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By Steven Marcy, BNA Staff Editor
The Securities and Exchange Commission and the energy industry agree that the SEC's 30-year-old rules for disclosing oil and gas assets need updating. However, no outright consensus was demonstrated in a review of comments the SEC received from the energy industry and accounting profession on its invitation for suggestions on how and what information to disclose.
Many of the nearly 80 comment letters urged the SEC to retain its requirement that proved reserves be disclosed, but also to allow disclosure of probable and possible reserves, which the SEC currently prohibits. For example, Big Four accounting firm Ernst & Young said in Feb. 18 comments that "companies should be permitted, but not required, to disclose reserve categories other than proved."
However, unlike the accounting profession, the oil and gas industry had major legal and other concerns about reporting probable and possible reserves.
John White, director of the SEC's Division of Corporation Finance, told a Practicing Law Institute conference on corporate governance Feb. 22 that he is optimistic that the SEC's Dec. 12 concept release on possibilities for revamping its rules for disclosing oil and gas reserves can be fashioned into a firm proposal by spring. He said that "the target is to adopt something in the fall" that would modernize the rules.
SEC rules in force since 1978 require oil and gas companies to disclose only "proved' reserves as measured by actual production. The rules prohibit including in financial statements probable reserves or anything deduced by such technologies as seismic sensing or computer modeling. The 1978 SEC rules—last updated in 1982—are based on techniques developed by the Society of Petroleum Engineers (SPE), which has since regularly updated them to reflect technological advances that the energy industry uses in making investment and business decisions.
The latest SPE techniques—adopted in March 2007 as the Petroleum Resources Management System (PRMS)—permit seismic testing, imaging, and computer modelling to discern the size and shape of oil and gas deposits. In its concept release, the SEC asked if these latest techniques should be permitted as additional information or even used as alternative ways of deducing the existence of proved reserves.
In a Dec. 11 SEC meeting discussing the concept release (3 APPR 1123, 12/14/07), now departed SEC Commissioner Annette Nazareth said that "our current rules need to be modernized." Given that oil and gas technologies are likely to continue evolving, it seems better to replace the "current highly prescriptive" rule with a "more principles-based rule," she said.
Nazareth also wondered if the SEC's current prescriptive rules "have almost, at this point, adversely affected" information on which investors can base their decisions on the oil and gas industries.
Complete Picture Hidden.
White said at the Dec. 11 meeting that industry and investor groups had asked for a revamp of the rules because they "do not allow an oil and gas company to present a complete picture" of its reserves. He said the industry already is using a range of reserve information "far beyond" proved reserves to make internal business decisions.
White said the SEC in disclosure requirements for other industries has tried to let investors "view the company with management eyes," and said the SEC is asking through its concept release if it is possible to give investors that kind of view of the oil and gas industry.
John Lee, a Texas A & M petroleum engineering professor hired by the SEC to advise on possible reserves disclosure reforms, said at the Dec. 11 meeting that if a more flexible reporting standard could be devised and still meet the criterion of a reserve having a "reasonable certainty" of being produced, then larger amounts would almost certainly be recorded on the balance sheets.
Newer technology that can calibrate seismic information along with underground measurements allows the industry to do a "reasonably good job of estimating the size and shape of a reserve," Lee said. Coupling that with oil and gas pressure data inside a formation does "a much better job of predicting the amount of production" that can be obtained from a reserve, he said. Many commentators subsequently urged the SEC to permit the techniques that Lee described.
Dept. of Energy Supports New Standard.
Karen Harbert, the Department of Energy's assistant secretary for policy and international affairs, and Guy Caruso, chief of the department's Energy Information Administration, said the newer seismic and modeling techniques are reliable enough to confirm the existence of oil and gas reserves. "The question presented is whether the SEC's utilization of an updated definition of proven reserves to provide more consistency with the technological advances in the industry will serve national and private interests," Harbert said in Feb. 21 comments. "We believe it will."
"The SPE PRMS is globally recognized as a key guideline for reserves and resources classification," Caruso said in Feb. 19 comments. "Adoption of a framework that requires respondents to demonstrate that their reserves estimate(s) comply with the definitions and related guidelines set forth in the SPE PRMS should improve the quality, consistency, and comparability of reserves data."
"Such disclosure might provide meaningful information that could permit present and potential investors to better understand the decision making of a company's management, and better evaluate the company's long-term prospects," Ernst & Young said. "If companies choose to make such disclosures, we believe that the Commission should require accompanying disclosure of the basis of preparation of the reserve estimates (e.g., price assumption, discount rate used) and a statement emphasizing that the ultimate development and production of such reserves are substantially less certain than proved reserves (i.e., risk factors)."
Petroleum Industry Concerns.
The oil and gas industry supported greater flexibility in determining proved reserves, but some quarters had concerns about legal liability over including probable and possible reserves in financial reports.
"We recommend that the Commission continue to require the reporting of proved reserves only, consistent with the definitions found in the SPE PRMS framework," the American Petroleum Institute said in its Feb. 19 comments. "We believe that investors, other financial statement users and registrants would not be well served by the mandated inclusion of probable reserves or other reserve/resource categories below the proved threshold due to the increased uncertainty of resources in these categories and the breadth of methodologies and evaluation techniques that may be employed in their calculation."
Shell International B.V. said in Feb. 19 comments that the SEC should confine reporting to proved reserves, but as determined under the more flexible SPE PRMS framework.
"The principal reserve disclosures of a company should be those of proved reserves," Shell said. "Other types of reserve information would, by definition, have lower levels of certainty associated with the data and would be subject to correspondingly greater fluctuation of estimates."
Shell said disclosure of other than proven reserves "would provide data that does not, by definition, have a high confidence level of reliability," and would constitute a "more likely than not" level of reliability.
"Such disclosure could be viewed as misinformation or misleading to investors," Shell said. "We believe that users of financial statements would not benefit from data that has a significant inherent volatility."
Retain Status Quo.
Two credit rating agencies—Moody's Investors Services and Fitch Ratings—also wanted to confine reporting only to proved reserves, but, in a minority view, they also did not want to allow the flexibility of a more principles-based approach that would recognize a wider use of technology. Moody's argued that allowing more speculative and less certain data to appear on financial reports might mislead investors.
The SEC in its concept release asked specifically if it should replace the rules-based, proved-reserve requirement with a more principles-based approach. "In summary, our response is no," Moody's said in its Feb. 19 comment letter. The firm said that it generally supports principles-based accounting and disclosure standards, but "we believe that the current rules and their interpretation by the SEC staff have appropriately established an expectation that subsequent revisions to proved reserves estimates are more likely to be positive than negative, which has enhanced our confidence in the reported information."
"The premise of any principles-based reporting standard is that transparent disclosure of the key judgments and estimates made by management will allow users of the information to identify inconsistencies between companies and adjust the reported information as they deem necessary," Moody's added. "Unfortunately, we believe that this premise would not work well in the context of oil and gas reserves disclosures because of the complexity of the estimation process and the nature of the key data inputs."
Moody's said it believes "that the current oil and gas reserves reporting and disclosure framework established by the SEC is fundamentally sound and adequately meets our needs as credit analysts. While there are opportunities to update and improve these disclosure requirements, we believe that any changes should be incremental rather than involving the adoption of the alternative classification systems discussed in the Concept Release."
In Feb. 10 comments, Fitch Ratings said it felt strongly that proved reserves should be disclosed separately based on a consistent definition because proved reserves more accurately reflect potential cash flows and market sensitivity and therefore provide better information about the risks of debt issued by oil and gas companies.
Standardize Additional Disclosures.
However, Fitch did not oppose the disclosure in financial reports of probable or possible reserves separately from proved reserves. "We do not object to including other reserve information in filings and note that such information is often available to investors through industry presentations and the like. The standardization of such additional disclosures would be a positive from an investor perspective."
However, Standard & Poor's supported the development of "principles-based guidance." Representing the rating agency's views in a Feb. 19 letter, Managing Editor and Chief Accountant Neri Bukspan, Director Sherman Myers, and Director David Lundberg said, "Articulating disclosures in a principle based fashion will accommodate future technological developments and better reflect the variety of activities [energy and petroleum] companies employ." The SEC should seek "consistency" in reserves disclosure so that investors can compare companies.
A principles-based framework would likely "introduce greater variability in reporting," the S&P letter conceded.
Nonetheless, they added that appropriate application and enforcement of such a framework would ultimately promote much greater disclosure quality.
Many commentators said they also want the SEC to allow the inclusion of oil from such nontraditional sources as Canadian tar sands and oil shale, where initial recovery techniques are more akin to mining than to oil and gas drilling.
Big Four accounting firm PricewaterhouseCoopers said in its Feb. 18 comments that including nontraditional resources such as tar sands would add insight for investors on how oil and gas companies actually operate.
"In our experience, oil and gas companies do not draw a distinction operationally between traditional and non-traditional resources," PwC said. "Allowing disclosure of nontraditional proved reserves … would help investors recognize the significance of these resources in relation to traditional oil and gas reserves."
Many commentators also said the SEC should require reported reserves to be subjected to independent, third-party analysis for verification, especially if the SEC moves toward a more principles-based approach that contrasts markedly with its current prescriptive approach.
Gauging Recoverability.
Commentators also found fault with the SEC's current practice of using year-end sales prices of oil and gas to determine if the reserves are economically recoverable. Most comments suggested requiring future prices, average monthly prices, or some combination of the two to better help investors gauge economic recoverability of reserves.
"We encourage the Commission to consider a pricing model based on established futures prices (subject to pricing differentials) and management's estimate of future operating costs on the date the reserve estimate is made," said accounting firm Grant Thornton in a recommendation typical of many others. "By doing so, the estimate of proved reserves disclosed to investors will be more closely aligned to the information relied upon by management and other third parties vested in their business to make investment, financing and other business decisions."
Current SEC rules require oil and gas exploration and production companies to measure the rate of an oil or gas flow from each drilling operation to prove the existence of a reserve and its size. Most commentators asked the SEC to allow the use of seismic testing and imaging and computer modeling to help determine the existence of reserves.
Accounting Standards Affected.
SEC Chairman Christopher Cox noted during the SEC's Dec. 11 discussion of the concept release that the SEC's oil and gas accounting and reporting rules stem from SPE practices and are mostly geophysical and technological in nature, but Big Four accounting firm Deloitte & Touche LLP noted that any changes in SEC guidance could also produce impacts on accounting literature and standards.
"We acknowledge that changes to oil and gas reserve definitions and disclosure requirements would likely affect other authoritative guidance, and some of the ramifications could be far reaching," Deloitte said, citing the Financial Accounting Standards Board's Statement of Financial Accounting Standard 19, Financial Accounting and Reporting by Oil and Gas Producing Companies, and FAS 69, Disclosures About Oil and Gas Producing Activities. Standards on asset impairment and auditing practices could also be altered by any updating of methods for assessing reserves, Deloitte said. Deloitte also noted that changes to the reserve estimation practices might create the need for "significant changes to other authoritative [accounting] guidance," but "we do not believe this should dissuade the Commission from improving the reserve definitions and disclosures."
PwC also said that changes the SEC might make to its definition of "proved reserve" could necessitate some guidance on applying the oil and gas accounting literature. PwC noted that if the proved-reserve definition is changed, "the unit-of-production amortization rate for many oil and gas companies will be revised. While paragraph 30 of FAS 19 … is clear that revisions to the amortization rate resulting from reserve `revisions' made in the normal course are considered changes in accounting estimates, we believe there could be different views within the preparer community concerning whether a change to the definition of proved reserves is a change in accounting principle or a change in estimate effected by a change in accounting principle under FAS 154 [Accounting Changes and Error Corrections]." PwC urged the SEC to coordinate with FASB "to provide transition guidance to account for the definition change prospectively."
The Center for Audit Quality, an autonomous public policy organization affiliated with the American Institute of Certified Public Accountants, said in its comments that any changes in the reserve assessments should consider the implications for the efforts to converge U.S. generally accepted accounting principles with international financial reporting standards. The SEC "should consider convergence with IFRS in connection with its [reserves] rulemaking, including the Commission's recent elimination of the requirement for foreign private issuers to reconcile their financial statements to U.S. GAAP," CAQ said. "Given that IFRS does not require the use of a particular definition of proved reserves, the elimination of the U.S. GAAP reconciliation now allows diversity in how IFRS companies report proved reserves in SEC filings."
Ernst & Young urged the SEC to "coordinate with the International Accounting Standards Board's extractive activities research project, which is considering how reserves should be defined and measured in accordance with [IFRS]."
The SEC oil and gas concept release and comment letters are at http://www.sec.gov/rules/concept.shtml. IASB's project page for extractive activities is at http://www.iasb.org/Current+Projects/IASB+Projects/Extractive+Activities/Summary.htm.
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