For the first time in almost 30 years, the Securities and Exchange Commission (SEC) has adopted significant revisions to the accounting rules governing reporting requirements for entities with oil and gas producing activities.  Centering on the determination of proved reserves, the changes better align the SEC’s accounting rules with industry standards used by management to make decisions.  The SEC also used this opportunity to provide more clarity to investors with regard to required filings at a time when the oil and gas industry has evolved significantly and far outgrown the old rules.

This development should be welcome news for energy producers. The potential benefits range from a reduction in pricing volatility and improvements in proving reserves to optional disclosure of reserves and greater access to capital.

Unfortunately, not all of the repercussions will be positive.  In many cases, SEC reporting costs will increase.  Additional time will be needed to complete the new disclosures, which will add cost.  Overall, the new rules should provide more information to investors through new disclosures and reserve pricing models. 

Background - On Dec. 29, 2008, the SEC adopted final rules set forth in Release No. 33-8995 changing Rule 4-10 of Regulation S-X and Item 102 of Regulation S-K.  This is effective for forms 10-K and 20-F filed on or after Dec. 31, 2009.  Early adoption is prohibited, which includes quarterly filings prior to the first annual report in which the rules are applicable.

The previous rules defined oil and gas producing activities as only those which involve traditional wells.  The new rules expose a greater number of entities to oil and gas accounting rules than before. This excluded hydrocarbons extracted from oil sands, coal beds and shale.  The new definition includes all extraction of saleable hydrocarbons, in solid, liquid or gaseous states, from oil sands, shale, coal beds, or other nonrenewable natural resources which are intended to be upgraded to synthetic oil or gas. It also covers activities with a view to such extraction.  The new definition continues to exclude the transporting, refining, processing, or marketing of oil or gas, as well as any coal or oil shale not intended to be converted to oil or gas. 

Pricing Volatility Reduced - Prior to the recent SEC release, determining reserves involved the use of a bright line test and single day pricing model.  Proved reserves could only be claimed in offsets immediately adjacent to areas containing developed producing wells.  The reserves also had to be economically producible based on current economic conditions.  The price representing current economic conditions was the price on the last day of the fiscal year.  These rules limited the acreage available for proved reserves and made them vulnerable to the high volatility of a single day’s economic conditions.

The SEC amended these requirements by using a 12 month average pricing model and replacing the bright line test with a principles-based test.  Instead of using the price of the last day of the fiscal year, the price is now the average of the first day of each of the 12 months during the fiscal year.  An exception occurs when a contractual obligation determines the price, in which case the contact price should be used for the related reserves. 

The two advantages of the pricing change are reduced volatility and an additional month’s lead time for the reserve calculations.  On Dec. 31, 2008, the price of a barrel of oil was $39.00, in comparison with the average price of a barrel of oil that year of $101.56, resulting in a $62.56 difference.  For the fiscal yearend of Dec. 31, 2008, many companies wrote off a significant amount of reserves because some were considered uneconomical to produce.  The majority of these reserves would not have been written off had the new pricing model been in place.

Reserve Determination Improvements - The new rules amend the method for determining proved reserves. They eliminate the bright line test that proved reserves could only be recognized in an adjacent offset to proved developed reserves.  The new method for proving reserves is the reasonable certainty test.  This test allows the use of reliable technology or combinations of technologies to be used to determine proved reserves as long as it is reasonably certain that the reserves are economically producible. 

In the past, oil and gas wells had to be placed in strategic locations to prove as many acres as possible.  This will no longer be necessary because reliable technology can now be used to determine proved reserves outside the immediate offsets.  Well development will now be driven by other factors, such as pipeline availability and developing acres that would soon be approaching the threshold of being proved for five years. 

The new disclosure requires that a company provide an explanation for all acreage that has been proved for five years or more and remains undeveloped.  Companies may want to reduce the volume of acres for which explanations are required because of the possibility of negative responses from investors or land owners. 

Reasonable Certainty and Reliable Technology - The SEC provides definitions of reasonable certainty and reliable technology in the new rules, which allows for deterministic or probabilistic approaches.  For the deterministic approach, reasonable certainty is defined as a “high degree of confidence” that the quantities will be recovered.  High degree of confidence is defined as much more likely to be achieved than not, and as more geoscience, engineering and economic data is made available, the estimated ultimate recovery is more likely to increase or remain constant than decrease.  The probabilistic approach definition is a 90 percent probability that the amounts recovered will equal or exceed the reserve estimate.

Reliable technology is any technology or combination of technologies that have been field tested and demonstrated consistency and repeatability in the evaluated or analogous formation.  This consistency and repeatability must be documented and a general description of the technology is required to be disclosed. 

Optional Disclosure of Reserves - The new rules also allow optional disclosure of probable and possible reserves.  Although many companies already disclose probable and possible reserves in press releases or through other media outlets, there is now an option to include these types of reserves in filings with the SEC.  Along with allowing these disclosures, the SEC provides definitions of both probable and possible reserves.  Although proving additional reserves has benefits, the new five year disclosure previously mentioned may cause some companies to decide to not prove acreage faster than they plan to develop the acreage.  

Another optional disclosure allowed by the SEC release is a reserve sensitivity analysis.   This will allow entities to show investors how different changes in prices or other factors can change the quantity of proved reserves.  The disclosure must be made in tabular format and it shall disclose price and cost schedules as well as the assumptions on which disclosed values are based on.

Potential for Greater Access to Capital - As a result of SEC Release 33-8995, the proved reserves may increase substantially with the next round of fiscal year end filings.  The change in the definition of oil and gas producing activities will provide proved reserves for companies that previously would not have recognized them and entities that own a large amount of unproven acreage could have significant increases in proved undeveloped reserves.  The increase in reserves could provide an advantage to some companies, as in many cases lines of credit are tied to proven reserves.  The increased proven reserves could allow additional access to capital through an increased line of credit. 

Need for Engineering Expertise - Other impacts these new rules could cause are an increase in expenditures on technology to prove reserves, an increased demand in third party reserve engineers, and additional reporting costs.  If a company wants to increase proved reserves, they may invest in new technology, either by developing it internally or via purchase from an outside party.

The services of third party reserve engineers could also increase in demand.  Often companies that estimate their reserves internally often use blanket assumptions for proved undeveloped acres.  If the new probable and possible reserve disclosures are utilized, more specific assumptions will need to be used.  This may require expertise that companies might not have available, which will cause them to turn to third party reserve engineers.